global impressions - Old Mutual Investment Group

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6.00. 7.00. P/B. Gentera. GT Bank. Axis Bank. Banco do Brasil. Bank of China-H. BPI Bank. ICICI Bank. HDFC Bank. BBCA. I
GLOBAL EMERGING MARKETS

GLOBAL IMPRESSIONS EMERGING MARKETS - UNCOVERED MEXICO NOVEMBER 2017 >>

THE ROAD FROM BAD TO WORSE IS PAVED WITH GOOD OPPORTUNITIES……. “When Mexico sends its people, they’re not sending their best. They’re not sending you. They’re not sending you. They’re sending people that have lots of problems, and they’re bringing those problems with us. They’re bringing drugs. They’re bringing crime. They’re rapists. And some, I assume, are good people.” Donald Trump

Set right in the middle of Donald Trump’s cross hairs during his infamous presidential campaign, Mexico has been on the receiving end of Trump’s vitriol. From emigration to trade, the once flourishing neighbour of the US is unexpectedly experiencing some economic and political turbulence. Long before Trump, border walls and NAFTA, Mexico was perhaps best known for its warmer weather, spicy-hot food, fiery tequila and sultry dances. Now the once alluring Mexico finds itself in the dangerous centre of two rogue state presidents. On the one hand they have Trump wanting to change the US immigration policy to reduce the Hispanic population in the US and his plan to build a wall between the two countries in order to separate them. On the other, they have Andres Manuel Lopez Obrador (AMLO), the presidential candidate of the newly formed extreme left party Morena in Mexico and a strong contender to win the upcoming 2018 elections. Morena has been gaining in popularity, particularly since Trump’s presidency as AMLO casts himself as the one who will tackle corruption and inequality and the only one who can save Mexico from its aggressive northern neighbour. AMLO’s populist and abrasive persona makes him a fascinating contender versus Trump. For instance, if NAFTA is not renegotiated before the 2018 elections, he would call Trump’s bluff and exit NAFTA, fighting fire with fire.

GLOBAL EMERGING MARKETS

HISTORY NEVER REPEATS ITSELF BUT IT RHYMES Emerging markets exhibit certain repetitive traits that we often come across. As often quoted in investment literature from Mark Twain “History never repeats itself but it rhymes”. This rhyme usually begins with some political event that casts a spell of fear and uncertainty across the markets. This heightened sense of fear and uncertainty creates increased risk, sending markets and the currency sharply lower. In emerging markets when markets tumble even the best companies tend to get caught up in the selloff, which is exactly what excites investors like us. The opportunity to buy great businesses at attractive valuations is usually quite rare but in emerging markets they tend to come around more often than one would find in developed markets. We saw this rhyme begin to play out again post Trump’s election as President. The Mexican currency and market tumbled and we booked our tickets to Mexico – ready to take advantage of the rare opportunity to buy great businesses at attractive valuations on behalf of our clients.

In the short term the markets are often ruled by fear and greed. Over the longer term, however, it is economic fundamentals that drive the market. Fortunately economic fundamentals tend to be more factual and measurable than the raw emotions of fear and greed. So we ask ourselves… do economic fundamentals warrant an interrelationship between the US and Mexico. Let us explore the law of comparative advantage, a law made popular by David Ricardo. The law argues that free trade works even if one partner to that deal holds the absolute advantage in all areas of production – that is, one partner makes products cheaper, better and faster than their trading partner. In 2016, Mexico exported $373 billion – of which 81% was to the US, making up 28% of Mexico’s GDP. What isn’t that evident from these figures, which are thrown around to illustrate Mexico’s dependence on the US, is the fact the 40% of these exported goods are made from US imports. Mexico allows the US to be globally competitive, having the lowest wages, even lower than China in recent months and because most of the goods imported from Mexico are intermediate goods that are resold as “made in America” goods. Having access to Mexico’s labour pricing advantage is ultimately a globally competitive advantage for the US. MEXICO AND CHINA: HOURLY US DOLLAR COMPENSATION COSTS IN MANUFACTURING 7 6 5 4 3

China Mexico

1 0 Jan 96

Jan 99

Jan 02

Jan 05

Jan 08

Jan 11

Jan 14

The first time we ever visited Mexico in 2013 to assess investment opportunities on behalf of our clients, we came across a company that had one of the most fascinating and unique distribution models. Back in 1990, Jose Ignacio Avalos Hernandez founded a non-governmental organisation (NGO), Compartamos, with the mission to alleviate poverty through the provision of microfinance to small businesses. Compartamos issued small business loans to women who often were at the very low end of the income pyramid. Compartamos issues group loans to groups of women (12-50) to aid their fledgling enterprises. What’s completely unique and intellectually fascinating about these loans is the following: • They are issued to women • For investment in small micro enterprises • Organised in groups (12-50)

WILL ECONOMIC FUNDAMENTALS TRUMP INVESTOR EMOTION?

2

GENTERA-GROWING FROM STRENGTH TO STRENGTH

Jan 17

Sources: BLS, Oxford Economics, Credit Suisse research

• Issued with the concept of “solidarity guarantee” Therefore the group is accountable for the loan. If an individual member defaults the entire group is held accountable (which in turn impacts their ability to borrow and run their own businesses). These small business are often the sole source of income in the family so the consequences of a single woman in the group defaulting are quite severe. You may wonder why the loans are only extended to women. Men in Mexico often left to the city or to the US in pursuit of better employment opportunities. This left women behind to provide for their families thus the need for them to form businesses. Judging by the relatively low ‘bad loans’ ratio in this business, the concept of “solidarity guarantee” is rather sound. It’s also key to note that these women are not your typical bank clients as they have no credit history and neither do their businesses have fancy accounting software that enables them to produce a long history of financial results. The traditional financial system excluded these women from the economy and thus Banco Compratamos was born. Such was the demand for these loans, that at around the year 2000 the business was incorporated as a non-profit organisation to facilitate its increasingly rapid growth. A bank licence was granted and eventually, in 2007, Compratamos listed on the stock exchange. Today Banco Compartamoss forms part of a larger listed business known as Gentera. With 2.5 million clients serviced by its 17000 employees in multiple geographies in Latin America. The former NGO is now a professionally run, niche finance company that earns attractive returns on these loans. Compartamos developed customised underwriting, where loan officers are on the ground physically soliciting and assessing the businesses of these women to ensure that the value of the loans are suited to the earnings trajectory of their businesses. This model has allowed Gentera to achieve phenomenal revenue growth over the last 10 years of more than 20% year-on-year on average due to the underpenetrated nature of its target market. The company also still maintains great levels of asset quality through its customised underwriting process, with a non-performing loan ratio of around 2-4% (considering the risk here this is a phenomenal outcome).

GLOBAL EMERGING MARKETS LIMITED ACCESS TO BANKING SERVICES

Population Segment

Population (mm) Bancarization (1) 8.0

A&B

21%

Political noise has a tendency to have an economic impact over time. In 2017, it’s been no different in Mexico.

96%

C+

16.6

83%

Cm - C

39.9

57%

D&E

52.5

At the beginning of 2017, we saw almost all banks in Mexico struggle with the substantial increase in cost of funding and Gentera was no exception. Markets price economic risk through the capital and currency markets and this resulted in the Mexican reference rate more than doubling, from 3.25% to 7%. Since banks need to raise money from the markets or from depositors, the rapid rise in this rate has had a substantial impact on the bottom line of banks. Clients demand less loans as they become more expensive.

79% 25%

Target Market

FEELING THE HEAT – MEXICO’S TOUGH POLITICAL AND ECONOMIC ENVIRONMENT

2013

Note 1: Population utilising banking services. Income level by bracket (approximate annual amount in USD): “A/B” +108 400; “C+” 76 500; “Cm/C” 29 700; “D” 8 900; “E” 3 400.

Mexico’s less wealthy populous, much like most emerging markets, has very limited access to financial services. Traditional banking’s model of branches and requiring credit history from clients creates an environment where companies like Gentera can thrive through their unique distribution model. PRIVATE NON-FINANCIAL SECTOR* DEBT SERVICE RATIOS (%)

We also saw a deterioration in asset quality (the weakening economic growth impacted clients’ small businesses, which limited their ability to repay the loans, thereby increasing the banks non-performing business). As a result of all this, Gentera is trading at a substantial discount to its average long-term valuation (as illustrated in the level investors pay for its assets or price-to-book ratio). GENTERA FORWARD PRICE TO BOOK RELATIVE 5.0

Gentera, S.A.B. de C.V. - PB - NTM

4.5

30 4.0

25

Brazil China

20

3.5 3.0

2.68

15

3.68

2.84

2.5

Russia India

10 5

2.0

‘11

‘12

‘13

‘14

‘15

0

Jan 00

Jan 04

Jan 08

* Households and corporates

Jan 12

Jan 16

Sources: BLS, Credit Suisse research

PRIVATE NON-FINANCIAL SECTOR* CREDIT TO GDP (%) 210%

China

180%

The market creates the best opportunities for us as investors when it takes cyclical issues in a company as structural. The rate rise, political noise and the poor economic times in Mexico are cyclical issues that are normal in every economy. The earnings power of Gentera, backed by its substantial competitive advantage through its unique distribution model, is under-appreciated by the market. The chart below illustrates just how attractive Gentera is priced relative to its profitability versus other emerging market banks. VALUATION VS RETURNS

150% 9.0%

120%

8.0%

Russia Brazil India Mexico

60% 30%

Jan 00

Jan 04

* Households and corporates

Jan 08

Jan 12

Jan 16

Sources: BLS, Credit Suisse research

Gentera

7.0% 6.0% ROA

90%

0%

‘16

Source: Factset

Mexico

Capitec Bank

5.0% 4.0% 3.0% 2.0% 1.0% 0.0%

0.00

Banco Macro SA

GT Bank

Credito Real Zenith Bank Inbursa

Sberbank Akbank

BBRI

Garanti Bank

Bank of China-H

1.00

HDFC Bank

Itaú Unibanco ICICI Bank BPI Bank

Banco do Brasil

y = 0.0041x + 0.0197 R2 = 0.0919

BBCA

Axis Bank

2.00

3.00

P/B

4.00

5.00

6.00

7.00

Source: Bank of America Merrill Lynch

GLOBAL EMERGING MARKETS

THE ROAD FROM BAD TO WORSE IS PAVED WITH GOOD OPPORTUNITIES… The IMF recently downgraded Mexico’s forecasted 2018 GDP growth rate citing the upcoming domestic elections, uncertainty around NAFTA negotiations and the recent earthquake. So there is plenty to worry about in Mexico, plenty of uncertainty and a lot of potential change on the horizon.

“When everyone believes something is risky, their unwillingness to buy usually reduces the price to the point where it’s not risky. When everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky.” Howard Marks

The Mexican Peso’s depreciation versus the US dollar and the underperformance of the Mexican market relative to emerging markets indicates that something is amiss in Mexico. The ultimate judgement we need to make is what is temporary versus what will structurally and permanently affect the earnings power of the individual companies we invest in. Fortunately, we never have to make decisions on countries, currencies and the political outcomes of trade negotiations. Our sole decision is to assess the earnings power of individual companies, namely the sustainability, potential growth and durability of that earnings power. Finally we price these earnings with consideration to the known and unknown risks in those earnings.

BOTTOM LINE With all the uncertainty, we are increasingly finding attractive investment opportunities in great companies in Mexico whose valuations reflect the temporary and cyclical circumstances of the prevailing political and macro landscape.

SHAMIEGA ISAACS

SIBONISO NXUMALO

EQUITY ANALYST

BOUTIQUE HEAD

GLOBAL EMERGING MARKETS

GLOBAL EMERGING MARKETS

CONTACT DETAILS: SIBONISO NXUMALO Tel: +27 (0)21 509 3879 Cell: +27(0)83 645 5311

Global Emerging Markets is a boutique within Old Mutual Investment Group (Pty) Ltd (Reg No 1993/003023/07), a licensed financial services provider, FSP 604, approved by the Registrar of Financial Services Providers (www.fsb.co.za) to provide advisory and/or intermediary services and advice in terms of the Financial Advisory and Intermediary Services Act 37, 2002 Market fluctuations and changes in rates of exchange or taxation may have an effect on the value, price or income of investments. Since the performance of financial markets fluctuates, an investor may not get back the full amount invested. Past performance is not necessarily a guide to future investment performance. The investment portfolios may be market-linked or policy based. Investors’ rights and obligations are set out in the relevant contracts. Unlisted investments have short term to long term liquidity risks and there are no guarantees on the investment capital nor on performance. It should be noted that investments within the fund may not be readily marketable. It may therefore be difficult for an investor to withdraw from the fund or to obtain reliable information about its value and the extent of the risks to which it is exposed. The value of the investment may fluctuate as the value of the underlying investments change. In respect of pooled, life wrapped products, the underlying assets are owned by Old Mutual Life Assurance Company (South Africa) Limited who may elect to exercise any votes on these underlying assets independently of Old Mutual Investment Group. In respect of these products, no fees or charges will be deducted if the policy is terminated within the first 30 days. Returns on these products depend on the performance of the underlying assets. Disclosures: Personal trading by staff is restricted to ensure that there is no conflict of interest. All directors and those staff who are likely to have access to price sensitive and unpublished information in relation to the Old Mutual Group are further restricted in their dealings in Old Mutual shares. All employees of the Old Mutual Investment Group are remunerated with salaries and standard incentives. Unless disclosed to the client, no commission or incentives are paid by the Old Mutual Investment Group to any persons other than its representatives. All inter-group transactions are done on an arms length basis. We outsource investment administration of our local funds to Curo Fund Services (Pty) Ltd, 35% of which is owned by the Old Mutual Investment Group. Disclaimer: The contents of this document and, to the extent applicable, the comments by presenters do not constitute advice as defined in FAIS. Although due care has been taken in compiling this document, Old Mutual Investment Group does not warrant the accuracy of the information contained herein and therefore does not accept any liability in respect of any loss you may suffer as a result of your reliance thereon. The processes, policies and business practices described may change from time to time and Old Mutual Investment Group specifically excludes any obligation to communicate such changes to the recipient of this document. This document is not an advertisement and it is not intended for general public distribution. The information herein does not constitute an offer to sell or a solicitation of an offer to buy any securities. This document is expressly not intended for persons who, due to their nationality or place of residence, are not permitted access to such information under applicable law. This document is not an advertisement and it is not intended for general public distribution. The recipient is advised to assess the information with the assistance of an advisor if necessary, with regard to its compatibility with his/her own circumstances in view of any legal, regulatory, tax and other implications. The information herein does not constitute an offer to sell or a solicitation of an offer to buy any securities. This document is expressly not intended for persons who, due to their nationality or place of residence, are not permitted access to such information under applicable law. Old Mutual Investment Group has comprehensive crime and professional indemnity insurance. For more detail, as well as for information on how to contact us and on how to access information please visit www.oldmutualinvest.com.