The Capital Cycle Podcast - Fishing in Uncrowded Waters

Episode Date: December 20, 2024

A review of several smaller capitalization Emerging Markets investments which remain out of favour in today’s highly concentrated markets.Presented by Edward Chancellor with Laura Fyfe, Analyst Emerging MarketsFor more information, or to access select articles from Marathon’s Global Investment Review publications which accompany this podcast series, please visit www.thecapitalcycle.co.uk Hosted on Acast. See acast.com/privacy for more information.

Hello, this is Edward Chancellor. Welcome to another episode of the Capital Cycle podcast. I've got with me, Laura Fife, who's an emerging markets analyst with Marathon. We're going to take another look at emerging markets, which we've already talked about with your colleague, Alex Duffy, a few months ago. Emerging, as everyone knows, has been out of favour for the last 10 to 15 years in the investment world. The charts show the emerging market stock index relative to the US at its lowest point since 2000, just after the Asian crisis. In part, the failure of emerging in recent years has been a capital cycle story. China, after all, experienced the largest investment boom in history and its stock market has been flat over the past decade or so. And commodities, which have a relatively large exposure.

in emerging markets also boomed and bust. But what I find, Laura, interesting about your piece is that you show that emerging surprisingly has much more in common with the U.S., at least from an investment perspective, than one might have thought. What, Laura, do you say they have in common? Well, they're also very concentrated. And I think that that's something that most people, most investors don't appreciate. And that's because investors have been so focused on the U.S. and it's done incredibly well over recent years. Investors are quite enthusiastic about U.S. generated returns and so much so, in fact,

that they're willing to pay a 20% premium to buy Taiwan Semiconductor, the largest emerging market company, over its local listed line. And that adds up to about $200 billion of extra money that they're forking out just to buy a U.S. listed version of the same company. The U.S. market, as most investors will know, is highly concentrated.

It's why we talk so much today about the so-called magnificent seven, but also top 10 companies by the share of market cab or top 50. You point out that the concentration in emerging is, first of all, concentration in one geographical region of the, I can't remember how many markets, Laura, are there in emerging? 24. 24 countries across four continents. So in that context, it's really surprising. to learn that 75% of index value comes from just four Asian countries.

And those are Taiwan, China, India, and Korea. So that's one concentration. Then there's the other concentration, which is the market capitalization of the largest emerging stocks, their share of the EM index. Will you explain to listeners how that stands? Yes. So the 10 largest companies hold a 26% share of the emerging market index. and that's just about on par with 2020 levels prior to the Chinese market crash.

So it's about as high as it's ever been by company size as well. And slightly lower than in the United States in terms of concentration. But I think you were saying that it's higher than for the overall world index, that's correct? Yes. If you look at the world index, which excludes emerging market companies, but includes and is dominated by U.S. companies, the share of emerging market companies, is actually higher when you look at the top five versus the top five American companies

dominating the World Index. And then there's the icing on the cake in terms of concentration is sector. And it probably won't surprise listeners to guess which sector is dominating. Yes, of course, technology. And technology comprises just about a quarter

of both indices, so world as well as emerging markets. And that's Taiwan Semiconductor and 10 cent, China's 10 cent and what are the other big emerging names? Well, if we look at the five largest companies in the world index, that's Nvidia, Apple, Microsoft, Amazon, and Meta. Those have an 18% share of their index. And then in emerging markets, we have five Asian technology-related companies being

Taiwan Semiconductor or TSM, as we just mentioned, Tencent, Samsung, Alibaba, and Maituan. And those hold an even higher 21% share of their index. You in the merging market teams have chosen to issue what you call the big fish, these large-cap stocks concentrated in technology and situated in Asia. And you're looking instead of what you call a small fish that swim in, let us say, different oceans. Can you explain that? Exactly. So, yes, we're interested in catching the best fish, whatever size and wherever they might be located. However, we've seen especially interesting opportunities where capital has yet to crowd. So those are in smaller companies and especially within the longer and more diverse tail of emerging markets where they're smaller non-Asian, non-tech-focused companies. Like, as you mentioned, South Africa and Mexico.

Yes, exactly. And we have greater comparative conviction in South Africa and Mexico, as well as in companies which have higher returns on lower investment needs. So one of the interesting things you point out, and this actually reminds me of recent podcasts we did with your colleague Robert Anstey where he talks about the marathon holdings among small midcaps in the US where they actually have better performance metrics than the overall market, but a relatively cheaper. So will you just point out the most generalized terms, marathons emerging positioning, both in terms of country weighting and in terms of how their returns and how their capital spending looks? Definitely. So by country, I would say that we are comparatively underweight Asian countries, such as those which I mentioned before, still have some strong companies that we hold there as well. And we are proportionally overweight to Mexico and South Africa.

and those are a couple of the company examples that we'll get into later on. And in terms of some capital cycle metrics we look at here at Marathon, I'll mention three. Those are return on invested capital, capital expenditure to sales, and capital expenditure to enterprise value. So on those three metrics, our portfolio, we think, is more attractively positioned relative to the index. So if you look at our top 10 emerging market holdings, those have a 16% average return on invested capital, which is above the index is 14% as well looking at capital expenditure to sales. Our top 10 holdings have about half the level of the index, 11% versus their 21. And finally, capex to enterprise value is also much lower.

2% versus the index is 5. And, Lori, you highlight three little fish in your piece that show the type of opportunities that you find attractive today. we'll talk about the individual companies a bit later. What do these companies have in common? Yes. So there's three little fish called AVI, Grooma and BidCorp. And all three of these have strong governance, high profitability, low capital requirements, and are attractively valued. You have a table here that shows that your three EM stocks, you mentioned, have 29% return on equity against the big fish in emerging markets, having an 18% average ROE. And yet your little fish are valued at 16 times earnings as opposed to 20 times earnings for the big fish.

So that gives a pretty clear picture of the again of this bifurcation of markets by size, with large cap stocks attracting more investor interest, despite not always earning. higher returns on equity. So tell me a bit more about your little fish. Let's describe in detail one by one what they do. We'll start with AVI. So AVI owns a premium portfolio of beverage, snack, apparel and personal care brands across South Africa. Its best known products are tea and biscuits. So it's quite a simple business and easy to understand one, but not an easy one to operate. And what are the other two? And next, we have a, Gruma, which is the world's largest tortilla and cornflower producer. It was actually responsible for

pioneering industrial tortilla production about 75 years ago, and it still uses the centuries-old traditional nxtimalization production process from its native Mexico. Finally, we have another South African company, BidCorp, which is South African stewarded, however, quite a global group of food distribution franchises. It has three decades of experience in establishing densities and trust and finds itself in the unique position of leading and learning from several distinct geographies, which is something that's quite difficult to replicate, despite there being relatively low entry barriers to the industry in general. And one of the things that Marathon's capital cycle approach trends to focus on is whether

managers' interests are aligned with outside investors, and you think that's case with these three companies. Definitely, definitely. So for AVI, Grooma, and BidCorp, their key leaders have been involved with the business for more than two decades each, and many are invested alongside us as shareholders. So maybe to start with Grooma, the son of Grooma's founder is the company's largest shareholder today. He assumed leadership of the business in 2012, and he's bolstered Gruma's balance sheet and improved its underlying cash flow generation quite significantly since. And over the most recent five years, he's repreeperate. purchased more than 10% of the company's share count as the share price has fallen. Finally, AVI as well. AVI CEO has led the company for nearly 20 years, which is quite impressive. Importantly, he's been the steward of a very cash-rendered of business and in a small and sometimes challenging market.

So his decision to only pursue investments above a 20% internal hurdle rate has been something that's really paid off. BidCorp's CEO and CFO helped spin it off from its parent company in 2016. and before that, they worked together for more than a decade. They've kept PIDCorp's balance sheet and shaped to enhance its densities, which, as I mentioned before, are quite important to its value proposition through small acquisitions at fair prices. And you say that all three of these companies are able to experience relatively strong growth despite controlling their capital spending. Yes, exactly. So despite spending only about 3% of its sales on CAPEX,

AVI has been able to generate high and consistent returns on invested capital. over the past two decades, actually averaging about 24%, which is twice the rate that its peers in South Africa have generated. Relative to those peers, it's also invested more behind its brands, and it's avoided some more elusive acquisition-led growth across Africa and had cash to spare. Acknowledging a lack of reinvestment returns above that hurdle that I mentioned earlier, it actually just returned this cash to shareholders, which is paid off quite well. So over 20 years, ABI's annualized total returns have been about 11% in U.S. dollars, which is outpaced those local peers I mentioned, as well as the broader emerging markets 7%. And how does the capital cycle look at Grooma, for instance? So looking at Grooma, Grooma's founding family controllers have actually done a really good job

of reinvesting the cash flows that its dominant domestic business have generated abroad at high incremental rates of return. In the U.S., it's been able to establish quite a dominant position and a dominant brand in the higher margin retail channel. Its mission tortillas, the mission brand, have garnered quadruple the market share of its next closest competitor and the higher margins that these garner have enabled it to spend more on renewing its brand strength and extending its pricing power and its marketing leadership in what I would see is a bit of a virtuous cycle. And big corp?

Big Corp has a competitive advantage because it's the critical connector of the fragmented food supply and food service industries in several markets. So it holds the number one market share in Australia, New Zealand, Czech Republic, Belgium, Poland, and its home initial market of South Africa. It's known for being the most reliable and cost-effective supplier of a wide range of time and temperature sensitive products. It's relied on as being within 30 minutes delivery time for 90% of its customers, which is quite important when you're a food supplier or a food recipient because two-thirds of the products that BidCorp transports are either frozen or chilled. Most recently, we spoke with BidCorp's CFO, and he explains the importance

of BidCorp's selective self-sourcing model, which enables them to cut out costs, which their smaller competitors simply can't afford to. And when they then maintain pricing power for these products, it's a powerful strategy in a low-margin industry. interesting is that these well-managed high-return businesses, all of which appear to have moats protecting their businesses, are relatively cheap. Yes, so despite their higher ROEs, the little fish are valued at more than a 20% discount to the big fish if we look at them on a price-to-earnings basis. Marathon was fortunate enough to invest in ABI when it was on sale at a decadal low P.E. of about 17 times.

and we believe its shares have been neglected simply because it's a small South African company, which one needs to look beyond the index to find. Gruma, on the other hand, appears undervalued on a sum of the parts basis. So I mentioned earlier that it has a very strong position in the U.S. market. On my conservative estimates, this business is worthy of one and a half times enterprise value to sales multiple, which would be about $17 per share. And looking at that, the market seems to ascribe very limited value to, the market leading businesses it has in its initial market of Mexico, as well as some smaller,

but still market leading positions in Europe and Asia. And then finally, BidCorp. So Australia and New Zealand, which are BidCorp's largest and most profitable markets, are actually home to a more fragmented, independent, and ultimately profitable restaurant race in America, which is where the world's largest distributor, which listeners may have heard of called Cisco, calls its main market. BidCorp is, however, valued on a lower multiple of its superior margin profile. This might simply be because investors paint it with a broad brush and see it as a South African Cisco when it might have some superior characteristics. In part because emerging at the moment is being neglected in favor of the dominant U.S. market.

The attraction of your little emerging market fish is that they swim, as you say, under the radar. Yes. And I think there are some really, really interesting niche examples of supply side stories in emerging markets. Also, most of their returns have been generated from fundamentals as opposed to share price appreciation. So they've been hard won, so to speak, as we believe sustainable returns should be. They've also, as you mentioned, evaded some of the enthusiasm of their larger peers, both within emerging markets and in the United States. So this means that they've attracted both lower valuations for your competitors and they might be resilient for the long term. As I said at the beginning, emerging was extremely cheap relative to the U.S. market back in 2000.

Over the following 10 years, emerging delivered 10% real per annum. The U.S. market was flat. I'm not saying that history is going to repeat itself. It's just that we're at a similar moment in which emerging looks to be out of fayor and therefore offering some very interesting opportunities. Well, thank you, Laura, and I've enjoyed this talk and look forward to speaking to you again. Thanks very much, Edward. Thank you for your time today.

I hope you will listen to the next edition of the Capital Cycle. This communication is provided for information purposes only. Please refer to Marathon's website and the Global Investment Reviews. for further information, including important disclosures.