Global Emerging Markets Letter

This document contains information which is no longer up to date. As such, it is maintained solely for information purposes to provide historical information. This document should not be relied upon, including for the purposes of making an investment decision. Reference to the names of each company mentioned in this communication is merely for explaining the investment strategy and Stewart Investors does not necessarily maintain positions in such companies.

Risk Factors

In the UK, EEA and Switzerland, this document is a financial promotion for the St Andrews Partners Global Emerging Markets strategies intended for retail and professional clients in the UK and professional clients in Switzerland and the EEA only and professional clients elsewhere where lawful.

Investing involves certain risks including:

> The value of investments and any income from them may go down as well as up and are not guaranteed. Investors may get back significantly less than the original amount invested.

> Emerging Market risk: Emerging markets tend to be more sensitive to economic and political conditions than developed markets. Other factors include greater liquidity risk, restrictions on investment or transfer of assets, failed/delayed settlement and difficulties valuing securities.

> Currency risk: the strategies invest in assets which are denominated in other currencies; changes in exchange rates will affect the value of the strategies and could create losses. Currency control decisions made by governments could affect the value of the strategies investments and could cause the strategies to defer or suspend redemptions of its shares.

Reference to specific securities (if any) is included for the purpose of illustration only and should not be construed as a recommendation to buy or sell. Reference to the names of any company is merely to explain the investment strategy and should not be construed as investment advice or a recommendation to invest in any of those companies.

If you are in any doubt as to the suitability of our strategies for your investment needs, please seek investment advice.

‘One can illustrate the strange concept of alternative histories as follows. Imagine an eccentric tycoon offering you $10m to play Russian roulette, i.e. to put a revolver containing one bullet in the six available chambers to your head and pull the trigger. Each realization would count as one history, for a total of six possible histories with equal probabilities. Five out of six histories would lead to enrichment; one would lead to an obituary with an embarrassing cause of death. The problem is that only one of the histories is observed in reality; and the winner of $10m would elicit admiration and praise of some fatuous journalist.’

‘Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently…after a few dozen trials one forgets about the existence of a bullet, under a numbing false sense of security. Second, unlike a well-defined precise game, one does not observe the barrel of reality. One is thus capable of unwittingly playing Russian roulette - and calling it by some alternative ‘low risk’ name.’

- Nassim Taleb, Fooled by Randomness

In good times, many businesses appear to be resilient and good quality. Our investment process is focused on thinking about risks - we worry constantly about the downside risks to the businesses we invest clients’ money in. It is impossible to tell whether the many risk factors we obsess about will materialise.

What actually happens in reality is only one of the many ‘alternative histories’. If, however, we think any of the risks are big enough potentially to cause a permanent loss of capital, we are happy not to own a business, even though that business is, on the face of it, of very high quality in popular perception. Just because an ‘Alibaba’ has not turned out to be a ‘Yukos’ does not mean that we don’t worry about it.1 

This letter discusses a few cases where investors ended up with significant permanent loss of capital by investing in companies which were seen as high quality at the peak of their popularity. While we avoided the majority of these, we still spend considerable time and energy in studying them, as we try to understand the various ways in which clients can lose money in stock markets.

The ‘Original Sin’

In 2003, Russia was seen as a country with a promise of reform, and Yukos was one of the first companies to adopt Western governance standards. In 1999, it was the first Russian oil company to adopt International Accounting Standards. Its 2002 annual report was audited by a reputed Big Four auditor,2 and independent directors constituted a majority of the company’s board. The main shareholder Mikhail Khodorkovsky was the richest man in Russia, as the company pumped almost 20% of Russian oil production. Khodorkovsky was the darling of investment analysts in London and New York: he was focused on driving efficiencies, talked about shareholder wealth and spoke the language of reform. He was also the leading philanthropist in Russia. 

Unfortunately, Khodorkovsky fell out with President Putin who is believed to have seen him as a political threat. 

In 2003, Khodorkovsky was arrested from his private jet, charged with various counts of fraud and tax evasion, and Yukos was served with demands for unpaid tax of almost $30 billion. The company had its assets frozen and the Russian Government forced the sale of certain key assets at auction in order to recover some of its alleged tax liabilities. The eventual owner of many of these key assets was Rosneft, Russia’s state-owned oil company. Yukos has since been liquidated on grounds of its insolvency.

The aftermath has seen Yukos’ former shareholders and management filing claims at various courts and arbitrators outside Russia claiming compensation from the Russian state for unlawful expropriation of the company’s assets, and, the principal arbitration continues at The Hague in the Netherlands.

Expropriation is an ever present risk, more so in countries with a fragile rule of law or private property rights. What may embolden a state in these circumstances is the presence of an ‘Original Sin’. In certain of the arbitration proceedings referred to earlier, the Russian State argued that the “unclean hands” of the Yukos founders at the time of its privatisation should prevent them from claiming that the Russian State had unlawfully expropriated the company’s assets. In unclear situations there are always questions raised by the state such as if an asset is seen as having been ‘stolen’ from the state in the first place, is it then morally wrong for the state to seek to recover that asset in the future? 

‘Original Sin’ can come from various sources: Central American business families who run exploitative cartels built under the protection of corrupt politicians, or well-established business families in South America who were allegedly dealing in drugs money only a few decades back; or supposedly private companies in mainland China, where the current owner acquired shares through an opaque ‘ownership reform’ from the company’s workers union.

The political ambitions of the main shareholder, while operating in an industry deemed strategically important to the Russian government, was one of the issues at Yukos. This is something we worry about in the context of the big Chinese internet firms. Why does the Chinese government allow these private media companies to thrive when it does not allow any other non state ownership of the media? What compromises do the major shareholders of these companies have to make to keep the Chinese government on their side? If one of the major shareholders were to fall out with the government, would these businesses then lose their licence to operate?

Fashions are fickle

Li Ning was hailed as China’s answer to Nike and Adidas. It was very well run and stewarded by a highly-regarded founder. At the height of its popularity in 2010, the company was the leading athletic shoes company in China. Sales grew from $300m in 2005 to $1.4 billion in 2010, almost five times within five years. Its shares traded on a price/earnings ratio of 25x, valuing the company at $7 billion. By that time, many marketing gurus were calling it one of the first ‘true’ brands to come out of China, and Li Ning was planning expansion into Europe and United States. Suddenly, sales began to decline. By 2013, revenues were 40% less than in 2010, and the market value had declined by almost 90% over the same period. It seemed that their core consumers, the Chinese middle classes in tier 2/3 cities,3 had moved away from the brand en masse.

Single brand fashion companies with relatively short histories are vulnerable to shifts in consumer behaviour. Financial metrics of these companies look excellent at the peak of their popularity, which makes them hard to resist, but the very nature of their fashion-driven rise makes them vulnerable to a fall. Consumers’ tastes are fickle. As always, the longer the history the more informative when considering a company’s track record and ability to adapt.

The Emperor has no clothes

During the first decade of the 2000s, African Bank was the hottest stock on the Johannesburg Stock Exchange. The shares rose from 5 South African Rands in 2001 to 30 in 2012, as their loan book grew multi-fold (they served 3 million customers at the peak). Founder Leon Kirkinis was regarded as the best banking brain in the country. African Bank specialised in lending to the poor, making unsecured loans at exorbitant interest rates, all funded through wholesale borrowing. This was obviously a risky business model, but Kirkinis was such an excellent salesman that African Bank’s shares traded significantly above its book value; a much higher valuation than the good quality banks in the country. The first cracks in the business model appeared in early 2013 when South Africa experienced strikes at its platinum mines, where many of African Bank’s customers worked. The bank’s bad loans rose quickly, it had trouble funding its loan book, and in August 2014 it was placed under “curatorship” by the South African regulators in an attempt to transform its business model and secure its future. A report was required under South African banking legislation to investigate the causes of the bank’s failure. 

Other than issues with the business model, the report identified a series of issues with Kirkinis. While a charismatic leader, he ran the bank with an iron fist. According to the report, he was arrogant and was accused of succumbing to hubris. He had an overwhelming influence over the bank’s board and over the entire operations of the bank. He effectively kept all the key decisions to himself; while the bank’s board was viewed as being deficient in composition and competency and failed to challenge Kirkinis appropriately. Even when the bank made a risky acquisition of a furniture retailer (Ellerines) in 2007, ostensibly without having carried out appropriate due diligence, no one on the bank’s board appeared to challenge him. A ‘hero worship’ culture appears to have meant very little questioning; this is usually very dangerous in any complex and fast growing business.

Are we solving a real problem?

In 2002, a fund established and managed by American property tycoon Sam Zell invested in a small Mexican home builder called Homex, owned by the De Nicolas family. Over the next six years, Homex went from building 5,000 homes a year to building 57,000, becoming one of the largest home builders in North America, valued at $4 billion at the peak of its popularity in 2008. In a country dominated by oligarchs,4 Homex was regarded as a high quality entrepreneurial company backed by an experienced American property mogul. Unfortunately, its growth was driven by a government subsidised lending programme, and soon after this programme was withdrawn by the government, the game was over. As Homex’s growth was funded through debt which it was unable to service, the company went bankrupt in 2014. It turned out that Mr. Zell’s fund sold its last shares in 2008.

Today, Homex is one of the country’s least popular companies. While its investor brochures claimed that Homex was a solution for Mexicans facing housing shortages, what the company actually created were poor quality developments with serious defects. As soon as the government policy changed, partly driven by the realisation that Mexican homebuilders were not really helping anyone but themselves, as well as creating environmental problems, the programme was stopped.

What is the purpose of a company? This is a question we often ask ourselves. If a business does not solve any real problem, it’s hard to justify its existence longer term, even more so if it is propped up by government subsidies. 

Tulips are rare

Li Hejun was called China’s Elon Musk.5 His company, Hanergy, started off as a builder and operator of hydro-electric dams, before becoming a solar panel maker in 2009. In a series of opaque transactions, Hanergy reverse took-over 566 HK, a small toy manufacturer listed on the Hong Kong stock exchange. By early 2015 its shares traded on 176x earnings, with a market cap of $40 billion. Li Hejun talked about owning solar farms all across China and building a solar-powered car. MIT’s Technology Review included it in their list of the world’s 50 smartest companies, and Li Hejun became the third richest man in China. In May 2015, the stock collapsed almost 50% in a day, amid rumours of large scale related party loans and transactions6 involving its unlisted parent company which was controlled by Li Hejun, which led the Hong Kong exchange to suspend trading in Hanergy’s shares. They remain suspended to this day.

In a civil court action brought against Li Hejun and certain of Hanergy’s other directors by Hong Kong’s Securities and Futures Commission, the court found Li Hejun to be incompetent and negligent in his duties as a director. 

He has been disqualified from being involved in the management of any Hong Kong registered company for eight years.

In their pursuit of chasing ‘green-technology’ dreams in China, many investors forgot how Li Hejun listed the company through a reverse takeover, which meant there was little opportunity for scrutiny of Hanergy and its business at the time of listing, unlike in a conventional IPO (initial public offering). Hanergy shares were also held through highly complex offshore holding structures and listed shares were pledged to support the debts of Mr Hejun.

Every bubble starts with some truth, but eventually get taken over by irrationality. Rising share prices usually numb investors’ sense of risk; many warning signs around unnecessarily complex legal structures which serve no legitimate commercial purpose or poor disclosure standards are ignored, which should be big red flags. 

We have seen this in a range of sectors from Ukrainian farmland and iron/copper ore to semiconductor memories. Eike Batista, for example, achieved an almost $50bn market cap for his group of companies in Brazil in 2012, by exploiting investors’ fear that the world was running out of commodities but also, according to the Brazilian authorities, relying on market manipulation, false representation and overstatement of assets. Currently, questionable and largely untested legal structures through which many high flying Chinese internet companies are listed is one of our main areas of concern. If the key shareholder does not demonstrate the standards of stewardship we are looking for, we are happy to stay away.

Don’t believe all the numbers

Satyam Computer Services was regarded as one of the leading Indian IT companies in 2007. It had a strong net cash position, grew its revenues at a double digit rate and had return on equity (ROE) of 30%. There was a Harvard professor on the board and a very good list of multinational clients. In 2008, Satyam turned out to be the biggest accounting fraud in Indian history, in which investors lost almost 80% of the value of their shares. 

Ramalinga Raju, Satyam’s major shareholder & CEO admitted in a letter to the company’s board that he had managed to convince both the company’s auditors (one of the global Big Four auditing firms) and his board that the company had over $1 billion in cash. This in fact was never the case. He further admitted to having overstated the company’s profits and assets for a number of years, but there is speculation in the Indian press that the cash was in fact buried within many related party property companies, linked to various Raju family members. 

As outsiders, it is almost impossible to spot an accounting fraud, especially if a Big Four auditor has signed off the accounts. What was more worrying was Raju’s family was closely linked with powerful politicians. The family owned a highly indebted infrastructure firm and was a significant owner of land in Southern India, mainly through a web of different entities. While Satyam’s accounts appeared squeaky clean, the family’s reputation merited closer examination due to a largely unexplained quick rise to wealth and power, particularly compared to the lengthy periods that it had taken for some of India’s other business families to develop their groups.

Ultimately, accounts can be faked albeit with some effort and the complicity of others, but it is very hard to hide your real reputation. In these markets, good reputations are increasingly hard to find, and that’s what we are really after.

Portfolio thoughts 

Any of these companies above in an ‘alternative history’ could have turned out to be just fine. However, our investment philosophy and decision-making process would, we believe, have ruled out owning a majority of them.

Our job involves dealing with the future. As the future is inherently unpredictable, most of our time is spent analysing history. We focus on the history of key people  at our investee companies, assessing their approach towards business risk, capital allocation and indebtedness. The best way to avoid playing ‘Russian roulette’ in our view is to back management who are conservative, honest and have built resilient businesses.

St Andrews Partners
January 2018

Source for company information: Stewart Investors investment team and company data. For illustrative purposes only. Reference to any companies mentioned in this communication is merely for explaining the investment strategy, and should not be construed as investment advice or investment recommendation of those companies. Companies mentioned herein may or may not form part of the holdings of Stewart Investors.

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Investment terms 

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  1. Alibaba is a major Chinese internet business. Yukos was a Russian oil & gas company.

  2. The ‘Big Four auditors’ are the largest four global accountancy firms.

  3. Tier 2/3 cities are large Chinese cities but not the largest (Tier1).

  4. An oligarch is a rich business leader with potential connections.

  5. Elon Musk is the businessman behind PayPal and Tesla.

  6. Related party transactions are business deals or arrangements between two parties which are joined by a special relationship prior to the deal.