AEC Commentary (Q3 2024)
October 2024
The fund returned ~4.5% in the third quarter which is a point shy of the 5.5% return of the M1EFSC benchmark. While the bogey results appear uneventful, there was immense movement through the last two weeks of the quarter. Following the mid-September interest rate cut in the US, and the nearly coinciding stimulus measures announced in China, there have been sharp shifts in individual country performance. The knee-jerk moves supported a 4.5% jump in the benchmark over the final ten trading days of September, versus a fractional .5% increase for the AEC fund. A 30% rally in China and Hong Kong provided most of the fuel for the index – both locales in which we have minimal exposure. Additionally, the US rate cut appeared to broaden risk appetite throughout the marginal EM geographies, to the detriment of India, our largest exposure, which showed a small decline for us over the last weeks of trading.
Ten years back, China felt like a “damned if you do, damned if you don’t” type of exposure. At the time China comprised ~25% of the small cap benchmark, so to ignore it was a defiant bet. Since then, a combination of index reallocations and equity underperformance has reduced China and Hong Kong to a much less influential ~8% of the small cap benchmark. The large cap EM index, on the other hand, continues to carry a 28% weight in China, and this exposure has been a burden to performance given the indices sit below a 2015 peak. Ten years returns include a trough for the Chinese exchanges, so looking at nine years and five years is more telling. Over the nine year period ending September 30th 2024, the MSCI China Index (MXCN) returned an absolute 50% versus the overall EM index at 70%, and an 100% return for the EM Small Cap index. Over the five year period the respective returns are 5%, 26% and 71%. Even including the 30% jump in the final weeks of September, results from China have been subpar.
As active managers, the Chinese market has always been a tough market for our approach, and as a result we have always been underweight. Communication and confidence are a challenge in China, but with the added layer of a government aiming to control the free market, it’s a region we have shied away from. Interestingly, demand for EM ex-China funds has exploded this year. Whether it be geopolitics or the same communication and confidence challenges as our own, it seems that global allocators have been outwardly shunning this market. Regardless of the reason, Chinese valuations have been whittled away to a degree that the one-time expensive market now sits in “value” territory. As recently as a month back, the Chinese market took yet another leg-down and arguably fell into “deep value” territory. Then came the stimulus announcement, and the subsequent sharp move higher. Allocators were caught flatfooted, and as a favored market for macro allocators to short, the news led to rapid short-covering. We have seen similarly sharp moves in the past. Some have fizzled quickly, and others have endured for months, but none have sustained for years, as demonstrated by the fact that the indices still sit below 2007 and 2015 levels. Nevertheless, China did not move from the 6th largest global economy in 2005, to the 2nd largest at present, via political and economic bumbling. We are not ignoring this reality, and continue to follow the Chinese companies we’ve come across in the past as well as seek out new ideas.
While it’s still too early to determine if enduring flows will follow the arguably “weak” stimulus, we've determined it a greater risk to remain out of China, and have therefore added four positions and a ~4% additional weighting over the past weeks. Three of the positions we added are companies we’ve owned before: China Lesso (2128 HK) – the leading plastic pipe company in China; Man Wah Holdings (1999 HK) – the largest sofa manufacturer in China and a top three player globally; and Fu Shou Yuan (1448 HK) – the leading deathcare player in Shanghai. China Meidong (1268 HK) is the only “new” position for us – interestingly, Meidong is a company that we opted against in 2018 (regrettably), and again midway through 2023 (fortunately). The stock moved up 1200% following our first touch, and fell 85% since our last touch. Today the stock sits 25% lower than when we first met them in 2018, and is valued at 3x free cash flow on what we believe to be very depressed profits. Meidong is an auto dealer that has a luxury portfolio (BMW, Porsche, etc.) and caters to tier 3 and 4 cities, where they can enter as the exclusive brand dealer. Similar to all dealers around the world, the bulk of revenue stems from new car sales, while generally half of the profits come from a high margin and recurring parts and service business. In extreme times, when new car inventory is too high and demand too low, dealers will generate a negative gross margin on new car sales as they aim to clear inventory. The 1H/24 was one such period. New car sales comprised 80% of sales and generated a -5% gross profit margin (GPM). The remaining 20% of revenues tied to parts and service generated a 60% GPM. The end result is a company that still generates strong cash flow even with half of the normal profits turning to losses. The upshot is that stressed periods, such as we’re seeing right now, tend to be short-lived. We’re grateful to have the luxury of patience thanks to the still-strong cash flow despite half the business stalling at a low point in a cycle.
The chart below displays our track record over short- and long-term periods:
| Periods ended 9/30/2024 | AEC | MSCI Emerging Markets
Small Cap Index |
|---|---|---|
| Quarter | 4.56% | 5.33% | 1 Year | 12.32% | 22.86% | 3 Years Annualized | 3.65% | 5.09% | 5 Years Annualized | 15.33% | 12.19% | ITD Annualized | 10.33% | 5.91% |
Data shows past, net of fees performance. Past performance is not indicative of future performance and current performance may be lower or higher than the data quoted.
PERFORMANCE
India continued to propel the fund forward, returning 19% last quarter and adding 6.9% to our performance. Seven of our top 10 contributors were Indian companies, while only two of our top 10 detractors were domiciled in India. While the fundamentals of our positions remain very strong, valuation expansion has been a component to performance and has led to continual discussions about the India strength within our walls. The central debate surrounds our ability to justify each of our positions individually based on the earnings growth we anticipate, versus a broader market composed of many companies with valuations that we cannot justify. As a firm reliant upon a regimented screening discipline, we have a history of sniffing out country cycles early due to the results of our screens. When we see strong and recovering fundamentals and reasonable valuations in concert, we know that it’s time to allocate more focus. We screened India in September, and while fundamentals appear solid, the valuations do not transmit “reasonable.” There is no immediate cause for alarm, and we expect to have more insight as we visit companies in India next month.
In Q3, Korea was our pain point, with the 19% decline of our positions pulling 3.3% from performance. The overall Korean index was down marginally (-2.5%), but our positions took a relative beating. What’s frustrating is that none of our holdings reported cracks in their theses, and a few reported surprisingly strong results. Even so, all but one position had a negative return last quarter. Because the fundamentals still check out, we have chosen to maintain our weight in Korea, and have added to Suprema (236200 KS) and FNS Tech (083500 KS) on the recent weakness.
From a sector perspective, we were positioned nearly 180 degrees off of what worked in the market. Real estate, communications services, and utilities were the best performing sectors, and we only carried a 4% weight across the three. Tech, industrials, and materials were the bottom three sector performers, and we carried 46% of our portfolio across those three. The only upshot from our off-allocation this period, is that our selection was very good, and we outperformed in all three of the lagging sectors.
We had an active quarter, adding a net eight new positions to the portfolio. In addition to the four Hong Kong listed companies mentioned previously, our most sizable addition was Genomma Lab (LABB MM). We closed the quarter with Genomma as a top three position. Genomma is a branded personal care and over the counter (OTC) drug company that services Latin America, Argentina, and the US. We’ve tracked the company for over a decade and seen it evolve from a disorganized family business to a first class enterprise. Five years back the company announced a massive investment plan that would vertically integrate all their production and lead to significant margin uplift and cash flow. Though the infrastructure was completed years ago, the onset of Covid perpetually delayed government approvals required to begin manufacturing – particularly on the OTC side of the business. Additionally, hyperinflation in Argentina has reduced the country's revenue contribution from 30% to 10% over the last three years on foreign exchange conversion alone, though the volume of business in Argentina has remained resilient. These headwinds from Argentina were masking the remaining double-digit growth of the business along with expanding margins. With Argentina down to 10% of revenue, the headwinds have now become inconsequential, and will allow for the remaining business to show its strength. Just as importantly, soon after we bought the stock, a significant OTC approval came through, which means that the other half of their efficiency cylinders will begin firing soon. We purchased the stock well below 6x trailing ebitda and 10x our expected forward earnings multiple. While we don’t love to use relative valuation, quality consumer goods companies tend to trade well above 10x EV/EBITDA and even with the stock moving higher, we see Genomma still trading below 7x FY25 EV/EBITDA expectations.
We remain very excited about the opportunities we see in emerging markets. The recent changes we’ve seen in the US and China may evolve into opportunities or devolve into pitfalls, but neither generates much urgency in our view. The backdrop of equity investing is ever-changing, and after decades at it, we’ve learned to stick to a course that has proven successful. The relative lack of investor attention continues to create tremendous EM opportunities for us to exploit in our portfolio. We aim to continue finding such opportunities in the largest and least covered asset class on the planet. We appreciate your support and welcome your feedback or questions.
Sincerely,
Spencer Stewart, Portfolio Manager
The MSCI Emerging Markets Small Cap Index includes small cap representation across 24 emerging markets countries. With 2,031 constituents, the index covers approximately 14% of the free float-adjusted market capitalization in each country. The small-cap segment tends to capture more local economic and sector characteristics relative to larger emerging markets capitalization segments. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown.
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The mention of specific securities and sectors illustrates the application of our investment approach only and is not to be considered a recommendation. The specific securities identified and described herein do not represent all of the securities purchased or sold for the portfolio, and it should not be assumed that investment in these securities were or will be profitable. There is no assurance that the securities purchased remain in the portfolio or that securities sold have not been repurchased. For a complete list of holdings please contact your portfolio adviser.
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