Latest Emerging Market Viewpoints
From Matt Linsey and the North of South Capital team
We have noticed two key trends in our asset class that while supportive of prices over the near term, could represent a significant risk in the future.
The first is the decline in yields available on emerging debt market. For the first time that we can remember there are hardly any bonds with yields to maturity exceeding 10.0%. While this might seem like an arbitrary number, it is reflective of the massive contraction in spreads seen over the past year.
Examples abound of investor enthusiasm for yield. Petrobras, whose ten year U.S. dollar bonds yielded more than 13.0% in January of last year, now yield a little over 6.0%. This is a spread compression of close to 700 basis points and goes a long way in explaining why the Brazilian equity market is up over 85% in U.S. dollar terms since the end of 2015.
Even countries where the macro trends have been universally bad (rising political uncertainty, expanding current account deficit) such as Turkey yields remain under control. Despite all the negative headlines and a depreciation of the lire by more than 20% relative to the U.S. dollar over the past year, yields on 20 year Turkish Government bonds in U.S. dollars have remained steady at a little over 5.75%.
One of the first questions we ask corporates is the cost and availability of credit. Almost without exception, unless the company is highly indebted, the response is that it is readily available. Those corporates that have issued higher yielding U.S. dollar Eurobonds in the past, particularly Chinese property companies, have been particularly popular over the past year. It is now difficult to find a U.S. dollar Chinese corporate bond yielding more than 7.0% to maturity.
Again, all this is very supportive for our equity markets, although with yields and spreads as low as they currently are; it is hard to see how they will fall much further. This leaves our markets vulnerable should the dollar strengthen meaningfully and developed market interest rates rise more than expected.
The other major trend is the almost universal bullishness regarding consumer stocks in our asset class. Yes, we are also positive on the outlook for many of our companies due to an expanding middle class in our markets. The difference is that for us valuations and corporate governance do matter.
Thailand remains one of the markets where this excessive zeal towards all things consumer related has reached its zenith. With strong inflows from “long term” investors in the developed markets- often endowments and pension funds as well as domestic retail investors, money would appear to be blindly bidding up share prices.
Even the debacle regarding Group Lease, which is now down more than 70% since its recent December peak, has failed to deter investors. It is, and we would agree, as an isolated incident of poor corporate governance. Despite this fact, it should be seen as a warning of the risks of investing in momentum driven growth stocks where earnings are at risks of decelerating.
One such example is Bangkok Dusit Medical. It has seen its market capitalisation almost double in U.S. dollars over the past three years despite its EBIDTA growing by less than 30% and its net income by even less. Growth is now clearly decelerating, particularly in its Bangkok based hospitals, where revenue only increased by 6.0% last year.
It is becoming more dependent on upcountry hospitals and domestic patients for growth. Not only are these lower margin, they also requiring the company to make significant capital expenditures, reducing free cash flow to negligible levels. Although the company is well managed, it is hard to justify its current valuations of 33x this year’s expected earnings given the slowdown in growth, which would appear to be structural in nature.
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