The etymology of ‘bankruptcy’ is from the Renaissance era meaning ‘broken bank’, which was quite appropriate last month for two such Anglo-Saxon institutions. So far contagion in the emerging world has been very limited, but the feedback loops will last for a while.
The most relevant will be tighter credit in the US private sector, the bulk of which comes from regional banks, and has already brought forward expectations for peak US rates putting further pressure on the dollar. Ironically this can be relatively positive for emerging market assets.
Inevitably there’ll be further regulatory measures applied to banks globally, but the good news is ‘the system’ has proved to be quite robust and able to absorb the failing institutions relatively well. This has been assisted by the triggering of contingent capital otherwise known as AT1s or CoCos, it’s the second significant conversion (the other being Banco Popular) and is proving to be a post-GFC regulatory measure that’s actually working.
Since the beginning of the year we’ve been reducing bank exposure, not so much from these events but for more fundamental reasons. Last year’s global rising tide of interest rates pushed up net interest margins across the board, but as EM central banks led the tightening cycle so they’ve been reaching peak rates earlier. Brazilian CPI peaked in June last year at 12% and has now fallen to 4.5% meaning there’s 800bp of real interest rates. We’re expecting rates to come down soon and so are locking-in companies with higher yields, notably in the utility sector.
Whilst financials are still 21% of the portfolio, banks are now 12% down from 17%. The balance is in infrastructure, payments companies and insurance which we’ve increased. This is mainly in South Korea where a change in accounting methodology (IFRS4 to IFRS17) will significantly boost earnings.
In China the post-covid recovery is proving to be more muted than many had expected. Whilst there’s been increased provision of liquidity there hasn’t been any large-scale stimulus. Rather the focus has increasingly been towards efficiency and profitability and reflected in a gathering momentum for state owned enterprise (SOE) reform.
Although this has been a developing theme for a while, it was highlighted in the Party Congress late last year and important policy makers are now announcing tangible policies. This year will be the first time SOEs will have return on equity (ROE) and operating cash flow as part of their KPIs and not just ‘volume’ orientated metrics.
There’s already been clear outperformance by those Chinese SOEs that initiate relatively simple value-enhancing measures such as management share incentives and we can expect this to continue. As we continue to profile the idiosyncratic nature our holdings, two good examples of this are Sinopec (which is one of our largest holdings) and its subsidiary Sinopec Engineering.
Sinopec is essentially the BP of China. It’s the largest refiner in the world but is also balanced with upstream oil and gas production, petrochemicals, retail distribution and is leading China’s endeavours in the production and use of hydrogen.
Being integrated it’s less sensitive to the price of oil but is benefiting from the post-Covid increase in mobility with refined product demand now above 2019 levels. It’s one of the few Chinese SOEs that genuinely prides itself on sharing profits with shareholders and is one of only a handful that has both a share buy-back program and a high dividend pay-out policy, which last year yielded 9.5%.
Its subsidiary Sinopec Engineering is a specialist EPC contractor in chemical and refining applications and is benefiting from the resumption of stalled projects as well a growing involvement in the Middle East and Central Asia.
It’s probably the most undervalued company in our portfolio, trading on 6x earnings and 0.5x book but it also has a negative enterprise value. This is achieved by having virtually no debt and cash on the balance sheet that’s significantly larger than its market cap. Even adjusting for cash that’s held as pre-payments for work contracted, you’re effectively getting the operating business for free.
The company has been increasing its dividend pay-out ratio and last year paid a 9.5% dividend which would theoretically be sustainable for well over a decade if the company merely breaks even. However, with such excess cash the ROE is only 5%, as a new KPI one of the easiest ways to improve this metric is to increase the dividend still further. We’ve seen this scenario before in other countries and it can lead to a very powerful revaluation.
As the fund launched less than a year ago we have certain regulatory restrictions on what we can include in this factsheet, so if you’d like to know more about the portfolio or any of the other topics covered in this commentary, please get in touch with our representatives.