From Russia with Love
I have been reviewing the funds of a manager that specializes in Russia, Prosperity Capital Management (PCM). It’s not time to buy in yet. But these funds are great examples of how “beta plus” can deliver excellent long-term profits for patient investors. “Beta plus” investments combine investing in rising markets with stock picking to add an extra kick.
The Russian stock market has been an excellent investment destination over the past decade, delivering powerful “beta” returns. And as I’ll explain later on, there are good reasons for this powerful beta trend to continue. A simple beta investment in Russian equities (no stock picking) has resulted in gains of 14.36% a year over the past decade (measured by the MSCI Russia Index and in US dollars).
Thanks to the power of compounding, that means a $10,000 invested in 2001 would now be worth $38,260 (before taxes and excluding dividends). This is exactly the kind of long-term beta trend that we are after at Bonner & Partners.
To put that in context, the MSCI India Index has returned 15.14% a year over the same period. A $10,000 beta investment in this index in 2001 would be worth $40,951 today (again excluding dividends and before taxes).
This may lead you to think that Russia and India are similarly attractive markets. But there is a crucial difference: The Russian stock market is dirt-cheap right now. The Indian stock market is still a little on the expensive side. (The Russian index is on a P/E of just over 6. India is on a P/E of about 16.)
So Russia has been a great place to invest over the past decade. And it is one of the cheapest stock markets in the world. It also has huge natural resources and is on China’s doorstep. This powerful combination makes it highly attractive for long-term value investors.
But the Russian stock market is also highly volatile. It tends to swing violently up and down when global investors go into panic mode. So given weak global sentiment, there is currently no rush to pile in.
The Power of “Beta Plus”
PCM’s funds have naturally benefitted from the rising tide in Russian stocks. Positive beta trend, in other words. But what is really incredible is how much they have outperformed the market.
These funds have achieved this “beta plus” using the same approach we take at Bonner & Partners. In fact, their investment strategy for stocks fits our own approach almost exactly.
They are “long only.” This makes sense in a rising market with a strong beta trend. And they are unleveraged – they use no debt to fund investments. This means if the market falls sharply, the fund managers never become forced sellers. Also, the managers are deep value investors in a growing market. They are patient and hold positions for long periods of time. And they don’t over diversify.
Of course, the key difference is that they only invest in one asset class, Russian stocks, because that is the product they have chosen to offer to investors. Legacy investors should never put all their eggs in one basket in this way.
PCM’s flagship fund, the Russian Prosperity Fund – which has been going since 1996 – has $1.3 billion under management. The minimum investment for this fund is $1 million, putting it out of reach for many private investors. But PCM also manages funds with no minimum requirement. (The company manages about $5 billion in total across several different Russian equity funds, each with a slightly different focus).
At the end of October, the top 10 stock investments – with an average P/E of 6.6 – made up 75% of the fund. The largest single investment makes up 19.9% of this fund and has an estimated dividend yield of 22% and a 2011 P/E of just 4.4.
Another important reason why I am holding off recommending PCM’s funds for now is that there are some potential structural changes going on in the next month or two. And these could affect who is allowed to invest, particularly Americans. Depending on these developments, I may recommend an investment in early 2012.
23% Gains a Year for the Last 15 Years!
There are a number of important lessons we can draw from PCM’s performance.
Between 1999 and 2009 they managed the world’s top three performing funds. Because these funds were invested in Russian equities, they were well positioned for beta. But they also significantly beat other Russian funds and equity funds invested in other rising markets.
The Russian Prosperity Fund has delivered a 23% a year after-fees return since starting in 1996 against 11% a year from the MSCI Russia Index. The time period here is significant – this fund started up two years before the 1998 Russian financial crisis (when Russia defaulted on its debt and markets there went into meltdown). In other words, it has beaten the market by 12% a year on average since inception using a potent mix of beta and alpha. And it has had to ride out some powerful storms along the way.
With compounding, an investment in the MSCI Russia Index has gone up 4.8 times over those 15 years. But an investment in this fund has gone up a staggering 23.2 times. Even if you assume taxes of 40% and inflation of 5% a year, an initial investment would now be worth 6.9 times the original amount, in real terms and after taxes.
And consider this: In 1998 the flagship fund was down 86%. And in 2008 it fell 78%. But in 1999 it was up 157%…and it rose 195% in 2009. Volatility was huge on those two occasions. But losses were short lived. And the fund managers delivered excellent long-term results by sticking to their guns. This is an extremely important lesson.
Conclusion: I can’t think of a more potent example of why we will stick to our strategy of buying value stocks in growing markets. Or of the power of compounding over the long run. It is tempting during years like 2011 to be distracted by short term price moves. But this would be a mistake.
Stock markets have fallen this year in most countries. I continue to believe that stocks will fall further before reaching a bottom. But this is not a certainty.
When the time is right, we will start to rotate out of cash and into more stock market investments. But for now the risk of holding cash (ideally spread across multiple accounts in several countries) is lower than the risk of holding a large allocation to stocks. But we continue to recommend a 20% strategic allocation to stock market investments in the Family Wealth Portfolio.
The stock market investments we have recommended are nearly all deep value investments. I estimate the average upside to fair value is over 160%. And the average dividend yield is about 5.3% (over twice the dividend yield of S&P 500).
Most of our stock market investments have fallen along with stock market indexes. In some cases, they have fallen further than the indexes and in other cases less. But this hasn’t changed our investment thesis. Nor have our fair value estimates fallen. In fact, in most cases earnings have grown and/or assets have increased in value, meaning fair value estimates have risen since our original recommendations.
Of course, it is never easy to watch the price of stocks we own fall. But legacy investing takes patience and the ability to stand behind our investment decisions…even when the market moves against you. You must remember that stocks are pieces of real businesses, not blips on a screen.
We have been careful to build into the Family Wealth Portfolio a large “margin of safety.” And I expect healthy profits over the long run across the portfolio. But there will be plenty of nerve jangling price volatility from time to time. It goes with the territory. In fact, this is good news. Occasional market crashes provide excellent buying opportunities. They allow us to use our cash “ammo” to buy stocks on the cheap.
Gazprom – An Incredible Bargain
The second largest investment in the Russia Prosperity Fund – at 10.1% of the fund’s value – is Gazprom OAO (PINK:OGZPY), which we recommended in December 2010 at a price of $14.69. (In fact, it was $29.38. But there has since been a 2-for-1 stock split. This means the price halved, but shareholders got two shares for each one previously owned.) The price has since fallen 19.6% to $11.81, but there are good reasons to expect this fall to be temporary.
When we recommended Gazprom I estimated the P/E at 5.3 and conservative earnings growth of 10% a year. On November 9, Gazprom released first-half results. Profits and earnings per share were up 56% against the first half of 2011, as sales volumes of natural gas and sales prices both increased.
The combination of a falling share price and rising profits now puts the company on a P/E of about 2.4. And the price-to-book ratio is now just 0.6 – down from 0.82 when recommended. So it’s even cheaper on this measure as well.
Conclusion: Gazprom is now incredibly cheap despite growing profits and net assets. Continue to hold it for the long run.
Chaoda Sells Citrus Holdings
On September 30, Chaoda Modern Agriculture (Holdings) Ltd (HK:682) / (PINK:CMGHF) announced its first-half results would be delayed to give its auditors a chance to run further checks on the company’s financial statements. This followed fraud allegations from an anonymous source.
Pending the release of these results, Chaoda remains suspended from trading in Hong Kong. There has been a frustrating lack of news since then. But there have been some developments, which I will deal with briefly here.
On November 22, Chaoda announced it would sell the majority of its shares in Asian Citrus Holdings Limited. Asian Citrus is an owner of orange plantations in China. Its stock is listed in Hong Kong and in London.
The sale by Chaoda of 100 million shares equals 8.2% of the total issued shares of Asian Citrus. And it leaves Chaoda with a remaining stake of 5.39%. The sale takes the form of a “placing.” This means, instead of offering the stock to the open market, an investment bank will find one or more investors to directly buy the shares at a fixed price.
Chaoda will receive around HK$461 million ($59 million) net of fees and recognize a loss of HK$91 million ($11.6 million) in its accounts. This is because the money received will be less than the carrying value of the asset on the balance sheet.
This looks like a strange transaction. Asian Citrus’s stock price has been hammered this year. Along with many stocks in China it has suffered from bearish sentiment about the Chinese economy. It has also had to deal with the “everything-in-China-is-a-fraud-syndrome” that has infected investors, following a series of high-profile accusations against listed Chinese companies (most still unproven or from dubious sources).
In short, Asian Citrus has been growing strongly. But its stock has suffered nonetheless.
So Chaoda looks to be selling its investment in Asian Citrus at the worst possible moment. Fortunately, the amounts of money involved are small in relation to Chaoda’s size. According to its most recently available accounts, Chaoda’s book (net asset) value was 24.9 billion yuan ($3.9 billion) at the end of December 2010. So the loss on sale is less than 0.3% of book value.
The official explanation for the sale, taken from the company announcement, is as follows: “In view of the (sic) market volatility, the Directors consider that it is in the best interests of the shareholders of the Company to carry out the disposal of the Placing Shares. [T]he net proceeds […] will be used for general working capital of the Group.”
As you are well aware, selling any asset at the bottom because of market price volatility is the worst thing an investor can do.
It is even stranger in Chaoda’s case because it would be surprising for the company to need working capital when, according to its financial statements, it had 3.9 billion yuan ($612 million) of cash at the end of December 2010. Also, it should have generated 70-80% as much again in cash profits in the intervening 11-month period since the end of December.
But we don’t know how much of that cash has been invested into new production assets. And it is possible that Chaoda is refocusing its assets into its core farming business. Maybe a big chunk of land has become available. And Chaoda needs to get all the cash it can to secure the land usage rights. Or maybe it has been investing large amounts in new farm infrastructure or logistics assets (trucks, refrigeration and so on).
But there are other possible motivations for the sale. Neither is completely satisfactory for us. But they could explain why Chaoda has moved to sell the bulk of its Asian Citrus holdings.
The first could be the uniquely Chinese issue of “face.” This concept is notoriously difficult to translate. But broadly speaking it is the respectability or deference someone can claim. It is closely linked to social standing. And critically, it can be won and lost depending on one’s conduct.
I can tell you from my experience working in China, that locals take the issue of “face” very seriously. Foreign businessmen often struggle to navigate this minefield during meetings with the Chinese. Seemingly innocent comments made by foreigners have been known to bring business negotiations to an abrupt and final halt. This usually happens when the senior negotiator on the Chinese side feels he has “lost face” in front of his subordinates.
Asian Citrus had been buying organic fertilizer from a company called Fujian Chaoda Group. (According to Asian Citrus, 17% of its fertilizer needs came from Fuijan Chaoda Group in the past year). Fujian Chaoda Group is a separate entity to Chaoda Modern Agriculture. But it is 95% owned by the Chaoda’s chairman, Kwok Ho. (Asian Citrus says these transactions were all made “for a number of years on arms length terms” – meaning at market prices.)
But Asian Citrus’s share price fell over 30% after the fraud accusations against Chaoda were made in September. It seems that Chaoda’s shareholding in Asian Citrus…and the fertilizer supply contract from another connected business…were enough to raise doubts in investors’ minds about Asian Citrus itself.
So in an effort to distance itself Asian Citrus announced on October 10 that it would not renew its fertilizer supply contract with Fujian Chaoda. And Asian Citrus’s stock price jumped 19% that day, having already started to recover from its initial fall.
It is possible that Chaoda is selling its stake in Asian Citrus simply due to a “face” issue. Kwok may feel offended by Asian Citrus’s actions. And the sale could be a simple tit-for-tat action.
Are Bond Redemptions to Blame?
There is another possible explanation for Chaoda’s sale of Asian Citrus.
On September 1, 2010, Chaoda issued $200 million of convertible bonds that mature on September 1, 2015. These pay 3.7% interest and can be converted into Chaoda stock at a price of HK$8.10 – substantially above the last traded price of HK$1.10.
Here’s where it gets interesting… Under the terms of these bonds, if the stock is suspended from trading for more than 60 days, bondholders can ask the company to redeem them. In other words, they can ask for their money back.
Chaoda was suspended from trading on September 26, at the company’s request and in accordance with exchange rules. If this suspension continues, these bonds will become redeemable in mid-December, subject to public holidays. And some or all bondholders could make a cash call on Chaoda.
If Chaoda’s accounts from December 2010 are accurate…and if business has continued as normal during 2011…it should have plenty of cash to cover these cash calls. But the issue is where the cash is held. If the bonds are redeemed, Chaoda will need cash held outside mainland China to make the payments – most likely in its bank accounts in Hong Kong. This is because the bonds were issued outside mainland China.
Moving cash in an out of China…and in and out of Chinese yuan…is heavily restricted, especially in large amounts. So Chaoda may not have had sufficient cash in Hong Kong in the event that large numbers of the convertible bondholders choose to redeem the bonds. So the sale of Asian Citrus stock, raising $59 million, may be part of a move to bolster liquidity in Chaoda’s international bank accounts.
Patience Is a Virtue…
On November 28, Chaoda management said it would hold the company’s annual general meeting in Hong Kong on December 30, 2011.
The AGM will consider a number of matters – such as a possible proposal of a final dividend, the re-election of directors, the appointment of auditors, and the power to engage in stock buybacks. Standard stuff, in other words.
But item number one on the agenda is what interests me most. “To receive and consider the audited financial statements and the reports of directors and the auditors for the financial year ended 30 June 2011.”
Conclusion: We don’t yet know what those accounts will contain. But at least they appear to be on the way. It has been a rough ride with Chaoda. But we must exercise discipline and patience here. If Chaoda has been the victim of fictional allegations, we should see its stock recover much of the losses it has suffered in recent months. If not, we may have to realize a loss. Chaoda’s difficulties are an important reminder of why we stress that no single stock position should make up more than 2% of any long-term legacy portfolio.
Until next week,