Category: insights

The Week That Was in Turkey – Weathering the Perfect Storm
Carlos Hardenberg, Founding Partner & Portfolio Manager, MCP
01 November 2022

Istanbul, a city which never fails to impress with its rich history, culture and hospitality, didn’t fail to impress us this time either with its resilience in navigating challenging times. We visited Istanbul in October, and the city was still buzzing with tourists – bustling hotels, long queues for the tourist attractions and ringing cash registers at high-street retailers. Foreign currency is flowing into the country, at the markets and retailers, but what is most evident is the foreign currency investment in real estate. Istanbul, a city with 15.5 million people, appears to be bursting at its seams.

There is always more than meets the eye and the week we spent in Turkey brought us closer to reality – an economic crisis is looming in Turkey – extreme currency depreciation, high inflation and an unorthodox economic policy by the incumbent leadership that continues to cut interest rates. These aspects, combined with the political uncertainty as the country heads into elections next year, has made planning and forecasting difficult for most companies and economists we interacted with. But there are hidden gems for investors to discover.

The outcome of the 2023 elections is probably the most interesting and most discussed topic in Turkey. We met several companies across sectors including retail, technology, healthcare, energy, manufacturing, industrials and banking. We also met with politicians, pollsters, economists, and policymakers on our trip to gain insights into the trends and indicators regarding the polls, but there is still uncertainty and we walked away with a contrasting conclusion at the end of every meeting.

We wanted to assess the following:

• Macroeconomics and monetary policy in Turkey
• Health of banks and large and small corporates
• Consumer confidence
• Adaptability and outlook of our portfolio companies

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The Macro:

• Depreciating currency: The Turkish lira has depreciated over 50% against the US dollar in the last year and is now at an all-time low. Concerns over inflation, the Russia-Ukraine war and economic instability are exacerbated by skyrocketing inflation and expansionary monetary policy. Managing FX risks has been one of the biggest worries for companies this year. It was interesting to see that even small businesses such as market vendors and taxi drivers preferred being paid in US dollars or euros over lira.

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• High inflation: Recent headline inflation stands at 83%. This is the highest reported inflation rate since 1998. The real inflation across food and transport appears to be higher still, thus hurting consumers even more. This has led to an 80-100% wage increase across the board which in turn might create a wage-price spiral. Companies are resorting to wage increases to attract and retain talent as more and more employees are choosing to move to other parts of the world for careers in stable economies that pay in hard currency.
• Energy crisis: The increased oil and gas prices affecting most net importers are also hurting Turkey. The country’s energy import bill has doubled in the last year and is adding to the widening fiscal deficit. The government has increased energy imports from Russia at discounted rates and delayed payments to contain energy bills.

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• Expansionary monetary policy: The Central Bank of Turkey believes that high borrowing costs lead to high inflation and has continued to cut lending rates. The interest rates are currently at 10.5% (vs. 14% at the start of the year) and the central bank has signaled further cuts to single-digit levels until inflation reaches 5%.

Winners: Exporters are benefitting from the weak currency and the low borrowing rates which provide them with a competitive edge over their Eastern European and Asian peers.  

Losers: Banks are negatively impacted as they are unable to reduce their borrowing costs due to the requirement of buying fixed-rate government bonds. Importers, including retailers and FMCG companies with limited pricing power are hit by the depreciating currency.

We expect loosening monetary measures to continue in 2023 as Turkey heads into the elections. Lower interest rates will benefit small enterprises, which form a large proportion of the voter base. But this appears to be largely priced-in given the currency depreciation and near all-time low stock market valuations.  

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The Businesses:

• Banks: Despite the currency crisis and cutting interest rate regime, banks are in good health. They are adequately capitalised and NPL ratios are within reasonable levels. There is a desire to cap their lending activity. Banks are required to buy long-duration fixed-rate government bonds, thereby increasing their borrowing costs. FX-indexed deposit schemes that assure customers of a return equivalent to a fixed rate plus the rate of TRY depreciation are being offered to attract Turkish lira savings into the system.

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• Large corporates: We met the two largest corporates in Turkey – Sabanci and KOC Holdings – to understand their outlook and measures taken to adapt their businesses to the rapidly changing economic environment. Increasing exposure to export business, improving technological and manufacturing efficiency through foreign collaborations, and rising investments in renewable energy are just some of the key strategic priorities for large corporates. It is heartening to see the excellent presentation and reporting of Turkish companies and the growing adoption of sustainable practices and reporting
• Small and medium-sized enterprises: These form the backbone of emerging economies. In Turkey, such enterprises are generally still in good health despite the mounting challenges they face. Their balance sheets remain robust with buoyant tourism and growing exports continuing to drive demand for their products and services.

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Consumer Confidence:

It is interesting to see how consumer behavior has been adapting to sky-high inflation and macroeconomic uncertainty. We met with some of the largest retailers in Turkey who alluded to visible signs of customers downtrading (if the price of a loaf of bread increases every two weeks, who wouldn’t?) and parallel trading from corner shops to organised retailers. The recent efforts in increasing e-taxation have created a level playing field and organised retailers are able to offer products at competitive prices. But consumer discretionary spending is being affected as locals are buying less cars and houses. Although interest rates are being cut, there is a cap on LTVs that makes borrowing difficult.

Medical tourism in Turkey has become a major source of foreign currency revenue. The advanced medical technology and quality talent available at lower rates are attracting medical tourists, especially from Eastern Europe and the Middle East, for medical and cosmetic procedures. We visited a 27k sqm hospital run by a leading Turkish hospital chain specialising in stem cell treatments for medical tourists. This 160-bed tertiary care hospital looked nothing like a regular hospital. Designed by a leading Turkish architect, the interior of the hospital resembled a human cell! It also had some of the most sophisticated MRI machines and a list of accreditations from renowned medical institutions across the globe.  

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Our Portfolio:

We met with both our Turkish portfolio companies – Mavi, a leading jeans/apparel brand and Logo, an ERP solutions provider – and continue to believe in their growth.

MAVI – Mavi is a popular denim and jeans brand in Turkey founded in 1991 (we noticed people wearing their jeans and sweatshirts in the busiest neighborhoods in Istanbul). We met with the CEO, Cuneyt Yavuz and Duygu Inceoz – senior director of IR, at their offices. The headquarters are situated above a store and exude a casual atmosphere, with all employees, including the CEO and IR, wearing jeans.

Our discussions focused on rising costs and the brand’s appeal and defensibility in such circumstances. Mavi has a dominant market share in Turkey and its competitive positioning has strengthened over time. It has continued its exceptional growth even in the last year. Foreign competitors such as Zara, H&M are forced to stock limited SKUs due to currency uncertainty and given their EUR pricing strategy, they are becoming increasingly expensive for local customers. Mavi also has an edge over its local competitors due to its scale which has enabled the company to secure capacity with its suppliers at discounted rates and to manage supply chain disruptions. A lean balance sheet further helps the management to navigate the crisis.

Mavi has seen a 30-40% increase in customer traffic over the last year and continues to see real (volume) growth. Mavi leveraged its scale and low cost of production to launch adjacent brands in the US targeting new customer segments. As part of this strategy, they recently acquired a premium US brand that expands the offering beyond jeans. Mavi has very low exposure to Russia and intends to exit the market completely.

Mavi expects to grow at >100% in 2022 on the back of a very strong 2021. The core risk lies around managing operating costs and margins. The current environment is a true test of the brand’s pricing power. However, it was encouraging to see Mavi’s digital investments across marketing, pricing, and supply chain management systems. They have built an in-house system that tracks the prices of all competitors and guides their own pricing decisions. We remain confident of Mavi’s ability to weather the storm. With a strong brand, a competitive edge and strategic acquisitions, we believe, the company will continue to drive shareholder value.

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LOGO – Logo is an ERP solutions provider for mid- and small-sized enterprises across Turkey. It is a key beneficiary of the growing digitalisation and formalisation of the economy. We met with the CFO and IR in one of their sales offices with beautiful views of Istanbul. It was a Friday and we truly experienced the new flexi-working style of technology companies with a significant number of employees working remotely.

Logo is a leader in digital transformation offerings with solutions like e-ledgers, e-dispatch, e-invoice, largely web-based and transitioning to cloud offerings. It has over 120k customers across Turkey and Romania. Its products and services compete with those of SAP by offering similar features at ~50% lower prices. Recently, the Turkish government has been focusing on formalising the economy and is mandating smaller businesses to generate e-invoices. Logo continues to benefit from this and has built a strong recurring revenue base across thousands of customers. Logo continues to innovate (spending ~20% of revenues on R&D) and to release new products and to win new customers.

Logo employs over 1,300 employees and has won the ‘Best Place to Work’ accolade numerous times over the years. It is a pay leader in Turkey and has been able to attract quality talent. Macro and currency depreciation are resulting in some loss of talent to Europe, which does worry Logo’s senior management. We also see the ability to attract and retain talent as one of the key risks for Logo, but given the strong employee culture and incentives, we are confident of them navigating this well.

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The Communist Party of China (CCP) plans to host the 20th Party Congress in Beijing on October 16 this year. Since 1977, the Congress takes place every five years. It is the most important event on the Party’s agenda because the new composition of the top-level leadership will be announced. Beijing’s political, economic and foreign policy priorities for the next five years and beyond will also be established. Two thousand three hundred representatives will participate in this major political event. They are nominated and elected from 38 provincial and regional units, central government bureaus, state-owned enterprises and the public financial system. The Congress is a tightly scripted event, as every decision, statement and personnel appointment is decided ahead of time following extensive closed-door negotiations [1].

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At the centre of attention is the highly anticipated announcement of President Xi’s third term in office. Xi was elected president of China in 2013 and was initially supposed to step down by the end of 2022, as the maximum tenure for a president is two five-year terms. However, in March 2018, the Congress amended China’s constitution to roll back presidential term limits, paving the way for Xi to remain in power beyond 2022. Some observers anticipate that Xi, currently 69 years old, could stay in office for another three terms and retire in 2037 at the age of 84, given that 2035 marks the first milestone for many of Xi’s political goals to achieve “socialist modernisation” by 2050 [2].

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Despite having a single ruling party, informal factions built upon personal relationships divide power inside the Party [i] . Several observations indicate that Xi has strengthened his position within the Party since becoming president, especially as factional rivals have been removed in a series of anti-corruption measures[3]. At the 19th Party Congress, the Xi Jinping Thought was added to the fundamental doctrines of the CCP and the country’s constitution, following the Mao Zedong Thought and the Deng Xiaoping Theory, making Xi the third name to appear in the principles[4].

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The Xi Jinping Thought has also been part of the ethics and politics curricula in primary, middle and high school since the autumn of 2021 [5]. Xi also broke an unspoken tradition of the Party established in 1992 during the Deng Xiaoping era – the incumbent president always internally nominates the presidential successor, and the previous president’s nominee ought to be appointed to the Standing Committee of the Politburo (PSC), China’s highest decision-making body, for a “grooming term” prior to the transition of power. It is believed that the continuing influence of the current president’s faction can be constrained by skipping one presidential shift (ten years) in the appointment of the presidential candidate. At the 19th Party Congress, when Xi ought to have appointed former president Hu’s nominees, he did not do so. One of the two politicians believed to have been nominated by Hu – Sun Zhengcai – was given a life sentence as a result of the anti-corruption movement in 2018, and the other– Hu Chunhua, also the current vice premier of China and a member of the Politburo — is an anticipated nominee to succeed Li Keqiang as premier. However, Hu Chunhua did not receive a seat on the PSC in 2017’s Party Congress, and Xi could try to block his promotion to become the premier despite his qualifications.

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The standing committee of the Political Bureau (PSC) consists of the country’s highest-ranking leaders and is the most important decision-making body regarding major policy issues. Changes in the composition of the PSC are anticipated to be announced at the 20th Party Congress, and the announcement will have profound implications on China’s political stability and Xi’s ability to push through his policy programs. The PSC currently has seven members, including President Xi. Power is divided as follows: Xi and his allies Li Zhanshu and Zhao Leji have three of the seven seats. Premier Li Keqiang and Chairman of the Political Consultative Conference Wang Yang are believed to not belong to Xi’s circle and are often more associated with the former president Hu Jintao. The two remaining members seem to have a neutral standing among factions [6]. There is no official rule which limits the number of terms for PSC members, but, according to the unwritten Party tradition since President Jiang Zeming, any member who turns 68 by the time of the Party Congress must retire from the PSC but can stay for another term if he is only 67 by the time of the event [7]. By this rule, except for Xi, two incumbent members – Han Zheng (68) and Li Zhanshu (72) – ought to retire. The following scenarios would indicate an increase in Xi’s power within the Party: 1) Xi is able to place his allies in the two positions to gain a majority; 2) Xi breaks the unspoken tradition and extends Li Zhanshu’s term; 3) Xi adds additional members to PSC to dilute Li Keqiang’s and Wang Yang’s relative power in the PSC. Eight of the other eighteen Politburo members will also retire based on the age rule, and the extent of Xi’s ability to replace these seats with allies will also reflect on his influence within the Party. The people replacing these seats will enter China’s most senior leadership councils and have a direct impact on policy.

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The 20th Party Congress will reflect on the progress made since the 19th Party Congress in 2017 and set policy goals and priorities for the next five years and beyond. Details regarding specific policies will roll out following these directions, as departmental- and provincial-level government create their own five-year plans aligning to the top-level goals. In the last Party Congress, Xi announced that China had successfully achieved the goal set by paramount leader Deng Xiaoping in 1979, of building a moderately prosperous society [8]. In contrast to previous leaders’ emphasis on a “peaceful and quiet rise”, Xi has taken a more assertive approach, envisioning China becoming a “fully developed, rich and powerful” nation with international influence by 2049 and entitling himself as the leader of this movement [9].

The CCP has worked to achieve this by modernising its military, pursuing extensive land reclamation efforts on disputed islands in the South China Sea, investing billions of dollars in countries worldwide through its massive Belt and Road Initiative, and taking on a more active role in international institutions [10]. In the 13th Chapter of Xi Jinping Thought related to economic growth, Xi highlights that China is in the economic transition from volume and export-driven growth to qualitative, innovation- and efficiency improvement-driven growth, at a mid-to-high expansion rate.. The government also plays a crucial role in resource allocation of the economy, while it encourages the vitality of both state-owned enterprises and the private sector. In terms of foreign policy, China continues the Belt and Road Initiative, encourages Chinese companies to invest overseas, and believes that globalisation is inevitable. Xi also reinforces the effectiveness of China’s “one country, two policy” strategy on governing Macau and Hong Kong, and is determined on “one China policy” on the issue of Taiwan [11]. Critique and scepticism around China’s Covid policy and worsening China-US relations are identified as two crucial challenges for Xi and his leadership [12].

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What will happen once Xi is re-elected?

• Zero-Covid

The Chinese government chose to prioritise lives over economic activities and growth, a policy that was effective in the first year of the Covid-19 outbreak but now causes the economy to lag its Asian and global peers. We should not anticipate a drastic pivot away from the current zero-Covid policy immediately following the conference. However, some publicised policy suggestions and official announcements indicate that a gradual and a successive international reopening can be expected [13]. We are starting to see first signs. Recently, Hong Kong removed the travel quarantine rules for international travellers after months of lockdown.

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• China–Taiwan

The expected continuation of Xi’s regime increases the key man risk, as Xi could view China’s reunification with Taiwan as a personal political goal. However, we view a Chinese military invasion at the current stage as unlikely, because the negative consequences would impact China’s long-term economic prospects, a price too high to pay. China is still dependent on Taiwan’s semiconductor know-how and manufacturing capacity, and a military action against Taiwan could damage capacity and interrupt production, negatively impacting global supply chains. Furthermore, China could face wide-ranging international sanctions and lose foreign investment. Finally, Taiwan is not Ukraine. It is a fortified island with strengthening military intelligence and defence capabilities, which have been bolstered by growing US commitment to the territory. Today, Taiwan and China are more economically integrated than ever before. Since travel restrictions have been fully relaxed in 2008, and investment restrictions were lifted the year after, the two regions developed significant cross trade from US$11bn in 2001 to over US$166bn today. We are monitoring the situation very carefully and are in close contact with our companies and experts on the ground in China and Taiwan.

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• Economic Policy

As indicated in the 14th five-year plan of the CCP, we expect China will continue its transition phase under a re-elected President Xi with a focus on improving factor productivity and technology independence. In Xi Jinping Thought the President pointed out that China needs to focus on supply-side problems, including overcapacity on low-end supply and scarcity of high-end supply, as well as dependency on foreign high-tech equipment and technology. The recently announced US export controls on advanced semiconductor chips and manufacturing equipment will very likely accelerate the ongoing efforts of the Chinese government to decrease its dependence on high-end chip imports. In the short term, we expect the government’s pragmatic focus on reigniting growth, supporting internal demand and ensuring stability to continue.

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How do we invest in China?

While no emerging market investor can afford to ignore China, we invest very conservatively in the country. A complex regulatory environment, corporate governance issues and a retail-driven market (70% of equity trading value) are among some of the biggest challenges, especially for the A-share market. Currently, we prefer to get exposure to China’s growing demand for products such as semiconductors, consumer electronics, premium health care and renewable energy through investments in Taiwan, South Korea and Hong Kong. These financial markets are more mature and provide better governance and transparency.

A good example is one of our largest investments, Hong Kong-based EC Healthcare, which operates private medical, aesthetics and veterinary clinics in Hong Kong and China. The company profits from an experienced management team and good governance as well as access to China’s growing market for quality health care. MCP used the recent weakness in the share price, which had been impacted by the Hong Kong lockdown to add to the position. EC Healthcare is Hong Kong’s largest non-hospital medical service provider, and is rapidly expanding organically and through M&As. The company is well positioned to benefit from the border reopening and the recovery of medical and aesthetics tourism.

We are delighted that EC Healthcare will be presenting their business, outlook, and progress on ESG factors at the MCP Investor Day 2022 (for Professional Investors only) on Monday, 14 November at 11am (GMT) at the Royal Society of Chemistry, Burlington House, Piccadilly, London W1J 0BA. This will be an in-person event with the option to join via Zoom. We would be delighted to welcome you on this occasion.

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Footnotes

[1] Cunningham, M. (2022, March 7). Looking Ahead to China’s 20th Party Congress. Retrieved from The Heritage Foundation: https://www.heritage.org/asia/report/looking-ahead-chinas-20th-party-congress

[2] Thomas, N. (2020, October 26). China Politics 2025: Stronger as Xi Goes. Retrieved from Macro Polo:https://macropolo.org/analysis/china-forecast-politics-2025-stronger-as-xi-jinping-goes/

[3] Some examples include the life imprisonments of ZhouYongkang, a former member of the 17t PSC in 2015, Sun Zhengcai,former member of the Politburo and highly anticipated candidate to the PSC in2018, Ling Jihua, former principal political advisor to Hu in 2016, and,famously, Bo Xilai, former Mayor of Dalian and Minister of Commerce.

[4] Buckley,C. (2017, October 24). China Enshrines ‘Xi Jinping Thought,’ Elevating Leader to Mao-Like Status. Retrieved from New York Times:https://www.nytimes.com/2017/10/24/world/asia/china-xi-jinping-communist-party.html

[5] Ministryof Education of the P.R China. (2021,July 8). 《习近平新时代中国特色社会主义思想学生读本》于今年秋季学期起在全国统一使用. Retrieved from Ministry of Education of the People’s Republic of China:http://www.moe.gov.cn/jyb_xwfb/gzdt_gzdt/s5987/202107/t20210708_543195.html

[6] These include the principal adviser Wang Huning, who has advised Xi and his two presidential predecessors Jiang and Hu; and Han Zheng, who was previously the Party Secretary of Shanghai and is believed to be associated with former president Jiang Zeming.

[7] Fang, B.(2022, August 20). 二十大报道：习近平连任挑战和政治局常委布局. Retrieved from VOA:https://www.voachinese.com/a/xi-jinping-standing-committee-members-20th-party-congress/6709178.html

[8]The moderately prosperous society is defined by sixteen quantified standards related to income, minimum average housing size, infrastructure, forest coverage, literacy rate, education spending, protein consumption, and life expectancy (Central Compilation and Translation Press, 2021).

[9] Xinhua Net . (2017, October 23). [十九大“新”观察]“新目标”怎么干？. Retrieved from Xinhua Net:http://www.xinhuanet.com/politics/19cpcnc/2017-10/23/c_129724802.htm

[10] Albert, E., Maizland, L., & Xu, B. (2021, June 23). The Chinese Communist Party. Retrieved from Council on Foreign Relations: https://www.cfr.org/backgrounder/chinese-communist-party

[11] Xinhua net. (2021). 习近平新时代中国特色社会主义思想三十讲课件. Retrieved from Xinhua Net:http://www.xinhuanet.com/politics/xjpsxkj/

[12]Cunningham, M. (2022, March 7). Looking Ahead to China’s 20th Party Congress. Retrieved from The Heritage Foundation:https://www.heritage.org/asia/report/looking-ahead-chinas-20th-party-congress

[13]Sources include the Suggestions on the revival of international tourism under the normalization of epidemic prevention and control, which advocates for are-opening of touristic regions to international travellers, March 2022; and the 14t Five-year plan publicised by the Civil Aviation Administration of China in 2021 that classifies 2021–2022 as a recovery phase and 2023–2025 as an expansion and growth phase, attached with specific quantified milestones.

[i] A common generalisation divides factions into the “elites” and the “populists”. The “elites” are descendants of former Party members and typically come from political centres such as Beijing and Shanghai. They are generally believed to place greater focus on economic development. Xi Jinping,  son of Xi Zhongxun, who once served as deputy prime minister of China and was an early comrade-in-arms of Mao Zedong, belongs to the “elites”. Xi’s predecessor, former President Hu Jintao, was a “populist”, also known as “tuanpai”. Politicians from this faction places higher emphasis on social equality and have commonly started their political career from the Chinese Communist Youth League – the party’s nation-wide organisation for youth aged 14–28 to study and a training ground for party cadres (Lai, 2012). Party elders are considered to be influential due to their mentor-protégé relationships with incumbent leaders, forming clans such as the “Shanghai clique” or the “Beijing clique”.

In June 2022, we spent a week in Brazil meeting companies across sectors as well as economists, entrepreneurs, local fund managers, investors and artists and have returned with a variety of insights into challenges and opportunities. But what impressed us the most was the level of digitalisation and the significant improvements in the ease of doing business for entrepreneurs.

São Paulo appears to be waking up from hibernation – streets are bustling, restaurants are crowded, high-street retailers are busy, hotels are occupied. The city of 22 million inhabitants – the largest in the southern hemisphere – presents a disproportionate distribution of wealth: a modern, affluent front and an impoverished backyard with over 40,000 homeless. Technology and digitalisation have taken full control of public life (we did not need any physical currency!) – even on the flea markets payments are made digitally, museum tickets can only be purchased via the internet, Uber drivers and food delivery services are omnipresent.

The pandemic has had two very palpable effects: 1) e-commerce and digitalisation have gone viral, and 2) demand for real estate in the non-urban areas has jumped, accompanied by a spur in renovation activities. Another noticeable change is the improvement in the ease of doing business for entrepreneurs. The government has reduced bureaucracy and it now takes less than a week to start a new business, versus months before. It is also far easier to conduct transactions such as land or property sales, which used to be a long and complicated process.

One important observation was that no matter whom we spoke to, “politics” is not (yet) at the top of people’s minds. There is visible frustration with both presidential candidates which has led to political apathy. But there is confidence in the fundamental checks and balances, the powerful and free media landscape and the independence of the judicial system and central banks. We expect the debate to heat up towards August as the country moves closer to the general elections in October.

During our trip we were looking for answers to these key questions:

1) What is the macroeconomic situation in Brazil?

2) Can the elections lead to a further deterioration of consumer confidence?

3) How vulnerable are the banks and the private sector to the rate hikes?

4) What has driven the value destruction in the stock market? (e-Commerce businesses have been facing enormous deratings recently)

5) Most importantly, how are our portfolio companies performing in this environment?

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The Macroeconomic Situation in Brazil

1) First of all, Brazil had to deal with a hefty recession in 2015/16 which caused a prolonged cycle of deleveraging which makes Brazil far more defensive today. A vast number of private sector companies went through a phase of cleaning up their balance sheets; large enterprises like Petrobras have reduced debt by over 30%.

Source: Bloomberg

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2) The key risk for Brazil today is less related to the war in Ukraine or the Fed’s monetary policy, and more driven by domestic debt levels with interest rates now above 13%, as well as commodity prices as the country remains a key exporter of various commodities.

3) The spike in inflation in Brazil has caused a rapid and almost unprecedented rise in the SELIC rate (Brazilian Federal Funds Rate) from a low of 2% back in March 2021 to currently 13.25%. With these measures, Brazil is leading the tightening cycle globally. The country has been through 16 months of tightening compared to 4 months in the US!

Source: Bloomberg

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4) The sharp increase in commodity prices in Brazil has led to a demand shock. Farmers have enjoyed an extraordinarily large dividend from the current prices and have gone on a spending spree.

5) Unemployment – which had jumped from 11.5% at the beginning of 2019 to over 15% at the height of the pandemic – has now for 11 consecutive months fallen to 9.8%. This is the lowest since February 2016 and a clear indicator that the private sector is normalising to pre-pandemic levels.

Source: Tradingeconomics

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6) Foreign reserves of USD 355bn and debt/GDP below 60% as well as strong export performance support the general macroeconomic conditions in Brazil.

We are expecting the monetary measures to take effect and slow down consumption over the coming months. Twenty twenty-three will probably be a difficult year for Brazil, with higher cost of funding, elevated inflation and subdued growth. However, the stock market has priced this in accordingly and is now offering reasonable valuations. At the same time, the currency looks reasonably valued. Low external debt serves as a strong support in this period of uncertainty.

Source: Bloomberg

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Politics and Elections

We talked to various stakeholders about the upcoming elections to understand the current sentiment. The country appears polarised. While the poorer regions tend to favour the former union leader, ex-convict, and former president (2003–2010) Luiz Inacio Lula da Silva (76), the more affluent regions and the agricultural lobby support the incumbent and ex-military officer Jair Bolsonaro (67). However, almost everyone we talked to appeared unhappy about both candidates. Bolsonaro has failed to win wider support due to his radical stance against minorities, and his mishandling of the Covid-19 pandemic (“it’s just a flu”). The many positive and business-friendly reforms introduced during Bolsonaro’s tenure – including the progress on privatisation (i.e. the $ 6-7bn Electrobras privatisation) – are hardly ever spoken about. All in all, while both candidates have very different political agendas, we believe that neither will harm the economy nor introduce policies that would considerably strangle Brazil’s economic development. Even if Lula were to win, he probably would not have a majority, so the risk of radical changes is contained.

Source: Bloomberg

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Banks and Private Sector Debt

It comes as no surprise that asset quality has been deteriorating in Brazil, as interest rates shot up and inflation increased. The government’s social assistance program – which injected BRL293bn into the economy during the pandemic, three times the historical average of social assistance – has contained delinquencies.

Source: Bloomberg

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The debt service ratio has jumped from 22% in 2018 to 28% today, which is rather concerning in view of the reduction in real wages. But we need to put the data into perspective: Brazilian (private) banks are well managed, with low NPL levels of less than 3% and particularly low corporate NPLs of less than 1.5%. Loan growth has been slowing significantly and is now below nominal GDP. While there is a risk of further tightening, the wider consensus right now points to a gradual reduction of the SELIC rate into 2023. The recent hikes sharply increased the cost of funding for the private sector. However, private companies have relatively low leverage compared to previous tightening cycles. Nonetheless, we need to monitor the impact on private households and the delinquencies resulting from the rate hikes very carefully. Furthermore, the monetary tightening could cause a recession of some form.

Source: Bloomberg

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The Stock Market

Not surprisingly the winners of the Brazilian stock market this year were utilities and energy, driven by spiking commodity prices. The losers were consumer discretionary, health care and technology. Retail and eCommerce have been particularly hard hit on the back of worries about rising interest rates and the cost-of-living crisis. Brazilian retail company Magazine Luisa fell by as much as 67% YTD. After a strong start into the year the stock market has had a difficult time – it is down 6% (in BRL) YTD. With interest rates at double digits, investors can just leave their money in the bank. On a positive note, our trip did confirm our view on Brazilian companies. They are often well-managed, highly innovative and have a strong edge. They have been unfairly punished by the general sentiment and macro-outlook. However, they are in a good position to perform strongly when the recovery sets in.

Source: Bloomberg

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Our Portfolio Companies

Over the week, we visited several companies operating in different sectors, including health care, IT, software, fintech, education, pharmaceutical, retail and banking. As TOTVS is one of our larger holdings, we summarise our takeaways from our meeting with the CEO, Dennis Herszkowicz, and his IR manager, Sergio Serio.

TOTVS is the largest technology company in Brazil specialised in the development of business solutions for companies of all sizes. More recently, it is being transformed into a leading fintech operator.

Sergio and his team had prepared a very hospitable reception. When you enter the open, well-designed TOTVS offices you can almost feel the positive working culture and creative energy that drives innovation in this company. Sergio gave us TOTVS’s perspective on the current situation. The company operates across different sectors and has a good insight into how their customers are coping in this environment. He said they were seeing low levels of debt across the corporate sector (their client base) and stable delinquencies. He felt that the interest rate hikes had been well digested by the economy and added that he would only start worrying if the US went into deep recession or local rates were to spike to over 20%. However, neither of these scenarios are his base case.

The backbone of the company is the enterprise resource planning (ERP) software and TOTVS has a dominant market position in this segment in Brazil. Partially aided by deregulation, but also through technological capabilities, TOTVS has ventured into new areas, as clients have sought additional solutions from them. Growth and diversification were achieved organically and through acquisitions. A good example is the recent purchase of RD Station in early 2021. This acquisition is in line with TOTVS’s aim of broadening its product portfolio from enterprise resource planning systems to management tools and systems in the fintech space. RD Station’s CRM system is already being used by TOTVS’s core customer base: Brazilian SMEs. Beyond boosting customer loyalty, an enhanced presence in the business performance space creates more customer lifetime value. Synergies from the existing client bases of TOTVS and RD Station through cross- and up-selling products are expected to enhance performance.

As it is broadening its client offering, TOTVS has reorganised its sales force to reflect this. This has already resulted in over 1,000 clients buying their new fintech products. The fintech joint venture with one of the largest private banks in the country – Banco Itaú – not only lowers cost of funding, but also limits TOTVS’s overall risk from lending activities.

The core risk for TOTVS now seems to be on the execution side of the business. To profit from the potential efficiencies and synergies resulting from the recent joint venture and acquisitions, TOTVS needs to execute on post-merger integration process of RD Station with a strong focus on creating synergies between the different sales teams.

Overall, the company is more diversified than ever before and enjoys a unique position with its dominant market share and fast-growing business with 40% annual growth!

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Some facts about Russia and Ukraine*:

• Last year Russia’s largest foreign trade partner by far was China, with a total trade volume of nearly $141bn, followed by Germany and the Netherlands.
• Ukraine’s largest foreign trade partners are Russia and China, followed by Germany and Poland.
• Following announcements of harsh sanctions, including blocking major Russian banks from the SWIFT international payments system, the Russian Rouble plunged around 30% since last Wednesday, while the Ukrainian Hryvna dropped about 5% over the last two weeks.
• Russia is the world’s second biggest exporter of crude oil, and the largest exporter of natural gas. Russia is also major producer of metals including aluminum, nickel and copper.
• Russia is the world’s largest wheat exporter, while Ukraine is among the top five.

Russia Invades Ukraine: Implications for Investors

What appeared a very unlikely scenario only a few months ago, a war in Europe, became tragic reality last week. On Wednesday evening, many Ukrainians went to bed in their clothes with bags packed in fear of an imminent Russian invasion. Sadly, their fears were to be proven justified. Despite numerous efforts by global leaders to find a diplomatic solution, and assurances by the Russian leadership that there was no intention to invade Ukraine, western alliances are now facing an aggression against a sovereign country of over 40 million people on a scale last witnessed a century ago.

What does this mean for investors? First of all, we would like to remind our investors that MCP neither holds Russian assets nor any company with significant exposure to Russia. The current crisis will have global implications and we are already seeing the typical “risk-off” movements into gold and other safe-haven assets, coinciding with a broad-based sell-off in emerging market currencies and stock markets. 2022 had started off with a lot of uncertainty. Stock markets were already headed for a volatile first half of the year, driven by worries about high inflation, rising interest rates, supply chain bottlenecks, Covid-19 outbreaks and slowing growth. We were cautiously optimistic that we would see a phase of stabilisation in the second half of 2022. However, the war in Ukraine will probably prolong the phase of uncertainty, at least in the short term.

Russia is one of largest energy suppliers in the world. One of its pipelines bringing gas to Europe runs through Ukraine. On the back of the Russian invasion into Ukraine and expected sanctions, energy prices have spiked. Higher energy prices mean higher input costs for companies, which will then be passed on to consumers in an already high inflationary environment. In addition, higher energy prices for households will reduce consumer spending power even further, impact the growth outlook and increase the risk of the economy entering a period of stagflation. Furthermore, the above scenario will complicate central banks’ monetary policy, as the effect of planned rate hikes on inflation might be limited in such an environment and potentially further stifle growth. Furthermore, Russia is an important producer of commodities which include copper, nickel, aluminium, steel, cobalt and palladium. Sanctions could further aggravate already strained supply chains. However, so far it seems sanctions have stopped short of these sensitive areas.

Stock markets reacted strongly to last week’s news. However, as history has shown, stocks tend to recover quickly after geopolitical shocks. We have already seen some indices clawing back their losses. A lot will depend on the severity of sanctions and the length of the conflict. In our opinion, the most important thing for investors is not to panic. Long-term and mid-term investors should focus on the fundamentals of their investments, which will ultimately determine the success of their portfolio.

MCP’s portfolios of quality companies with strong capital structures have shown resilience in times of heightened volatility. We have been very careful not to take unnecessary risks and have outperformed the MSCI EM Mid Cap Index at a lower standard deviation and a lower maximum drawdown since the strategy’s inception. We sold our only investment in Russia at the end of 2021 over governance concerns, and have a strong preference for countries with lower risks and higher governance standards. Our bottom-up stock selection process has led to a strong bias for Asia, where we are finding the most interesting opportunities.

We remain bullish on the long-term prospects of our holdings. The companies we look for have strong balance sheets, low levels of debt and high profitability. In many cases their quality and competitive edge have enabled them to gain market share during the last couple of years. Furthermore, many of our companies focus on specialised components that are catering to some of the most innovative industries and trends such as AI, autonomous driving, sensor technology, renewable energy, internet of things and cybersecurity. This, we believe, will continue to drive the demand for our companies’ products. The current crisis might dampen the pace of the economic recovery in the wake of the Covid-19 pandemic, but we believe it will not stop it.

Mobius Capital Partners will be holding a webinar for professional investors on Monday, 7 March at 11 AM (GMT) to provide an update on the portfolio, strategy and performance of the Mobius Emerging Markets Fund. MCP’s Founding Partner Carlos Hardenberg will also provide an outlook on emerging markets and share his views on the Russia-Ukraine conflict.

Please email Anna von Hahn at anna@mcp-em.com should you like to participate.

*Source: Statista/Bloomberg; Photo credit: Eugene on Unsplash.com: https://unsplash.com/photos/z0j9Qf9jZ58

Hargreaves Lansdown’s Head of Investment Analysis, Emma Wall, speaks to MCP’s Usman Ali about the world of ESG (Environmental, Social and Governance) and responsible investing.

In the video below MCP’s Founding Partner Carlos Hardenberg gives a brief summary on how emerging markets have changed over the twenty years that he has been investing in the asset class. During that period developing countries have gone through a tremendous transformation that has created exciting opportunities for investors well beyond the well-know economic growth argument.

Since the establishment of Mobius Capital Partners, integrating ESG+Culture factors into our research and engagement has been a core component of our investment process. Given our focus on a single strategy, combined with running a highly concentrated portfolio, our ability to conduct thorough research an engagement with all portfolio companies differentiates us from our peers. Accordingly, our ESG+C™ reporting aims to provide transparency on a range of factors, using a framework which is systematic and consistent. What do we mean by ESG+Culture and why is it important? Whilst a focus on Environmental, Social and Governance (ESG) factors has become common over the years, we believe a crucial and missing component within this is Corporate Culture. Whilst some may categorise this factor within governance or even social, we believe culture warrants a distinct and separate categorisation. This is particularly true for emerging market investors, who interact and engage with an incredibly diverse range of corporate cultures throughout the world. There is strong evidence showing that ESG leaders outperform their peers. We believe that by integrating corporate culture into our research process, the outperformance should be greater.

Chart 4, Source: UNPRI Report: ESG and Alpha in China/MSCI, all risk and return figures are annualised (USD)

From 1980 onwards, the concept of corporate culture started gaining attention from academics as well as managers (1). According to the Harvard Business Review, there is evidence that a strong corporate culture benefits a company’s performance. Harvard academic James L. Heskett states that corporate culture “can account for 20–30% of the differential in corporate performance”(2). Furthermore, Andrew Chamberlain, chief economist at Glassdoor, investigated the relationship of a company’s share price development after the companies’ inclusion in the ‘100 best firms to work for’ ranking (3). Chamberlain constructed a portfolio of 36 publicly traded companies of the 2009 Glassdoor “Best Places to Work” ranking. The portfolio consisting of companies such as Netflix (4.4 Glassdoor score) and Procter & Gamble (3.9 Glassdoor score) performed 236% over a five-year period. This equals an outperformance of 115.6% versus the S&P 500 (4). By weighting the companies within the portfolio according to their Glassdoor score, the performance could be improved by 6.7% over a five-year period.

Chart 5, Does Company Culture Pay Off? -Andrew Chamberlain, Ph.D. Chief Economist, Glassdoor

Within emerging markets, we are yet to find a consistent ranking of ‘best firms to work for’ and accordingly it is difficult to replicate the Glassdoor study. LinkedIn for example published a list of top companies in China to work for using data from 40 million users. Top companies included Chinese companies (Alibaba) as well as U.S. companies operating in China (Tesla). However, we believe more consistent rankings will be published over the next decade. What is clear is that assessing corporate culture provides us with a differentiated lens and allows us to select outstanding companies to hold for the long-term. **The ESG+Culture Factsheet:**Within the process of creating the ESG+C™ factsheet, we faced two major challenges:**Our Framework:**By adding culture to the assessment of ESG factors, we decided to create a proprietary framework which allows us to assess corporate culture. Our culture framework consists of five focus areas: “Equality”, “Freedom”, “Recruitment”, “Innovation” and “Remuneration”. The five focus areas within culture are subdivided into different factors influencing the focus area. Many of these factors cannot be quantified themselves. However, proxies can be used to ensure the inclusion of different factors on a quantitative basis.**Data Sources and Limitations:**Information from companies is only considered if it is publicly available and traceable to the source. Accordingly, we avoided private questionnaires or surveys as such a process is difficult to replicate on a quarterly basis. Based on this principle, annual reports are one of the central data sources. Unfortunately, not every company is reporting in English in emerging markets. Furthermore, the reliability of existing data sources is sometimes questionable. Many companies have recognised the importance of ESG and therefore include it into their reporting. Still, there exists a great inconsistency among the various ESG reports. Data is always subject to adjustments due to regulatory requirements from national stock exchanges. **Quantifying qualitative data:**ESG reporting from many of our competitors running emerging market portfolios typically utilises case studies of single portfolio companies. These individual assessments do not show a holistic picture nor do they show the development of the overall portfolio. Culture is often assessed by conducting surveys, a complex and resource intensive approach. Both are lacking transparency and are not objective.Quantifying qualitative data helps to evaluate the overall portfolio and provides comparable data. In general, three different groups of proxies can be identified. First, proxies based on a binary evaluation verifying the existence or implementation of standards or services. Secondly, the weighted average of factors such as the proportion of women in leadership positions. Thirdly, by using external scores such as ratings from the Carbon Disclosure Project.**Portfolio findings:**Whilst this is by no means an empirical exercise, we have several observations from the data within our portfolio. Within the environmental category, whilst 50% of the portfolio publishes an environmental report, only 13% of portfolio companies’ (13%) formulated concrete environmental targets. Among the social factors, more than 40% of the portfolio companies report on their contribution to the UN Sustainable Development Goals (SDG). Most of these portfolio companies contributed to the 8th goal (decent work and economic growth), the 3rd goal (good health and well-being), and the 4th goal (quality education).Reporting according to the standards of the “Global Reporting Initiative (GRI)” has been identified as one of the governance metrics. Across the portfolio, 42% of companies report in line with GRI reporting standards. This is closely correlated to companies which report on the UN SDG goals. While it is common in Latin America to report in line with the GRI standards (100%), Asian companies within the portfolio tend not to utilise the GRI framework (21%). This is not surprising as Brazil became one of the first GRI hubs already in 2007. GRI hubs in Asia were launched later und usually cover multiple countries, increasing the complexity of integrating the GRI standards into different regulatory systems. Reporting in accordance with the GRI standards enables companies to disclose their environmental, social and governance activities. The GRI standards include, for example, reporting on the contribution to the UN Sustainable Development Goals.As previously described, remuneration is one of the five areas of the culture framework. From our decades of experience of investing in emerging markets, share option schemes can provide employees the opportunity to take real ownership within a business. Furthermore, share option schemes create a long-term incentive to act in the interests of a company.72% of portfolio companies offer share option schemes to their employees. The assessment of share option schemes revealed regional differences. Companies within the portfolio incorporated in Europe, Middle East, or Africa (EMEA) tend not to (33%) offer share option schemes to employees. In contrast, Asian (68%) and especially Latin American (100%) companies offer share option schemes to a large extent. Employee satisfaction and engagement is an important dimension to assess culture. Typically, internal surveys are used to measure these factors. As these surveys often lack transparency and their reliability needs to be questioned, we decided to only use publicly available data. Therefore, job and recruiting websites such as Glassdoor appeared to be a suitable data source. Using Glassdoor data is supported by an approach published in the MIT Sloan Management Review. The main reasons for utilising this approach is the reduction of polarization through a series of policies designed to promote honest and representative reviews by Glassdoor. Additionally, unlike other platforms, Glassdoor reviews gravitate towards the centre of the distribution, with fewer extremely positive or negative ratings, drawing a more realistic and less extreme picture. Whilst not all companies in the portfolio have a Glassdoor score, 71% do. Across the portfolio, the average Glassdoor score has an average of 3.63 on a five-point scale.**What are the implications of the ESG+C findings for our engagement:**Based on the reporting, we were able to derive implications for future engagement. Across the portfolio, 18% percent of board members and 17% of management teams are female. As a result of this observation, we will continue to engage on improving gender diversity at the board level as well as across the C-suite. Only 16% of portfolio companies set quantitative environmental targets. We will continue to engage on this area to significantly increase the percentage of portfolio companies with concrete environmental targets. Quantitative environmental targets include the reduction of waste production, reduction of water consumption and CO2 emissions. These quantitative targets can be directly linked to the executive compensation and therefore play a central role in improving the sustainability profile of portfolio companies.Whilst ESG reporting has become more common for portfolios investing in developed markets, the data challenges within our investment universe have made this task difficult for our portfolio. Nonetheless, we anticipate more companies across the market cap spectrum in emerging and frontier markets will improve their reporting over the next decade. At Mobius Capital Partners, we will continue to act as long-term stewards of your capital by engaging with all portfolio companies and will continue to enhance our ESG+C reporting.

**Footnotes:**The Handbook of Organizational Culture and Climate,Sonja A. Sackman – Neal M. Ashkanasy et al.Does Company Culture Pay Off? – Andrew Chamberlain – GlassdoorWhat Great Companies Know About Culture – John Coleman, Harvard Business Reviewhttps://www.glassdoor.com/Award/Best-Places-to-Work-2009-LST_KQ0,24.htm

Further Reading:

‘We cannot “see” corporate culture but it has a clear impact on returns’ ESG Clarity speaks to MCP’s Usman Ali about our ESG+Culture approachTarget top employers to beat the stock market, study finds, The Daily Telegraph on culture driving outperformanceThe ESG+Culture FactsheetPhoto by Jonathan Chng on Unsplash

For Professional Investors onlyInvestment Outlook 2021: Opportunities and Threats in Emerging MarketsLIVE-Stream: 20 January 2021The Investment Team provides an update on performance and engagement for the Mobius Emerging Markets Fund and the Mobius Investment Trust and introduces the new ESG+Culture reporting framework. From January 2021, MCP is reporting on the progress the portfolio is making in areas such as diversity, ESG reporting, company culture and board independence on a quarterly basis. During the webinar, China expert, Arthur Kroeber, joins from Beijing to talk about China’s economy and what to expect from China over the coming years.Please email Anna von Hahn at anna@mobiuscapitalpartners.com should you have any questions or would like further information.

https://vimeo.com/467273550Carlos Hardenberg, Founding Partner of Mobius Capital Partners (MCP) and Marcin Lewczuk, Partner and Investment Team member at MCP, give an update on the Mobius Investment Trust’s performance, portfolio as well as the Investment Team’s active engagement with portfolio companies.MMIT has seen strong performance YTD with the NAV and share price up more than 10% and the Trust outperforming the MSCI EM Mid Cap Index (GBP) over 1/3/6/12 and 18 months.

www.mobiusinvestmenttrust.com