Street Capitalist: Event Driven Value Investments

With domestic equity markets in the US in trouble, under fire by the credit crisis, inflation, and recession fears – it might be time to find a safe haven. Like in the old days, sometimes the frontier is the best place to be. One of the problems with even emerging markets, is that they are heavily invested by foreigners, if something goes wrong in the US, you can see a contraction in the markets elsewhere. For example, during August, a dip in the S&P 500 registered in a dip in the iShares MSCI Brazil Index (EWZ)

This seems to refute the idea of decoupling, although perhaps what it really shows is that market participants inadvertently create correlations based on positions and the use of margin. Still, compared to the S&P 500, Brazil’s stock market index is performing better than the S&P 500, its performance is still negative YTD and not entirely completely unrelated.

Example:

Bob runs a hedge fund with securities all over the globe and employs a hefty use of leverage. If his positions in the United States begin to tank, he will be forced to meet his margin call by selling some of his profitable securities, in this case, Brazilian equities. If there are more participants, like Bob, we can expect the same kind of reactions, causing a market drawdown like we saw in the graph pictured above.

It is precisely this kind of accidental-correlation which makes emerging markets a particularly dicy place to invest during periods of increased volatility. This is where frontier markets come in. They are still relatively new to most investors, and those who do invest in them typically have longer term views on their directions. This makes for markets where there are greater inefficiencies to exploit.

In my previous post (Looking for the Next Bull Market? Ask the UN) I described a method of using development indicators as a means for predicting how well certain countries will advance, and how that generally for tells of greater market returns.

Below are some new insights on evaluating investments in frontier markets. On monday, the Financial Times featured an interview with Slim Feriani a managing director at Progressive Asset Management, Here (subscription required).

In one of the first questions he’s asked about corruption, and how sensitive he is to corruption in frontier markets. It is easy to see his rationale, a lot of developing nations are viewed to be highly corrupt, some rightfully so. But what Feriani says is interesting:

We see it as being the other way round. Investing in the stock markets of many frontier countries helps improve governance and visibility. We saw a similar thing in the late 1990s early 2000s in Russia where corporate managements tuned into the fact that the best way to improve their lots was to adopt Western best practice in terms of corporate governance and to be rewarded by higher stock market valuations.

So the increase in foreign capital seems to fight against corruption, because the entrepreneurs of these countries know that by making their nation a good place to invest, they will attract more money and capital so that their businesses can expand and grow. The real risk underscored here, which needs to be taken into account would be political risk — instability would be the greatest factor for a nation’s markets to go south.

Feriani uses a simple framework for investigating possible investments:

At the top-down level we assess individual markets at both the macro and corporate level within a framework of “Quality, Growth, Valuation and Change”. Hence, political stability falls under our assessment of “Change”. Rather than just manage our investment sitting at our desks here in London we place a lot of emphasis on travelling to the markets we invest in.

Frontier markets are everywhere, but Feriani gives us his choices for where be believes the best opportunities are:

Regarding liquidity and transparency things vary from country to country but to sum up the Middle East typically has very liquid markets while sub Saharan Africa is more difficult. Transparency is not perfect in either but rapid improvements are taking place – the influence of foreign investment is helping foster this process.

At this stage, we believe the Middle East & Africa are among the most attractive regional frontier opportunities. They currently account for half of our of our frontier markets fund.
The case for investments in the Middle East is a strong one. The influx of petrodollars and relatively high levels of unemployment, large early-20s population, and prior bad experiences with a decline in oil prices means that many Middle Eastern nations will seek greater domestic investment in order to build new industries and create jobs.

One of the most difficult aspects for individual investors is actually being able to invest in frontier markets. They seem relatively closed off from us and aren’t available to most. However, Feriani also mentioned a number of products that someone who has access to the AIM exchange in london could purchase:

…our fund Advance Frontier Markets Fund (a closed-end fund) trades on the Alternative Investment Markets of the London Stock Exchange and can be purchased through your stockbroker. Our fund also qualifies for PEPs and ISAs thanks to its secondary listing on the Channel Islands Stock Exchange. The Bloomberg ticker for the ordinary shares and warrants is AFMF LN and AFMW LN. There’s no minimum investment and therefore anyone could invest as much or as little as they wish.

…On the exchange traded funds front, Deutsche Bank has been the first mover with its x-trackers ETF range (XSFR LN is its Bloomberg ticker). However, it has been around for only 4 weeks (i.e., small and not properly tested yet) and is limited to only the 30 largest and most liquid stocks in the largest and most liquid frontier markets. We believe the more diversification the better and safer, particularly in this space.

Now, the company I’m about to discuss is not based in one of these frontier markets, or does most of its business in these markets. Instead, it has operations that are geographically diverse and would be able to profit from increases in infrastructure activity in some of these markets. I think it is attractive, especially because I’m not entirely a fan of just investing in an index, I’d rather find a good business.

What I like to do is combine this macro perspectives with my value investing side, and one idea I’ve seen to take advantage of these trends through an undervalued company is KHD Humboldt Wedag International Ltd. (KHD).

Here is a description of the company:

During the year ended December 31, 2006, KHD focused on its industrial plant engineering and equipment supply business for the cement, coal and minerals processing industries and was engaged in the supplying technologies, equipment and engineering services for cement, coal and minerals processing, as well as designing and building plants that produce clinker, cement, clean coal and minerals, such as copper, gold and diamonds.

With many investors expecting a recession in the United States, a company like KHD which receives much of its revenues through the construction of cement plants is extremely beneficial. These plants are critical for emerging and frontier markets. Take a look at the places where the derive much of their cement plant revenue:

The 60 cement plants in the US seems like a big number, but they have already been built. The fact that KHD has operations in Europe, South Africa, the Middle East, and Eastern Europe means that some of its revenue sources will be able to withstand a US downturn. The Coal plant business also shows significant activity outside of the United States, with only 6 built while the vast majority are being built in Europe and China.
See Below:

According to KHD, they feel that demand for cement will almost double from 1,758 million tonnes in 2003 to 2,347 million tonnes in 2015. Such activity would mean increased economic activity and they outline some of the main areas. Specifically, North Africa/ Middle East for infrastructure and export opportunities. Eastern Europe for the replacement of old technology, infrastructure projects, and the the recovery of Soviet Union stagnation. Russia/Eastern Europe, Middle East, and Asia made up 90% of KHD’s order intake in Q2-2007 which again affirms the idea that they should be able to weather a US downturn well.

Financials

KHD is growing quickly, for the past three years KHD’s revenues have steadily inclined, marked by a jump in 2006-2007 by an 88% increase from $143 million to $270 million.

EBIT (Earnings Before Interest and Taxes) also grew quickly during this period, surging 150% from $14 million to $35 million.

In addition, KHD owns royalty interests in an iron ore mine with an increase in earnings from 2006 to 2007 by an increase in iron ore prices. With the current M&A environment with iron ore, we can reasonably expect prices to rise and the value of the mine to rise with it, making it an attractive asset.

KHD maintains a significant amount of cash, currently $9 per share, with virtually no debt. The company is extremely well equipped to deal with any downturn in credit markets and instead can self-finance many of its own operations. Management seems to always place their focus on creating shareholder value, which means that we shouldn’t worry about a waste of this surplus cash, I’m relatively sure that it will be deployed well.

With adjusted 2007 net earnings of $52M and an EV of about $453M, KHD trades at a multiple of 8.7X when its current growth rate warrants a significantly higher multiple of 15X-18X, meaning a per-share valuation of $41.37 to $50.00 or 72% to 108% higher than current levels.

At this point in time, the sell-off by the market for KHD seems unwarranted, and has priced KHD at an exceptionally undervalued level, which remains very attractive. I can speculate that some of this is due to the lack of news from the company, however they have released a statement saying that they have no real idea regarding the recent sell-off.