Virtus Emerging Markets Opportunities Fund
4Q 2016 COMMENTARY
After underperforming their developed market peers in recent years, emerging market equities outperformed for most of 2016, helped by economic stability across major emerging economies, and supported by ongoing structural reforms, recovering commodity prices, low inflation, and solid exports. However, the fourth quarter brought a variety of sidewinds in addition to the major headwind of funds flowing back to developed markets following the U.S. election on the back of positive sentiment for policies the Trump government might implement, as well as solid figures coming out of Europe. As a result, the developed market to emerging market investment flow reversed and the U.S. dollar strengthened against most major emerging market currencies.
A number of country-specific events impacted sentiment over the past quarter, including demonetization in India, the South Korean president’s fall from grace and the country facing a negative reaction by China to the deployment of the Thaad anti-ballistic missile system. China appears to be guiding part of its massive outbound tourist spend elsewhere as a signal of discontent, Brazil passed a law to limit public spending for 20 years, South Africa maintained its investment grade rating, and Turkey faced violent challenges.
A confluence of events in the fourth quarter created headwinds for our high quality style and led to the Fund's negative performance. The difficult environment led us to give back returns that the strategy had generated in the first half of 2016, underperforming the MSCI Emerging Markets Index, while still ending the year in positive territory.
Many markets have seen a sharp sector rotation into financials and cyclicals, and out of sectors perceived as "bond proxies" such as consumer staples, telecommunication services, and utilities. Our relative performance was driven by this strong momentum away from quality names, rather than a deterioration in the fundamentals of our portfolio holdings. In fact, this year many of our companies continued to deliver earnings growth in line with our expectations and consistent with that of previous years. Where there were issues with either growth or valuations, we adjusted holdings accordingly.
Consumer staples ("staples") was the largest detractor from fourth quarter performance, resulting from the market rotation out of quality. Our staples holdings underperformed the staples sector within the MSCI Emerging Markets Index; however, our large overweight to staples was the main contributor to the negative performance. Specifically, our holdings Ambev and British American Tobacco underperformed. We have long held a significant overweight to consumer staples companies due to our bottom-up focus on high quality growth franchises with deep moats. While investors who view staples as defensive or a dividend play rotated out of the sector, as a buy-and-hold asset manager, we continue to view staples as an attractive sector. Demand for products that staples companies sell is not economically sensitive. We are able to find staples companies with earnings derived from a broad set of geographies and products, which helps reduce risk to the underlying earnings stream within our portfolios. And, we believe many staples companies have strong brands which results in superior profitability.
In the financials sector, our long-held Indian financials holdings — HDFC Bank, a leading retail bank, and Housing Development Finance Corporation, a leading mortgage lender — both pulled back over the quarter, detracting from relative results. Their share prices came under pressure from the reversed fund flows from emerging markets back to developed markets in the past quarter. In addition, the impact from India's currency reform led to market uncertainty about broad economic activity. However, we believe these specific reforms will be a benefit to these holdings over the mid and long term as the formal economy grows and some traditional cash savings are encouraged into the banking system as deposits (See Investment Case Study: "India-Switching Legal Tender to Drive the Formal Economy" later in this commentary). Lastly, United Overseas Bank Ltd., in Singapore, which we purchased last quarter, aided absolute portfolio returns as Singaporean banks are seen as beneficiaries of rising interest rates.
Our lack of exposure to the energy sector also detracted from relative performance as OPEC’s agreement to its first production cuts in eight years led to a rally in energy producers.
Our Chinese e-Commerce holdings, namely Alibaba, detracted from relative results. Alibaba’s share price came under pressure due to a broad sell-off in the Internet sector; we do not see a meaningful change in Alibaba’s fundamentals. In the information technology space, our lack of exposure to Korea’s Samsung Electronics also detracted from relative returns.
Over the quarter, Mexico was a negative contributor for the strategy. Although our holdings Fomento Economico Mexicano (FEMSA) and Wal-Mart de Mexico detracted from returns, we are comfortable holding companies like these that we believe are powerful franchises and enduring growth businesses that are consistent with our longer-term investing view (See Investment Case Study "Musings on Mexico" later in this commentary).
We experienced stronger negative performance from countries where the sector rotation was more pronounced, such as Brazil, where strong performance from the energy and materials companies in the benchmark worked against our relative performance, and in Russia, where our lack of exposure negatively impacted our relative performance.
Our Korean holdings Amorepacific Corporation and LG Household and Healthcare came under pressure due to news that surfaced in October of a government crackdown on cut-rate Chinese travel agencies specializing in South Korean shopping excursions (see Investment Case Study "Korean Cosmetics: Update on Our Investing Rationale" later in this commentary).
Lastly, our underweight to utilities and real estate slightly added to relative portfolio performance.
Over the quarter, we purchased utilities stock Infraestructura Energetica Nova (“Ienova”), a company that engages in the development, construction, and operation of large energy projects in Mexico. We believe Ienova is well-positioned to benefit from the development of energy infrastructure in Mexico, mainly in pipeline, transmission lines, and renewable energy. These assets have long-term and predictable earnings streams. The company had a secondary equity offering and we took the opportunity to add in this liquidity event.
In the industrials sector, we added The Airports of Thailand Public Company Limited (“AOT”) to the portfolio. AOT, the leading airport business operator in Thailand, manages, operates, and develops six international airports. AOT's main revenue derives from aeronautical landing, parking, passenger service, and aircraft service charges. The firm’s non-aeronautical revenue is from concessions, office, and real property rents and services. Thailand and Southeast Asia currently have a low penetration of flight per capita. We believe AOT represents a means to capitalize on potential passenger traffic growth. And, earnings expectations and valuations came down in the last few months, which created an attractive entry opportunity.
We added to our existing positions in Ultrapar Participacoes S.A (“Ultrapar”) and Anheuser-Busch InBev SA (“ABI”). Ultrapar made a couple of acquisitions in 2016 that we expect will accelerate its organic growth in the 2017 to 2018 period. In addition, as the Brazilian economy starts to recover, although timid, Ultrapar will likely start to benefit from volume growth and margin expansion. ABI dominates the beer market, with roughly one-quarter of beer volumes and close to one-half of beer profits globally. With the combined ABI/SABMiller (“SAB”) business, it is now more exposed to faster growing markets. This should lead to both fast top- and bottom-line growth and a sales increase from using the legacy SAB distribution in emerging markets to sell ABI’s global beer brands. Once SAB is digested and the debt reduced, ABI is likely to generate high levels of free cash flow and will either do another accretive acquisition or return large amounts of cash to shareholders, either of which would be beneficial to shareholders. Although currently several of its markets, such as Brazil and Mexico, are going through rough patches, this dominant franchise should remain strong longer term.
Over the quarter, we sold SABMiller Limited as it was purchased by ABI. And, in the consumer discretionary sector, we sold New Oriental Education & Technology Group, Inc. Among the company’s various services, it helps Chinese students choose and prepare applications for colleges outside of China. Over the quarter, allegations were made of fraudulent activity by New Oriental, claiming that, in some instances, employees of the company were ghost-writing application essays and had arrangements with third-party companies that facilitated direct access to admissions officers at a handful of U.S. universities.
THE IMPORTANCE OF PERSPECTIVE
We believe it is helpful to look at the Fund's performance from a broader perspective, and compare short-term returns with longer-term excess returns. Short-term performance is heavily influenced by valuation, one of the three main drivers of returns, while earnings growth and dividends have less effect. Over longer observation periods, earnings growth and dividends have a greater influence on total shareholder return.
The chart below compares excess returns of the Fund against the MSCI Emerging Markets Index for both 3-and 36-month rolling periods. Looking at the Fund's track record of excess returns, it is apparent that we have gone through a number of periods of underperformance, but over 3-year rolling periods, the Fund's excess returns have been considerably more consistent than during the shorter periods, resulting from solid performance from the underlying holdings. This distinction we feel is key. We look to outperform the market with less volatility over a full market cycle, and short-term underperformance during times of market optimism are part of our investment profile, albeit at times painful. We maintain conviction in our quality style of generating alpha by investing in steadily growing companies that compound earnings over long time periods.
ADDRESSING PERIODS OF UNDERPERFORMANCE: 2009, 2013, AND TODAY
Late in the first quarter of 2009, fears of economic depression dissipated after the global financial crisis, equity markets rallied, and investors preferred the shares of more highly leveraged and cyclical companies throughout much of the year. Even when there was a significant disparity between the anticipated operating performance of these companies and their relative share performance, investors remained optimistic. Meanwhile, shares of higher quality, more stable companies, which had lost less ground when investors’ fears were peaking, appreciated but underperformed on a relative basis.
In 2009, U.S. Fed Chairman Ben Bernanke signalled that the Fed would “taper” quantitative easing, which while initially seen as a negative in terms of withdrawing support for providing ultra-loose monetary policy to support growth, came to be seen as a positive throughout the year because the economy showed signs of improvement. From the announcement in May 2013, the U.S. market was up 13% through year-end 2013. Financials, on the perception of future rate/yield rises, outperformed the S&P 500® while consumer staples lagged. Europe, on the back of ECB President Mario Draghi’s support, saw similar types of performance during this time period as well, with consumer staples underperforming and financials outperforming. Lastly, there was a rotation out of emerging markets, especially those countries with U.S. dollar-denominated debt exposure and high current account deficits, into developed markets.
Fast forward to 2016 and an environment that is similar to that of 2009 and 2013, where lower quality stocks outperformed. Trump's election, the impending impact of Brexit, and potential inflationary policies have driven long-dated Treasury yields higher. Also, commodity prices have risen on OPEC cuts and infrastructure growth speculation. The result has been a rotation from sectors perceived as bond proxies (consumer staples, telecommunication services, and utilities) into cyclicals and financials.
2017 OUTLOOK: FOCUS ON EARNINGS AMID UNCERTAINTY
We believe the global economic recovery will continue in 2017. Developed economies are likely to continue strengthening, albeit slowly. Since the 2008 financial crisis, developed economies have benefited from the extraordinary measures undertaken by major central banks and the healing that comes from the passage of time. The U.S. economy remains on especially solid footing. Real GDP is expected to rise from around 1.6% in 2016 to more than 2.0% this year. Importantly, labor conditions have noticeably improved—the unemployment rate has declined to a nine-year low—and inflation is now moving towards the Fed’s 2.0% target (Source: Bloomberg). Prospects for the eurozone, however, are less robust, where a number of banks continue to restructure, and it is difficult to isolate how much of the current recovery across the periphery nations is underwritten by the ongoing quantitative easing from the European Central Bank (ECB). Thus, even if the Federal Reserve tightens policy further this year, as expected, the ECB and Bank of England are unlikely to withdraw monetary accommodation anytime soon with the looming confidence risks of the Brexit negotiations kicking into gear and upcoming elections in France (April 2017) and Germany (second half of 2017).
Equity markets have rallied since the U.S. election and are looking for Trump’s administration to launch a number of initiatives designed to accelerate growth of the U.S. economy and bring income growth back to the middle classes. While this optimism may be warranted, we are cautious about the U.S. equity market getting too far ahead of itself and underappreciating potential risks, particularly in regards to timing.
This paradigm shift presents new challenges for global investors. For several decades, investors have become accustomed to a constant direction in the world economy, led by the U.S. and other developed markets outsourcing production to lower cost emerging market-based companies. Any shift in the U.S. position on trade direction is likely to have a magnified impact on global supply chains and, if so, could result in a number of secondary impacts. This naturally would have a bottom-up impact for many companies, particularly those that export to the U.S. as an important part of their business.
Given this uncertain backdrop, we are constantly evaluating and re-evaluating opportunities for sustainable earnings growth driven by what we believe are solid structural drivers. We have rarely found the labor or regulatory arbitrage of emerging market to developed market exporters of lower value-added products attractive and do not hold any companies where this is the primary driver of their earnings. If a company is to export, then we feel a barrier greater than a cheap currency or low wages is vital and look for companies that could stand on their own two feet even if they were located in developed markets, e.g., certain Indian generic pharmaceutical companies that develop and own proprietary intellectual property.
We continue to carry out our rigorous analysis to ensure our existing holdings remain in a position to deliver the long-term growth we seek. We have learned over a number of market cycles that, when the markets are on a cyclical rally, it is important to maintain the discipline of our style and keep focused on long-term earnings, as this is what we believe is the key driver to long-term returns. In the near term, this can lead to market underperformance while valuations fluctuate, but over the long term, we strongly believe earnings growth and dividends are far greater contributors to returns than swings in valuation multiples.
3 INVESTMENT CASE STUDIES
CS #1: Musings on Mexico
The franchises we own in Mexico have weathered currency swings and economic volatility before, including during the severe 1994 crisis. Can they do it again? In assessing the impact of President-elect Trump’s various campaign proposals, we have considered what they could mean for the businesses we own. Although it is unclear how much of the campaign rhetoric is going to become reality, we want to assess the impact from the worst-case scenario if his promises come to pass. The impacts will differ business by business. We feel the area of greatest potential vulnerability are those firms that derive the bulk of their revenues from exports to the U.S. — companies we do not own. Those companies’ earnings are actually benefiting from the fall in the peso but are at risk down the road should Trump follow through on his proposals. Also, with rising interest rates, there is going to be more pressure on heavily indebted companies, which again we do not own. Lastly, should Mexico end up in a recession because of lower investment in the country, the businesses we own tend be less economically sensitive.
The market’s worst fears concern Trump’s protectionist leanings. For Mexico, a repeal of NAFTA would have particularly dire consequences, constraining U.S. and Mexican companies from operating in each other's markets. Also the risk of deportation of millions of illegal Mexican immigrants from the U.S. could lead to both a fall in remittances, which reached a level of $25bn for the 12 months to November 2016, equal to just over 2% of GDP, as well as potentially a sharp rise in Mexican unemployment. It’s no wonder then that the Mexican peso has lost significant value versus the dollar since the election. Meanwhile, The Banco de México, the central bank, raised its interbank interest rate by 0.5% to 5.75% in December, its highest rate since 2009, economists have cut their GDP forecasts for Mexico, and stocks doing business and based in Mexico have been indiscriminately pummeled.
Nobody knows, of course, if Trump’s platform to restrict trade with Mexico will be implemented, never mind successful. Some suspect his incendiary talk was campaign banter. Already the wall has become “a fence,” and the new administration says it will soften its stance on illegal immigrants, restricting deportation to criminals versus all illegals. Although risks still abound, we believe our portfolio is insulated from the direst circumstances: We do not own Mexican companies whose primary business is exporting into the U.S. While our holdings are not fully insulated from economic dislocations, they tend to be less economically sensitive and less leveraged. Moreover, we own dominant franchises that are expected to perform well even during economic downturns, as they have done in the past.
Walmex de Mexico, our largest Mexican holding, is a good case in point. The company operates approximately 3000 stores in Mexico (approximately 80% group sales) and five Central American countries. The group operates different store formats from Bodegas to Sam’s Club super stores, consistently generating returns on invested capital of around 14% and returns on equity of 18% on annual revenues of about $30 billion. Importantly, most of the products it sells are consumer staples, demand for which should be resilient even in a weakening economy. Furthermore, the company (which is 71% equity-owned by U.S.-based Wal-Mart) has net cash of about $1 billion on its balance sheet which it plans to deploy in its existing footprint. In fact, the company just announced that it will invest $1 billion USD into its Mexican distribution network over the next three years. Judging by past experiences a franchise like Walmex should be able to take advantage of competitive weakness in periods of economic dislocation to consolidate its market position. We expect it to continue to gain market share in Mexican retail. On FY17e ~21x P/E, the stock trades in line with other emerging market peers, but with a great shareholder return track record and more visible growth runway, including double-digit EPS growth.
Another holding of ours is Fomento Economico Mexicano (FEMSA), a Mexican multinational beverage and retail company. It operates the largest independent Coca-Cola bottling group in the world, called Coke Femsa (it owns a 48% stake), as well as the largest convenience store chain in Mexico. It is also the second largest shareholder of the global brewer Heineken International with a 20% equity stake. While the company would no doubt feel an impact on its convenience store revenues, its growth story is a more defensive one as it takes share from smaller and financially weaker peers. FEMSA is well funded, has limited debt (~1.8x EBITDA), and only 20% of that is U.S.-dollar denominated debt. FEMSA also performed well through the last economic crisis in Mexico.
In infrastructure, we own Ienova a beneficiary of structural improvements in the Mexican economy, such as deregulation of the energy sector, and is not just a play on a favorable trade balance with the U.S. Mexico increasingly needs U.S.-produced gasoline and gas to fuel electricity and its domestic economy. This could be where Mexico is most immediately vulnerable to an end to NAFTA, given the U.S. ban on energy exports outside of NAFTA. Even so, Ienova is the kind of operator and developer of energy infrastructure in Mexico that would not be impacted by these headwinds. The company has no export business and focuses mainly on building pipelines, transmission lines and renewable power plants. These are assets with long-term contracts and predictable stream of earnings. Deregulation of the energy sector in Mexico opened a gamut of opportunities for private investors to develop infrastructure to support the growth of the local economy (example: low-cost natural gas power plants) and the exploration/development of hydrocarbon reserves. In fact, the repeal of NAFTA and a more inward looking economic development may perversely give companies such as Ienova even more of an upside.
Our investing decisions aren’t derived from big-picture country calls, or guided by macro and political prevailing winds. We recognize the risks brought on by policy uncertainty; that’s part of our job as emerging market investors. We believe that investors looking at Mexico in mid-1994 would have been best served not to make a call on the macro gold-rush going in, just like it’s best not to make a call on the fear-induced sell-off now. Rather, our philosophy is to figure out whether structural reforms and local demand can lead to and support enduring business trends and, therefore, investable companies.
CS #2: India – Switching Legal Tender to Drive the Formal Economy
On November 8, 2016, India’s Prime Minister, Narendra Modi, made a shock announcement that the country’s 500 and 1,000 rupee notes would be scrapped by year-end to be replaced by new 500 and 2,000 rupee notes. Old notes needed to be deposited into a bank account, exchanged for smaller denominations or a capped amount of new notes, or spent at permitted locations by year end or they would become worthless. The scrapped notes accounted for 86% of the value of all outstanding cash.
This surprise move appears designed to achieve a number of goals:
- Drive a higher proportion of the economy through the formal sector
- Convert cash savings and working capital into bank deposits that support future lending
- Improve tax collection
- Reduce stored value of illicit income
- Rapid timetable kept opposition to a minimum
As the move was a surprise, the central bank had not pre-printed sufficient replacement notes. India has one of the world’s largest shadow economies, with cash making up an estimated 85% of transactions (Source: EuroMonitor 2012). The country’s bank system still has low penetration as illustrated by the high population per ATM (see accompanying table). As a result, the cash shortage has led to a sharp slowdown in economic activity.
Despite the near-term negatives, we believe the government’s aim, along with other new policies such as the Goods and Services Tax (GST), is sensible and should bring important medium and long-term benefits to the economy. The move, although disruptive in terms of hours spent in queues at banks and inconvenience, has proven quite popular with the public who understand that any initiative to reduce the benefits of corruption is likely to benefit them. However, in the near term, households have been scrambling for cash, slowing the purchase of all but the most essential products, and small businesses, such as the FMCG network, which delivers around half of all grocery items to millions of mom and pop stores across India, still works primarily in cash.
How long will the problem last? Regarding the physical cash shortage, four cash printing presses are working around the clock to replace the approximately 22 billion cancelled notes. Full replacement dates range from the end of March to July, depending on whether they run two or three shifts at the presses, but will be reduced by cash printed before the announcement (which is not public), the cash that ends up deposited in bank accounts, and any cash that does not get converted.
Source: Bank for International Settlements, Retail Banking Research (U.S. ATMs), Statista (Euro Area ATMs).
Note: relatively high U.S. dollar and euro cash balances likely due to holdings in other regions.
Looking at the current impact of this change, a broad review has been undertaken by the Indian bank IDFC. This review found harder hit areas, which include Northern and Western India, rural areas, discretionary goods such as autos, construction, manufacturing, and smaller cash-based companies, while the South, metropolitan areas, less cyclical goods such as staples, and companies able to accept credit cards have held up better. Credit extension has helped in some areas, particularly those selling to smaller wholesale or retail businesses, and has helped volumes for larger operations. For a sense of magnitude, a rural high-ticket good, such as tractors, has seen sales plunge with a number of dealers looking at 50-60% sales declines over the November/December period. At the other end, consumer staples sales in Tier 1 cities appear to be recovering, but there is little doubt this period has been highly disruptive, albeit likely to only be short-lived.
Regarding our Indian holdings, the shake-up from the cash conversion has not led to any material change in long-term forecasts for any of our holdings. Our investment companies are less cyclical than their broad index peers, which is a core feature of any business we look for. All are powerful nationwide companies operating in the formal economy, carry conservative levels of debt, and are highly cash generative. However, in the near term, we expect numbers to report below previous expectations over the coming quarters.
At year-end 2016, India was the largest country weight in our Emerging Markets strategy at 20.9%. Of our Indian exposure, the financials sector, with two banks, was the largest sector with 10% weight. The three Indian consumer staples holdings added a further 6% weight. Our largest holding is HDFC Bank, the nationwide retail bank. We feel the company is well placed to benefit from this change over the long term, both from a rise in deposits as well as increased transaction volumes processed through the company’s cards and mobile systems. HDFC Bank has focused on digital banking over the last decade and has the highest proportion of customer-initiated transactions through the Internet and mobile, reaching 71% of their total transactions for FY2016. The bank has 40% share in merchant acquiring and is the leading credit card issuer with 7.3 million cards in issue as of year-end Mar 2016.
Over the short term, we anticipate HDFC Bank will likely report below-trend growth, as the fall in overall economic activity is likely to slow demand for new loans, as well as pressure on lending margins as a result of a new and aggressive loan pricing push by the government-controlled (and largest) Indian bank, State Bank of India. However, the strength of the HDFC Bank-lending process gives us confidence that we are unlikely to see a material uptick in non-performing loans, which is not the expectation for lending across India as a whole. HDFC Bank’s customers, in general, come from the middle income group, such as government workers, which we do not believe should be heavily impacted by the short-term shortage of physical cash.
Our second largest exposure is to India’s dominant tobacco company, ITC. Initial reports appear to show that by December volumes were holding up well and the company was confident enough to put through a 14% price rise on two of its larger brands in the last few days of December. However, more discretionary items that the company sells through its FMCG (fast moving consumer goods) division, such as cookies and personal products, are reported to have seen volume falls. Given the heavy proportion of income driven by tobacco in the company’s portfolio, we anticipate earnings should not be heavily impacted by the cash conversion.
CS #3: Korean Cosmetics: Update on Our Investment Rationale
In late October 2016, news began to surface of a government crackdown on cut-rate Chinese travel agencies specializing in South Korean shopping excursions. While there was no official dictate, speculation that the move was politically motivated impacted share prices of Korean cosmetics giant Amorepacific and LG Household & Healthcare (LGHH) since both are dependent on a robust tourist trade. In the following Q&A, we examine these recent developments and why we continue to like the long-term outlook for these two companies.
A free-trade agreement signed by Korea and China in 2015 governs almost $300 billion in trade of goods and services between the two countries, up from $215 billion in 2012. At the time the deal was signed, Korean president Park Geun-hye wrote in a letter to China’s President Xi Jinping that they had forged an “historic milestone in the countries’ efforts to deepen their strategic cooperative partnership.” But trading partners have differences from time to time, and trade restrictions are often used as political tools. Before the recent tourism clampdown, China also made headlines with moves to curb the activities of Korean popstars in China. Why is this happening? The most common speculation is that China is retaliating against South Korea’s decision to let the U.S. deploy an anti-missile system, Terminal High-Altitude Area Defense (THAAD), in the country.
Political ill wills can obviously cause volatility in markets. Our channel checks with Chinese tour operators and government officials confirm that China regulators are indeed discouraging visits to South Korea. But, interestingly, the campaign to ban low-priced tours may have some legitimate underpinnings. Many Chinese tourists who visit Korea (estimates vary from 20% to 40%) are motivated to go on group tours because of extremely low package prices. The most common package tour product to Korea costs no more than RMB 2,000 (approximately USD $300) per person, which covers accommodations and flights; some tours are as low as approximately $100. These cut-rate tours, however, usually include compulsory visits to undesirable or previously undisclosed shopping destinations, abbreviated visiting times at others, and sometimes hidden costs.
Such tour scams have existed in China for some time. What began domestically has spread to outbound tours including Hong Kong, Thailand, and South Korea. The Chinese government at both the central and local level has taken sporadic measures to regulate this market, but high-profile moves in cracking down on abuses have been rare. That may be changing; China’s tourism regulator issued an official notice on October 13, initiating a campaign to ban unreasonably low-priced tours from November to April 2017.
There is also a perceptible focus on curbing trips to Korea, likely for political reasons. Our research shows that local Chinese travel agencies are enthusiastically promoting package tours to the Philippines. These tours were banned, at one time, due to a territorial dispute between the two countries. In order to avoid scrutiny, travel agencies now tell us they are pushing trips to Cebu, Boracay, and Bohol in the Philippines that don’t have compulsory shopping activities.
Why don’t we view new travel restrictions as negative?
More than six million Chinese citizens visited South Korea in 2015, and it looks like 2016 will surpass that record. Some 80% of those travelers, according to the Korea Tourism Organization, named shopping as their top reason among many for visiting South Korea.
Both Amorepacific and LG Household and Healthcare have benefited from surging demand for foreign products and specifically for high-quality, Korean-based cosmetics by Chinese customers. The main reason for the demand is that there is a high consumption tax levied by China for imported cosmetics, and so Chinese consumers are keen to purchase their Korean high-end cosmetics abroad. As such, about a third of cosmetic sales from Amorepacific and LGHH’s cosmetics sales come from duty-free channels and more than 80% of those sales are generated by Chinese visitors seeking quality goods at discounted prices.
We are skeptical that the impact of travel restrictions will be widespread, and in our view the Korean cosmetics industry will not bear the entire brunt of any fall-off in travel. First, there are more than 26,000 travel agencies nationwide in China to be covered for this crackdown campaign. Actual guidelines and the intensity of the crackdown also appear to differ by region and there is no strict definition as such of what “low-priced” means. Also, similar crackdowns on tour prices in the past have proven ineffective. For example, in 2015 the China National Tourism Administration (CNTA) adopted a ban on tour packages that were 30% lower than its official published price ranges. The CNTA price recommendation for a five-day tour to Korea was about RMB 3,500, but package tours from Beijing to Seoul can still be had for less than RMB 1,000 per person on sites such as Qunar.com and Alitrip.com.
Why do we like Amorepacific and LGHH over the long term?
Amorepacific is Korea’s largest personal care company. It manufactures and sells cosmetics, hair care, medical products, cosmetic glass containers, tea raw materials, and printing equipment. The company has demonstrated a consistent ability to develop new and innovative products for the mass market to the premium segments in both Korea and China. This has resulted in establishing a strong brand and loyal customer base. It has also recently had strong success with a natural cosmetic brand called Innisfree, which it has aggressively rolled out over the last few years, particularly in China. We believe it has the best growth outlook among its competitors, both domestic and global. While duty free sales have been a tailwind in recent years, the company has been steadily building out a retail presence in mainland China. We forecast that Amorepacific should be able to compound its EPS at a rate of around 20% over the coming few years.
LG Household & Healthcare was founded in 1947 and is a leader in household goods including oral care, skin care, and laundry products. Its cosmetics lines have cultivated a following among discriminating cosmetic shoppers: Whoo is one of the top selling brands in Korea duty-free shopping, and the company’s efforts to improve brand equity are paying off among non-Korean consumers. The company has consistently delivered revenue growth of between 13% and 19% and is expected to show EPS CAGR of around 15% for 2016 and 2017.