Via Capitalist Exploits, an interesting interview with Clemente Cappello of Sturgeon Capital, who has been making Central Asia his core area of focus for the past 5 years:

Chris: Clemente, can you illustrate the macroeconomic case for investing in central Asian countries?

Clemente: We often say that we’re not trying to be the smartest, most sophisticated guys in the market with our strategies. We like to make the “dumb” trade. By that we mean: Invest in fast growing, low debt, cheap markets, avoiding the usual Frontier Market pitfalls of counterparty risk, outright frauds, etc. It’s much easier to do well with the wind at your back. Simple (but not easy, as Warren Buffet would say).

So quite simply, the macroeconomic case for the Central Asian economies can be made by highlighting three key points:

1. The region is awash with (relatively unexploited) natural resources. More importantly, and particularly in relation to oil and gas, production and exports are rising. Coupled with a low cost base for Central Asian natural resource companies and a relatively attractive fiscal policy, regional producers and exporters stand to benefit much more than, say, those in Russia, where government taxation means Russian producers have much less exposure to upside. Conversely, with rising production and a low cost base, Central Asian producers are also able not only to tolerate but to continue growing in a low commodity price environment. This capitalisation on the current commodity super-cycle have seen some Central Asian countries post impressive GDP growth and maintain and continue strong economic profiles e.g. very low Debt/GDP ratios with well managed Central Bank policy;

2. So, we have a region capitalising on a wealth of untapped energy, metal, mineral and other natural resources, which is relatively well-placed to weather volatility in commodity prices, which has also witnessed some of the most rapid per country GDP growth in the world in recent years. Secondly, add to that the fact that these markets are literally in the middle of three of the 5 (including South Africa) BRICS countries i.e. Russia in the North, India in the South, China in the East. China, and more recently India, are spending billions of dollars investing in infrastructure and licenses to secure supply for their own booming economies. So if you like, investing in Central Asia is a bit of a leveraged play on the South East Asian growth story. If Asia is the supplier to the West, then we’re investing in Central Asia as “the supplier of the supplier”;

3. The third key point to make is that these equity markets are cheap. Not only the local markets (although the Kazakhstan local index is down around 70% off of its 2007/8 highs, and is currently trading at a 50%+ discount to both the MSCI Frontier and Emerging Market Indices), but also companies that can be classified as mid-large cap companies, listed in London, Hong Kong, New York, Toronto, Sydney, etc. that have a substantial exposure to Central Asian economies. These businesses have suffered from (a) a chronic lack of mainstream analyst coverage which has led to (b) the categorization of poorly understood “Central Asian” stocks as the first to go as a “sell” in a portfolio in a general “risk off” environment. We’ve continued to see quality companies continue to increase value for shareholders by various value metric estimations (earnings per share, dividend per share, etc.) and institute markedly improved corporate governance, yet see their share price pushed to unjustifiable lows. Historically, fundamentally and relatively, these markets are cheap. It’s not something we’ll often say, but in this case, companies have delivered but investors have not.

Chris: Some of the largest known reserves of natural resources in the world are sitting in this region. Kazakhstan alone holds the 3rd largest known Uranium reserves, 4th largest natural gas reserves, and large gold, coal and oil reserves. Resource wealth doesn’t automatically translate into regional wealth… just look at the DRC. What makes this region different, and why now?

Clemente: You used the example of the Democratic Republic of Congo there, which is quite pertinent given that we often hear from certain investors to whom we speak regarding the region say, “but what about Africa, isn’t that the best part of the world for frontier market investments right now?” Whilst our expertise does not lie in African market investments, from what we do know, we would say that compared to Africa, Central Asia has a very different, and we would argue from an investors perspective, much stronger heritage in terms of its history and culture.

Most notably, as it has seen a 21st Century re-emergence, the region was once the way of the old Silk Route named after the lucrative trade in Chinese silk which began over 2000 years ago. This soon became the lifeblood route of trade between Europe, Africa and China, covering most of the civilized world. Various parts of Central Asia have been a large part of the Mongol, Alexandrian, Persian and Turkic empires.

More recently, for all of its failings, the Soviet Union maintained and built upon relatively high levels and broad education across the Central Asian countries. A relatively high level of education across the region still exists today.

What this means for us as investors is that we have a long-standing and deep-seated tradition of trading and merchant culture, with a high level of education in a relatively young population. This equates to an educated, able and competitive workforce for local companies. There are a lot of very smart young executives and entrepreneurs who, having moved abroad and had the advantage of experience in developed market companies and business and finance schools, are returning to the region to develop and head up many local businesses.

This further translates into a good understanding by local management of proper corporate governance, management and business development strategy and practices. Regional companies listed on developed market exchanges such as the London Stock Exchange are viewed by many as a matter of national pride and a sign of the significant progress and potential for Central Asian economies.

For us as investors, these qualitative influences are ultimately expressed as this translates into better corporate governance and genuine corporate concern for shareholder interests (versus some other Frontier Markets where the shareholder is last on the list of stakeholders in the equation for both co-owners and managers alike).

Chris: Well, as a guy who grew up and has traveled extensively throughout Africa I can certainly see your points… What is the banking system like? Give me an overview (of course there are lots of different countries so let’s pick one country and we’ll delve into others later on.)

Clemente: You’re right the story is different across the region. In general, the more sophisticated banking markets suffered significantly from the effects of the 2008/09 early stages of the current global financial crisis. The less sophisticated escaped largely unscathed.

The Kazakh banking sector is the most mature, developed and sophisticated banking sector of the region. The sector is still recovering from the heavy losses sustained by one if its biggest banks, BTA, which has undergone two substantial re-structurings, seeing the government inject several billion dollars into BTA and other casualties in the sector. There are two points to note here:

1. In general, the governments/sovereign wealth funds/central banks are all well capitalized. For example, both Kazakhstan and Azerbaijan have strong GDP growth, increasing revenues from oil and gas exports and Debt/GDP levels of 15% and 5% respectively. Both relatively young Sovereign Wealth Funds have between 30 and 40 billion dollars, and are growing fast;

2. As the fundamentals of the economies of the region continue to improve and recover post-2008, the banking sector benefits. For example, non-performing loans (NPL’s) have been reduced by the strong and continued GDP growth in the region, and real estate prices have stabilised and in some parts of the region, such as Kazakhstan’s “regional business capital” of Almaty, have even begun to show signs of modest growth.

Chris: What is liquidity like and how do you deal with that?

Clemente: As an investor we like to start from a macro view so we always have our research looking both outward and inward when we’re looking at Central Asian markets. From this perspective, we see that liquidity is low in general, both globally and locally, when it comes to equity markets. It is something we tend to look at quite closely. There are two sides to the listed equity space for the region as we view it: you have the Central Asian listed companies, so companies listed in Georgia, Kazakhstan, Uzbekistan, Mongolia, etc. These are, with a few exceptions, relatively illiquid stocks. Then you have the mid-large cap, developed market listed, multi-billion dollar companies such as ENRC, Uranium One, Dragon Oil, Kazakhmys, etc. These are companies which still have good liquidity, and which have seen their share price hammered by a lack of good coverage by analysts/investors, leading to most Central Asia-related stocks being homogeneously categorized into the first “sell” of a “risk off” mentality.

For this reason, these are the stocks that we’re focusing on right now. Our view as regards listed equity right now is this: why take additional local market liquidity, counterparty, currency, etc. risks when multi-billion dollar developed market listings that are from or substantially related to the area are trading at such attractive prices?

Chris: How cheap? PE? Dividend yields?

Clemente: Just as an example, using what we view as the most mature listed local market in the region, Kazakhstan, the above chart shows the KASE trading at 2012 and 2013 PE ratios that are half that of the MSCI Frontier and Emerging Market indices, and even at a discount to Russia. This data is from 24 April 2012, so the valuations are even more compelling today.

Regarding dividend yield, KazMunaiGas currently has a dividend yield of around 7.8%. So yields are similar to Russia but the companies have a much stronger growth profile, and benefit from stronger corporate governance and a stable political environment.

Chris: Do you focus mainly on the resource sector or do you look to capitalize on GDP growth in the region in general.

Clemente: We’re not focused on the resource sector per se, but given that we’re investing in frontier and emerging economies, there is naturally a greater weighting across the entire investable universe towards industrials and the resource sector, and on top of that Central Asian growth is currently driven by natural resource and oil and gas exports. Having said that, our default position is a preference to capitalize on GDP growth in the region in general. We like to go where the oil and resource wealth is headed, so to financials, consumer, manufacturing, agriculture, etc. rather than only focus on one particular sector. Chris: What are the biggest impediments to doing business in this region?

Clemente: I suppose practically one of the biggest impediments for new comers is that there is still a lot of Soviet-era bureaucracy when it comes to brokerage accounts, licenses, business registrations, etc. Although, most notably Georgia, and increasingly Azerbaijan and Kazakhstan have implemented significant changes to remove or substantially improve these processes. For example, Georgia was recently ranked as the world’s top reformer in a World Bank survey.

Chris: You’ve been involved in the region since 2006 or so, can you give me a little colour as to what you’ve seen evolving during this time.

Clemente: In a word, the region has become much more internationalised. Particularly Azerbaijan, Georgia, Kazakhstan and Mongolia. Uzbekistan, Turkmenistan, Kyrgyzstan and Tajikistan are still relatively more closed and/or less well known, but since 2006 that is also something that we have seen gradually begin to change and this change has gained momentum lately with interest from the Middle East and Emerging Asia investors.

The oil and gas revenues in Kazakhstan and Azerbaijan, the natural resource wealth that has begun to be exploited in Mongolia and the substantial reforms undertaken in Georgia have all attracted positive investor and general attention from the developed world. Sovereign wealth from the Middle East and Asia, obviously China and India, and big corporates from the US and Europe have all become substantial investors in one or more of the Central Asian economies.

Chris: The money flow is undeniable. As a large sovereign operating in the same neighborhood, more or less, how could you not deploy some capital in these places. It’s where the growth is coming from right now. Corporate governance is always an issue in frontier markets. How do you deal with this?

Clemente: The short answer is research. You really need to know who you’re dealing with and who you’re investing alongside in these markets. We spend around half of our time there and have teams on the ground in Azerbaijan, Georgia and Uzbekistan (Kazakhstan and Mongolia soon to follow) that maintain our information edge. This keeps our finger on the pulse, and gives us, hopefully, a more rounded combined macro and micro view.

Not everything that you read in the mainstream financial press regarding companies from the region provides the unbiased “full picture” (shocking, I know), but similarly to be in these markets 100% of the time can lead to a rose tinted view. It’s important to step back and take a realistic view of these companies.

Not only do you need to know the company that you’re investing in, but also the companies with which that company contracts and does business. There is a lot of cross-ownership in these markets as many of the dominant companies have grown out of a relatively small group of early conglomerates.

There may be some cases where the CEO of a company we’re looking at is also a shareholder in a major supplier to that company. That doesn’t mean that we’re never going to invest, we just want to know this, have the conversation with the CEO, and be comfortable that as shareholders our interests are aligned and prioritised as we would expect them to be.

To help us with this, we also sometimes use business intelligence companies to get a real three dimensional picture of the company and its ownership and management structures and relationships.

Chris: I’m not going to argue that Kazakhstan is the epitome of safety, good corporate governance and superior political structure but I’ll buy most anything at the right price. When looking at Kazakhstan the market as a whole trades around 4.5 price to earnings. When I look at India it trades at about 15.

Now the question really is this: Is Kazakhstan 3 times more risky for my capital? The second question relates to the upside? Does India provide me with more, the same or less upside potential than Kazakhstan? What are your thoughts on that?

Clemente: Again, I’ll refer to our old friend Warren Buffett in taking the view that when it comes to pricing, buying with a margin of safety reduces risk. On the other hand, Kazakhstan could go to zero, and this is not something that is without precedent historically. Our view is that if the world does not fall apart, regardless of double-dip, austerity in Europe, Grexit, China hard landing/soft landing, etc. then Kazakhstan and the Central Asian region in general will do very well.

The Kazakh, and eventually other regional stock markets, should compound this as (a) companies grow substantially and (b) valuations catch up with, at the very least, the frontier markets average and possible more if we see the region become “trendy” (as we saw with the BRIC countries in the early 2000’s).

Chris: Which is your favourite market in the region? I spoke to Paul Henderson and he has lived in Azerbaijan for several years previously. This market has been growing like a weed on steroids. What’s happening over there?

Clemente: Today, my favourite market, and the easiest to invest in in our experience, is Kazakhstan. The country has a relatively developed local stock market and several attractively priced mid-large cap companies listed in developed markets. Local business and finance infrastructure and services providers are good, and importantly, corporate governance is of a high standard compared to other frontier market economies, and certainly compared to Russia.

For the future, we continue to keep an eye on less developed capital markets such as Azerbaijan. There a number of private equity and fixed income opportunities there, but the stock market is still in the very early stages of development.

One of the most interesting markets is Uzbekistan. The local listed market is quite vibrant (versus others in the region) and the private equity opportunities we are seeing are very promising. There are some issues with currency controls and repatriation of profits, as well as the usual bureaucracy issues of an emerging post-soviet economy.

We have invested in infrastructure for the future, acquiring 33% of a leading independent investment banking and brokerage business there, and have recently made our first investment via the Sturgeon Central Asia Fund as well. Uzbekistan, and its neighbour Turkmenistan, are ones to watch, although we’re probably 3 – 5 years early (where we like to be).