Via Value Investing Letter, an interesting look at investing in Iraq:

Introduction

Euphrates Advisors manages the Euphrates Iraq Fund, which applies a contrarian, deep value approach to investing in Iraqi equities. This article is a modified version of the December 2012 Investor Newsletter. It describes our experience in this frontier market in 2012, and highlights some opportunities available in 2013.

Our full-year net return belies the volatile monthly path that got us there. In the first half of 2012, selling overwhelmed the thinly traded market in which we deal, pushing Iraqi equities down to levels not seen since the darkest days of the civil war in 2006. Foreign investors, many in the form of generalist frontier funds with single-digit Iraq allocations, lost their nerve at the first sign of trouble and hastily parted ways with their stocks. The relationship between business value and market price meant nothing, as they sold with a determination that only increased each day the market moved lower.

They did this despite the fact that the economic performance of most listed businesses on the Iraq Stock Exchange was never better. Their behavior exemplifies the perils of investing in things one does not understand. Decisions based on headlines and superficial analysis from subscription intelligence services often results in buying high and selling low, an activity we like to avoid.

While this causes short-term volatility and price declines, it is also responsible for the opportunities markets like Iraq offer a specialized fund like ours. By way of illustration, consider the open market transactions we made in Baghdad Soft Drinks as the selling “climax” materialized during the market bottom of mid-2012.

Taking the Pepsi Challenge

From January to June 2012, Baghdad Soft Drinks declined 38%. As the selling gathered strength and the price declines accelerated (causing the valuation of the operating business to become that much more attractive), the paradoxical urge among investors to sell only grew. To our astonishment, each morning it seemed we were greeted with larger and larger blocks of Baghdad Soft Drinks on offer until liquidations peaked in July.

Source: Bloomberg, Euphrates Advisors Research

This wave of selling by general frontier market investors who, we can safely say, never really knew why they owned Baghdad Soft Drinks, presented Euphrates with an opportunity we sought to fully exploit¹:

• From June to August 2012, foreigners sold 1.94 billion shares of Baghdad Soft Drinks.
• During the same period, Euphrates purchased over 781 million shares – or 40% of all the shares sold on the exchange by foreign investors during this period – within a price range of 0.96 – 1.12 Iraqi dinar.
• At the low end of the range, non-Iraqi investors sold us Baghdad Soft Drinks at 3.7 times 2012 earnings (ex-cash).
• We were able to buy 0.6% of the entire company at an average price of 1.03, just under 4 times earnings (ex-cash).
• By December 31, 2012, the market value of this stock had appreciated by slightly less than 50%.
• Since the summer capitulation, the company announced a .133 dinar cash dividend payable in the first half of 2013, equal to 12.91% of our cost basis.
• The company now trades at 4.6 times our estimate of 2013 net income (ex-cash).

This is precisely the kind of opportunity we welcome as long-term value investors in Iraq. Six months ago we could not imagine a scenario in which the domestic political problems in Iraq that triggered the market correction could have lasting fundamental consequences for Baghdad Soft Drinks’ business. Selling Pepsi in one of the hottest places on Earth is a slamdunk in almost any political environment (except perhaps Mayor Bloomberg’s New York City). And it is folly to think otherwise. At the risk of sounding like an Economics 101 textbook, the marginal propensity to consume Pepsi in Iraq is not remotely affected by the sometimes inelegant maneuverings of democratically elected politicians.

Perception vs.Reality

As we enter 2013, regional and international media continue their negative coverage of Iraq. Domestic opposition parties and Iraq’s wealthy neighbors have become quite good at advancing the narrative that Iraq is a “boiling cauldron of violence and terrorism,” to quote one former retired US Army General that now rents his influence to the highest bidding PR firm. While these statements make for entertaining television and reinforce inaccurate perceptions, they have no basis in fact. To be sure, as shown below, most major Iraqi cities are as safe – or safer – than their US peers. Najaf and Basra are both safer than Wichita. One has a better chance of being killed by violence in Miami than Baghdad.

Source: FBI Uniform Crime Report (2011), Iraq Body Count, Euphrates Advisors Research

Still, we do acknowledge the past four years have produced no shortage of high-profile security events. From gun battles in major cities to multiple-fatality terrorist attacks, political assassinations, and allegations of high-level complicity in extrajudicial murders, investors have endured just about every conceivable emerging market risk. Four years and 60,000 murders later, an impartial observer might characterize this state of affairs as a slow burning civil war. Never ones to sugarcoat, we are the first to admit the situation in Mexico is a decidedly bitter pill for equity investors to swallow.

Or at least it should be. Oddly, the same investment community that avoids Iraq due to its high levels of violence has no misgivings about pushing Mexican equities to record high valuations – despite a murder pandemic that has produced more fatalities in the last four years than the US military suffered over the course of the entire Vietnam War. As the table below makes plain, Mexico is objectively more violent than Iraq, has lower GDP and earnings growth, declining and lower oil production – and much more expensive equities.

Mexico vs. Iraq: Efficient Markets?

Source: Bloomberg, IMF, Trans-Border Institute, Iraq Body Count, Euphrates Advisors Research

As managers focused on Iraq, a market the vast majority of Western investors deem a “failed state” and “uninvestable,” we find the contrast with Mexico nothing short of astonishing. It illustrates how far investors depart from rationally discounting the same risk in different markets, misguided by narratives rooted in fiction. Iraq is a “failed state” (despite strong indications to the contrary) while Mexico offers “the promise of political reform” and “a reasonable risk-reward trade-off.” Once cemented into the conventional wisdom, these narratives take time to dislodge and can have a dramatic impact on investor behavior. Little wonder then, that international institutional investors, led by PIMCO’s Bill Gross, own more than half of Mexico’s $144 billion fixed-rate peso bond market².

While the pairing of Mexico and Iraq offers one of the most extreme examples of how investors assess the same risk differently in different markets, it also highlights the potential rewards that come from a contrarian worldview, provided it is ultimately correct. Since the Iraqi market is deemed “off-limits” by the global investment community, Euphrates is able to buy the country’s emerging franchises at fractions of their intrinsic value. This is notwithstanding the fact that Iraqi equities exhibit all the traits of what risk-bearing investors typically covet:

• They are uncorrelated to every major asset class, including the S&P 500, other emerging markets and crude oil.
• They have option-like return potential with no time decay.
• They are tiny, have dominant market positions in their respective industries, and could become giants in a petro-state rivaling Saudi Arabia and Russia.
• They are dirt cheap.

Iraqi equities nevertheless remain the lepers of the frontier market investment universe.

Looking more broadly at the market, it is worth revisiting current equity valuations in light of the rally Iraq experienced over the second half of 2012. Because Iraqi banks and other businesses periodically use rights offerings to fund their expansions, the best measure of relative business valuation is market capitalization – which accounts for changes in the number of shares outstanding – rather than a simple share price.

Below we show the changes in market capitalization and earnings since the previous market high in 2011.

Change in Market Capitalization vs. Change in Earnings at Selected Iraqi Companies
(2011 market high – present)

Source: Iraq Stock Exchange, Bloomberg, Euphrates Advisors Research

The valuations of the businesses we own, shown through declines in market capitalizations (and share prices), remain well below the most recent peak seen in 2011. At the same time the valuations of these businesses have fallen, however, earnings have continued to grow – in some cases exponentially. The result is the broad-based de-rating of the market we have witnessed over the last 15 months. We believe this creates strong, valuation-based support for Iraqi equities as we begin the new year.

¹ The Iraq Stock Exchange classifies all trades as Iraqi or non-Iraqi, which allows us to compile the trade history shown above.

² “Pimco Leads Bullish Investors Backing Pena Nieto: Mexico Credit,” Bloomberg November 30, 2012. While we acknowledge that Mexico’s greater market size and better liquidity are important for large institutions like PIMCO, in our own meetings and research we see no evidence that institutional market participants are pricing Mexican risk correctly. Indeed, many remain unaware of the absolute levels of violence and civil unrest prevailing in the country. The research we read from major sell side firms makes no serious mention of it.