Performance
The Asia Consumer Fund was up 5.9% in July, taking its gain year-to-date to 23.1%. The top movers this month were United Breweries (up 43% - see below), John Keells (up 22%) and Wumart (up 21%). 

Selling too soon
There is no doubt that based on short term valuation metrics Asia’s top consumer companies have enjoyed something of a re-rating. Our 26 holdings are trading on a 12 month forward PER of 23.6x on an equally weighted basis; whereas these 26 names have tended to trade in a range of 15 – 20x on this basis over the past ten years.

Investors, however, who are concerned about short term valuations are in danger of missing the bigger picture. For example, we foolishly sold our stake in Unilever Indonesia in February 2004 on valuation grounds, having made four times our money. We calculated then that the stock was on a 12 month forward PER of 20x. Fast forward six years and its revenues have doubled; its profits have almost tripled; and its share price has increased a further five times.   

We failed to foresee the way the business would expand both vertically and horizontally. Now food and beverage categories make up a quarter of sales while consumption per capita of premium items, such as skin care products, has more than tripled. Even so the company’s revenues still only add up to USD8 per Indonesian; and it is yet to introduce a multitude of other Unilever products. Despite almost eight decades of history in the country, its journey, in our view, is only just beginning.

The same can be said about United Breweries in India. At one point we owned almost 10% of the company, finally selling out in March 2007, having made five times our money, as the stock had reached what we, and, no doubt our investors, felt was an unacceptably high valuation.  But was an enterprise value of USD1.3bn so high for a company with 49% of the Indian beer market? Back then UB sold only 66 million cases, which worked out at less than 0.5 litres per person. Furthermore, its profitability was low with EBITDA margins of only 13%, on account of poor utilisation of its various factories and distribution network.

Again, fast forward three years, and its market share has increased to 52% and it sells 100 million cases. The company’s profitability, meanwhile, has improved dramatically as it harvests the benefit of economies of scale and pricing power that its dominance brings. With beer consumption in India at a mere 1.4 litres per person (the global average is over 20 litres), the annual 30% revenue growth recorded for the past five years could last another decade before slowing.

Meanwhile, we have only been able to buy back 2.2% of the company; how clever we would look now if we still had that 10% as the stock is up 90% year-to-date.

Dominant consumer companies operating in emerging markets have the potential to evolve and grow earnings in ways that a simple “S curve” analysis cannot capture. For example Nestle India, has yet to launch a number of its parent’s blockbuster products, the likes of Perrier, NaturNes Gerber, Pure Life bottled water and Buitoni pasta. Glaxo India has not yet introduced brands like Lucozade and Ribena.

The same argument applies for indigenous emerging market companies like Tingyi and Want Want, which nowadays are very different businesses to those that listed a decade and a half ago. Today, these firms have spread way beyond their noodle and rice cracker origins, offering an array of other F&B categories. Both have exploited the power of their brands (Want Want’s “Hot Kid” logo is known throughout China), their logistical prowess (Tingyi’s distribution network is second only to China’s postal service) and their ability to launch new product lines.

These transformational characteristics are arguably the source of dominant consumer companies’ habit of significantly out-performing wider stock market indices.  Time and again, we have learned the hard way that no valuation methodology, whether a PER analysis or our own “Arisaig Crystal Ball”, can adequately reflect this capacity to generate long-term alpha.

Growth
It is hard to comprehend, when not sitting day-to-day in an Asian office, quite the extent of the growth opportunity. Take this month for example. Four of our holdings have reported quarterly results as follows: United Breweries, net profit up 114% year-on-year; Korean cosmetics and household products group, LG H&H, net profit up 55%; Vinamilk, Vietnam’s dominant beverages company, net profit up 49%; and Colgate India, net profit up 18%.

Colgate’s market share in India has now reached 53% in toothpaste and 41% in toothbrushes, both up significantly on last year. For sure, its competitors like Unilever, P&G and Glaxo will turn up the heat, but as we have seen from Brazil, once Colgate gets its head this far in front of the chasing pack it is very hard to knock off its pedestal.

Its market dominance means that it can spend 15% of its revenues on promoting its products, which it does by sponsoring oral hygiene education in schools and villages, and yet still earn 20% net profit margins. Given that monthly household consumption of toothpaste is still only 115 grams in India, less than half that of China, and one third of that of Malaysia, many years of growth seem assured.  

Our 26 names, excluding Jubilant Foodworks which only listed this year, have generated on average a return to shareholders, net of dividends, of 26.3% per annum over the past ten years. Based on what is unfolding before our eyes we see no reason to believe that this number will be very different over the coming ten.

Reform in India
As we often say, Indian companies have done well despite being Indian. Turn up the heat of reform, allow the treacle in which they wade to warm, and who knows what they might achieve. 

So it is with some excitement that we can report that things are finally starting to change, thanks largely to the fact that the Congress Party, led by the mild mannered Manmohan Singh, who was responsible for the reforms of the early 1990s, has a solid mandate. With no elections on the immediate horizon, he has the best opportunity in decades to liberalise the economy. 

His recent decision to stop subsidising gasoline was a bold move, and one which will no doubt be unpopular in the short run. But with a fiscal deficit of 6.6% of GDP, the USD10bn cost of fuel subsidies is too great a burden for India’s underdeveloped tax base to support.

What’s more, it now seems that the country’s USD350bn retail sector may finally be opened to foreign direct investment. Singh’s government seems to accept that bringing in the expertise of the likes of Tesco and Carrefour is the best way to reduce the supply bottlenecks that contribute to scandalous levels of food wastage and double digit inflation.  

Investors stand to benefit from the country’s adoption of International Financial Reporting Standards (IFRS) next year. A further proposal to make all listed companies maintain a minimum free float of 25% is being interpreted as a step towards the long overdue privatisation of the cumbersome state-owned companies.

Meanwhile, the introduction of a Goods and Services Tax (GST), a new Direct Tax Code and the potentially revolutionary Unique Identification Scheme (UID) will simplify and widen the tax base.

Sri Lanka travels
Vinay and Puneet visited Sri Lanka, which is finally enjoying peace after three decades of conflict. Even the shabby circumstances surrounding President Rajapaksa’s re-election seem to have done little to dampen the atmosphere of optimism. 

The pacification of the northern and eastern regions has meant that the territory under government control has grown by 25%. These provinces were once the rice bowl of Sri Lanka, but production dropped to 15% of peacetime levels during the war. Agriculture is now booming: the sector in the eastern province recording year-on-year growth of 37% during the first quarter of 2010.

Surging food production is already pulling down inflation, with the headline number recently falling below 5% for the first time in living memory. Interest rates are expected to fall to single digit, a boon to investment activity.

With the war now over tourists are once again flocking to this beautiful island. Indeed, tourist arrivals were up 48% year-on-year to end June. Even so, the total number of people visiting Sri Lanka, at 500,000, is still absurdly small. Compare this with the 21 million who visit Malaysia or the 15 million who visit Thailand.

Our holding Aitken Spence, the second largest hotel operator in the country, expects both room rates and occupancy levels to double from the USD60 and 40% levels of last year. So far we have made 16 times our money on this investment but there is much more to come.

The return of infrastructure spending, with USD3bn forecast for each of the next five years versus virtually zero in each of the past five, will be a fillip to consumption. Our other Sri Lankan holding, John Keells, reported 45% volume growth last quarter in its soft drinks business and 15% same store sales growth in its supermarkets. Meanwhile, its ports business will benefit from the increase in domestic trade, which still only accounts for 15% of container arrivals, the balance being the much less profitable transhipment to India. 

Interestingly, much of the investment in new port facilities is expected to come from China, which is competing with India to extend its strategic presence in the region.  If there is a cloud on the horizon, it is that Sri Lanka may soon find itself caught up in a new “Great Game” between Asia’s two emerging superpowers.

Performance
The NAV per share of the Africa Fund rose 5.4% in the month of July. Our return for 2010 is now a positive 15.7%.

A number of our markets did well this month. In spite of general nervousness, the Turkish and South African exchanges decided risk was back “on” and rose 13.8% and 13.2% respectively in USD terms.

Casablanca
Torquil, Damian, and JK were vagabonding at the end of the month, visiting Casablanca to see our three holdings there.

Morocco is a land of reliefs. On the one hand, the sophistication of the coastal strip and cities like Marrakech, filled with affluent Francophone professionals and retired “troisieme-ageurs” seeking refuge from Europe; on the other, the austere existence of the rural communities of the Atlas, prospering and struggling alternately as the rains dictate.

Morocco continues to post GDP growth in the 4-5% range and with 77 companies on the stock exchange there is enough breadth to satisfy most investment criteria. That said, it was clear from our meetings that foreign activity over the last few years has generally been at a low ebb.

First up was Label Vie, which listed in 2008 and which we have owned since April. This is the number two retailer in a very fragmented market. It runs a chain of 28 supermarkets and two hypermarkets, the latter in a JV with Carrefour.

Though Label Vie’s founders initially wished merely to join the ranks of the 60,000 “maman et papa” retailers which dominate Morocco, in the last ten years these objectives have become much more ambitious. The original shareholders agreed in 2002 to take in external capital and the fuel for expansion was in place. Today it has a 13% market share in formal retailing in a landscape of only 100 such outlets (11% of the overall market).

The company seems to have the momentum to maintain a healthy rate of store opening and growth. We expect the top line to continue to grow at 30-50% for the next few years. Volume and scale should help to improve ROCE, which is only now rising above 10%. Although Label Vie trades at 25x 2010 earnings and 16.5x 2011 we expect that the pace of growth of its store network will burn off this multiple rapidly.

Our meeting at Brasseries du Maroc focused on recent tax changes which will dampen turnover for 2010, although with core net profits should remain flat year-on-year. We expect that the non-recurrence of one-off tax charges from 2009 related to a historic merger will mean that headline profits will rise.

The stock has had a rough 2010 so far but was one of our bulwarks in 2009, rising 125.0%. With a generous dividend policy and a 30% ROCE we see this as a “steady-eddy” position.

Finally we met Centrale Laitiere. In the last six months we have managed to pick up much of the free float in advance of the planned sell-down by ONA and a proposed share split. These technical factors should bring this high quality business, 29% owned by Danone, to the attention of a wider audience.

Over the last ten years this operation has embarked on a concerted brand-building programme in response to the emergence of a local competitor. Consumption of dairy-derivative products (yogurts, fruit compotes et al.) has risen from 4kg to 12kg per head per annum driven by a promotional campaign emphasizing their nutritional value and attendant health benefits.

At the operating level the company is clearly prospering, with a 60% market share both in milk and in dairy derivatives, generating a 35% ROCE. Profits should grow 9% this year to around USD75m, putting the stock on 16x forward earnings.

Pyramid Scheme
Damian and JK then pushed on to Cairo to meet a couple of interesting food and beverage companies, albeit with great difficulty. It has always been a big, challenging place and has become even more hectic in the last year.

Part of this is due to the continued exodus from downtown, tacitly encouraged by the government. The Egyptian middle class is settling in a perimeter of settlements based around a new ring road that is quite distant from the historic city.

In many ways Egypt is very reminiscent of China.  The government is pushing an export-led growth model which is both capital- and labour-intensive, exploiting its large mass of unskilled young workers and its proximity to European export markets. We met a number of standard bearers of this push, including Oriental Weavers and Olympic Group.

We were impressed by management and their determination to build scale and competitive advantage in their markets.

We are satisfied that we have good exposure to this market through our perennial holding, Commercial International Bank which has continued to report good results. With a forward earnings multiple of 12.5x and a consistent 20-22% ROE it is a both affordable and high-quality play on the entire economy.

In Other News
The South African retailer, Shoprite, reported excellent results for the year to June 30, with sales increasing 14% year-on-year. The most exciting part was the 18% increase in Rand value of their ex-South Africa operations.

Nestle Nigeria reported excellent first half results. Revenues increased 25% and earnings increased 46%. As we anticipated, new capacity is being absorbed as soon as it comes on line. This rate of earnings growth and cash generation will rapidly burn away the heavy gearing incurred in FY09’s capex frenzy.

The parent, Nestle S.A., has announced its plans to invest USD943m in its African operations by 2013. Currently Africa makes up only 3% of its total revenues. We expect this figure to change dramatically in the coming decade.

Likewise Unilever Ghana looked good in the first half. Sales grew 6%, although this does not capture the effect of discontinued low-margin products, whilst earnings recovered sharply from last year’s GHS1.5m loss to a GHS8.6m profit.

On an annualised basis, the company now trades at 14x forward earnings, although this excludes the likely cash benefit of the pending sale of part of its palm oil plantation assets to Wilmar of Singapore, which will probably represent a one-off gain of about GHS15m.

This, the largest provider of FMCGs for a youthful and oil-rich nation of 25 million people, has a market cap of USD156m, is highly profitable and pays a 7-8% yield (depending on the Wilmar transaction) – all in all, in our view, a bargain.

Performance
The NAV of the Latin America Fund increased by 12.2% in July. The Fund is up 19.6% year-to-date which compares to a flat performance for the MSCI Latin America (Net) Index. Since becoming fully invested in October 2009, the Fund has returned 41.6% versus a 10.7% performance for the MSCI Latam Index over this nine month period.

James, Rui, Joao and David Lanning, our new recruit to the Latam squad, who has just completed a Masters in Latin American Studies at Oxford University, will be doing a tour of Brazil and Mexico in early September, re-meeting all our holdings plus other candidates.

James and Rui will then be presenting the Fund to Arisaig investors and interested parties in Europe in the second half of September and in the USA through October. The Fund will open for subscription on 1^st November. Our goal is to raise up to USD100m from existing Arisaig investors who already own our Asia and Africa Funds, plus others that believe in the case for dominant consumer companies in Emerging Markets.

Chile
We wrote about Mexico in May and Colombia in June. July sees the turn of Chile, a country which we have now visited six times in the past 18 months and where we have three holdings accounting for 10.8% of the Fund.

Once a miserable mining outpost locked between the Andes and the Pacific, beset by an inhospitable climate that swings from bitter winters to sweltering summers and with a GDP per capita on a par with Peru’s, Chile is now, by some distance, the richest and the most stable country on the continent.

Surprising as it may seem, much of the credit for the transformation goes to the widely vilified General Pinochet who, in between torturing and massacring his people in the late 1970s and 1980s, introduced far-reaching economic changes, many of which were modeled on Germany. These included granting independence to the Central Bank; establishing a stabilisation fund that sets aside the profits of the state-run copper mining industry; launching a central provident fund, similar to Singapore’s, to pay for private sector pensions and health care; and initiating a privatisation process that saw 30% of the stock market pass into local individual hands (with a further third owned each by local pension funds and foreigners).

Politically, Chile is more stable than any other country in the region. Following 20 years of left-wing led coalition rule, November 2009 saw the election of the centre-right Sebastian Pinera, an energetic entrepreneur in his mid-forties, who made his billions developing the local airline, LAN, into one of the best in the region. His team of Harvard and Chicago trained ministers are expected to implement liberal, pro-business policies.  

The Stock Market
The capitalisation of the stock market stands at USD270bn of which 16% are mining companies and a further 14% banks. Although there are 22 names that might qualify as being consumer businesses only five or six are, in our view, investible.  

Indeed, one feature of Chile which sets it aside and, arguably, makes it a less attractive investment destination than say Brazil, is that many of the sectors we follow are already highly consolidated. For example, three pharmacy chains control 96% of the market whereas in Brazil there are about 200 chains with the largest (one of which is Drogasil, which we own) controlling only 5% of the market.

The Retail Sector
In the retail segment, three groups, the impressive Falabella and the much less impressive Cencosud and Ripley, dominate across all segments, from supermarkets to department stores and from DIY chains to mall ownership and management.

Unfortunately, these are more financial companies than retailers, making their money from their credit card and consumer finance activities whilst their retail margins are often negative. Their huge asset base means that ROCEs are very low. This, combined with high exposure to interest rate swings, means that they have proven to be poor long term investments.

If Chile has an Achilles’ heel, it is in the surprisingly large build-up of credit offered to customers by these stores. In fact, this is a phenomenon we see across much of the region, one best explained as a hangover from the era of hyperinflation which seems to have left a deep-seated desire amongst consumers to buy as much as possible on credit. Astonishingly, it is possible to buy items as cheap as a simple USD5 “T” shirt on credit paying in six monthly installments with customers seemly indifferent to the exorbitant interest rates that they are paying.

These three retail groups offer between them 12 million active store cards which, together with the six million issued by the local banks, add up to far too many for a population of only 16 million people. With the Central Credit Bureau only retaining negative data on borrowers there is nothing to stop card owners from rotating their debts from store to store. Indeed, this activity has mushroomed in recent years, mirroring the debt boom elsewhere.

The business model works on the basis that default rates of about 8% cover the 4% per month interest charged. But clearly, if either default or interest rates rise, then profits are severely impacted. As this activity is funded by commercial bank loans, profitability tends to be highly volatile. In our view, this sector should not exist. It only does so because of excessive restrictions on banks’ consumer finance activities. Meanwhile, low income customers subsidise rich customers who do not buy on credit but enjoy the low retail prices that are a feature of the system.

Favouring, as we do, businesses with low fixed asset intensity, and reasonable predictability of earnings, this feature makes the retail sector in Chile uninvestible for us. This is unfortunate, not least because it would otherwise be the best way of gaining exposure to the larger and higher growth markets of Colombia and Peru, where the three Chilean retailers are all now focusing.

We have, instead, focused our attention on a smaller group of companies which have no credit or financing operations and which dominate the consumer sectors in which they operate. The Latam Fund currently owns three of these, accounting for 10.8% of the portfolio: Compania Cervecerias Unidas (CCU), the dominant brewery and soft drinks group, Forus, the largest shoe retailing chain in the Andean region, and Farmacias Ahumada (FASA), the largest pharmacy chain in Latin America. 

Compania Cervecerias Unidas (CCU)
CCU dominates the Chilean beer sector with an 85% market share. Owned 66% jointly by Heineken and the Luksic family, who also own the largest copper mine as well as the largest bank, CCU is a rare success story in a sector otherwise dominated in Latin America by ABInbev and SABMiller. Indeed, ABInbev controls the other 15% of the Chilean beer sector in a somewhat cozy duopoly.

With beer consumption still quite low at 37 litres per head, the sector in Chile has ample scope to grow further, as well as being something of cash cow to fund other initiatives, including beer in Argentina (CCU is the number two player with a 22% market share), mineral water and juices, which it dominates with a 55% share, and wine. Indeed, CCU is the joint venture partner of choice in Chile with bottling and/or distribution agreements with the likes of Nestle in purified water; Lipton in ice tea; Schweppes in soft drinks; and Pepsi and Cadbury in confectionery.

The company is one of the cheapest brewers in the world trading on 12x 2011 earnings and generating a 4% dividend yield. For such a profitable brewer (EBITDA margins of 32% - amongst the highest in our universe of beer stocks) the company’s ROCE at 20% is on the low side, weighed down by the inventory-heavy and low margin winery. We regard the stock as a steady eddy, likely to be gradually re-rated over time and, as one of the last independent brewers on the continent, a potential M&A target. 

Forus
Forus is a mid to high end shoe retailer with 20 brands equally split between its own and international marques, such as Merrell, Columbia, Hush Puppies, Caterpillar and Church’s. Whilst the company’s main focus is on Chile, where it has 191 outlets, it is rapidly becoming the dominant player in Colombia, Peru and Uruguay, which already account for 15% of sales.

The founders, the Castanera family, whom we know well (we have met them seven times) still own 72% of the company and are very hands-on. One of the main strengths of the business, in our view, is the dependence placed upon them by Wolverine, the owner of the international brands, who see Latin America as a major growth driver and Forus as an important partner given the Castanera’s long history of sourcing in China. Another strength lies in the boutique nature of their outlets which find favour with customers looking for a more personalised shopping experience than is on offer from the credit-focused department stores that dominate the Andean retail scene.

Forus has compounded its earnings at 20% per annum since listing in 2004 and trades on 8x 2011 EV/EBITDA. 

Farmacias Ahumada (FASA)
Our third holding, FASA, is the largest drugstore chain in Latin America. Originating in Chile where it runs 347 stores with a 30% market share, it is also number two in the highly fragmented Peruvian market, with a 5% market share and 162 stores, having bought Boticas Fasa in 1995; and number two in Mexico with 716 stores, having bought Farmacias Benavides in 2003.

Although there is no doubt that the Chilean market, which accounts for 30% of profits, is slowing, our interest in the company lies in its Mexican business where it makes a very low return. Having met the management of Benavides in Monterrey, as well as of its main competitor, Fragua, in Guadalajara (a stock we also own), we believe Benavides is well placed to do better.

Clearly we were not the only ones to take this view as Casa SABA, Mexico’s largest pharmaceutical distribution company, made an offer to acquire FASA in May which has been accepted. We decided to retain our stake for now, but await more detailed announcements on SABA’s strategy.