Dear Investors and Friends,
March marks the one-year anniversary of the launch of the AFC Uzbekistan Fund (AUF) on 29th March 2019. The fund launched with assets under management of USD 1.3 mln and ends its first year at USD 4.5 mln.
Much happened in Uzbekistan in March including the Agency for State Asset Management establishing a plan for the privatization of 81% of the government’s 2,965 state-owned enterprises, the elimination of cotton quotas for farmers and the unfortunate arrival of COVID-19. Nonetheless, some of the global developments related to COVID-19 dramatically enhances our conviction for investing into Uzbekistan as the country is increasingly recognised as a regional exporter with the largest manufacturing and agro-industrial base in the region and as its guaranteed supply of USD foreign exchange through monetizing its robust gold and commodities reserves should ensure a strong fiscal buffer. Amid these positives, the final few days of March saw increased sellers in the market which led the March NAV of the fund to decrease to an estimated USD 990 (-8.0%), -1.0% since inception, according to internal calculations.
AFC Uzbekistan Fund valuations as of 31st March 2020:
| Estimated weighted harmonic average trailing P/E (only companies with profit): |
3.87x |
| Estimated weighted harmonic average P/B: |
0.65x |
| Estimated weighted portfolio dividend yield: |
4.93% |
The negative performance for the month occurred in the final days of March. We attribute this to two events:
The first is our largest holding in the portfolio, Qizilqum Cement (QZSM), which announced it would not pay a dividend for 2019 in order to self-fund a 1.1 mln ton per year capacity expansion, estimated to cost USD 110 mln. By suspending its dividend, QZSM is planning to use the USD 57 mln of cash on its balance sheet (the current market capitalization is USD 69 mln) to self-fund. We, like other shareholders would have preferred to have seen a dividend cut rather than a suspension and QZSM to finance a portion of this project with debt, since the company is debt free (Uzbek companies keep very strong balance sheets with very few holding debt, a net positive as the rest of the world faces unsustainable increases in debt). QZSM historically payed a dividend resulting in a low teens dividend yield, thus being the main attraction to local investors as opposed to the immense growth and earnings potential of the company. This led some large sellers to come into the market during the final days of the month, suppressing the share price.
The second contributor to the negative performance for the month was likely the government’s actions to suppress the spread of COVID-19 (discussed in further depth below). On 29th March the government announced private vehicle usage would be banned from 30th March onwards unless owners obtained special permits. This short notice is likely to be what caused a spike in selling across a number of our holdings as investors (mainly employees of these companies) sought to increase liquidity in order to cover daily living costs, with the current ban on private vehicles to remain through 20th April when it is planned the lockdown will be lifted.
Of course we are displeased with our performance for the month, though the effect of QZSM being sold down only shows to further highlight the deep value on offer in Uzbekistan, with the catalyst being a transformation of the capital markets and rising demand for cement combined with the government seeking to privatize a portion of QZSM, likely to a foreign operator. QZSM ended March with a P/E of 2.41x, P/B of 0.41x and an EV/ton of installed capacity of USD 3.51 (replacement cost for a new cement plant in Uzbekistan is estimated at between USD 100 to USD 125 per ton).
Uzbekistan one year since fund launch:
The past year has seen Uzbekistan experience growth and transformation across many areas of the economy and society. While still facing very obvious challenges, including capacity constraints in government and execution of the dozens of backlogged presidential decrees signed as part of the country’s liberalization, things are certainly moving in the right direction. Some of the notable changes include the elimination of all capital controls, the liberalization of restrictions on foreign ownership of bank shares, the Uzbek Som being freely floated, legislation passed permitting the privatization of all non-agricultural land (previously all land was government owned and secured on long term lease) and a privatization strategy to sell down 81% of the government’s 2,965 state-owned enterprises through either auctions or the Tashkent Stock Exchange as the state currently represents an estimated 55% of GDP.
These reforms over a short 12 months are impressive. The coming 12 months should see Uzbekistan’s strengths become clearer to investors with the onset of the virus crisis. These include Uzbekistan’s regional manufacturing dominance, domestic sources of foreign exchange (namely gold and other commodities) and low debt levels which will help to buffer it against a dramatic slowdown in globalization and surge in demand for USD.
Is regionalization the new globalization?
Today’s globalization has its roots in the post-World War II world where manufacturers in western countries benefitted from the labour arbitrage captured in outsourcing manufacturing to countries with significantly lower labour costs—mainly Asia—a deflationary exercise. Globalization led to enhanced efficiency in global supply chains, seeing many industries transition to just-in-time inventory management which helped to keep working capital and inventory requirements low. The system worked beautifully until a black swan event such as COVID-19 came along to freeze the system.
With supply chains impaired, an increasingly nationalist focus is appearing across the world as we are seeing little to no coordination among EU countries regarding closing of their borders, many countries shuttering their borders and airports to all foreign travel and trade (the Crisis Staff head, Roman Prymula of the Czech Republic told Czech Television recently that border controls may have to be kept in place for an extended period of time and possibly up to two years), while Vietnam, the world’s third largest rice exporter, temporarily banned rice exports to ensure domestic demand is met and Kazakhstan banned exports of “socially significant food products”. It is worth pondering if this is indeed a watershed moment for globalization and its future is to be reshaped as the concept of regionalization becomes increasingly prevalent, where clusters of countries leverage their strengths to supply regional partners (i.e. manufacturing in Mexico for the USA; an accelerating trend in recent years).
For example, taking a look at Vietnam, it hosts a large manufacturing and agro-industrial complex making it the “factory” of ASEAN and certainly to the Indo-Chinese region with its economies of scale and integrated supply chains. As Vietnam should be to ASEAN, Uzbekistan should be to the Commonwealth of Independent States (CIS) countries (Armenia, Azerbaijan, Belarus, Kazakhstan, Kyrgyzstan, Moldova, Russia, Tajikistan) as well as Afghanistan and Turkmenistan, helping it to develop a gravity for foreign direct investments.
In preparation for an expected German invasion prior to World War II, Joseph Stalin ordered strategic industrial assets to be moved from Eastern Europe to Uzbekistan. This turned Uzbekistan into the most industrialized Soviet Republic. With its vast industrial base, after Uzbekistan gained independence in 1991, President Karimov decided not to follow the Washington Consensus of free-markets, but instead focused on protectionism through high import duties, turning the country into a fortress of sorts through import substitution – Uzbekistan became one of the first CIS countries to have its own auto manufacturer and national airline while it pursued self-sufficiency in wheat, oil and meat. This created significant hardship for its citizens as protectionism is inherently inflationary (bucking the trend of the deflationary effects of globalization), but over these 30 years Uzbekistan was successful in bolstering its industrial capacity with the production of valued-added construction materials (steel bars and pipes, glass bottles and widows, cement, etc.), food products (packaged juices, wine, beer, dried fruits, processed meat products, poultry, biscuits, cooking oil, rice, fresh fruits, vegetables and etc.). These sacrifices under the previous regime have given Uzbekistan the gift of being to the region as Vietnam is increasingly being to the rest of the world (often regarded as a second, but mini China).
Uzbekistan, with its large labour force (hosting the largest population in Central Asia at 34 mln) and manufacturing base, has the potential to create a gravity for manufacturing firms and investors in the value-added commodities sphere. This is already occurring with the most recent example being the development of a textile cluster in Bekabad City in South-Central Uzbekistan where a foreign company, SPUNMELT, plans to build a factory for the production of 7,000 tons of raw material used in the production of surgical masks. Uzbekistan already has domestic mask production, but the raw material (which is polypropylene based) is currently being sourced from China, Turkey and Russia. Uzbekistan being a major producer of polypropylene courtesy of its sizable natural gas and chemical industry, aims to become self-sufficient in this raw material and become a net exporter to the rest of Central Asia.
Uzbekistan’s FX ace in the hole:
As the gears of global trade cease up over the short-term and countries go into lockdown due to COVID-19, countries with short USD exposure (those that have borrowed USD at the sovereign or corporate level) are likely to begin experiencing increasing and varying degrees of strain on their debt service. With global trade and tourism not bringing USD into these countries, FX reserves will have to be spent to service debts which will in turn weaken their currencies versus the USD. This will be compounded by many countries now initiating stimulus which will consume yet more of the FX reserves. The longer the global economy is in lockdown the more severe the situation will become. Major exporting nations such as Mexico now face this issue as orders for manufactured goods have collapsed with western countries battling the virus.
While Uzbekistan’s external debt/GDP (sovereign and corporate debt) stands at 46% of GDP and it likely seeks long-term modest depreciation in the Uzbek Som to support exports, the country would benefit from making sure this happens in an orderly fashion, especially as the country maintains a current account deficit of USD 3.2 bln in 2019 (a decrease from USD 3.5 bln in 2018) due to the reindustrialization of the country which is leading to strong imports of machinery for textiles, steel, cement, and food processing sectors. Uzbekistan should be able to manage this situation well as in the current time of a global economic crisis it’s proverbial ace in the hole is gold—a commodity in extraordinarily high demand due to worries about the global economy and whose price we expect to rise substantially over the coming years as countries continue to debase their currencies, with over USD 10 trln in global stimulus enacted year to date and certainly with more to come.
Already having a free-floating currency, Uzbekistan has the opportunity to temporarily bolster the exchange rate during the current instability through exercising its gold production. As discussed in last month’s communication, Uzbekistan is ranked 9th in global gold production and hosts two of the largest gold producing companies in the world: Navoi Metallurgical & Mining Combinat and Almalyk Mining & Metallurgical Combinat. By monetizing a portion of production, being that FX reserves topped USD 30 bln in February (USD 17.25 bln of which is gold, equal to 33% of GDP) it has a guaranteed source of foreign exchange to support the economy and currency.
We believe these factors make Uzbekistan an increasingly safe haven of sorts over the coming years.
Impressive response to Covid-19 & Economic Impact:
Uzbekistan received its first case of COVID-19 on 15th March. The country’s response has been exceptionally proactive, equal to the responses seen in Singapore, South Korea, Taiwan and Hong Kong in combating this challenge as it takes the route of not “turning off” the economy but rather being aggressive in isolating cases and increasing restrictions as cases have risen—at present there are 159 active cases, 2 deaths and 12 recoveries.
Proactive measures were taken from the first virus case where starting from 16th March the spring holiday was brought forward and schools were closed through 20th till the first week of April, weddings were banned as well as large social gatherings. Then, on 22nd March after the start of the Navruz holiday, celebrating the start of spring, as cases rose all food and beverage establishments were forced to close and only permitted to fulfill carryout and delivery orders. The week of 23rd March saw a ratcheting of government measures including fines, equivalent to USD 70, for people outside without a mask, cities into lockdown whereby one cannot travel to other cities and the banning of groups of more than three people in public. On 30th March all passenger cars were banned from the streets (special permits for those who need to use their car can acquire one) and lockdown was extended to 20th April to ensure the virus is stamped out.
Meanwhile, construction sites are busy and there is traffic on the roads, of course a decrease from normal levels, but life continues unlike in many other countries with the virus.
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