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Fund Performance

Country Snapshot:
Pakistan

Travel Notes

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Fund Performance

In December 2012, Leopard Asia Frontier Fund (LAFF) USD A-shares gained 3.6%, compared with the MSCI Frontier Markets Asia Index (+5.9%) and with the MSCI World Index USD (+1.7%).

For the month of December, indexes within the LAFF investment universe were all positive with the exception of Cambodia, which was unchanged. The top-performing index was Mongolia (+16.4%), followed by Vietnam (+9.5%). The strong month for the Mongolian Stock Exchange (MSE) was assisted by the Mongolian government's US $1.5 billion sovereign infrastructure bond, announced on November 29. It was Mongolia's debut international sovereign bond issue, and the size of the deal (the bond is worth 15% of Mongolia's projected GDP for 2012) prompted Asia Money to award it "The Best Sovereign Bond of 2012". Another important contributor to the MSE's continued recovery was the recent reaffirmation of the Oyu Tolgoi Investment Agreement by President Elbegdorj. In May, investor confidence in Mongolia was damaged after the controversial Foreign Investment Law (SEFIL) was adopted, which called for stricter review of foreign investments. But on December 26, President Elbegdorj publicly announced that Mongolia needs to respect the Oyu Tolgoi Agreement and underlined the importance of creating a better financial environment for foreign investors, expressing disapproval with the foreign investment law enacted by Parliament. In Vietnam, solid growth occurred in December as inflation eased for the first time in four months and the central bank reduced borrowing costs. The curbing of inflation (6.8% in December 2012) will help instill greater investor confidence, and Vietnam's rapidly-growing population of 90 million will continue to contribute to growth in consumer-related stocks, a particular sector of focus for LAFF.

The top two performing portfolio stocks were both from Mongolia: a beer and liquor producer (+23%) and a copper mine (+22.2%). Their positive growth came on the heels of the rebounding Mongolian stock market, which picked back up as foreign investors re-registered in the new trading system. The improved outlook for China's economy and increased demand for Mongolian copper and coal also drove the country's growth. These were followed by a Vietnamese brewery (+21.9%) and a Sri Lankan subsidiary of a global food producer (+21.7%).

As of December 31, the portfolio was invested in 82 shares, 1 closed-end fund (with 44.1% discount to NAV), 1 GDR (with 61.1% discount) and held 5.1% in cash. During the reporting month, we added three new stocks in both Mongolia and Pakistan and one stock in Vietnam. We increased existing positions in Cambodia, Laos, Papua New Guinea, and Vietnam. The stocks LAFF holds are listed on stock exchanges in Bangladesh, Canada, Hong Kong, Laos, London, Mongolia, New York, Pakistan, Papua New Guinea, Sri Lanka, Thailand and Vietnam. The two biggest stock positions are a power producer from Laos (5.5%) and a pharmaceutical company from Bangladesh (4.3%). The countries with the largest asset allocation are Vietnam (17.4%), Sri Lanka (17.1%), and Pakistan (12.7%). The sectors with the largest allocation of assets are consumer goods (36.3%) and financials (14.9%).

Factsheets highlighting the fund's performance as of 31st December 2012 are available here:

Country Snapshot: Pakistan

Every month we highlight economic developments in one country within the Asia Frontier Capital Universe.

Bypassing Pakistan's Woes, Karachi's Bourse Booms

When Pakistan receives international media coverage, it is usually not pretty. The world's sixth most populous country has remained in the headlines due to its shaky security situation, including bomb attacks and an ongoing Taliban insurgency near the border with Afghanistan. This year's upcoming elections will cast a spotlight on the tense political environment that has become synonymous with instability and corruption. On the economic front, falling foreign reserves and the downward sliding Pakistani rupee may potentially require an IMF bailout. But despite the political and economic uncertainty, the Karachi Stock Exchange (KSE) performed exceptionally well in 2012, exceeding all expectations and proving that even in a notoriously turbulent emerging market such as Pakistan, there are many attractive stocks and gains to be had for astute investors.

The KSE is the largest bourse in Pakistan and has been one of the best performing exchanges in Asia this year, with the benchmark KSE-100 index rising 49% in local currency and 38% in USD. Bloomberg hailed the KSE as one of the top 10 stock markets in the world in 2012 and a variety of factors have contributed to the market's success. The State Bank of Pakistan's (SBP) easing monetary policy has cut interest rates and decreased inflation. As interest rates have fallen, investors have turned to the stock market to achieve higher returns as companies have taken advantage of cheaper loans to gain leverage. Growth in the stock market has also been spurred by the resolution of capital gains tax issues, healthy corporate earnings, and low valuations of Pakistani equities. Finally, Pakistan's rising income levels and large remittances (a record US $1.4 billion was sent back to Pakistan in October, up 30% from a year earlier) are creating a new middle-class that has helped drive up consumer expenditures. Given the KSE's surge, it is surprising that 2012 saw only 3 IPOs in Pakistan, compared to the 10-year average of 11 IPOs a year.

One of the KSE's darlings has been the cement sector - as of December 26, cement stocks had posted returns of 156% for the year. Improved margins in the cement sector have been driven by increasing cement prices (up more than 25%) and greater local demand. The country's rising middle class has contributed to this increase in domestic demand, and growth is forecasted to continue - Pakistan's current per capita cement consumption of 180 kg is amongst the lowest in the region. In addition, this year's elections are expected to provide a major boost to the cement sector, as pre-election government spending will focus on construction and infrastructure projects. Cost pressures for cement producers have also been reduced due to a decrease in interest rates and lower coal prices. Coal, which accounts for 50-60% of the cost of production of cement, was down 23% in 2012.

The textile sector also performed well in 2012, moving away from previous years' slumps and benefiting from stable cotton prices. The weakening of the Pakistani rupee drove textile exports and revenue growth, and piqued investor interest in cheap textile shares. In December, it was announced that Pakistan is likely to get Generalized System of Preferences (GSP) Plus status for textile exports to the European Union by January 2014, a move that will grant tariff-free access to the European market and will spark major growth in the textile industry, which is already Pakistan's largest export sector.

The food and consumer goods sector is also booming due to the rising purchasing power parity of the middle-class. Pakistan's middle class has doubled in the last decade to 70 million, and consumer spending has increased by 26% on average over the past three years. This has garnered the attention of a number of international restaurant franchises and since 2011, the country has seen a large influx of global food chains including Hardee's, Fatburger, and Cinnabon. Franchise powerhouses like McDonald's, Pizza Hut, and KFC have been in the country for almost two decades and are opening new outlets as demand for fast food continues to grow. Additionally, interest was roused amongst foreign investors with the announcement in November that Unilever Pakistan is planning to de-list, aiming to buy back US $335 million in shares from exchanges in Karachi, Lahore, and Islamabad. This will provide a large capital inflow for the country that can be redeployed in the fast-moving consumer goods (FMCG) sector and also suggests increased future investment by Unilever in Pakistan.

Although the KSE outperformed predictions in 2012, there are a number of concerns for Pakistan moving forward. This year will likely usher in political change for the South Asian nation, and the world will hold its breath when Pakistanis go to the polls in 2013. With Pakistan's civilian government slated to end its 5-year term this year, it is expected that Nawaz Sharif's Pakistan Muslim League-N (PML-N) will become the largest party after the general elections. This should bode well with investors, as PML-N has historically been business-friendly and pro-investment.

Economically, Pakistan's GDP grew at a sluggish 3.7% in 2012, hampered by the government's growing budget deficit and electricity outages that hurt the country's export industries. If an IMF bailout is indeed needed in 2013, the austerity measures that will most likely be required will pose a difficult dilemma for the current administration - cutting back on government spending during an election cycle could be a risky political move. But another IMF loan may be necessary - with only 1% of the population paying income taxes and the agricultural sector paying no taxes, government revenues from taxes make up less than 1/10th of GDP.

Two other challenges for Pakistan will be power shortages and its volatile level of security. Energy rationing and the lack of oil and gas availability have been damaging for a variety of power-intensive industries. Fertilizer, one of the country's main exports, is a prime example. The sector relies on gas for the production of urea and sales were down compared to last year as a result of nationwide gas curtailment. Electricity outages continue in Pakistan, and the All Pakistan Textile Mills Association estimates that outages could cost the country US $3 billion in textile exports this fiscal year. Progress will need to be made towards getting a handle on the country's security situation, particularly with insurgencies near the Afghanistan border. But improved US-Pakistan relations have provided a much-needed macroeconomic boost for the country - the US has pledged US $2.5 billion as part of its Coalition Support Fund (CSF), intended for Pakistani military operations in the war against terrorism. Pakistan received US $1.12 billion of the CSF in July, and a second tranche of US $688 million on December 28.

Despite Pakistan's negative reputation, 2012 showed that there is little correlation between the country's lackluster political and economic outlook and the stellar returns provided by its stock market. Steps are being taken towards better regulatory reform, and Pakistan's burgeoning middle class is generating large domestic demand for consumer goods. Even in Pakistan, where questions loom over the upcoming general elections and the future trajectory for the economy, there are many winning stocks to be found on Karachi's soaring stock exchange.

Travel Notes

Research Trip to Karachi, Pakistan

It was an eye-opener to me when I planned my trip to Karachi that hardly any international airlines fly to Pakistan - a stark contrast from my last visit to the country 19 years ago. Singapore Airlines, Malaysia Airlines, British Airways, and Lufthansa have all completely stopped servicing Pakistan; now all traffic goes through Dubai, with Emirates the main beneficiary. The hotel offerings in Karachi also had not changed since my last visit. The Pearl Continental Hotel (where I stayed last time), Sheraton, and Marriott are the only five-star hotels in town. In contrast to my recent trip to Papua New Guinea (see October LAFF Newsletter), the prices of these hotels are reasonable, at around US $80 per night. These are all good indications that hardly any foreign investors go to Pakistan and are great signs to a contrarian investor.

When I arrived at Karachi International Airport from Bangkok, it was like déjà vu: the airport looked unchanged from 19 years ago, with no visible new buildings/terminals except for the huge McDonald's outside of the terminal building.

I arrived around 6 pm and was afraid I would get stuck in traffic on the way to the hotel - this huge city of 21 million has notoriously bad traffic jams. On the main road from the airport to the hotel, only a few lights were on - mainly banks and gas stations - due to the ongoing power shortage in Pakistan. It is estimated that the entire country has a power shortage of 4,000 MW. Because of this, many energy-intensive industries like cement, textiles, and fertilizer are struggling. Due to the shortage of power a lot of gas is diverted from industrial use to power generation. Despite the fact that Pakistan has its own gas and oil fields, the energy problem seems likely to continue in the short term unless the sanctions against Iran by the US and the European Union are lifted. This would permit the construction of a gas pipeline from Iran to Pakistan and further on to India.

When I arrived at the Pearl Oriental Hotel, nothing seemed to have changed since my last visit, with the exception of the security check at the hotel entrance. All guests had to go through a separate small building equipped with an x-ray machine, metal detector, and pat-downs like in an airport.

During my four-day stay in Karachi, I visited service providers and listed companies, some of which Leopard Asia Frontier Fund is already invested in. The main topics during these visits were the energy shortage, security situation, the current government's inactivity, preferential treatment of farmers over businesses, and the upcoming elections in 2013. One of my main observations during this trip was that in general, businesses seem to hold back on investments and capacity expansion due to government policies, which affect nearly every sector and contribute to the power shortage.

The aforementioned challenges lead to the question: "Why was the Pakistani stock market one of the world's best performing exchanges in 2012?" The answer is simple:

• The market was extremely undervalued at the beginning of 2012 (and still is)
•  Due to several interest rate cuts from 12% in August to 9.5% in December, much of the subsequent liquidity flowed into the stock market
•  Local investors are able to get their money "documented" through stock market investments without punishment from the tax department

Not all of my time was spent in business meetings. I was able to check out the largest shopping center in Karachi, a brand-new, international-standard complex catering to Pakistan's rapidly growing middle-class. The mall and the integrated office building were built on a huge block of land reclaimed from the sea. Despite the fact that only a few Western brands have opened shop at the mall, more and more global retailers and food chains are entering the Pakistani market. At another corner of the reclaimed land in Kolachi, I was able to taste delicious local Pakistani food at one of the dozen or so newly-built restaurants alongside the Indian Ocean. When we left the restaurant at 11pm, there were still families lining up to get a table, despite the fact that the restaurant was located in a remote area inaccessible by public transportation. In general, life in this country of 180 million people starts much later than in Europe and I experienced this when the local stockbroker took me back to the airport late Friday night. On the way back to the airport, we had intended to drive through "Old Karachi" (Burns Road and Tariq Road), but had to abandon this adventure due to the traffic that started after sunset.

The trip was an interesting experience and provided good exposure to both the challenges that Pakistan faces - namely energy shortages and instability - as well as the high-potential sectors that have fuelled the Karachi Stock Exchange's success this year. Despite problems on Pakistan's surface, the visit made it clear to me that a contrarian investor looking in the right places can find lucrative stocks and attractive sectors in the country.

Photo of the Month:

Fund Manager Thomas Hugger outside of the Karachi Stock Exchange,
Pakistan's largest bourse and one of the world's best performing in 2012

Emerging Frontiers Blog

We invite you to stay updated with daily investment news and analyses within Asian frontier markets by visiting Leopard Capital's free Emerging Frontiers Blog. Emerging Frontiers now includes news and analysis from all countries within the Leopard Asia Frontier Fund universe.

Kind Regards,

Thomas Hugger
Fund Manager

Disclaimer:

This document does not constitute an offer to sell, or a solicitation of an offer to invest in AFC Asia Frontier Fund, AFC Asia Frontier Fund (non-US), AFC Vietnam Fund or any other funds sponsored by Asia Frontier Capital Ltd. or its affiliates. We will not make such offer or solicitation prior to the delivery of a definitive offering memorandum and other materials relating to the matters herein. Before making an investment decision with respect to our Funds, we advise potential investors to read carefully the respective offering memorandum, the limited partnership agreement or operating agreement, and the related subscription documents, and to consult with their tax, legal, and financial advisors. We have compiled this information from sources we believe to be reliable, but we cannot guarantee its correctness. We present our opinions without warranty. Past performance is no guarantee of future results. © Asia Frontier Capital Ltd. All rights reserved.

The representative of the Fund in Switzerland is Hugo Fund Services SA, 6 Cours de Rive, 1204 Geneva. The distribution of Shares in Switzerland must exclusively be made to qualified investors. The place of performance and jurisdiction for Shares in the Fund distributed in Switzerland are at the registered office of the Representative.

By accessing information contained herein, users are deemed to be representing and warranting that they are either a Hong Kong Professional Investor or are observing the applicable laws and regulations of their relevant jurisdictions.

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