When interest rates rise, only attractive valuations can help

Only for professional investors!

Dear investors and shareholders,

in the first half of the year, it still looked as if nothing could dampen the good mood of investors on the stock markets. However, in the last third quarter, the mood deteriorated noticeably again. This was mainly due to interest rates, which suddenly rose significantly again.

For example, in the USA, the yield on 10-year government bonds was still 3.8% at the end of June but by the end of September it suddenly shot up again to 4.6% and is now rising even further. In the first half of the year, the market still believed that the central banks fight against inflation was almost complete. Whatever the case may be, the central banks themselves (especially the American Fed) obviously don't believe this.

Oil is becoming a driver of inflation again

A key factor that shook inflation optimism was oil prices, which also rose significantly again in the third quarter. Brent oil rose in price from the end of June to the end of September from 75 to 92 dollars per barrel or by more than 20%. The wake-up call for investors was the production cuts by oil producers Saudi Arabia and Russia by 1 million and 300,000 barrels per day respectively.

The two important oil producing countries had not announced any new cuts but had simply declared that they would maintain their current production cuts for the time being. However, it suddenly became clear to market participants that the oil market is by no means over-supplied. In addition, the USA already pumped half of its strategic oil reserves into the market last year, so its scope for manoeuvre in the event of future shortages is now significantly limited.

Outperformance thanks to high weighting of oil stocks

In the AvH Emerging Markets Fund we have been heavily overweight in oil stocks and other fossil energies for a good two years. In previous quarters this was still a burden for the fund but in the third quarter, our oil stocks stabilized the portfolio and outperformed the overall weak market.

We assume that oil prices will continue to rise in the coming years. Despite the weak global economy, global oil demand will increase by another 2 million to 102 million barrels per day this year, which is another record high. Even the International Energy Agency, which already sees the “end of the oil age” approaching, expects global oil consumption to continue to rise at least until 2030. It should be emphasized that this increase is still continuous, even though solar and wind power plants with an output of several hundred thousand megawatts have already been built in recent years.

Problematic energy transition

I've just returned from a trip where I was in Australia again. If there is one country that should be ideal for alternative energies, it is this sunny continent with its vast unused areas in the sparsely populated outback. In fact, per capita solar capacity in Australia is now higher than anywhere else in the world. Nevertheless, the country is currently experiencing that its energy transition is costing it dearly.

Australia's enthusiasm for solar energy has long since faded. The higher the proportion of alternative energies has grown in recent years, the more unstable the power grid has become. This is because, as expected, the production of solar and wind power fluctuates greatly. To be on the safe side, utilities must keep their conventional power plants in reserve and also invest in their operational readiness, while the utilization of these power plants falls. As a result, production costs and electricity prices have risen significantly.

Nobody wants coal stocks

At the same time, Australia is one of the largest coal producers in the world. In the beautiful city of Brisbane, the headquarters of Australian coal companies are lined up one after the other. I have now visited some of them again and discussed the prospects of the international coal industry with their managers.

Global demand for coal is also still rising from record high to record high. It remains indispensable, especially for steel production, and affordable alternatives (e.g. with green hydrogen) are still a long way off. At the same time, it is becoming increasingly difficult to get new mines approved around the world. Nevertheless, most coal stocks are valued extremely low and there are currently only a few investors who, like the AvH Emerging Markets Fund, see substance and prospects in this sector.

An Australian unique piece

However, I didn't just look at coal companies in Australia, I also examined other companies, including a car finance company and the largest gas station operator there. In my opinion Australia is structurally healthier than most other rich countries. Due to the recent correction and the falling Australian dollar, valuations are now more attractive again for investors from the euro and dollar zones.

A true Australian one-off is Shaver Shop Group, a retailer that specializes almost exclusively in razors and hair removal. The company now operates 120 stores in Australia and New Zealand and has a market share of an impressive 40% in its niche segment.

One of the things I like about Shaver Shop is the generous margins that the majority of the high-priced items generate. In addition, investments are low and the company's drive for expansion is only weak, which also benefits cash flow. The stock is valued at a P/E ratio of just 7 and the dividend yield is around 10%. For this reason, we already built up a small position in Shaver Shop at the beginning of the quarter and will buy more here if the share price gets cheaper.

On-site visits are essential!

In addition to Australia, I also visited Indonesia, Vietnam, Fiji and Qatar. I was on the road for more than two weeks, completed twelve flights and interviewed the managers and CEOs of over 30 companies. I can only emphasize again and again that I think it is extremely important to get an idea of potential target companies on site. Since I have been managing this fund, there have been a number of companies where I have completely changed my opinion after an on-site visit, for better or for worse.

Indonesia remains exceptional

A highlight on my information trip was once again Indonesia. Indonesian stocks represent around 20% of the portfolio at AvH Emerging Markets. This means we are ranked higher there than in any other country and my positive impression was confirmed again during this visit.

Indonesia is an island nation with 275 million inhabitants, making it the fourth most populous country. It is rich in natural resources and its people are both hardworking and pragmatic. The wage level is not yet very high but is rising steadily. Indonesia's economy has been growing above average for many years. Its competitiveness and attractive domestic market are now attracting more and more capital. Foreign direct investment has almost tripled in the last decade.

Growth-promoting policies – a rarity!

Indonesia's government policy is also primarily growth-promoting and realistic. The current President Joko Widodo has made a special contribution to the country's infrastructure. One of the impressive features is the high- speed train between the two major cities of Jakarta and Bandung, which recently went into operation. The 140-kilometer-long route, on which trains now run at speeds of up to 350 km/h, was built in just four years. In Germany (and many other Western countries) it would not have even been possible to complete the planning process in this short time.

Indonesia's raw materials policy is also pro-prosperity. The international mining companies can no longer simply extract important raw materials such as copper and nickel but must also refine them within the country. Gold is no longer even allowed to be exported as a bar, but must first be processed into jewellery, while coal producers must hand over 25% of their production to domestic power plant operators. This policy is of course controversial in the international raw materials sector, but it creates many additional jobs for the country and, in the medium term, also for key industries.

The new Indonesian discovery

A visit to the Indonesian retail chain Matahari Department Store was particularly enlightening for me. The company has been active since the 1970s and now operates over 150 branches in 80 Indonesian cities. Clothing from more than 100 national and international brand suppliers is sold there. The target group is mainly customers from the fast-growing Indonesian middle class.

The stock is currently cheap. While sales are expected to continue to grow in the current year, EBITDA is expected to decline in the low single-digit percentage range. This is mainly due to the fact that in 2022, due to the Covid pandemic, the shop landlords granted discounts on the rents that were no longer available this year. As a result, the stock only trades with a price-earnings ratio of around 4, and the dividend yield is over 15%. It now fits perfectly into our investment profile, and we started making our first purchases immediately after my visit there.

We are also very satisfied with our other Indonesian positions. The MAP Aktif share price has already more than tripled since we started trading in 2020, while the retail group continues to reliably show sales growth of 10 to 15% per year. However, the securities of the gold wholesaler Hartadinata Abadi, which we joined in July, have not yet taken off. The rapidly growing company primarily supplies jewellers in Indonesia and neighbouring countries. In addition, the pawn shop business is currently experiencing strong growth, as Indonesian households own a relatively large amount of gold jewellery.

Vietnam: Is the party over?

This time I found my stay in Vietnam somewhat sobering. It was certainly my twentieth visit to the country, which has been booming continuously for decades and has inspired the imaginations of investors. After all these years of euphoria, the air now seems to be gone. Growth momentum is slowing, competition with Chinese exporters is becoming tougher again, and the real estate sector is showing all the signs of an impending crisis.

Regardless, most investors are likely to hold on to their Vietnam stocks for the time being. As a result, the ratings are still comparatively high. At least I can no longer find any investments in Vietnam that I find particularly attractive or compelling. For me, Indonesia is currently the far more interesting stock market, both from a valuation and from an economic perspective.

Better too early than too late

A real curiosity is undoubtedly the SPX (South Pacific Exchange) in Fiji. During a short trip to the archipelago, I was able to get an impression of this stock exchange. However, there are very few stocks there, such as shares in a local marina, and the liquidity is low even by my standards. I don't want to rule out the possibility that a few undiscovered gems will be found on this stock exchange in a few years. For now, the Suva trading center is not yet our top priority.

Geopolitics and interest rates – the big burdens

The third quarter showed once again that the stock markets are a two-way street and that there are still many problems that can weigh on the markets. Since then, another brutal war has broken out between Israel and the Palestinians in the Gaza Strip. The risk that this conflict will escalate further and, in the worst case, spread to the entire Middle East cannot be completely ruled out and is putting additional strain on the markets.

The persistent inflation and interest rate pressure also remains a burden that will obviously not disappear overnight. The crises in Sri Lanka, Ghana, Pakistan, Argentina and Turkey have supposedly shown that emerging markets are particularly vulnerable in such situations.

However, this should not obscure the fact that many emerging countries have pursued particularly exemplary monetary policies in the last two years. In addition, higher interest rates are nothing new for most emerging markets, they have never had the extremely low interest rates that have kept rich countries afloat since the financial crisis. However, for the western industrialized countries the sudden jump in interest rates is a real shock, the economic consequences of which are not yet foreseeable.

Interest rates versus valuations

It's true that higher market interest rates tend to make stocks less attractive. In particular, unprofitable companies, companies with too much debt and stocks with too high valuations are of course viewed more critically when interest rates rise sharply.

In our opinion, the shares in the AvH Emerging Markets remain attractive even in an environment with higher interest rates. The average P/E valuation of the fund positions is currently only 4.7. The average price-to-book ratio is 0.75 and the average dividend yield is 6.6%. Accordingly, our investments are certainly still impressive compared to the currently higher market interest rates.

Yours, Axel Krohne

Head of Portfolio Management

AvH Emerging Markets Fund UI