Sturgeon Capital report for the month ended December 31, 2015 titled, “Iran Strategy.” We previously reported about Sturgeon investing in Iran.
See the full letter below.
[drizzle]
[[Manager Commentary:
We are delighted to be sending out this inaugural monthly manager report for what is one of the first foreign investment funds actively investing in Iran in partnership with Mofid Securities, the largest broker in Iran.
Sanctions
Saturday 16th January 2016 marked an historic day for the Iranian investment landscape and international investors alike. The International Atomic Energy Agency (IAEA) verified that Iran had met its obligations under the Joint Comprehensive Plan of Action (JCPOA) leading to “Implementation Day” and triggering the easing of many of the long standing sanctions imposed against Iran by the US, EU and UN. Practically this has had the following implications for Iran and Iranian businesses:
- Iran can now freely sell its oil in the international market;
- Most Iranian banks can reconnect to the SWIFT network meaning the country can get paid for oil sales and businesses/citizens can again transfer money internationally through the banking system. The SWIFT reconnection is expected to be completed by the end of January 2016;
- Sector sanctions are lifted, including banking, insurance, automotive and petrochemical sectors;
- Non-US businesses/citizens will no longer be penalized by the US for doing business with Iran.
While the lifting of the vast majority of sanctions has indeed made investing in the Iranian markets much easier and has broadened the investment universe substantially, it is important for investors to understand that certain sanctions are still in place. The sanctions lifted on Implementation Day relate to nuclear proliferation and were the ones that were intended to have the most significant impact upon the Iranian economy. Sanctions related to human rights violations and links to terrorism still remain. Practically this means that doing business with the Revolutionary Guard (IRGC) or any related entities remains prohibited. From an asset management perspective this means that the Fund cannot invest in any company controlled by the IRGC. In terms of the listed equity market, the IRGC control or are linked to 4 large listed companies, otherwise its influence primarily extends to non-listed enterprises.
From a US investor perspective primary sanctions remain, meaning US businesses (with the exception of those in the aviation sector) still cannot do business with Iran. However, secondary sanctions have been lifted meaning that non-US businesses/citizens doing business with Iran will no longer be penalized by US authorities.
What Does This Mean for Iran?
- Access to substantial funds frozen abroad under the previous sanctions regime. The estimates of the value of these funds are wide ranging. Critics of the deal claim Iran will now receive a windfall of more than $100bn. The US Treasury puts it at around $50bn, while the Iranian Central Bank puts the figure at $33bn. These funds will go a long way in helping the government to keep a stable currency and re-invest in the economy.
- Access to international oil markets for Iranian oil and the ability to be paid the proceeds directly as opposed to payment being held in foreign accounts as was necessary under the sanctions regime. In 2015 Iranian oil production averaged 2.8 million barrels per day. The government has stated that it is targeting an additional 500,000 barrels per day increase on average for 2016, rising to a daily production of 3.8 million barrels for 2017. Even at these low oil prices this substantial increase in oil revenues will allow significant fiscal flexibility for the Iranian Government.
- Iranian businesses are now able to access international capital markets and financing. For many industrial companies, this will have a dramatically positive impact as the manufacturing equipment required to increase production is not produced in Iran and up until now could not be purchased from abroad.
Slowly Iran will once again become a country that the international community can do business with. After a decade of harsh international sanctions substantial investment is required across all sectors, presenting numerous opportunities in both the short and long term for the Sturgeon Central Asia Fund Iran Strategy to capitalise upon.
Sturgeon CAF Iran – What Does This Mean for the Fund?
Being one of the first foreign funds post-JCPOA to invest in Iran we have already been actively investing in the Iranian equity markets since 1st December 2015. In order to ensure sanctions compliance our investment universe was necessarily restricted to around 50 companies of which 10 are now in the Fund portfolio. With the lifting of sanctions the investment universe has widened to include the whole of the stock market, with the exception of the four entities controlled by the IRGC. Four additional names are being added to the portfolio which were previously sanctioned and we are currently analysing several other potential opportunities.
An Investment Strategy for a Changing Business Landscape
Whilst we share the optimism sparked amongst the Iranian business and investor community by the lifting of sanctions, we have deliberately structured the Fund and investment strategy so as not to rely on sanctions relief as a critical factor for the Fund to be able to be actively investing and operational. The general perception is that the lifting of sanctions will lead to immediate improvements in the economy but our view is more cautious in this regard. Of course there will likely be immediate and obvious benefits e.g. an increase in consumer confidence and investor sentiment, but the real and substantial microeconomic benefits will take much longer to play out. Furthermore, as an investor in Iran, the lifting of sanctions introduces an unknown factor which is seldom discussed i.e. a shift in the competitive landscape for local businesses that for a long period of time have never had to deal with significant international competition.
There are a number of industries that will inevitably be disrupted by the entry of foreign competition, regardless of any government intervention or protection such as tariffs, subsidies, etc. Given this we have a deliberate bias in favour of businesses operating in sectors which have a comparative advantage due to the fact that they are in Iran versus international competitors in other markets. One such example is the Iranian glass industry. Feedstock, (gas and soda ash) is the largest variable cost for a glass manufacturer, and both are abundant and cheap in Iran. With manufacturing wages in the Iranian market on par with those in Vietnam, the cost of producing glass in Iran is amongst the lowest in the world. One such company currently in the portfolio is achieving operating margins of over 40% and has maintained them for the past five years. In comparison, the five year average operating margins for two of the largest global glass producers, Owens-Illnois and Saint Gobain, have been 10.2% and 5.1% respectively. Moreover the company has increased capacity by 60% in the past 12 months. In the case of the Iranian glass manufacturing industry, the analysis suggests that the probability of disruption by new foreign entrants is very low.
In fact the effect of sanctions relief will most likely be a significant positive for Iranian glass manufacturers, providing new opportunities for the export of glass products to neighbouring countries. Foreign markets have only accounted for 4% of the company’s revenues this year.
We take the following approach to identifying new investment opportunities for the portfolio:
- Care first about the downside: what are the ways we can lose money? What are the potential negative consequences for the company or industry of the lifting of sanctions?
- Look for businesses that have the market space and ability to grow domestically.
- Derive a valuation for the company on the basis of the above two factors, i.e. a multiple of what the business can conservatively earn in line with what the domestic market has to offer, before factoring in any positive effects on growth as a result of sanctions relief.
The above three steps will cover the majority of our investment thesis. Only after having covered them, do we consider what the upside for the business could be as a result of the lifting of sanctions (increased exports, access to international capital markets, etc.). That is, our thesis does not rely on the effect of sanctions being lifted. Any benefits from sanctions relief will always be viewed as an additional positive catalyst for growth. We believe this approach to be an appropriately conservative one that provides a clear margin of safety for the investments we make.
Iranian Corporate Access
The past month saw us travelling to Iran twice where we met with the management of 14 companies. It should be noted that meetings with management are not common place in Iran, and Investor Relations is non-existent. Many calls to arrange meetings were met with responses such as:
- “Why do you want to see us?”
- “We only meet with shareholders at our AGM”
- The best response – “We don’t care about our share price”
It suffices to say that the last response - ”we don’t care about our share price” - acts as a good filter as to whether we should be shareholders or not! The main point to note is that as potential shareholders, in order to get close to the business i.e. meet with management, meet employees, view facilities, etc. investors must offer management and owners a significant value-add for them to engage. This is where one of our competitive advantages lies. From the original pre-sanction investment universe of 50 companies, we have met and established relationships with 80% of those 50 as well as many other companies that have now been brought into the investment universe following the lifting of sanctions. The relationships have been and will continue to be established and developed based on 3 key propositions to owner-managers of target companies:
As potential shareholders we provide supportive long term capital: As discussed in our recent white paper (available on request), this is a scarce resource in Iran. For example, There are two main sources of capital in the Iranian public markets, both with restrictive short-term agendas as investors:
- Government/Quasi Government Institutions. Generally very long-term holders of equity or debt. These institutions focus on high regular dividend pay outs which restricts the companies when making any meaningful capital investment plan for retained earnings as 100% or more is paid out in dividends.
- Retail Investors. Mostly momentum driven, these investors drive considerable short-term volatility in share prices. Many companies which are currently under review as potential additions to the portfolio have a strong underlying business, good management with a vested interest, and ample re-investment opportunities. Short term retail investors, much like government institutions, often disrupt long term capital investment and growth plans with demand for dividend pay outs. The companies provide an opportunity for the Fund to take a sizeable stake alongside management and with a joint controlling interest, giving them the freedom to manage and operate their businesses for the long term.
With a 10 year track record of investing in Central Asia and the New Silk Road, a region composed of countries that are the most obvious export destinations for Iranian businesses, we are in a position to advise portfolio companies on doing business in the region through our established network.
We are able to provide guidance to management on how best to access international capital markets. Whilst many managers are experts in managing their business operations, by virtue of Iran having been a closed market for an extended period of time, they do not have the expertise to understand and access the international capital markets now open to Iranian companies post-sanctions. As shareholders we can provide that advice and access.
A Brief Comment on Interest Rates: The Overlooked Catalyst
As we have previously highlighted in our recently published white paper and elsewhere, but which is not widely discussed by mainstream investors, interest rates are a key factor for the Iranian economy both pre and post-sanctions relief. The impact could arguably be greater than sanctions relief. Currently the earnings yield of the Iranian stock market (+20%) is on par with the yield that investors can achieve by simply depositing money in the bank, thus providing no premium incentive to investors to take exposure to risk assets e.g. equities.
The central bank has been explicit in reducing interest rates to bring them in line with inflation (currently at 10.8%) and has already made steps to cut rates, whereas interbank rates have dramatically reduced from 29% to 19% in the past few months, along with deposit rates reducing to 18% from 20%.
The market hasn’t fully reacted to this move yet, as commercial banks lag behind in implementing deposit rate cuts. However, should these cuts continue we expect to see a significant rally in the market in 2016 irrespective of foreign inflows.
Operations And Portfolio
Although the Fund launched on 1st December 2015 the portfolio is being built gradually. The first trades in the local markets have been executed and settled. Given that we are currently building our positions and in order to avoid being front-run, we will give more updates in the next monthly report where we will also provide a clearer picture of the Fund’s broader investment activities. From an operational perspective, we are awaiting the re-activation of SWIFT, which is expected to be largely completed by the end of January. This will mean that the use of exchange houses to transfer funds to Iran will no longer be necessary, reducing both counterparty risk and transaction costs.
On the political front we are keeping our eye on the parliamentary elections coming up in Iran on 26th February. Given the boost that the current reformist government is likely to enjoy from having delivered on its promise to secure a deal to have sanctions lifted, there is a good chance that the elections will allow the reformists to consolidate more power in parliament which should, all else being equal, be a positive for markets.
From an almost standing start in January 2015, it has been a long, often challenging, but always fascinating road to the launch of the Fund on 1st December 2015. We are proud to be amongst one of the first international portfolio investors active in the Iranian markets and look forward to a rewarding 2016 as we explore the abundance of opportunities that continue to present themselves in one of the last great frontier markets open to investors today.
