Why a Swedish fund divested its Argentina portfolio to invest in Sri Lanka

Tundra Fund is helping foreign investors discover socially responsible companies with strong growth potential in Sri Lanka’s lacklustre equities market

Tundra Fund, a $400 million portfolio management firm based in Sweden, has invested in a few listed Sri Lankan banking, consumer retail and construction stocks, expecting 15% annual returns over the long term despite the country’s stock exchange’s All Share Index declining 11.7% in the 39 months to end-March 2018. The fund recently divested its entire portfolio in Argentina and shifted the funds to Sri Lanka when it reallocated a $160 million portfolio it manages called the Tundra Sustainable Frontier Fund. This smaller fund has equity investments in seven countries, including a 12% allocation in Sri Lanka comprising 10 listed stocks worth nearly $20 million.

“We have a long-term focus and are excited about Sri Lanka’s growth potential. Second, valuations in Sri Lanka are very attractive at this stage, which was why we exited a 5% allocation in Argentina to invest in Sri Lanka,” says Mattias Martinsson, founding partner and chief invest ment officer at Tundra Fund. Investors are increasingly asking for companies to demonstrate ethical behaviour, not just to report decent earnings. They have limited visibility on companies in poorer countries where reporting on environmental, social and governance responsibilities are absent. Tundra Fund’s strategy is to shed light on these markets.

Tundra Fund specialises in applying the standards of rich countries to emerging and frontier markets, so investors can invest in the long-term growth potential. The fund doesn’t allocate more than one percent in any given company to minimise risks, and a company must demonstrate potential to deliver nothing less than an annual return of 15% for Tundra to invest. But Sri Lanka is a special place, Martinsson believes. Martinsson says Sri Lanka’s long-term structural growth case is much stronger than that of other frontier markets Tundra has invested in. “I feel Sri Lanka will be the first to reach a per capita GDP of $10,000,” Martinsson says.

Excerpts are as follows:

Sri Lanka is a small market of 20 million people, compared to the rest of economies in your portfolio; so what’s so exciting about the economy here?
We feel Sri Lanka is a special case. We believe there is potential for strong economic growth given its strategic location in the region and high literacy rate. Sri Lanka has the possibility of becoming a trading hub with steady growth in its skilled workforce, so companies don’t have a problem hiring talent. Add to this the development of tourism, and you realise that the country has unique advantages over the rest of the countries in our fund.

Tourism contributes around 4% to GDP and is growing 12-15% annually; so we believe the impact on economic growth will be significant. I won’t be surprised if annual tourism arrivals double within the next 10 years. This means that everyone can get their first job and become a consumer. So yes, I think Sri Lanka’s long-term structural growth case is very strong, much stronger than most of our other frontier markets. I feel Sri Lanka will be the first to reach a per capita GDP of $10,000.

How has Tundra Fund performed, particularly the Sri Lankan portfolio?
We manage around $400 million in assets, and around $160 million is in the Tundra Sustainable Frontier Fund, which returned 26% in 2017. Since inception in 2013, the fund has returned 50%, whereas the benchmark was up 30% in the same period. However, emerging and frontier markets have been through a tough couple of years lately, but we’re in it for the long term. If we look at the Sri Lankan portfolio, it has returned about 35% since inception.

We’ve been investing in Sri Lanka since 2013. A criterion we have is that the stocks we invest in must return 15% annually. Around 8% of the portfolio was allocated to Sri Lanka in 2017. Recently, we exited a 5% allocation in Argentina and invested those funds to top-up holdings in Sampath Bank and Cargills Ceylon, and include Hatton National Bank, Commercial Bank and Nestlé Lanka to the portfolio, which includes Tokyo Cement, Access Engineering, John Keells Holdings, Richard Pieris and CT Holdings. The Sri Lankan portfolio is worth $18 million.

Sri Lankan stocks have been lacklustre over the last few years, so how realistic are you to expect 15% annual returns?
Valuations for equities have indeed come down. There’s been some turbulence in the market due to political factors over the last few years. It’s been a stagnant and boring time for Sri Lanka equities. It’s probably better to invest elsewhere because, as I said, a stock has to return at least 15% annually to qualify.

However, there are two reasons why we’re investing in Sri Lanka. First, we have a long-term focus and are excited about Sri Lanka’s growth potential. Second, valuations in Sri Lanka are very attractive at this stage. The problem is that the market is not liquid enough, so we can’t buy as much as we would like to. We sold everything in Argentina because Sri Lankan valuations looked much more favourable, especially the banks. Despite the impact on profitability due to new Basel III capital requirements the Central Bank of Sri Lanka has enforced and the low level of equity capital, the valuations of listed Sri Lankan banks were more attractive than the risks. Pakistan offers the same valuations, but the risks are higher.

We don’t invest more than 1% in any company, and we expect at least 15% annual returns over the long term, nothing less. We don’t expect the Sri Lankan portfolio to generate these returns over the next few years, but over the long term, we’re confident it will.

We had Ceylon Cold Stores, which we exited some time ago when we felt it was a good time to book profits. We bought the stock quite cheaply and made a 400% gain. Consumer stocks are my favourite, and this is why we’re exposed to Cargills Ceylon, Richard Pieris and Nestlé Lanka.

Would you consider investing in other companies?
We constantly screen the market and see many attractive valuations. We are long-term investors, so we like to pick stocks exposed to a large share of the economy and will grow with it. Take construction in Sri Lanka; it’s a growth sector, which is why we are exposed to Access Engineering and Tokyo Cement.

The problem is low liquidity levels in the Colombo Stock Exchange. In a market like Sri Lanka, we have to wait for someone to sell a considerable block of shares when we see a company we like to invest in. There has been a lot of foreign selling lately, so that gave us an opportunity to expand the portfolio.

While we look for companies that will grow with the economy, they also have to demonstrate an ability to survive local and foreign competition. They need to have strong brands. We would have preferred to have invested much more in Ceylon Cold Stores, but we never managed to get the position we wanted because liquidity was too low and the opportunity eventually ran away.

What is Tundra Fund’s investment strategy?
We focus on what we call the next generation of emerging markets, or frontier markets. Unlike most funds, we focus on a few markets with bigger populations, somewhat developed financial infrastructure, and strong medium-to-long term GDP growth potential.

If you look at the seven billion global population, around a sixth of them live in developing economies where growth has overtaken the developed world, and we think this trend will continue over the next two decades. Within the developing world, we’ve picked economies that are often overlooked. China, India and Brazil used to enjoy a lot of investor attention, but those countries are becoming less appealing, with growth rates expected to slow down. Tundra Fund has 10 investment analysts and portfolio managers looking at seven markets and stocks that will return at least 15% annually over the long term. We’ve invested in Vietnam, Egypt, Pakistan, Sri Lanka, Bangladesh, Nigeria and Kenya. Around 800 million people live in these countries, so they are sizable markets and economic growth prospects look good. China is also investing in these markets and Taiwanese companies are investing in Vietnam.

After World War II, Japan became industrialised and was the fastest growing economy, followed by South Korea, Taiwan and China. We believe it’s time for the next generation of economies to take over the mantle. So, it’s up to countries like Sri Lanka, Pakistan, Vietnam and Bangladesh to realise that potential. So we decided to exclusively focus on this part of the world, and for us that is 800 million people, and we believe the fastest growth will be achieved in these markets.

We make an effort to convince investors, they understand the potential, but they also have their prejudices, which can be an obstacle. For instance, not many investors have been to Sri Lanka and don’t know what the country looks like. They probably associate Sri Lanka with its civil conflict. This is an obstacle. This is the reason why we focus on ESG, or Environmental and Social Governance, reporting standards. For instance, when we invest in a Sri Lankan company, investors will know we used developed market standards to measure values that are important to them, not just earnings potential.

This is what the Tundra Fund is built around, giving investors insights into companies in developing markets using developed market standards, especially on ESG, and giving them an opportunity to enter early and invest in long-term growth. In 2016, ESG-screened assets were worth 26% of all global investment assets, and they have grown at twice the pace over the last couple of years. I expect the trend to pick up.

Maybe five years from now, companies without ESG reporting will find it extremely difficult to attract foreign investments. This is why we visited Sri Lanka to engage the Colombo Stock Exchange and promote ESG reporting among listed companies here. There is a huge opportunity to attract long-term foreign investors.