When the deal is finalized, it will trigger the start of a flood of investment into Mongolia.
13
In the center of Ulaanbaatar, just a few hundred yards away from an enormous statue of Genghis Khan, sits one of Louis Vuitton’s most successful stores in Asia. The luxury retailer moved into the capital city of Mongolia in 2009. Sitting in an Italian restaurant overlooking a temple, a foreign businessman who had been in Mongolia’s capital for years told me the party to launch the store cost a few million dollars. It sold out of its entire inventory within the first three months of operation. That’s unheard of – especially for a city where, at the time, the average citizen earned as much per year as someone in Sudan makes today. The over-5,000-square-foot store sits at the entrance of one of the city’s most prominent skyscrapers. Nestled among the city’s skyscrapers are dozens of small stores – from pizza shops and coffee houses to Irish pubs. There are also several fancy-looking malls and boutique stores with prices at least as high as you’d find in New York. Construction cranes are on just about every corner of this small city. The streets are so clogged with cars – including plenty of BMWs and Range Rovers – that it’s often faster to walk than drive. I abandoned the taxi that was driving me back to my hotel in favor of walking several times. Ulaanbaatar is a testament to the growing wealth of Mongolia. You see, the country is sitting on some of the world’s richest earth. According to some estimates, the value of Mongolia’s natural resource deposits could reach $2 trillion – the equivalent to the gross domestic product (GDP) of Italy for a year. Thanks to its natural resources, Mongolia is one of the world’s fastest-growing economies. In 2011, Mongolia’s economy grew by an incredible 17.5%. And the International Monetary Fund (IMF) forecasts that Mongolia will continue to be one of world’s fastest-growing economies over the next decade. But just 10 minutes outside of Ulaanbaatar, people live in small houses and gers (a felt tent typical in Central Asia) without running water or paved roads. Around a quarter of Mongolians live in poverty today. Average GDP per capita (the value of the country’s annual production divided by number of citizens) is $3,700. By comparison, the U.S.’s is $41,749. But in time, the Mongolians living in poverty are going to move up the socioeconomic ladder... and into the 25,000 or so apartments that are built every year in Ulaanbaatar. That’s where this month’s opportunity lies – in the booming Ulaanbaatar real estate market. Prevailing terrible sentiment toward Mongolia means that investors aren’t giving the country a second glance. Because of that, we can buy shares in a com- pany well-positioned to capitalize on Mongolia’s growth story – for just a fraction of what the shares The Market Is Ignoring One of the World’s Greatest Growth Stories MAY 2014 How we’ll set ourselves up to profit from one company taking advantage
Transcript
In the center of Ulaanbaatar, just a few hundred yards away from an enormous statue of Genghis Khan, sits one of Louis Vuitton’s most successful stores in Asia.
The luxury retailer moved into the capital city of Mongolia in 2009.
Sitting in an Italian restaurant overlooking a temple, a foreign businessman who had been in Mongolia’s capital for years told me the party to launch the store cost a few million dollars.
It sold out of its entire inventory within the first three months of operation. That’s unheard of – especially for a city where, at the time, the average citizen earned as much per year as someone in Sudan makes today.
The over-5,000-square-foot store sits at the entrance of one of the city’s most prominent skyscrapers.
Nestled among the city’s skyscrapers are dozens of small stores – from pizza shops and coffee houses to Irish pubs. There are also several fancy-looking malls and boutique stores with prices at least as high as you’d find in New York.
Construction cranes are on just about every corner of this small city. The streets are so clogged with cars – including plenty of BMWs and Range Rovers – that it’s often faster to walk than drive. I abandoned the taxi that was driving me back to my hotel in favor of walking several times.
Ulaanbaatar is a testament to the growing wealth of Mongolia.
You see, the country is sitting on some of the world’s richest earth. According to some estimates, the value of Mongolia’s natural resource deposits could reach $2 trillion – the equivalent to the gross domestic product (GDP) of Italy for a year.
Thanks to its natural resources, Mongolia is one of the world’s fastest-growing economies. In 2011, Mongolia’s economy grew by an incredible 17.5%. And the International Monetary Fund (IMF) forecasts that Mongolia will continue to be one of world’s fastest-growing economies over the next decade.
But just 10 minutes outside of Ulaanbaatar, people live in small houses and gers (a felt tent typical in Central Asia) without running water or paved roads. Around a quarter of Mongolians live in poverty today.
Average GDP per capita (the value of the country’s annual production divided by number of citizens) is $3,700. By comparison, the U.S.’s is $41,749.
But in time, the Mongolians living in poverty are going to move up the socioeconomic ladder... and into the 25,000 or so apartments that are built every year in Ulaanbaatar.
That’s where this month’s opportunity lies – in the booming Ulaanbaatar real estate market.
Prevailing terrible sentiment toward Mongolia means that investors aren’t giving the country a second glance. Because of that, we can buy shares in a com-pany well-positioned to capitalize on Mongolia’s growth story – for just a fraction of what the shares
The Market Is Ignoring One of the World’s Greatest Growth Stories
MAY 2014
How we’ll set ourselves up to profit from one company taking advantage
will be selling for in a few years.
But before we get into this month’s recommendation, let’s take a deeper look at Mongolia.
From Booming Frontier Market to Pariah
When you get outside Mongolia’s bustling capital of Ulaanbaatar, you can understand why the country’s nickname is “Land of the Blue Sky.” Wedged between Russia and China and roughly the size of Alaska, Mongolia is beautiful, endless, and open.
It has the second-lowest population density of any country in the world. On average, there are just two people per square kilometer. By comparison, there’s an average 34 people per square kilometer in the U.S.
If you take the total number of people who cram into New York’s Times Square for New Year’s Eve... and multiply by three... that’s how many people live in all of Mongolia.
And underneath all that blue sky sits some of the world’s richest earth. As I mentioned earlier, accord-ing to some estimates, the value of Mongolia’s cop-per, gold, coal, tin, uranium (the fuel used in nuclear power stations), and tungsten (a rare metal used in a variety of objects like light bulbs and x-rays) deposits could reach $2 trillion.
That’s a lot of money… And for a country with a GDP of just $11 billion (as much as Gainesville, Florida), it’s an inconceivably enormous figure.
The growth potential of Mongolia – as it begins to chip away at that $2 trillion – is huge. Over the past 10 years, Mongolia’s GDP has grown at an average of 9% per year. And as I mentioned earlier, the IMF forecasts that Mongolia will continue to be one of
the world’s fastest-growing economies over the next decade.
Mongolia’s economic growth has been driven by its mineral wealth for a number of years now. But the real money didn’t start moving in until October 2009, when Canadian mineral exploration and development company Ivanhoe Mines and the Mongolian gov-ernment agreed on terms to operate the Oyu Tolgoi copper mine.
With further development, it’s estimated the Oyu Tolgoi mine will be one of the largest copper mines in the world. It’s capable of generating around 3% of the world’s total annual copper production.
The deposit is so rich that it can produce around a quarter of the total gold output of the entire country of Indonesia, one of the largest gold-producing coun-tries in the world, as a byproduct. That’s right, it can produce that much gold simply as an afterthought of copper production. “This mine... it’s a freak of nature, it’s so rich,” a global mining expert told me.
Dozens of mining companies – interpreting the deal as a sign that Mongolia was a place where they could do business – rushed in. Many businesses that sup-port mining companies – like drilling, transportation, and infrastructure businesses – also opened shop in Mongolia.
Soon after, investors poured into the country’s tiny stock market. From late 2009 to its peak in early 2011, the Mongolian Stock Exchange appreciated 433%. Foreigners invested in high-yielding local bank ac-counts that seemed to offer a one-way road to wealth. With its astronomical wealth in the ground, Mongolia was a “sure bet.”
Of course, there’s no such thing as a sure bet.
Things fell apart in July 2012 when Mongolia’s govern-
MARKET INSIGHT MongoliaPopulation 2.8 million – about the population of ChicagoCapital Ulaanbaatar
Size 604,000 square miles – three times the size of Spain
Gross Domestic Product $11 billion – as big as Amarillo, Texas
Stock Market Capitalization $750 million
Transparency International’s Corruption Perception Index Ranked No. 83 out of 177 countries – on the same level as Jamaica
World Economic Forum’s Global Competitiveness Index Ranked No. 83 out of 148 countries – on the same level as Mexico
Ease of Doing Business Ranked No. 76 out of 189 countries – on the same level as the Czech Republic
ment passed a law to limit foreign investment in com-panies operating in strategic industries (like mining) to a 49% stake.
In essence, the law gave the government veto power over any significant investment in the country’s min-ing sector. And investors fled soon after it was passed.
To understand why Mongolia’s government passed a law so detrimental to investment in its economy, take a look at where Mongolia is located:
As I said earlier, it’s wedged between Russia and China.
China accounts for more than 80% of Mongolia’s ex-ports, mainly natural resources. The Oyu Tolgoi mine is just 50 miles from the Chinese border.
But Mongolia and China have a complicated history. Mongolia was a region of China less than 100 years ago. Today, China has more than twice the number of soldiers as Mongolia has people. And the possibility that some of China’s 1.4 billion people could get a bit of breathing room under Mongolia’s blue sky – while helping exploit the country’s minerals – keeps Mongolians up at night.
Just to the north looms Mongolia’s big brother, Russia. During the Cold War, Mongolia was independent but under the wing of the Soviet Union.
Many people over the age of 40 in Mongolia learned Russian as children and still speak the language (al-though with a heavy accent). The Mongolian alphabet is the same as the Russian alphabet. Many parts of Ulaanbaatar are a carbon copy of post-Soviet cities in Central Asia like Bishkek and Almaty. For exam-ple, dozens of apartment blocks built throughout the Soviet Union (called Khrushchyovkas) can be found throughout Ulaanbaatar.
So Russia has influence over Mongolia. “Russia is a good balance to China,” a local banker told me. “Nei-
ther will let the other do anything in Mongolia.”
But that balance was upset in April 2012 when Chinese state-owned aluminum producer Chalco announced it was going to buy a controlling stake in SouthGobi Re-sources, a Mongolian coal company, from a Canadian mining firm. The $900 million deal would have been the biggest Chinese investment in Mongolia to date.
But the deal stirred up latent Mongolian concerns about Chinese encroachment on its strategic assets. So in July 2012, a law to block the deal was passed… but it also blocked all other significant foreign investment, too.
Mongolia’s concern over the SouthGobi deal was rea-sonable, as it would have been a big step toward China controlling Mongolia’s coal industry. But the execution to prevent it was terrible.
Trying the Local Cuisine
One of the things I like the most about traveling is exploring the local cuisine. Some of my best meals in recent months have involved kebabs and rice in Tehran, Iran; beef in Harare, Zimbabwe; and borscht in Kiev, Ukraine.
I wasn't sure what to expect in Mongolia. Coun-tries under the former Soviet Union's influence favor bland palates. For example, for years, ketchup and black pepper were at the far end of the spicy spectrum in post-Soviet Russia – before the slow invasion of foreign culinary influence. And, unfortunately, Mongolia didn't disappoint... While I was there, I ate a lot of bland lamb and beef, dumplings, and noodle-like dishes.
When I was in Ulaanbaatar, I went to a Mongo-lian barbeque place. You might have seen these in the West. You pile raw meat, chopped vegetables, and spices into a heaping bowl, and a guy wear-ing a funny hat stir-fries it all on an enormous flatiron griddle.
But “Mongolian barbeque” is about as Mongo-lian as apple pie. The first Mongolian barbeque restaurant was opened in Taipei, the capital of Taiwan, in 1976. As far as I can tell, labeling it “Mongolian” was a marketing gimmick.
Maybe the most authentic thing about the place was the cooked sheep head in the adjoining buffet, nestled on a bed of potatoes and carrots. I like to try the local cuisine... but in this case, I stuck with the inauthentic.
“I can understand where the government was coming from, but they completely overstepped... They shot themselves in the foot in the biggest way you can imag-ine,” one foreign businessman who has been in Ulaan-baatar for more than a decade told me over lunch.
Things got worse a few months later when the govern-ment pushed for Rio Tinto to re-negotiate the terms of the Oyu Tolgoi mine deal.
In a matter of months, Mongolia went from a booming frontier market to a pariah.
“Mongolia has a heady brew of mammoth problems,” the Financial Times warned in 2012.
Mining companies that had so eagerly piled into Mon-golia just months before scaled back their plans just as quickly. Foreign investment, critical to Mongolia’s growth, collapsed 54% in 2013.
The stock market collapsed and still hasn’t recovered. It’s down 53% from its highs in early 2011. You can see this in the chart of the Mongolian Stock Exchange Top 20 Index below. This index tracks the top 20 securities in the Mongolian Stock Exchange.
Inflation is running at more than 12% in the country. And Mongolia’s currency, the togrog, has fallen 37% against the U.S. dollar since June 2012.
Mongolia’s foreign reserves, which are used in part to support the togrog, are half of what they were a year ago. And Mongolia’s current account (which reflects the difference between imports and exports and is a key measure that investors use to assess the health of emerging economies) clocked in with a deficit of 27% in 2013.
To make things worse, the slowdown in the Chinese economy and a decline in global commodities prices globally have hurt Mongolia’s trade position.
Despite the unintended consequences from the law, Mongolia’s economy continued its fast-paced growth.
Some investors like to think that strong fundamen-tals, cheap valuations, and earnings growth will raise a market’s valuations regardless of politics. But as Mongolia shows, bad politics can ruin a market... for a while, at least.
In 2013, a new government was elected in Mongolia. It swiftly passed a new investment law that lifted virtu-ally all of the foreign investment restrictions that had been imposed. A number of other reform measures were passed, showing that the government is a com-plete break with the past. And the country’s president, Tsakhiagiin Elbegdorj, has said that the Mongolian government will not interfere with business at all.
But stock investors haven’t caught on to the fact that things are falling back into place in Mongolia. And that’s exactly why we’re investing there this month.
Mongolia Fits My Criteria for Contrarian Returns
When I look at a market, I use a set of criteria to see if it fits the bill for potentially enormous contrari-an returns (see the S&A Global Contrarian How-To Guide for more details). I look at...
Sentiment: As I’ve explained, despite being one of the world’s fastest-growing economies, Mongolia stumbled… and sentiment turned toxic.
The Financial Times regularly refers to Mongolia as a “faltering economy.” (Despite the fact that most wouldn’t view economic growth in the double digits as a problem.)
While I was visiting Ulaanbaatar a few weeks ago, Stan-dard & Poor’s ratings agency downgraded Mongolia’s sovereign credit rating (the credit rating of a national government)... to even deeper in “junk” territory.
In Ulaanbaatar, I met a relocation-services specialist,
who helps families (mostly associated with multina-tional firms) move their belongings to a new country. Since the middle of last year, “everyone’s been moving out,” he told me.
But Mongolia’s government is trying hard to put the train back on the tracks.
In early May, the government kicked off a 50-point plan to jumpstart the economy, with measures to sup-port mining, manufacturing, and infrastructure.
“I’d far rather have these guys running my country than the people we have now,” one American investor who has spent a lot of time in Mongolia told me.
And sentiment is slowing changing.
One way to gauge sentiment toward a country is to look at its bond yields. Bond markets are generally much larger and deeper (that is, there is more trading in them) than stock markets. And bond markets are often a leading indicator for equity markets. If bond prices are going up, it’s a good bet stocks may soon follow.
For example, there has been a sharp rally in Mongo-lia’s 2022 5.125% Eurobond (a type of international bond). It suggests underlying confidence on the part of bond investors... which is encouraging for Mongolia’s stock market.
Valuation: The share prices of Mongolian companies are a fraction of what they were just a few years ago.
As I mentioned, the country’s stock market is down 53% from its highs in 2011. If you factor in the depre-ciation of the togrog (Mongolia’s stock market is de-nominated in togrog), the Mongolian Stock Exchange is down more like 75%.
Similarly, the share prices of many of the largest for-eign-traded companies that have operations in Mon-golia are also far below their highs, as you can see in the following table.
So assets in Mongolia appear cheap right now.
But getting a handle on the valuation of the Mongolian Stock Exchange is difficult. You see, Mongolia’s ac-counting practices result in lower earnings than you’d see in equivalent operations under Western account-ing standards.
For example, in Mongolia, companies don’t depreci-ate capital expenditures (it’s posted as a current-year expense). And foreign-exchange losses – any company with foreign-currency denominated loans in Mongo-lia has them since the togrog has depreciated – are a direct hit to profits. In Western accounting standards, they don’t affect profitability in the same way.
So what does all this mean? At this stage in the commodities cycle (that is, while the prices of many commodities are weak), Mongolia’s stock market isn’t necessarily cheap... but it’s not expensive, ei-ther. Remember, Mongolia’s market is tied to natural resources. And with Mongolia’s strong catalysts (more on those in a moment), there’s enormous upside in Mongolia’s market from here.
But unlike the last boom in Mongolian stocks, this time the growth will be a gradual process. And there’s always the risk that shares could fall lower.
If the Chinese economy – which is the primary buyer of Mongolia’s natural resources – slows down more than expected, Mongolia will probably suffer more than most other markets.
And if commodities prices continue to be weak (in part because of a slowdown in China), Mongolia will be hit hard. Finally, if there’s a renewed exodus from risk in the global markets (like there was earlier this year when emerging markets fell sharply), Mongolia will fall.
The good thing is that Mongolia’s economy is growing fast. And Mongolian assets aren’t trading at all-time highs… Foreign investment, along with the togrog and the stock market, has already collapsed. A cheap asset can always get cheaper. But with the catalysts I’m about to tell you about, the way back up is clear for Mongolia.
COMPANY EXCHANGE RECENT HIGH
CURRENT PRICE
CURRENT MARKET CAP*
Turquoise Hill Resources NYSE $20.74 $3.83 $7.7 million
Mongolia Energy Corp. Hong Kong HK$18.06 HK$0.155 $135.1 million
Mongolian Mining Corp. Hong Kong HK$11.50 HK$0.61 $291.6 million
SouthGobi Resources Toronto C$20.39 C$0.62 $106.4 million
* In U.S. dollars
Catalysts: As I said earlier, Mongolia is open for business again. But not many investors have noticed.
Foreign direct investment was down another 28% in the first two months of 2014. The currency has fallen 9% in 2014 so far. The Mongolian Stock Exchange is down 14% in dollar terms in 2014, enough to make it one of the worst-performing markets in the world this year.
This will change... probably sometime soon. I see a number of potential catalysts that will move Mongolia back onto the radar.
There’s one catalyst that was at the top of the list of most of the people I spoke with in Ulaanbaatar.
Rio Tinto, one of the world’s largest mining companies, holds a 66% stake in the Oyu Tolgoi mine (through a separately traded mining company, Turquoise Hill Re-sources, which is 51% owned by Rio Tinto). So far, Rio Tinto has invested more than $6 billion in the project to access the mine’s natural resources.
But Rio Tinto has been locked in negotiations to further develop the mine with the Mongolian govern-ment. Rio Tinto wants to use “phase two” to turn Oyu Tolgoi into the world’s largest copper mine that pro-duces 3% of the world’s total annual copper.
But deadlines to initiate the financing for the $4.2 bil-lion phase-two project have been missed repeatedly.
The Mongolian government is balking at Rio Tinto’s efforts to increase the size of phase two, because this will push back when Mongolia will begin to receive dividends from the mine. The way the deal is struc-tured is that Rio Tinto – as the investor in the mine – recoups its investment before the Mongolian gov-ernment (which isn’t investing any cash into the mine) makes a return.
But Rio Tinto might not really mind that the project is delayed. Financing will be available regardless of when the two sides come to a deal. There will always be dozens of big banks and multilateral lenders lining up to help one of the world’s biggest mining companies develop what will be the world’s largest copper mine.
And Rio Tinto may want to eventually buy more shares of Turquoise Hill Resources. Because phase two hasn’t started yet, shares of Turquoise are cheap. So Rio Tinto may want to use the opportunity to get more control on the cheap.
“In some ways, it’s a bad situation,” one long-time in-vestor in Mongolia told me. “Mongolia ends up looking
like it’s being difficult. But really, it’s trying to make sure that it’s not being taken advantage of by a big global miner that has played this kind of game before.”
Unlike Rio Tinto, Mongolia doesn’t have the luxury of time. “It’s a bit of a race now,” an economist in Ulaan-baatar said. “Growth is still strong, but the macroeco-nomic fundamentals are deteriorating. It's a question of whether it will all come together in time.”
The question is whether the deal will happen before the further decline of the togrog and foreign investment.
Phase two matters so much that Mongolian’s 50-point economic stimulus package specifically instructs the government to “accelerate the development of the Oyu Tolgoi project” and to “provide government policy support” to implement the project.
So the Mongolian government will finalize the deal. It’s just a question of whether it happens within the next few months... later in 2014… or in early 2015.
When the deal is finalized, it will trigger the start of a flood of investment into Mongolia. It will also signal that Mongolia is safe territory again for investors. More mining companies will follow Rio Tinto... and stock investors won’t be far behind.
In the meantime, the Mongolian government has strongly signaled that it’s going to stick to its word this time and not interfere with business. There’s no guar-antee that the Mongolian government won’t change its tune again and pass anti-investor legislation… but it’s clear that the government has learned its lesson.
Most importantly, members of parliament – who play a key role in developing policy – got hit last time by anti-investor regulations where it matters the most: Their own wallets.
“I’d estimate that close to half of the members of parliament have interests in the mining industry,” a banker in Ulaanbaatar told me. “They felt the pullback in investment almost immediately. And they don’t want it to happen again.”
And the consequences of bad policy couldn’t be clear-er. The IMF has two separate forecasts for economic growth in Mongolia – a strong and a weak policy scenario.
The scenarios are based on fiscal and monetary pol-icies, how the government pays its expenses, and the impact these measures have on the country’s economy.
In the strong policy environment (which means Mon-
golia’s government is enacting fiscally conservative policies), GDP growth from 2014 to 2018 averages 7.3% per year. In the weak policy environment (which means Mongolia’s government is enacting policies that lead to excessive spending and fuel inflation), GDP growth averages just 2.5% per year.
Which way will Mongolia go?
If I was a member of Mongolia’s parliament and I wanted to maximize the return of my mining invest-ments, the choice would be clear to me. I think it will be to them, too. So it’s likely Mongolia’s government will keep its word and do everything it can to promote investment in the country.
Another more market-specific catalyst for Mongolia is the country’s stock market becoming part of a frontier index. A lot of fund managers make their investment decisions based on the weighting of particular mar-kets in an index.
In Ulaanbaatar, I had breakfast with a banker at one of Mongolia’s largest brokerage houses. He told me that Mongolia becoming a part of a frontier index will be a big trigger for the stock market.
So once Mongolia’s stock exchange is added to a key frontier index that a lot of investment funds follow (like one of the indices produced by MSCI, one of the largest index companies), there will be a sharp increase in investment flow into the market. That’s not going to happen any time soon, but it likely will at some point.
Summing it all up, it’s just a matter of time before in-vestors return to Mongolia. The country has enormous potential… and although it’s a small market, early investors could earn huge returns.
“If they get it right, Ulaanbaatar is going to be another Doha or Kuwait City,” one investor told me, referring
to the glistening capitals of two energy-rich Middle Eastern countries. “That’s what $2 trillion can do.”
Finding the Right Recommendation
When I visit a market, sometimes I have a difficult time finding the right investment opportunity. Even if the market overall is attractive, shares of specific com-panies I like might be too expensive, or a stock might not be liquid enough (that is, the shares don’t trade much), or I might not trust the management.
With Mongolia, I faced other challenges. A number of traded stocks are more directly linked to big-picture drivers – like commodities prices – than to the inter-nal dynamics of what’s going on in Mongolia.
There’s nothing wrong with that... but it’s not how we’re looking to profit from Mongolia’s catalysts.
I want to recommend a stock that’s more driven by the growing wealth of Mongolians, rather than by commodities prices (even though the two are closely linked).
I found just that in this month’s recommendation…
Enormous Growth Potential in Mongolian Real Estate
Mongolia Growth Group (OTCMKTS: MNGGF) owns and manages real estate in downtown Ulaan-baatar – including around 8% of total street-level retail real estate on Peace Avenue, Ulaanbaatar’s main “high street.” (A country’s “high street” is its main shopping and business zone.)
One of its other main focuses is redevelopment proj-ects... where it buys buildings and either knocks them down and starts over, or else renovates them beyond recognition, and then rents the properties.
Many of these sites are on prime real estate on Peace Avenue. And there’s a lot of redevelopment work to be done.
“When you look at all the old Soviet buildings here, it’s pretty clear that the entire city will have to be recycled over the next 20 or so years,” a real estate professional who doesn’t work for MNGGF told me.
But real estate is a much easier business if real estate prices are on the rise. This has been, and will continue to be, the case in Ulaanbaatar for years to come. With overall economic growth rising, people have more money... and they want to spend it in restaurants and
stores. That helps push up rents.
Rising wealth also attracts international companies. There’s an Ermenegildo Zegna, a men’s luxury store, next door to Louis Vuitton. There are other high-end luxury retailers on the way. You can get fried chicken at just one KFC in town... but it’s only a matter of time before McDonald’s and Starbucks find their way to Ulaanbaatar. And they’re all going to want to be on Peace Avenue.
As a result, MNGGF has seen its rents move up 34% over the past year in local currency terms... and that’s just the beginning. Rental rates for retail real estate on the high street in Ulaanbaatar are still just a small frac-tion of rates in other emerging markets’ high streets.
Even in a rising price environment, it’s still easy to make a mess out of investing in real estate, though. You can get ripped off if you don’t know the market... contractors and builders can cheat you... your own employees might be in business against you... you might wind up with deadbeat tenants… or you might get nickel-and-dimed to bankruptcy through petty corruption. These potential challenges are magnified if the market turns against you.
But MNGGF has been insulating itself against a lot of these risks since it launched in February 2011. Let me explain…
Investing with the Leaders in Mongolia’s Real Estate
Harris Kupperman, the company’s founder, was an American hedge-fund manager who saw an opportu-nity in Mongolia. He figured out a way to exploit the underdevelopment of the real estate market in Mongo-lia, which was lagging the growth of the economy.
In every market, there’s going to be someone who gets
in early to do what has worked in dozens of other mar-kets around the world... Harris was first in the door in the Mongolian real estate arena.
From the beginning, Harris made it clear that he was in Ulaanbaatar for the long haul. That helped attract the strongest professionals in the market – and retain them as the company grew.
There’s no magic potion to building a successful business as a foreigner in a market like Mongolia. But building a business around a core of talented local professionals who have international education and experience – but also understand the local context – is a good start. Finding the right people isn’t easy, though... Harris told me that he has probably inter-viewed around 1,000 people to fill 25 positions.
You see, in a market like Ulaanbaatar, you have to be local.
“If you’re a foreigner walking into town looking for something to buy, you’ll pay twice as much as some-one from around here who knows how the market operates... That’s just the way things work,” Harris told me.
As a local firm with roots throughout the business community (in small markets like Ulaanbaatar, every-body knows everybody else), MNGGF enjoys advan-tages that parachute bankers – investors who visit only every so often – don’t. Harris told me that local banks give MNGGF access to lists of non-performing loans (loans that are past due) that they have on their books... and they’re willing to negotiate to sell these properties quickly.
“If you can get a property at 60 cents on the dollar, you’re already a long way ahead,” Harris said. And if you’re on the ground, and ready to do due diligence and sign the paperwork tomorrow, you’ve got a huge competitive advantage.
At least as importantly, MNGGF promotes from within, and encourages its employees to improve their skills. This makes them more valuable to the company... and it also improves the chances that they’ll stick around. Har-ris told me that in the history of the company, only one employee he didn’t want to lose went to another firm.
But the way to lift a well-run local firm to one that could hold its own with similar companies anywhere else in the world is to bring in an international-caliber professional who has deep and broad experience in the industry… and has built similar companies from the ground up before.
It wasn’t easy, but Harris eventually found Paul Byrne.
Earlier in his career, Byrne helped develop the Hong Kong airport and the new World Trade Center in New York. More recently, he headed up a major real estate development firm in Dubai, in the United Arab Emir-ates, where he was in charge of 15 malls, 10 hotels and resorts, and seven mixed-use developments spread over 12 countries in the Middle East.
After spending a few months as a consultant for MNG-GF, Byrne joined the company as CEO in March. He has continued the process of disposing of small, labor-inten-sive properties (MNGGF has around 65 different proper-ties), focusing on larger assets that are more profitable.
Byrne is laying the groundwork to bring more large-scale development projects to the firm, sharing risk with external investors who can also borrow money at better rates than what’s available to MNGGF.
And Byrne is light years ahead of the rest of the market.
“There aren’t many developers here who are good at staging,” he told me.
Ideally, in a big development, you want to finish and rent out one part, while you’re still working on completing the rest (what’s known as “staging”). That way, you can use cash flow from the rent to cover your interest expense.
“People here too often try to finish the whole thing at once... and go bust before they can rent out any space.”
And MNGGF is going to continue to stay out of build-ing apartment buildings.
“Residential is too easy... I prefer businesses where the barriers to entry are higher,” Byrne told me.
Eventually, he wants to roll MNGGF’s properties into a real estate investment trust (REIT) structure. Among other advantages, this structure could more easily borrow money to invest in projects.
On another front, Byrne is going to develop the com-pany’s property-management business, that is, man-aging other people’s property for them. Done correct-ly, this can be hugely profitable... and in a market like Ulaanbaatar, there isn’t much competition.
One question I had before speaking with Byrne was his motivation: Why would a guy who could retire to a sunny island – or, at any rate, get any job he pleased anywhere in the world – sign up for a five-year stint in Ulaanbaatar?
There was one simple answer: Money. “In terms of the ability to build from a low base, Mongolia is unique,”
Corruption in Mongolia
A challenge that often confronts small, foreigner- run companies in emerging markets is that they're an easy target for small-time thugs looking for "protection" money... and for various government inspectors who assume that the rich, clueless people from out of town will readily pay them to go away.
In Moscow, businesses ranging from the old grandma selling onions from her garden on the sidewalk to the big bank I used to work for are regularly shaken down. (My employer had an entire "government relations" team comprised pri-marily of former security-services agents to keep sticky-fingered regulators and inspectors at bay.)
Harris laughed when I asked him if MNGGF has to pay people off.
"People try sometimes... They say, 'You'll get this permit, and it will take a year. But you could get it tomorrow, if you wanted.' So we say, 'OK, we'll wait a year!' And we do."
It also helps that Mongolia is a small place where it's not difficult to meet high-level decision makers who can help bypass petty bribery. And as MNG-GF is one of the larger foreign investors in Ulaan-baatar, the government is eager to make sure that its experience can serve as a good example for other potential investors.
Mongolia's standing Transparency International's Corruption Perceptions Index, which measures levels of corruption in different countries, has im-proved dramatically in recent years. It has fallen from 120 (the higher the number, the more corrupt the country) in 2009, to 83 last year. It has a long way to go... but that's extraordinary progress. With more firms taking a stand like MNGGF, Mongolia's progress will be all the faster.
MONGOLIA'S CORRUPTION PERCEPTIONS INDEX RANKING
2009 120
2010 116
2011 120
2012 94
2013 83
Source: Transparency International
he told me. “It’s a blue-sky opportunity. The country has a huge natural resource base. And it’s ignored.”
What also appealed to Byrne was that he was walking into a great situation. “MNGGF is in a sweet spot. We have first-mover advantage here. Harris found the best people, and we’re building from that. So we’re in a perfect position.”
Byrne bought shares of MNGGF when he joined, and he has been paid mostly in share options, rather than cash... so he’ll only make money if MNGGF’s share price rises.
“I see this as a $1 billion company,” he told me. And giv-en that the last company that he ran was several times larger than that, chances are good he’ll be able to do it.
Harris, who is now the executive chairman (now that Byrne is CEO), spends a lot of time on business devel-opment and investor relations. He was recently on a long marketing trip to talk to investors about MNGGF.
“Three years ago, we had no capital, no business plan, and three employees... and we had over 300 people who wanted to hear what we had to say,” he said.
“This year, we have one of the largest real estate companies in the country, 45 employees, and a new CEO... and we had less than 100 investors attending meetings with us.”
Over the past year, MNGGF’s share price has been in a steady downtrend... which was interrupted by a sharp rally a few months ago, just after Byrne joined the company. Since then, shares have drifted back down.
Are MNGGF’s shares cheap today?
If you look at the book value of all the real estate assets held by MNGGF, and add the value of the real estate man-agement company, it’s probably close to the company’s
current market capitalization of around $75 million. So at first glance, the company doesn’t look all that cheap.
But the book value figure is discounted heavily be-cause of numerous accounting oddities. For example, a property that is waiting on a particular license might be marked down by a quarter, only to be marked back up when the license comes through.
A property purchased at well below market value nev-ertheless appears on the books at the price at which MNGGF bought it.
And book value doesn’t account for the sharp growth in rents that MNGGF is charging... or for large capi-tal appreciation as the underlying value of MNGGF’s assets rise.
MNGGF is an unusual opportunity. It’s an indirect play on what will likely be a continued boom in a small but rapidly evolving economy. Ulaanbaatar’s real estate is deeply undervalued... and MNGGF has put together a portfolio of many of the city’s most attractive assets. Rising rental income plus capital appreciation should power growth.
The company’s strong roots, coupled with Byrne’s unique experience in the field, will give MNGGF an enormous edge. Finally, the fact that Harris and Byrne will only make money if the share price goes up ensures that everyone’s objectives are aligned.
As soon as investors pour back into Mongolia, MNG-GF will be one of the first companies they look at.
We’re not buying MNGGF’s shares for a quick return... This may take a while. But I can see a very credible roadmap for the share price increasing several times over in the next few years.
Buy Mongolia Growth Group (OTCMKTS: MNGGF) up to $2.50. Use a 40% trailing stop to protect your capital.
We’re using a wider stop than usual because of the pos-sibility for volatility in Mongolian stocks. MNGGF offers an excellent value at current levels, but shares might bounce around a lot before they move up. I want to be sure we don’t get stopped out of the stock while we’re waiting for the market to realize the company’s value.
How to Buy MNGGF
You can buy MNGGF either on the Nasdaq, on the pink sheets (ticker MNGGF), or on the Toronto Venture Stock Exchange (ticker YAK). I’ll be fol-lowing the Nasdaq share price.
What’s Contrarian Now
Country Price-To-Earnings Ratio (1-Year Forward) 3-Month Market Performance* 6-Month Market
Performance3-Month Local Currency
vs. U.S. Dollar*6-Month Local Currency
vs. U.S. Dollar
Venezuela 12 -20% -7% 0% 0%
Ukraine 3 -9% -16% -34% -44%
Russia 5 -4% -9% 3% -5%
On My Radar
• Clashes between protestors and the government earlier in the year helped push the Venezuelan market down. Years of political and macroeconomic mismanagement are continuing to take their toll, making the country's stock market one of the worst-performing in the world this year.
• Ukraine's economy is forecast to shrink by 5% this year, in part due to Russia's involvement in the country. Al-though funding from the International Monetary Fund will help stabilize the economy, investment will remain low as long as geopolitical uncertainty looms over the market.
• Russia's markets have moved up in recent weeks despite continued uncertainty over its objectives in Ukraine. As long as geopolitical risk remains high, Russia's stock market will likely remain one of the world's cheapest.
Source: Bloomberg * In U.S. dollar terms
The S&A Global Contrarian Portfolio Review
I have a brief update this week… focusing on our Ka-zakh bank Kazkommertsbank (LSE: KKB).
Shares are down around 40% from their highs in early April (although we’re still up 27% from our entry point). We knew this would be a rocky ride… and it certainly has been.
KKB’s shares are down for two reasons. First, the company recently posted weak first-quarter results. Net income was down 86% from the previous quar-ter, and non-performing loans rose to 36.1% of loans outstanding, from 32.4% as of the end of last year. Net interest margin, a key indicator of profitability for banks, also declined.
Some of this weakness was related to foreign-ex-change losses following the devaluation of the Ka-zakh currency in February. But the results also show that KKB, and the Kazakh banking sector, still have a long way to go.
The second big reason for the drop in KKB was that the European Bank for Reconstruction and Develop-ment (EBRD), a developmental lender and investor active throughout Eastern Europe and Central Asia, sold its 10% stake in KKB. The EBRD sold its shares to the main shareholder of KKB, who is also chair-man of the board.
The fact that EBRD was a shareholder in KKB provid-ed a measure of comfort to other shareholders, be-cause it’s a big, important regional investor that would look out for the rights of minority investors. We don’t have that protection anymore.
So the story has changed somewhat… but we’ll still do well holding shares of KKB. As I’ve said before, the Kazakh government has made the stabilization of the banking sector – and reducing the level of
non-performing loans throughout the industry – a top priority.
And KKB, in combination with BTA (the bank it’s merging with), is the biggest bank in Kazakhstan. The government won’t let it fail. KKB is a buy up to $2.
What’s Next...
Next week, I’ll be is traveling to a country that has been stealing headlines recently for all the wrong rea-sons – Thailand.
Two days after declaring martial law but saying it wasn’t a coup, the military on Thursday went on television to announce that it is taking control of the government. This comes after six months of political turmoil… which is only part of the eight years of on-and-off strife the country has endured between the same two groups that are fighting each other now.
Some of the people I’ve been in touch with in Bang-kok, Thailand’s capital, have warned me that they can’t talk politics because it could land both of us in hot water with the authorities. And the military imple-mented a nationwide curfew in effect from 10 p.m. to 5 a.m. every night.
This is the 12th coup in Thailand since 1932… so it’s nothing all that new for people there. But it’s hurting investor sentiment, and might be just the sort of setup we look for in the S&A Global Contrarian. I’ll have more details for you soon.
Regards,
Kim Iskyan May 23, 2014
The S&A Global Contrarian Portfolio
Prices as of May 22, 2014
Stock Exchange Ref. Date Ref. Price Recent Price Dividends Return Industry Advice Stop Price
Kazkommertsbank (KKB) London 12/19/13 $1.56 $1.98 26.9% Banking Buy up to $2.00 $1.17
