Tech stocks in emerging markets: what to look for
Looking at tech stocks in emerging markets? Take care to consider investments with a catalyst to unlock a company’s potential and share price. Global Emerging Markets Opportunities portfolio managers James Syme and Paul Wimborne (pictured above) explain
TECHNOLOGY companies generally face an extremely supportive operating environment at present.
Covid-19 has hugely accelerated online migration. Along with the rise in artificial intelligence and machine learning this requires massive investment in new hardware.
Pendal’s Global Emerging Markets Opportunities portfolio has significant exposure to companies that are benefiting from these trends.
But we retain a preference for investments that also have a catalyst to unlock the company’s potential and its share price. This includes some of the largest holdings in the fund.
Naspers, Prosus & Tencent: Twin discounts
One of our largest aggregate portfolio positions is in the related companies of Naspers (a South African holding company), its subsidiary Prosus (a Dutch media conglomerate focused on the internet in emerging markets), and Prosus’s biggest investment, Tencent (a Chinese internet giant).
One of the oddities about the listings of these three is that Naspers trades at a discount to the market value of its shares in Prosus; and Prosus trades at a discount to the market value of its stake in Tencent (let alone the value of Tencent and Prosus’s other listed and unlisted investments).
Naspers has a market capitalisation of US$85 billion (all data as at October 31, 2020 unless otherwise indicated). Almost all of the Naspers balance sheet consists of its 72.5% stake in Prosus. Prosus has a market capitalisation of US$162.7 billion, making that 72.5% stake worth US$117.9 billion.
There are various explanations — mostly around the gap in liquidity, index membership and investor market access between South Africa and the Netherlands.
Sitting behind that valuation anomaly is another, more complicated and potentially larger one.
Prosus owns 28% of listed Russian internet company Mail.ru, 22% of German-listed food delivery company Delivery Hero and 6% of US-listed Chinese online travel retailer Ctrip. These three holdings are worth US$7.7 billion.
Crucially, it also owns 30.9% of Chinese social media and gaming behemoth Tencent. That stake has a market value of US$225.8 billion.
A long tail of unlisted emerging market online companies in classifieds, food delivery, payments, travel, education, and social media has a value (while harder to assess) conservatively estimated at more than US$20 billion.
At its December 2019 capital markets day, Prosus management indicated a desire to create at least US$100 billion in shareholder value over the medium term.
As a step towards achieving that, in October 2020 Prosus announced a US$5 billion buyback, consisting of US$1.37 billion in Prosus shares and US$3.63 billion in Naspers shares. This sits alongside a commitment to increase Prosus’s free float by reducing the Naspers stake to below 70%.
The really big step, however, would be Prosus selling some of its stake in Tencent to do further buybacks.
There are no immediate indications that this is about to happen, but it should be noted that the last such sale (in March 2018) followed a very strong share price run in Tencent, as we have seen year-to-date.
Through these twin discounts in the group’s market capitalisations, there exists very substantial potential for gains to shareholders from proactive steps to buy back shares. We have seen a concrete step towards this in October and expect further steps in current months.
Samsung: Reform in the chaebol sector
Another one of the portfolio’s largest positions is Samsung Electronics (SEC) in South Korea. SEC is a multi-faceted conglomerate operating across various consumer electronics and IT products.
Using its last four quarterly results as a guide, the biggest division by revenue is IT & Mobile, which produced US$9.7 billion in operating profits on US$85.4 billion in revenue with a margin of 11.4%.
The next biggest (but most profitable) division is semiconductor products, which produced US$15.4 billion in operating profits on US$59.8 billion in revenues with a margin of 25.8%. There are also smaller units producing display products and consumer electronics which together produced US$4 billion in operating profits.
This operational profit translated into US$21.3 billion of free cash flow for the period.
SEC has a market capitalisation of US$297.8 billion. But crucially, its balance sheet is extremely cash-heavy.
At the end of September SEC had US$105.2 billion in cash and only US$17.5 billion debt. The company has tended to grow organically, and does not use its cash for acquisitions, making this essentially surplus cash able to be returned to shareholders.
Since 2015 SEC has had a far more positive approach to dividends and share buy-backs, currently operating a shareholder return policy of paying out KRW 9.6 trillion (US$8.7 billion) in dividends each year.
It is seeking to return a minimum of half of free cash flow over the three-year period 2018-2020 through dividends or share buy-backs.
The company was due to announce an update to this policy in the fourth quarter of 2020. However, Samsung group chairman KH Lee passed away on October 25, having been unwell since a heart attack in 2014.
Mr Lee had led the Samsung Group since 1987 following the death of his father, Samsung founder BC Lee. He had transformed Samsung into a world-leader in multiple sectors, with SEC at the heart of the group.
Mr Lee’s son JY Lee has been acting chairman of SEC since 2014 and drive the change in shareholder return policy.
JY Lee is set to inherit stakes of major Samsung group companies, including SEC, and we expect SEC to continue to improve its shareholder return policy.
The Lee family’s control over SEC may decline as it sells down stakes in related group companies to meet inheritance tax obligations, while the Moon government’s pressure on chaebol holding structures continues to increase.
(Chaebol refers to a business conglomerate structure that originated in South Korea in the 1960s, creating global multinationals with big international operations. The Korean word chaebol means business family or monopoly.)
This is likely to increase the role of minority shareholders in major decisions at SEC, which should drive an improving shareholder return policy at SEC. As a result, the announcement of the new shareholder return policy has been moved to late January.
This will be a key moment for SEC.
The buy-back program has been on hold since mid-2018 because a capital expenditure bulge meant the KRW 9.6 trillion dividend payment commitment met the free cash flow return commitment.
However the last four quarters have seen free cashflow run at an annualised level of around KRW 25.6 trillion (US$21.6 billion).
This suggests that either the commitment to pay dividends increases, or the buy-back program resumes.
In conclusion, we certainly find many opportunities in the broader technology space, but prefer to focus our larger positions on those with strong operating momentum and an additional potential driver of returns from restructuring and the unlocking of value.
We are particularly excited about potential newsflow for these holdings in the next few months.
James Syme and Paul Wimborne are senior fund managers and co-managers of Pendal’s Global Emerging Markets Opportunities fund.
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