Geoffrey Batt — Perception and Reality
Winter 2014
Geoffrey Batt is the managing partner and founder of the Euphrates Iraq Fund. He has been investing on the Iraq Stock Exchange since January 2008. Mr. Batt launched the Euphrates Iraq Fund in October 2010. Prior to his Iraq investments, Mr. Batt was an analyst at Quantrarian Capital Management. He studied philosophy at Columbia University.
Graham & Doddsville (G&D): Let’s start with your background — what drew you to investing, and in particular, to investing in Iraq?
Geoffrey Batt (GB): I studied philosophy at Columbia as an undergrad and had absolutely no intention whatsoever of getting involved in finance. I didn’t know anything about the stock market. I honestly didn’t know the difference between a stock and a bond. I was strictly interested in academics and very much wanted to pursue a Ph.D. in philosophy. I took a graduate seminar in my junior year and there was a third year Ph.D. student in the class who was much older, maybe in his forties. But he was, in my opinion, clearly the smartest guy in the room, probably smarter than the professor. He was also a bit eccentric to put it politely. He seemed very interesting, though, and one day we bumped into each other on campus, started talking, and a friendship developed from that. After knowing him for a while, I mentioned that I was going to have to leave school for a year to save up money because I couldn’t renew my student loans.
I revealed this to him having really no idea who he was. But then he started telling me this story of how, before school, he was running a fund that was one of the first to invest in post- Soviet era Russian equities during the 1990s. Russia turned out to be one of the best places in the world to invest in at that time so it was quite successful, but he also had a lifelong dream of pursuing a philosophy doctorate. It turned out that he was in the process of starting a new family office to focus on investing in East Asian emerging markets and asked if I’d be interested in working for him during the time off. If it went well, he told me I’d get a bonus that would more than cover my tuition and in the meantime I’d get to learn about the world. He said something along the lines of, “the last thing the world needs is another philosopher with no real experience.” He was of the opinion that philosophy provides a good training for financial markets.
I actually thought he was nuts. He didn’t fit my conception of what an ultra- high net worth individual looked like. But I went to the library and looked him up and it was all true. His name was Dan Cloud. You couldn’t bring up good pictures on the internet at the time but I saw there was a Barron’s article on him that I had to look up on microfilm. Everything he said was there. So I decided to give it a shot. I went to work for him, with his family office, and learned about East Asia and the markets that they were investing in — Thailand, Hong Kong, South Korea, Singapore, Indonesia, Vietnam, et cetera. Dan was very much a macro driven investor, looking at things from a top down point of view. What he had me looking for were countries that seemed to have the best potential to grow very rapidly and had the most interesting demographic profiles. I more or less just tried to learn on the job, and I would say after six months or so I started getting very interested in companies themselves. I didn’t have the slightest clue about how to analyze or value them so I spent the next six months trying to learn. The first thing I read was The Intelligent Investor. I felt pretty confident that I understood it, so I went on to Security Analysis and read that. I still read it — to this day, I think I’ve finished it seven or eight times. Security Analysis gave me a basic framework, however imperfectly I understood it, that I could use to approach valuing companies on an individual level. And that’s when it became very interesting to me. The macro stuff, it has its place, I suppose. I’m not a value purist in the sense that I altogether shun macro considerations. But to me, the real interesting work is in finding the next big company, the kind of deeply undervalued company that has the potential to appreciate ten, twenty, thirty times over a ten year period.
G&D: How did that year working for Dan turn out?
GB: The year went really well. We were mostly invested in Thailand and I think the market was up 110% or so in 2003–04. I got a bonus, which at the time seemed quite large. In retrospect, it wasn’t, but when you’re approaching things from the perspective of what you’re going to earn in philosophy, it seemed like quite a lot of money.
And so I went back to school and had enough money left over to invest on my own. And you know, before I started working for him, my focus was 100% philosophy. When I came back, it was 50/50–50% philosophy and 50% markets. And as that year progressed, it gradually shifted to 0% philosophy and 100% markets. Toward the end, I was sitting in class with my laptop open reading 10-Qs and 10-Ks rather than paying attention to the professor. I was two classes short of graduating and decided that I had enough.
In retrospect, it was an unwise decision because I didn’t have as much money as I thought I did. Maybe I was a bit delusional in thinking it, but I was determined to just go out on my own and become an independent investor. I still had library access at Columbia and there was a Bloomberg there so I thought it would be perfect. I told Dan my plans and he said, “Look, you can’t just go out on your own and not have structure. You really need to have a mentor for this process, somebody who can help guide you if you’re going in the wrong direction or to provide you with advice and support and criticism.” So I decided to strike up that relationship with him informally where I would start on my own but he would serve as my mentor.
G&D: And what was the focus going to be initially?
GB: Several different stock markets over time have gone through these historic equity re-ratings and what I was really taught to do when I was working for Dan, and what he was taught to do when he first got involved in the business, was to find opportunities for historic re-ratings.
Let me try to define what that is. It’s a type of secular bull market that tends to last for seven to fifteen years, In the case of Japan, their bull market started in 1950 and lasted until 1989. That is one of the longest ones that I am aware of.
Russia was fourteen to fifteen years. You can get a secular bull market that lasts for seven to fifteen years and during that period companies on the exchange can see their profits go up 20x. Initially they might be trading at 2–4x earnings and by the end of the bull market, they are trading at 15–20x earnings. There’s an improvement that gradually gets recognized. Initially, the market goes up but the moves are commensurate with profit growth. If profits grow 40% and the company is trading at 8x earnings, then the stock goes up 40% but still trades at 8x earnings. But towards the end, people get really exuberant and assume that the good times are going to last forever and that’s when you see multiple expansion. So it’s when you get significant profit growth over a long period of time coupled with multiple expansion that you can get these spectacular stock market moves.
When Dan first got involved in the business, it was in China in the 1980s. He finished school and went off to China to work for a British brokerage firm. The guys who taught him made their fortunes investing in Hong Kong and South Korea in the 1960s and 1970s. South Korea was socially and politically an utter basket case at that time. It was ruled by a dictator, Park, for around 19 years. He was a guy who had suspended the constitution two or three times, murdered the opposition. Park was brutal but this was also the period that is referred to as the South Korean economic miracle. So despite the fact there was quite a lot of political and social instability in that country, it happened contemporaneously with an economic miracle. These guys recognized that and they believed that many of the things that typically keep people away from markets — bombings, violence, general instability — really don’t matter that much. As long as it’s not related to the economic development of the country, it doesn’t matter. That was what Dan was taught.
So he later went off and was searching for the next big thing. He found it in Russia and launched his fund in 1994. Russia from 1992- 1994 was also a basket case. Yeltsin lost an election in 1993 but decided it wasn’t valid just by decree and suspended the constitution. Parliament was obviously very upset about that so he sent tanks in to fire on Parliament in 1993. Literally, the President of Russia was using the military to fire on the Parliament building and kill MPs. But it turned out that was the ideal time to get involved in Russia. These sorts of alarming states of affairs, they really, it turns out in retrospect, don’t matter much. They’re terrifying and for that reason most investors don’t get involved in their markets. When it’s most opportune to invest in a market, most people are doing anything but investing there. They stay very far away.
But he was there and started a fund, Firebird. And I think that fund was up 50x, net after two and twenty, so it was an extraordinary run. I think it was one of the best performing emerging market funds in the world during that period. So that’s really what I was taught to look for — these types of really alarming and chaotic transitional situations in a country that, for whatever reason, was living in the stone ages or had some kind of very flawed economic system in place for decades. Something transformative occurs that is followed by a move away from whatever was plaguing it before to something more positive, more market and capitalist oriented. If you can find that kind of situation, that’s a potential candidate for a historic equity re-rating.
G&D: What else goes into it?
GB: There’s a lot more but that’s the first thing you want to look for. It seems to me at least, the greatest opportunities in any market, any asset class, any investment generally that you’re going to make, are those in which there’s a very wide gap between perception and reality. So the perception of a country that has these characteristics is obviously going to be very negative because there’s political instability, social instability, and so on. But if the economic situation is positive, if the country has a couple years of very high GDP growth, inflation is relatively stable and they have price stability, then this is where I think the macro very much comes into play.
You want to look at things like, are deposits in the banking sector growing? Is the currency relatively stable? Generally what you’re looking for are signs of macro stability and economic growth. If you can find these things, then that implies there are institutions in place that are capable of achieving this stability. If you have price and currency stability, that presupposes a central bank exists that is capable of imposing stability on the system. And that also presupposes that you have some sort of technocrat running the institution. So if you have credible institutions at the financial and economic level that are able to achieve macro stability, then whatever has been holding back that country from realizing its potential, if they can transition away from it, macro conditions aren’t going to interfere with development.
If you look at countries that had the potential to do this but failed, like any South American country in the 1960s, what destroyed them is that they had chronically high inflation, they had persistently weak currencies, and they lacked the institutional framework that was vital to achieve the stability that you needed to get that kind of economic take-off. If you’re a business person, how do you plan for the future if the currency is devalued by 80% and there’s prospect for further devaluation? How do you plan for the future if you cannot estimate what your real returns are going to be because the currency and prices are so unstable? It leads to a very short term outlook. That is what prevents an economy from realizing its potential.
G&D: In some of these countries where there is perceived political risk, how do you separate out the noise from true risk? Take Yeltsin for example, if you have a leader or autocrat who is willing to go and fire on Parliament, how do you get comfortable that he also isn’t also willing to devalue the currency?
GB: Right. So this is obviously a key consideration and a great question. In South Korea, I’m not so sure I could ever have gotten comfortable with the fact that Park ruled the way he did.
Dictatorships can be very stable, but, by their very nature, they’re stable until they’re not. If there’s an issue, if suddenly the dictator can no longer rule, what follows? Also if the dictator goes crazy, there’s no mechanism to easily remove him and then you can get a dangerous scenario where he just starts printing money or devaluing the currency — you could have a revolution or other undesirable developments follow. Still, the South Korean example under Park demonstrates that economic miracles and historic equity re-ratings can happen even in iron-fisted dictatorships.
That said, I have a preference for transitional countries where there is a democratic political system in place. Taking Russia and Yeltsin, you could make an argument that what Yeltsin was actually doing was establishing legitimacy of the state itself — that the state itself was being undermined by a group that was trying to take control, the former Communist party, and Yeltsin was trying to prevent that. So you could argue his aims were noble and he was actually trying to install a capitalist, democratic framework, and that action, though autocratic, was directed toward something that was ultimately in the country’s best interest.
When you look at a country that has a great deal of violence and where the political leaders have a reputation for ruling with an iron fist, even if democratic, the key is this: why are they doing it? Are they doing it to enrich themselves? Or is it mixed motives — maybe partially to enrich themselves but also to help the country? No one is entirely acting out of altruistic motives but in dictatorships that lead to disaster, it is often purely just corruption and self-
enrichment. In the case of Russia and also in the case of Iraq, what you find is that what these guys are really doing is attempting to establish the state’s monopoly on the just use of force. That is a critical part of establishing the legitimacy or sovereignty of a country. In these transitional situations, what seems to matter most is that the state demonstrates to the people that only it has the authority to use force justly. Really what the state is doing is demonstrating it has the capability and willingness to establish law and order. Sometimes that can be brutal. But if it’s done to ultimately achieve democratic ends, then it seems like it’s justifiable and something that at least I can get comfortable with. So I think that probably applies to what Yeltsin did. And when I look at Iraq, I think it very much applies to what has happened in Iraq since 2008. To the extent there has been political violence, it’s been done for reasons that are almost always justifiable in those terms.
We observe the behavior of the Iraqi political elite very closely. What we ask is this — are they behaving in a pragmatic way? Is there a rational self-interest to what they’re doing? Are they
able to make pragmatic compromise? Rather than drive the car off a cliff, do they actually stop short before they go over the edge? I mean, if you want to prove a point, you can prove a point and ultimately
die for it. Or you could stop short and compromise and admit that some parts of your arguments are wrong or you’re not going to push for certain parts of whatever you were striving for. In Iraq, this is what we tend to find. The various political actors that are constantly feuding with each other use heated and often alarming rhetoric, but at the end of the day, when they’re on the brink, they always pull back and make some kind of pragmatic compromise. And it tends to be compromise that is rationally self-interested.
That, to me, is very encouraging because you see the same, or similar, sorts of behaviors in democracies throughout the world, including the West.
G&D: For instance, in raising the debt ceiling?
GB: Right. And that to me is even more insane in a way because, and I guess this is contentious, at least in the Iraqi political system they tend to be arguing about things of great significance. I mean this is a country in the very early stages of its development, ten years removed from Saddam, and they have quite a lot they need to work out. In our country, this seems completely unnecessary — to put a gun to our head when we don’t really need to. So I would say, in a way, politicians in Iraq operate more rationally than politicians in the US. This is a sad state of affairs I suppose.
But getting back to how I found Iraq, I was searching for that next thing. In 2007, every market in the world was in a bull market. It’s hard to think of any asset class that didn’t produce a fairly spectacular gain over the prior five-year period. Equity markets around the world were strong, commodities were strong, even certain currency markets had produced very strong returns. It was hard to find anything that fit into this category of deeply distressed, transitional situation. And it was right around that time that I read an article about how Iraq was increasing its oil production, which I thought was very strange.
I had thought of Iraq as a failed state in the middle of a civil war. I knew nothing about it beyond what I read in the New York Times or saw on TV. And so I thought the article was odd because how on earth is a failed state in a civil war increasing oil production? You can’t reconcile those two data points. Increasing oil production implies there is a functional state that is capable of achieving this.
One of those two points of view had to be incorrect. So I looked into the matter more closely and saw it wasn’t just oil production, but that they had a hyperinflation that started in 1990 and ended in 2006.
They did have a civil war but it had ended by early 2007
and so by that summer, violence was about 75% below its peak. Deposits in the banking sector were increasing, electricity generation was increasing, and the economy was starting to grow pretty rapidly. When I looked at these macro variables, what I found was that the consensus view was very much at odds with reality, that what you were seeing on television was about as far removed from what was actually happening in Iraq as it could be. Yes, things were awful but the media was not making the distinction. They weren’t showing you any improvements that took place over that year. But it looked to me like there was pretty compelling objective evidence that Iraq had reached a turning point.
This is exactly the sort of situation that you want to look for when you’re searching for these potential historic equity re-ratings.
There is objective data that portrays a positive picture yet there is a perception that none of that is happening, there is a perception that quite the opposite is happening, that there is capital flight, hyperinflation, chronically weak currency, falling oil production, economic depression, and so on. That was the image that I had in my head; I think that was a fairly representative view in the West at that time and still is.
G&D: And was that
enough to convince you?
GB: I went back to Dan with the idea and he said something like, “You’ve come to me with 100 ideas and 99 of them were bad or okay, but I know this one is good because the very first thought that I had when you mentioned it to me was how can I steal it from you?” But he said he would help me pursue it. I should study it for the next six months and see if I could confirm that the data is accurate. So I studied the country, its markets, its political situation, and its history for the next six months. And by the end of 2007, I was convinced that there was a legitimate change taking place and that the country had turned a very important corner in its development. Then the question became, how do you take advantage of that? It just so happened that there was a stock market. It was very small and I was shocked to find it. I think at the time the whole market had a capitalization of about $2 billion, which was smaller than the Palestinian stock exchange which had only launched in the summer of 2007.
I e-mailed every broker that was on the stock exchange website, maybe 50 brokers, and I got 5 or 10 replies. Only a few of them were in English and only one of them was in coherent English, so I chose him. I wired $2,000 there, bought a stock, sold it the next day and wired the money back out of the country to see if I could complete the whole cycle. It turned out that it was very easy to do. So with that, I put most of my investable assets into Iraq, and then around January 2008, Dan gave me a managed account and put me in touch with his two partners at Firebird. I presented the idea to them and they each gave me a managed account as well. I had my own money there and three managed accounts for two years.
Back then, I was probably one of the few, if not the only person, in the West who was investing in this market. I thought there could be demand for this kind of frontier investment and I was credibly in a position to create a fund to capture what I thought was untapped demand. The one problem was that I didn’t have a track record and I had a very unorthodox background so I needed someone with a pedigree. And that was Dan. I started the company and sold him 20% of it, with the agreement that he would be a partner but not be involved in day-to-day operations. Having him made it pretty easy to market. People thought, “The guy who found Russia is now looking at Iraq, so there must be something interesting there.” So that is how I got involved. I was looking for what I thought was the next historic equity re-rating, and only found it after I thought I had pretty much exhausted all of the options. It was a complete shock that it turned out to be Iraq because it was the very last place that I would have anticipated. But that’s the key, take some country with a stigma like North Korea or Myanmar — people are really excited about Myanmar now, so maybe that’s not such a good example — and see where it leads.
G&D: Zimbabwe?
GB: Actually, people are excited about Zimbabwe, too. They’re enthusiastic about a lot of Africa right now, which is interesting. Take Nigeria for example. Nigeria has a serious and growing problem with Al- Qaeda. They don’t control the northeast part of their country and it’s in a state of emergency. But if you look at the valuations in Nigeria, consumer products companies are trading for 30x earnings. They might be growing fairly rapidly but the multiples being assigned to their earnings are absurdly high and certainly don’t price in the risks. Iraq, on the other hand, is actually quite similar if you just look at the data. Iraq produces more oil and its oil production is increasing while Nigeria’s is flat. Iraq has substantially greater foreign exchange reserves. They produce more electricity with a smaller population and their electricity generation increases each year. GDP per capita is higher and GDP itself is higher. Relative to every development that you can think of, Iraq has the edge. Both have a problem with Al-Qaeda and the levels of violence are somewhat comparable — Iraq is worse but it’s not that much worse. But you can buy a branded consumer products company for 7x earnings in Iraq whereas in Nigeria it’s trading at 30x earnings.
So it’s fascinating when you look at the interest that people have in Africa that they completely disregard the risks that are attendant in those countries and take those very same risks and exclusively focus on them in Iraq. The same is true in Mexico. Sixty thousand people died in Mexico from 2007 to 2011 in what was very much a civil war. The government still does not control parts of western Mexico. The police and military have given up. Look at their consumer product goods companies — they trade at 40x earnings. This actually illustrates quite nicely the irrational extremes that markets go to. Do they teach efficient markets theory at Columbia these days?
G&D: It depends. In some classes, they do, with limits.
GB: But efficient markets theory is completely incompatible with value investing and I would imagine that for business schools generally, it is a part of the curriculum. Just look at the behavior of market participants and how they appraise value where the conditions are almost identical, but the only difference is geography or the name of the country. In one situation the perceived risks are very low and the valuations are quite high and in the other country the perceived risks are very high and the valuations are quite low. It shows how far the investing community departs from a rational assessment of value and how difficult it is for a market to accurately price risk. The places that you would last think you’d want to put money can turn out to be the most interesting. That’s how I found Iraq and it was quite a surprise. But after I studied it closely, it fit the narrative beautifully. That’s why I am there.
G&D: You mentioned a couple key indicators about Iraq, like power generation and natural resource production. Is there a standard set of data that you look for when you are
evaluating countries?
GB: Does the country have the ability to become much larger in the future than it is in the present? So in the case of Russia after the collapse of the Soviet Union, Germany and Italy after World War II, and South Korea after the war there, you were looking at countries where the economies were quite small for various reasons, but they had the potential to become orders of magnitude larger. When you look at a country like Sri Lanka, what do they really have? How much tea can they actually export? How much is that going to drive their economy in the next twenty or thirty years?
There are markets that can be interesting for a year or two, maybe up to five years, but you want more than that. Does it have economic scalability to it? You want to look for the presence of credible institutions that are capable of achieving the macro stability that is necessary for the country to grow over time. And you want to look for cheap assets. You must have a mispricing. If Iraq was already pricing all this in during 2007–08, if everyone was optimistic about the future and stocks there were trading at 30–40x earnings, then you weren’t being compensated for the risk. After the other conditions are satisfied, that last factor is vital because it’s your margin of safety.
G&D: Do you need foreign institutional investors to get involved for a country to re- rate?
GB: It depends. You would think that you absolutely need foreign money to fuel it but South Korea, to the best of my knowledge, didn’t have that much foreign money and neither did Germany or Italy in the 1950s. Most foreign money
stayed away from Japan until the 1970s. During the 1950s and 1960s they had capital controls in Japan so if you invested you couldn’t take your money out for two years and that kept a lot of people away. Emerging markets were something very few people went near prior to the 1980s. So the historic re-ratings that have taken place since then, I think, have had a foreign component to them. But I don’t think it is essential.
History shows that they’ve happened without foreign money, particularly in a petro-state. Take Saudi Arabia — you can’t invest there directly and they’ve had spectacular bull markets that were driven entirely by petro dollars and the oil cycle.
G&D: How did Iraq fit into that framework?
GB: Iraq is a neat case. It was a country that, in the 1960s and 1970s, was on the verge of becoming one of the most powerful petro- states in the world. Oil production was around 500,000 barrels a day in the 1950s. By 1979, the year Saddam comes into power, it was 3.5 million barrels/ day. GDP per capita went from $500 in the mid-1960s to $3,500 by 1979. They had this extraordinary economic transformation taking place and Saddam destroyed it all. For the next two and a half decades, it was really one of the single greatest episodes of wealth destruction the world has ever seen outside of Myanmar and North Korea. It was dreadful. By the time Saddam was overthrown, GDP per capita was back to $500 again. Oil production is right around the same level it was at in the mid-1960s. The country was on a trajectory that was going to have it rival Saudi Arabia in terms of oil production and exports, and have an economy that was almost as large, but it was derailed. It was taken off course by the mismanagement of a dictator. That actually made Iraq stand out much more than South Korea or, say, Hong Kong. South Korea never really had a history of growth before the 1960s and 1970s. It was mainly subsistence level agriculture with no real history of modern economic development. Iraq had that and they lost it. It was just a matter of whether they could get it back. When you look at their oil industry, they have the ability over the next fifteen to twenty years to rival Saudi. They could conceivably become the second swing oil producer in the world.
Saudi would no longer be the only country that has enough spare capacity to meet unexpected demand for the world. So I think they have an ability not only to matter economically, not only to be orders of magnitude larger in the future than they are today, but to be one of the most important economies in the world in 20–25 years. And that’s not an overstatement; if they are producing 9–10 million barrels of oil a day, that puts them right up there with anyone else.
And when you look at the tiny size of their banking sector, the tiny size of their consumer product sector, the valuations that we found in their real estate markets in 2008–09 and even present, it was a country which was stunted. It was like a giant stuffed in this tiny little cage. It is very difficult to tell when it is stuffed inside but once you take it out, it stands fifty feet tall.
Take their banking sector as an example. In 2003, there were $300 million of assets in the private banks. Now the private banks have about $16 billion. They’ve gone from $300 million to
$16 billion in ten years. GDP in 2004 was $25 billion. By the end of 2012, it was $210 billion. So even though they have experienced extraordinarily rapid growth, banking assets are still less than 10% of GDP. The top five banks in Saudi Arabia have assets that are about 50% of GDP. So let’s say Iraq has a $600 billion economy by 2030. If the top five banks were to equally split half of that, it would be $60 billion in assets for each bank. The biggest bank right now has
$1.5 billion in assets and a market cap of $300 million. So when I talk about scalable economic growth and scope for growth, this
gives you an idea. And it’s very rare to find a market in a country that has that much scope for growth.
That’s what I think makes Iraq unique — it has more scope for growth than any country I am aware of in the world today.
G&D: Once you found an interesting situation like Iraq, how did you think about efficiently screening the opportunity set there?
GB: Well, thankfully there are only about 90 companies on the exchange and I would say about 20–30 of them are what I would call investable. It is a very narrow set of companies. So a lot of this is simplified by the small size of the exchange and its limited number of offerings. We are really making two types of investments. We’re investing in emerging franchises, which are companies that are outside the oil space and tend to be managed by entrepreneurial people. They’re very much profit-driven. They’re owner-managers, so they have significant stakes in the business themselves.
They’re transparent and they appreciate the importance of reputation, brand, and establishing dominance in their particular industry. Because they’re able to achieve that, it gives them pricing power, it gives them scale, and it gives them all these other benefits. Another, second category of company would be the classic Ben Graham, deep-value kind of investment. It’s far from a franchise. It’s just simply that net current assets are “x” and the stock market appraisal of that is 0.1x, so you’re buying a dollar for ten cents. Most of the investments we make are the first category.
When I first started to invest in Iraq, I went more towards the latter category, which I think was a mistake. What I’ve learned from making investments in companies that seem very cheap based on net asset value or net current asset value is that it’s very easy to underestimate management’s ability to destroy value. Even slightly sub-par management can make a series of decisions that will wipe away your initial margin of safety.
Then there’s still the question of how you realize the value. Graham was of the opinion that the market would eventually correct itself, that the market in the short run was a voting machine and in the long run was a weighing machine so that eventually, it will be valued correctly. That’s probably true in the West, but less so in a frontier market, where you’re going to have to be very careful about assuming an activist role and you can’t rely on the market to be even slightly efficient over a long period of time. It could stay inefficient and undervalue an investment for a decade and you could end up in a value trap for ten years. So it’s difficult to realize the value if it’s not destroyed, and there’s a high probability that sub-par management will destroy it anyway.
G&D: How do you approach portfolio management given that there are only 20 to 30 companies you would call investable?
GB: We have twelve companies in our portfolio and the top ten make up 95% of it, so it’s very concentrated. The largest position is 30% of the portfolio, so we obviously don’t define risk as price volatility. We’re thinking about it in terms of probability of permanent loss of capital.
The most important thing we look for is a business where we can trust the people who are running it. By definition, trust is something that’s built over time. For the first few years that I was involved in Iraq, that’s more or less what I was learning — who I could trust, what companies were putting out financial statements that faithfully represented the condition of the business, which companies seemed like they were doing well but may not have been accurately reporting performance, which companies had unsavory people running the business, and so on. You start to figure that out over
a few years. And after you travel there and meet the people, you’re in a much better position to say with confidence if you should trust them.
I think this is, again, the market benefiting us. Because there’s such a small group of companies that we think are investable, it gives us the ability to concentrate rather than look all over the place. There are some frontier market funds that have investments across twenty countries. How on earth could you possibly know the management in each country? And they have fifty or more investments! How can you possibly know if you can trust these guys or not?
Even a team of ten or fifteen people can’t pay enough attention to each company to establish that. I think trust in the people managing the business is paramount, because it’s pretty easy to spot a good company. So, if you see a bank in a country like Iraq that is experiencing its first private credit cycle and has an economy that is growing pretty rapidly, you’d expect to see the balance sheet grow very rapidly. You look at the balance sheets over time and it’s pretty obvious which companies look interesting and which ones don’t. This one is growing but puts all its money into T-bills. It’s completely risk- averse. OK, that’s not very interesting. However, this one over here has seen its
loan to deposit ratio go from 5% to 40%. They have a very low NPL ratio, ROE has been trending up. All the metrics that you would use to analyze a bank are not only looking positive, but they’re really strong, and yet it’s trading for just 5x earnings. If you see a bank that is growing earnings at 40% or 50% a year, trades at 5x earnings and a discount to tangible book, and has a ROE of 30%, that looks really interesting, right? Then you meet the management, get to know them over a period of years, and that’s what lets you build the confidence there is something real behind those numbers.
G&D: How long did it take you to get comfortable enough to make your first investment in Iraq?
GB: Initially, I wasn’t comfortable with any particular company. In January 2008, when I started, I bought everything that traded, so it was the exact opposite strategy. Back then, it was very difficult to find information about these companies from a distance. Quite a lot has changed since that time.
Now, quarterly reports are published in a timely manner, sometimes even ahead of when US companies file. It’s not unusual in a very early stage frontier market to have extremely limited data that you can use to conduct due diligence. The rational strategy if you’re going to invest in that setting is to have smaller positions. How can you have conviction about something like that? It’s more of a macro investment.
What I’ve found is that having my own money invested in these companies is really what makes the difference. When you have money invested in a bunch of companies that you don’t know much about, you suddenly have a very strong motivation to know as much about them as you possibly can. And so once the money was invested, I had to find out everything I could. And that really was what the next two years were about. It took about two years after I made my first investment before I felt confident that I really did understand which businesses were legitimate, which ones should be avoided, which ones could go either way. And that’s also why there wasn’t a fund initially. I didn’t feel as if I had the requisite understanding of the companies and the market until I was involved for more than two years. So initially it was just a very broad bet on the market and that later became a very concentrated set of value investments.
G&D: What do you think makes philosophy a good training ground for investors?
GB: When you study the history of philosophy, what you find is that many of the great philosophers were deeply skeptical people. They were like Steve Jobs in a way, iconoclasts who looked at convention as if it was something to be broken. Socrates is a perfect example of this. He walked around Greece and challenged any kind of convention or power structure he saw. And I think the general idea that you learn from studying these historical philosophers is that there’s a lot to be gained from a skeptical world view. If you simply accept what you’re told, if you are simply a receptacle that takes in whatever information is provided to you without critically accessing it, it’s going to be very hard for you to do anything other than live a conventional life. If you look at the people who have had the most success in markets, or in business generally, you find they tend to be people who are skeptical of whatever the prevailing convention is and will challenge it and try to change it. To get involved in Iraq, you had to be very open-minded and had to have a very skeptical view about the ability of the media to provide you with an accurate portrayal of reality. If I were not skeptical, I would have seen the data, and I would have said even if Iraq were increasing oil production, the country’s still just a basket case because that’s what I read in the New York Times. Philosophy is useful in a general sense because it can give you a skeptical world view.
Then you can take that skepticism and apply it at the company level.
Thousands of years ago, philosophers were asking questions like how would you define a table? And if you went around the room, each one of us would come up with a definition of a table and everyone else would poke holes in it. The smartest philosophers in the world have struggled with these very basic ideas and they can’t find a satisfactory way to treat the problem.
You realize that about 99.9% of everything you hear is complete and utter bullshit. Take the convention that markets are efficient. Approaching it from a philosophy background, it was very easy for me to take that idea and reject it.
I remember Caterpillar in 2010 or 2011 printing a five- year earnings forecast.
We’re talking about construction and mining equipment, which are as cyclical as anything can be. How on earth can the CEO know what their earnings situation is going to look like five years from now?
And to the extent the market actually believes what he is putting out and pricing it into the shares, that is an extraordinary mistake. When I looked at the sell-side, they were pointing out just how bullish they were on CAT. Since then the stock has just gone sideways and now of course we’re approaching 2015 and they’re guiding down because it’s just not the market or economy they thought it was going to be.
So when you apply philosophy to your analysis of individual companies, it makes you much more skeptical of management’s ability to forecast into the future. To the extent a manager or a company is going to get your trust, they’re going to have to earn it and that’s going to take quite a long time.
Philosophy teaches you to take whatever the prevailing wisdom is and challenge it. Sometimes it turns out the prevailing wisdom is right, so you should accept it; other times it turns out the prevailing wisdom is way off the mark. If you find a situation like that, then there’s typically an opportunity to profit from it.
G&D: Would you mind talking about a specific investment idea within Iraq?
GB: Sure, I can discuss Baghdad Soft Drinks, the Pepsi bottling and distribution company there. Pepsi has 80% market share in Iraq. It’s one of the few countries where it’s dominant. Normally it’s the reverse — Coke is closer to 80% and Pepsi is 20% — but Coke has struggled in Iraq for a number of identifiable reasons.
Baghdad Soft Drinks received its Pepsi license in 1984 and lost it in 1991 when sanctions were imposed on Iraq after the first Gulf War. By the time Saddam was overthrown in 2003, Pepsi was eager to return to Iraq so they reached out to Baghdad Soft Drinks in order to reestablish the relationship. Some of their factories had been severely damaged by the war. What hadn’t been damaged was obsolete because, while the sanctions were in place, they couldn’t import equipment. So the equipment from the 1980s was still there in 2003. The company was just a mess. Pepsi floated a $30 million loan to help rehabilitate operations.
The management at that point in time were ex- Baathists. Saddam was from the Baath Party, and the party’s economic ideology was basically Arab socialism. You had 3,000 employees when you needed just 1,000. Pepsi, in one of the hottest places on earth and where people don’t want to drink Coke, pretty much sells itself. You could put a dog or a five year old kid in charge and sales would grow. The question is what part of that is going to fall to the bottom line. What I found was that most of the revenue growth in the company from 2003–2007 was being soaked up by these inefficiencies. By the time you got to the bottom line, there was nothing left. By 2007, the company was unable to service the loan from Pepsi. It contacted two local businessmen for help. The two guys looked at the situation and eventually approached Pepsi about selling them the loan. Pepsi agreed and the businessmen immediately converted the loan into a controlling stake in the company, firing the managers who had initially asked for their help. They also fired 2,000 of the 3,000 employees and instituted a performance-based compensation scheme for the remainder. A year later, revenues had tripled and they turned their first profit. They became fully certified by Pepsi for quality control and quality assurance for the first time and the thousand remaining employees were paid double what they made under their previous salary.
Starting in 2007 and continuing to the present, the new management really focused on streamlining the operations and making them much more efficient. If you looked at their EBITDA margins under the old management, they were typically either negative or 1%-2%. If you look at Coke and Pepsi bottling and distribution companies in comparable emerging markets, the EBITDA margin range is normally 15%-20%. We’ve seen a normalization of Baghdad Soft Drink’s margins so they’re now about 15.5%.
The new owners spent a lot of money up front to put in a direct distribution system and it’s now paying off. The public electricity grid at the time was unreliable, so they built their own generator to make sure they could run 24/7. They made the company much more efficient and with a company like this, it’s about volume growth and efficiency. Iraq consumes about 21 liters of soft drinks per capita. If you look at other emerging market countries, it’s anywhere from 60–100 liters. You have a growing population, growing GDP per capita, and each year they’re consuming more Pepsi. It’s the dominant soft drink company there so there are compelling reasons to believe that sales will continue to grow.
Management has demonstrated its ability to improve operating efficiency. If sales can grow at the 20%-35% rate we expect and margins expand by 200–300 basis points, then suddenly earnings could be up 100%. It’s that kind of story. We own 11% of the company. According to the CEO, we’re the only Westerner to ever visit the bottling facility. In 2012, there was a bear market in Iraq, with the market low occurring sometime in the summer of that year. At that time, the stock was trading at about 3x earnings and had a 10% dividend yield. To give you an idea, in 2012, the company’s earnings actually grew over 400%. We were just scooping up as much as we possibly could. That’s why it’s 30% of the fund. It was 15% but with the total return, it’s since doubled. We haven’t sold a share. It still trades for around 6–7x earnings and remains deeply undervalued.
G&D: Before we finish, do you have any thoughts on where the next Iraq-type market opportunity may be?
GB: It’s hard for me to think of a place now. Maybe Afghanistan? Five or ten years from now, maybe it will be Iran. Iraq was the very last place I thought I would find an opportunity like this and I don’t know if there is a similar place today. Maybe it’s still Iraq.
G&D: Thank you so much for sitting down with us, Mr. Batt.
