Originally posted at http://capitalistexploits.at/

By: Chris Tell

Since this blog is pretty much a running commentary of our “exploits”, today I decided to post up an email conversation I had with our colleague Harris Kupperman. I took a few liberties with editing, but only slightly so that it would make sense to you, dear readers.

By now most of you will likely be familiar with Harris Kupperman (Kuppy), whom I believe we first introduced here. For those unfamiliar with Harris, he is a protégé hedge fund manager who saw an opportunity in the land of Chinggis Khan, and in similar fashion set out to build his own little empire. He is the CEO of Mongolia Growth Group (YAK.V – MNGGF). ——–

Chris: Harris, we’re told that Oyu Tolgoi pours its first concentrate this Friday (the 21st of June). Regardless of what skittish investors are thinking of in terms of Mongolia, the facts are that there never was a lot of risk to OT actually happening. (Note: We recommended shares in Turquoise Hill a while back in a Trade Alert. It might not be a bad idea to revisit that idea now). We always thought the political posturing was key to this. Further to that, on the 26th of this month elections will be held. The incumbent Elbegdorj is set to take it away, and his stance has been progressive and pro-business. What think ye?

Harris: Let’s start with the obvious. The first rule of frontier markets investing is that you should pretty much ignore whatever nonsense is in the English language papers — particularly if those papers do not even have full-time correspondents living in the country in question. In the end, the major papers are all fighting for readership and sensationalist articles sell newspapers.

The real truth is that over the past year, the papers have made advertising profits by beating up on OT, but there was never any real risk that the mine would produce a whole lot of copper. Even more amazingly, it seems to be starting up roughly on time — which is a true rarity in mining.

Mongolia understands and recognizes that it needs foreign capital in order to build out its dozens of very sizeable mining assets. In addition, it needs foreign capital to finance the infrastructure in general. No one is going to do anything that seriously imperils that. No matter who wins the election next week, I think that the country will continue on the same path of openness, pro-business governance and rapid development.

Chris: I couldn’t agree with you more regarding what passes as news these days. It’s truly astonishing really, and interestingly has become one of our main centres of attention over the last 10 years or so. Identifying the disconnect between the perceptions created by a media-fed populace incapable of, or unwilling to, rationalize the sensationalist sales pitches which pass as news, versus the reality on the ground, has (not) coincidentally provided us with numerous opportunities to profit in the past.

Right now I find it somewhat amusing that a flood of hot money is flowing into places like Myanmar, a country many years behind Mongolia in terms of financial stability, political stability and still far from foreign investor friendly. I’m not denying the vast opportunities, but pricing of assets and the perception of risk is far less than the real risks right now. Basically it’s the opposite of what I look for.

I’ve said it before and I know from experience that many will lose their shirts in Myanmar just like many lost their shirts in Mongolia more recently. Stupid money will always follow the major news cycle which is great from a trading perspective, but in frontier markets the way to make fortunes is in identifying at what stage of the cycle we’re in. The MSE is down some 80% from its highs and we’re seeing insiders buying. ??What’s your take on values in Mongolia right now?

Harris: I agree completely on Myanmar, hot money is flowing in and a lot of shady characters will be taking it from investors. Just like rare earths and whatever else the fad was before that… When this all shakes out in a few years, Myanmar will probably be worth a good long look. For now, it’s over-promoted and over-promised. From what I hear, prices for assets are just short of ridiculous and legal title isn’t even secure.

You want to go where the story is strong and investors have given up interest — or even better, where investors are genuinely bearish. 2 years ago, Mongolia was white hot, a lot of money flowed in and the MSE went vertical. The companies on the MSE have continued to grow, meanwhile, most of them have dropped in price — substantially. All of this negative talk about Oyu Tolgoi has scared off investors right when they should be buying! The mine is going to ship its first copper before shortly. That will start the process of injecting a whole lot of capital into a country that is starved for growth capital.

Our research on lots of these commodity booms seems to show that you want to invest right at the inflection point where the money stops going into the ground, but instead starts coming out of the ground as the resources are produced. In typical form, the investors got it all wrong. They rushed in on the promise of what will happen in the next few years, then they lost focus before it actually has come to fruition. That’s the opportunity today as an investor in Mongolia.

On the subject of the MSE, I haven’t really looked through the individual names, but my friends who follow this closely tell me that there’s very real value there today. That’s for other investors to sort out though. There just isn’t enough liquidity for me. Besides, transparency and corporate governance still aren’t what I would want.

I’d rather focus my time on our company, Mongolia Growth Group, where I know what the numbers are and I trust that the assets are real.

Chris: OK so give me the dirty on present day UB real estate. I’m also curious about this new mortgage law.

Harris: Right now if you want to borrow money in Mongolia it will cost you about 15% in US Dollars and around 25% in Togrogs. In addition, it’s nearly impossible to get a mortgage for more than 5 years. These high rates are making it prohibitively expensive for Mongolian families to buy apartments or trade up to nicer apartments. This is a very real problem, as we have seen from some of our employees who spend a disproportionately large percentage of their salaries on interest payments for their apartments.

The Mongolian Government recently set up the framework for lower interest mortgages. These mortgages will be for 20 years, and are fixed at 8% interest rates. This means that the carrying cost of home ownership will drop substantially — which should allow families that have homes to reduce their interest payments and have more disposable income. It will also mean that families without property can now start on the property ladder with their first purchases.

This is a really huge development for Mongolia and the property sector. The development of a liquid mortgage market has always been a big focus of our company. It starts with apartments but will eventually lead to lower interest rates for commercial mortgages as well. Lower interest rates will then lead to lower capitalization rates on property assets. Remember, the move from a 15 yield to a 7.5 yield means that your property asset doubles in value. That’s a stunningly huge move for a property asset. The creation of a more mature mortgage market is one very big step in this process.

Chris: Interesting. The leverage available in real estate is what has made many of the wealthiest people I know their fortunes. There was a time when I leveraged the snot out of my own balance sheet, where my net spread was over 5%, and it was one of the most profitable investment period of my life.

Regarding Mongolian RE, I’ve shied away from owning apartments or anything of that sort outright. It’s just very difficult to manage from afar and I would need to buy a lot to achieve the diversification I need in order to mitigate the inevitable management problems. ??As you well know I’ve been an incredibly happy shareholder of your company since its founders round and beyond. It’s my favoured way of participating, but I can’t help but think about leverage in a bull market where your running costs are self-financing. While your strategy has never been to build a cash flow machine with MGG, are you, or will you consider adding any debt to the balance sheet given the environment?

Harris: As you note, property has created many billionaires and debt is naturally a big part of that wealth creation. I am a risk adverse guy, I really don’t want MGG to be taking on a lot of financial leverage. Property already gives an investor huge leverage to what happens in Mongolia. You don’t need to turbo-charge that upside. That said, I’m not opposed to some debt. The important thing is that it has to be long-dated debt and it has to have an interest cost that is palatable.

I think that as the mortgage market matures, we will begin to take on debt locally. Even more interestingly, as our company starts to show cash flow, I think we will be able to get overseas debt in the form of a bond offering and get it at interest rates that are substantially lower than we could get in Mongolia. That would be the real value creator — a long dated bond that would let us buy property that yields a huge spread over our funding cost, just like you did. The beauty of being public is that it allows you to eventually do this, and as the only overseas publicly traded property company in Mongolia, we would be one of the only companies in Mongolia that could do this. More importantly, a large bond offering would finally justify all of those fees that we’ve paid along the way to get to this point.

Chris: I hear you; pubco costs are horrendous. Getting in early when assets are not yet financialised makes perfect sense. Liquidity is poor while fundamentals of a rapidly growing, industrializing frontier market economy are driving demand and growth. The memory of fund managers is short lived indeed. 2 years ago you’ll recall many touting the fact that Mongolia would be experiencing double digit GDP growth on the back of the substantial mining assets discovered, and now being brought into production.

Many of these guys were raising tens of millions of dollars without much clue as to how or where to put that money to work. I remember having conversations with some and asking them how they were going to allocate their cash into this tiny economy. They had no answer but were very happy to take 2/20 and just raise as much as they possibly could. I’m glad many of these clowns have blown away in the wind. I was encouraged to see Sam Zell, a man who has proved his acumen in real estate, recently mentioning that his two favourite RE markets in the world are Colombia and Mongolia.

Typically when we look at previous booms of this nature the initial money which is made is about 1/3rd of the entire market move, which may last up to a couple of decades before flattening out or coming back to earth. To me it feels like we’re on the verge of the 2/3 move given the leverage coming into the market, the real economic growth, and the extent of the pull back thus far. I think the reason much of the move is in the latter stages is likely due to access to the market. Buying assets in Myanmar, Mongolia, Cambodia, Mozambique, etc. – all countries we’re focused on – is impossible to do from your sofa and E-Trade account.

One thing I find interesting though is that the liquidity often follows the brand names. We’ve just had KFC setup shop in UB. Are you aware of any others who will surely follow?

Harris: One thing that we wanted to do with MGG was to create a way for investors, like our own management team, which owns 30% of the company, to invest in the shares without all of the headaches of opening special accounts or filling out forms and locking up your money for years. I am sure that other companies like ours will be set up over time and flood the market with capital and liquidity. As you say, this is the next 2/3 of the move as these guys chase after scarce assets.

In terms of brand names, we always knew that the big move in property values would come when brands moved into the country. Brands pay rent on time and sign long term leases that they honor. More importantly, they are professional operators of businesses, so they know what they can afford to pay in rent, and then they pay top dollar for the best locations. What this eventually lets you do is it lets you borrow against the future income streams that are rather reliable. So, naturally we have been very attracted to bringing international brands into Mongolia.

When we started to reach out to these firms in 2011 they ignored Mongolia. In 2012 they asked for some more information, then ignored Mongolia. Now in 2013, with KFC opening their first branch, these guys are all converging on Mongolia. They all want a presence in one of the last emerging markets that has almost zero penetration of international brands. We’ve been approached by a number of brands already – a number have sent representatives to Mongolia and they want to be involved. It probably isn’t 2013 that they open shop, but I expect that by 2014 we will be signing lots of leases with these guys. For that matter, we signed our first 2 leases with an international firm last week. It was a huge milestone for us—it proves that our thesis is playing out.

Chris: OK so lets talk valuation. Real estate price growth is averaging what… 3% monthly?

Harris: Ha ha — that’s so 2011… Prices are increasing rapidly, but it’s more like 1 to 2% a month lately. Basically prices are tracking rental increases, and cap rates are staying constant in the low teens.

Chris: Book value for MGG is somewhere around $2.50 to $3 per share, so I’m looking conservatively at forward book value 12 months out to be $3.50 upward. Figuring out price to book is difficult for such a small market as Ulaanbaatar, but the way I think about this is to compare it to other emerging markets with larger data sets. I figure it’s probably somewhere around 3x book. Bear in mind this is simply a rule of thumb figure based on doing this for a long time, so don’t quote me on the figure but I’m confident I’m not too far off.

Since the only way you get paid in your company, given that you take no salary, is by creating shareholder value. So, what do you think of the present valuation of the company?

Harris: Let me start with the obvious, our lawyers would kill me if I validated your book value number or told you what I thought the right multiple to book should be. That’s for you to do, but you should be pretty capable of doing it, as you’ve spent a month in Ulaanbaatar and know many property people who are familiar with our assets.

In terms of how I think of our company valuation, we have created something that is truly unique in Mongolia. We have created the only publicly traded platform for overseas investors to invest in Mongolian property assets. We have a unique offering in terms of our ability to source assets, perform due diligence on them, add value through renovations, lease them and then manage them once they have tenants.

We are one of very few companies in Mongolia that have this ability, and while we’ve only been a company for less than 3 years, we have recruited a number of Mongolians with very substantial experience in the property market in Mongolia. In the end, our people are our biggest asset as we move onto the next phase of our company, which is using our platform to take capital from overseas and invest it in Mongolia at very high rates of return, and do it in a way that provides investors with liquidity, transparency and a management team that has a whole lot of skin in the game – looking out for their investment. As you say, I take no compensation. I’m at MGG because I think that over time my shares will appreciate substantially.

In terms of our physical assets, we have invested approximately $40 million in Mongolian property that has appreciated quite a bit. I think you’d have to spend well more than twice what we paid if you were to try and replicate our portfolio today. Our portfolio is specifically designed to have the maximum leverage to the growth of consumer spending as the Mongolian consumer sees his wages and net worth increase. I think that this is a trend that we can play for a long time, as Mongolia will become a very wealthy country over the next few decades. It took us over 2 years to get positioned with the assets and the team. The next few years will be the time that we can use these resources to create real value for our shareholders.