Asia Frontier Capital Travel Report: Mongolia

This month Asia Frontier Capital's analyst Scott Osheroff traveled through Mongolia.

Scott visited one of the largest tanneries in Mongolia: Darkhan Nekhii which is listed on the Mongolia Stock Exchange "MSE".

Gobi Cashmere is the largest cashmere company in Mongolia and also listed on the Mongolia Stock Exchange.

In line with our process of covering frontier countries from the ground, this month AFC's Regional Investment Analyst, Scott Osheroff, recounts his recent travels through Mongolia.

It is 6am in Ulaanbaatar and just out my apartment window the sound of steel rebar being positioned into the beginnings of a 30-storey skyscraper has become my regular alarm clock. With eyes half open, I peer out the window. The construction site is already a hive of activity as the distant sunrise slowly illuminates the newly opened Shangri-La Hotel (OTCPK:SHALF) (OTCPK:SHALY) across the street.

With the blunt hammering of progress pounding its way into everyday life in Mongolia, you could be forgiven for forgetting about the hurdles facing the local economy. The landlocked nation is dealing with a stimulus-induced construction boom which is showing signs of struggle, as the present global commodities slump hampers the growth potential of resource reliant economies like Mongolia. Looking forward, Mongolia must also work out how to deal with the rollover of the USD 1.5 billion Chinggis sovereign bonds coming due. These are a few of the factors building towards a situation where distressed asset prices in real estate and listed equities could soon become a value investor's paradise for those willing to do the groundwork and research.

I arrived in Ulaanbaatar in early August to begin an extensive due diligence trip on AFC's portfolio investments. Visiting listed companies and their unlisted competition to better evaluate the opportunities available, I met with management teams from the mining, cashmere production, real estate, media and consumer goods industries. There remain some great success stories amongst the overall malaise surrounding Mongolian business.

One of the more interesting companies that I visited was a tannery, Darkhan Nekhii, located in Darkhan City, outside of the capital Ulaanbaatar. One of the largest tanneries in Mongolia and an interesting business for us as investors, the company processes hides predominantly for export which is a sound strategy as Mongolia boasts over 60 million animals - roughly 20 for every person in the country. I spent the day with management who took me on a tour of the factory which appeared to be operating at full capacity, contrary to management downplaying their successes. It was an encouraging visit as Darkhan Nekhii is well positioned to grow its export market share and innovate its value add processes in order to remain ahead of increasing government regulation in the sector.

Darkhan Nekhii FactorySource: Asia Frontier Capital

At present it is illegal to export raw hides. The government is trying to keep value add production onshore and is thus in discussions to also potentially ban exports of wet blue - a commodity product. Unlike its smaller competition, Darkhan Nekhii is in the comfortable position of already processing hides beyond wet blue and therefore won't feel as great an impact as their smaller competition, perhaps allowing the company to do a roll-up, buying out smaller competition.

Outside of leather, another highlight from my trip was to Gobi Cashmere, the largest cashmere company in Mongolia and one of the largest integrated cashmere companies in the world. Supplying a global retail franchisee base of 47 stores and boasting well known corporate clients in the USA, Gobi is arguably one of the best run companies on the Mongolian Stock Exchange. It is also the second largest company by market cap, yet continues to trade at a sizable discount factoring in its double digit earnings per share growth rate. Gobi has weathered a deteriorating domestic economy through its overseas distribution and its steady source of foreign currency has buffered it against a decline of the Tugrik exchange rate which has dropped roughly -50% versus the USD since March 2012. Gobi's international expansion is a reflection of management's competency and vision. This year they pushed further into Chinese cities unabated as capacity utilization increased and reinvestment into growing it s production lines supported their ability to fulfil continued robust demand for their cashmere.

Beyond company visits, it is important to see developments from the ground to get a more holistic view of the domestic economy. Since I was here seven months ago there have been continued signs of positive changes and the addition of new entertainment and food venues are helping Ulaanbaatar become a more palatable city for tourists and expats. New KFC and Pizza Hut locations outside of the city center have sprung up from the sites of old Soviet buildings and additional locations of well-known Korean coffee companies, such as Caffe Bene, and the American brand The Coffee Bean and Tea Leaf, have sprouted. This bourgeoning push towards café culture is reminiscent of similar trends in other parts of Asia, such as Vietnam and Cambodia.

The Coffee BeanSource: Asia Frontier Capital

In Zaisan, an upper class neighbourhood, there was previously very little to do in the local scene but this is also changing. During my trip I took in a dinner of khuushur (fried meat pancakes) and kebabs in a newly renovated outdoor food court with friends before taking a hike to the top of a monument commemorating Russian and Mongolian partnership in WWII where our perched view over the city was a perfect venue to watch the sunset.

Sunset at ZaisanSource: Asia Frontier Capital

The natural beauty of Mongolia can be truly staggering and it was a joy to watch the evening descend over the capital. Looking out to the horizon I contemplated how Mongolia would change in the coming years given that it holds more than USD 1 trillion in resources under the steppe. Mongolian investment represents a call option on global resource prices which is further supported by Chinese switching costs. With the infrastructure being built to support commodity exports of coal, iron ore as well as others, Mongolia has the opportunity to become the low cost supplier of bulk commodities to its resource hungry southern neighbour and could effectively price out Australia and Indonesia. There is no doubt Mongolia will rise again as a premier investment destination, the question is simply when? Patience and prudence when investing in Mongolia is the key to generating outsized returns and being in position when highly discounted Mongolian assets climb in value will help bolster the upsi de for investors in the AFC Asia Frontier Fund

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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Source: Asia Frontier Capital Travel Report: Mongolia