Challenging the MSCI: Time to reconsider Mexico and Indonesia weights

April 13, 2023

Several banknotes of Mexican & Indonesian currencies.

We are nearing our second year of our Emerging Markets Small Cap Fund and continuously monitoring various sectors across 24 countries. Almost 60% of the MSCI Emerging Markets Small Cap Index is represented by four countries: Taiwan, India, South Korea and China. In our view, these countries have advanced nicely in the emerging markets (EM) small-cap arena. Many of today’s technological developments are driven by companies that have been in the Index, including TSMC from Taiwan (circa 1994-95), Korea-based battery maker, LG Chem (circa 2001), India’s Apollo Hospitals (circa 2021) and consumer names from China.

These countries and companies have also been well represented in the MSCI Emerging Markets Small Cap Index having satisfied regulatory requirements, with some exceeding expectations by innovating such that they get “upgraded” in valuation or become classified as EM large caps. There are also ongoing discussions to elevate Korea from an EM to a developed market (DM).

We nevertheless feel that MSCI classifications can be inefficient. MSCI attempts to select promising EMs in advance using mostly backward-looking data, which can lead to mistakes. Argentina is an example. It was reclassified as an EM in 2018 and then cut in 2021. Vietnam should eventually be included in the Index despite foreign ownership limits, among other issues. It is more indicative of an EM than a FM classification. Saudi Arabia also has foreign ownership issues, yet is included in the EM Index.

Both Mexico and Indonesia make up close to 2% of the Index, but why? Considering their history, this is presumably due to a retrospective bias. From a forward-looking standpoint since 2020, our view is that their Index weightings are underestimated.

Mexico rising

Mexico comprises 2.1% of the MSCI EM SC Index (as of January 31, 2023). Although it has similar domestic issues as its peers, we believe it offers outstanding investment opportunities. Mexico is becoming increasingly relevant on the global stage considering its proximity to the U.S. and that many companies from Asia and beyond are setting up there. U.S.-based companies are following suit, including Tesla that will invest US$10 billion in a new plant in Nuevo Leon. Many of our Taiwan- and Korea-based companies are also expanding to Mexico. This nearshoring trend creates attractive investment opportunities across all sectors. According to the Inter-American Development Bank and Coldwell Banker Richard Ellis, nearshoring could represent a US$35.3 billion opportunity for Mexico, positioning the country as having the highest exports growth potential worldwide.[1] The share of Mexico’s nearshoring demand (based on % of net absorption) has increased from 10% in 2019 to 25% in Q2 2022.[2]

It’s worth mentioning that January 2023 was the strongest start of any year for Mexico’s stock exchange since 1996, despite the U.S. slowdown. We believe Mexico stands to benefit from the U.S. – Mexico – Canada Agreement for the next few years. The country’s fiscal accounts are well managed, it has low debt (50% of GDP) and its central bank will be one of the first globally to lower interest rates (currently at 11.25%). Moreover, the Mexican peso has outperformed other currencies, explained by more remittances and new foreign investments. As of Q3 2022, foreign direct investment already surpassed 2021 inflows, mostly concentrated in manufacturing and logistics.

All sectors seem robust and are expanding nicely. For example, the banking sector is one of the best capitalized in Latin America (together with Chile’s), net interest margin securities (NIMS) and cost of funding are healthy and the system as a standalone has ample liquidity and capital. Mexico is not immune to global banking events, but the main point is that its system remains strong. Why then is Mexico such a low weight in the Index? Its economics are changing, trends are evolving and global conditions for Mexico are rapidly improving. The following chart compares the returns of the MSCI Mexico Small Cap Index to its EM and World small-cap counterparts, with Mexico outperforming since 2020. Besides the factors already mentioned and that Mexico is the U.S.’s second-largest trade partner, other positive tailwinds for the country include its pension reforms and the rising possibility of a favourable outcome in its presidential elections next year. It wouldn’t surprise us if the MSCI increased its Mexico weighting in the interim.

Graph showing Mexico outperforming both its emerging market and global peers between March 2020 and April 2023.
Source: Bloomberg.

Indonesia rising

We just attended Indonesia’s largest conference – its most important of the year – where President Joko Widodo made the opening speech. At how many private conferences (especially in EMs) would a country’s president be so involved in promoting the country as a viable and attractive environment for investment? This is uncommon and means a lot. The event was exceptionally investor-friendly, with the government keen to attract capital. We also enjoyed intimate dinners with top Indonesian officials including Luhut Binsar, Coordinating Minister of Maritime and Investment Affairs who shared knowledgeable insights on the future of the country with us.

Prior to 2020, Indonesia had many restrictions that made enticing foreign capital tedious, costly and time consuming. Then the government passed its Omnibus Law, simplifying many processes and clarifying regulations to help foreign investors better understand them.

Over 500 investors from around the world attended the conference. When asked to compare Indonesia’s current investment climate to five years ago, 94% of attendees said it had improved. Despite global turmoil, Indonesia’s macroeconomic indicators in 2022 were among the best in the G20. We remain confident in the country’s economic resilience in 2023.

As the world’s fourth-largest country with a population close to 300 million, Indonesia enjoys sound demographics and is commodity rich. Its government is focused on capitalizing on trends such as nickel downstreaming where the country can be a key player in the electric vehicle market and substantially increase its country exports. We believe the downstream industry has the potential to be a transformational pillar in Indonesia’s economy and contribute to strong growth and employment. The target pipeline investment for battery chain development according to government officials at the conference is US$31.9 billion. 

In terms of fiscal discipline, the country has carried a surplus trade balance for 32 consecutive months supported by the strong performance of its downstream exports. During her presentation at the conference, Finance Minister Dr. Sri Mulyani Indrawati highlighted that as of Q3 2020, Indonesia’s GDP growth has been 5.7% year over year, one of the best in the G20, while inflation has sat at 5.5% and gross debt to GDP has averaged 41%, which are some of the lowest figures in the G20.

Sector-wise, the country’s recovery has been relatively even with mining and manufacturing surpassing pre-pandemic levels by 2022. And structural tailwinds that we also favour include Indonesia’s emerging middle class and its increasing purchasing power. Consumption benefits the most from this trend, but so do other sectors.

So, why theses low Index weights? We understand that the MSCI follows certain criteria to arrive at this outcome; however, with a forward-looking perspective we believe there’s a high probability that both Indonesia’s and Mexico’s weights will be revised. Relative to the Index, we are overweight in both countries.

Graph showing Indonesia outperforming both its emerging market and global peers between March 2020 and April 2023.
Source: Bloomberg.

This is the result of our strong bottom-up ideas that we think we have identified correctly against Indonesia’s and Mexico’s favourable investment backdrop and disciplined fiscal policies that are especially important during uncertain times.

Our approach in action

The following holdings in our view are quality companies with the balance sheets, cash flows and management team to prove it.

In Mexico, we own Grupo Aeroportuario del Centro (OMA MM). The company has a 50-year monopoly on developing, operating and maintaining 13 airports across northern and central Mexico. OMA enjoys strong margins (63% EBITDA Margin 2023E[3]), generates plenty of cash and has improved profitability on an ongoing basis even with 80% of its costs being fixed. As it relates to nearshoring, OMA is developing airports near the U.S. border and close to 65% of its traffic is associated with manufacturing and exports.

We are also positive regarding the experience of its new shareholder, Vinci Group, which builds and operates airports worldwide (on July 31 2022, Fintech informed OMA that it had entered into a share purchase agreement with a subsidiary of VINCI Airports SAS to indirectly sell 29.9% of its capital stock). OMA has maintained strong year-over-year passenger growth of +30% as of Q1 2023 and we expect its business traffic to continue recovering, where the company has larger exposure than the other two listed Mexican airports and which also reflects positively on profitability.

In Indonesia, we own Sido Muncul (SIDO IJ), the country’s largest herbal medicine company with some 300 herbal and supplement, food and beverage and pharmaceutical products. Since its IPO in 2013, Sido has grown its revenue per share and operating profit (OP) per share at c5% and c12% CAGR, respectively. In most quarters it has delivered on expectations, supported by a strong balance sheet with superior OP margins and return on invested capital, high cash flow generation and low capital intensity. As people become more health conscious, they are adopting the “back to-nature” secular trend with herbal medicines, the fastest-growing category within consumer health. Sido’s leading product portfolio, proprietary formulations and strong brand equity (it’s a household name in traditional herbal products) allow it to maintain its dominant position despite its premium pricing model. The company has a strong distribution network and vertical integration and its new extraction facilities provide superior yields and raw materials efficiencies.

Sino products on store shelves, Jakarta, January 2023.

[1] Source: Actinver Institutional Research.

[2] Ibid.

[3] Source: Bloomberg Consensus.

Global Alpha Capital Management Ltd.
April 13th, 2023