Investment Analysis: The Mongolian Growth Group (MNGGF.PK) – Adventures in Exponential Growth
Oct 31st, 2012 by Above Average Odds
“The power of value investing flies in the face of anything taught in academics. Value is the way stocks are eventually priced. It requires the perspective of patience because the market will eventually gravitate toward value.”
– Joel Greenblatt
Thesis:
Mongolian Growth Group (“MGG”) is an obscure, underappreciated micro cap franchise with an attractive highly skewed risk/reward equation and substantial downside protection.
Investment Highlights:
An investment in Mongolian Growth Group around the current price possesses nearly all the qualities we look for in a great long-term investment. These include: (1) a low valuation (2) a good, incentivized management team backed by a savvy board, (3) near to medium-term operating momentum and (4) multiple internal and external high-probability catalysts which we expect will drive substantial upside.
Other attractive attributes of MGG include:
- A simple business model with an unlevered balance sheet and tangible assets
- A strong competitive position in a rapidly appreciating niche market
- Improving economics on an attractive and fast growing asset base
- A high likelihood of experiencing meaningful improvements in profitability and cash flow
- Leverage to strong expected growth in the Mongolian Economy
- Relatively low correlation to the general market
- Opportunity to deploy capital at high ROIC’s for an extended period of time
MGG owns city-center real estate assets in Ulaanbaatar, Mongolia (“UB”). Due to the development of the country’s mining sector and certain capital market related factors, we expect per capita income in the country to substantially increase over the next 5-10 years.
This growth in the real earnings power of Mongolian citizens will be a function of a multitude of factors, but primarily driven by:
(1) The continued development, and commencement of production at two world-class “mega” mines within the next 1-2 years. Mines expected to garner over $10B in development capital over the next five years, as well as create tens of thousands of new high paying jobs (salary’s that pay ~10x the present average), not to mention generate $5-7B billion in recurring export revenue on a tiny economy whose current run rate GDP is only ~$8.6B. Additional capital devoted to further discovery, defining, developing, and bringing into production, dozens of other mines within the near to medium-term should augment per capita incomes further.
(2) Various capital market developments, such as the creation of liquid, fully functioning mortgage, bond, and stock markets should be an additional positive aiding the growth in average incomes, by helping further facilitate foreign direct investment and in turn to grow the economy. There is also the upcoming IPO of TT, where the equity of one of the world’s largest, low-cost coal mines will be distributed amongst the citizenry -allowing Mongolians to participate directly in the success and growth of the asset or if they choose and/or sell it back to the government for cash.
Basically, as mines turn on and progress on the capital market front continues, we expect a dynamic, (positive) feedback loop to develop and reverberate throughout the Mongolian economy as a whole, triggering the development of all kinds of different businesses that will benefit from a higher level of economic activity. As the Mongolian “snowball” starts to roll down hill, it should give way to a virtuous cycle that drives down interest rates/funding costs, which frees up capital to fund more businesses, which in turn provides government with higher tax revenues to invest in critical infrastructure/related projects, which will drive down manufacturing and transport costs, increasing productivity and so on, all of which will cause GDP to grow rapidly and per capita incomes to grow even faster.
With that in mind and considering the direct correlation between per capita income growth and Mongolian real estate values, we expect MFG’s diversified portfolio of high quality retail, office, and redevelopment property in downtown UB to compound at 30-50% per year going forward undergirded by a combination of rapidly rising rental yields and compressing cap rates. By purchasing the stock today at ~1.25x our estimate of “true” book value, MGG offers investors a direct way to get outsized leverage to Mongolian per capita income growth, a highly attractive theme and durable, multi-year tailwind.
Viewed from a different angle Mongolian real estate, as the largest direct beneficiary of growth in GDP and average incomes, typically appreciates at ~3x the growth rate of the underlying economy. With Mongolian GDP set to more than double over the next 5 years irrespective of either macro or micro factors – so pretty much regardless of the health of global financial markets or political developments at home – an investment in Mongolian real estate offers low-risk growth in a no growth world, basically a stable shelter from any oncoming economic storm. Evidence of this can be gleamed from the fact that even in a contracting economy that lacked the tremendous embedded growth tailwinds of the next 5 years, Mongolian real estate was flat (read held up like a champ) amidst the great recession.
Given that, we view MGG conceptually as a LEAP or long-term call option on near certain growth within the Mongolian economy with a high probability of expiring deep in the money - a rare vantage point offering investors a chance to dance in the rain in a risk-fraught global economic environment.
Why the Opportunity Exists
We believe there are three key reasons why MGG is mispriced.
1. Macro Concerns Regarding Economic Sensitivity
Given various recent data points from the first couple of quarters this year, fear surrounding Mongolia’s vulnerability to commodity prices and a Chinese hard landing seem overblown, especially given the imminent ramp of Oyi Tolgoi, the primary driver of Mongolia’s near to medium-term economic growth. To be clear, OT is a game changer, 100% financed and given its abundant level of gold byproduct, actually has negative cash costs on its copper production.
Notably, OT, as well as most of the other larger tier 1 projects set to come online within the near to medium-term, are all low cost producers with dominant competitive positions driven by a structural cost advantage relative to traditional sources of Chinese supply. This reality should all but ensure that they continue to take a larger and larger share of Chinese demand over time. Given its coming off such a low base, we don’t think its a stretch to say that the Mongolia’s prospects and embedded economic growth will be by and large relatively immune to 1) the state of global capital markets 2) near to medium-term cyclical swings in commodity pricing and/or 3) a Chinese hard landing. These are important points.
2. Understated Book Value
With a stated BV of ~$1.63/share the company doesn’t appear statistically cheap upon first glance, certainly not cheap enough to look particularly interesting in the world we live in and/or without digging a bit deeper. Yet for various reasons we believe that true economic BV by YE ’12 is easily north of ~3/share and set to appreciate rapidly. In other words, what appears to be trading at something closer to 2x BV is in reality trading at a depressed multiple approximating 1.25x.
A small premium to BV (all things considered) is simply way too cheap in our opinion, making MGG one of the more remarkably mis-priced investments we’ve come across in some time. Especially though given the company has been compounding BV at a run rate approaching 50% and the fact that a basket of less attractive emerging market RE focused comps trade anywhere between 4-5x.
So IFRS numbers vastly understate reality here. Confidence in this assessment is derived through IFRS numbers being naturally backward looking and calculated based on yields and subjective cap rates. Notably, MGG’s assets have extremely depressed yields (they were booked at below market rates) and because the most valuable piece of the property portfolio is the land making up MGG’s redevelopment parcels – and hence naturally doesn’t generate current income. That said, over half of their property contracts are set to rollover at rates on average 50% higher over the next 12 months which obviously distorts the calculation even further but again, because more than half of value here lies with a redevelopment portfolio that doesn’t generate income such a method makes very little sense.
We’ve also had talks with a multiple independent sources that have spent significant amounts of time with boots on the ground and who have each crosschecked MGG’s listings with present valuations of comparable assets and built estimates through a property-by-property build-out from the bottom up.
3. CNSX Listing
MGG currently trades on the Canadian National Stock Exchange, basically the worst exchange in Canada, which makes MGG’s equity by and large un-investable for most institutions due to mandate restrictions and liquidity related issues. This is about to change with an imminent up-list to the TSX-V. The dynamics here are actually very similar to the underlying dynamics of the real estate portfolio. Because the stock is un-investable at this point for the vast majority of institutional investors, the idea is to purchase these assets before that changes. So by “front-running” this liquidity unlocking event (the day it becomes investable) current shareholders should be able to sit back and enjoy themselves as the price is subject to a sharp, upward revaluation due to a massive pool of newly investable capital getting put to work in what is a small, very illiquid float with finite supply of sellers.
In addition, all Canadian equity markets have recently been crushed due to justifiable fear surrounding a slow down in Asia. This liquidity vacuum has pummeled non-resource based Canadian domiciled investments right alongside their resource based peers (particularly the more one goes down the exchange quality spectrum).
Long story short, we are comfortable that the business is both significantly mis-priced and (like the country it operates within) misunderstood.
Mongolia: A Unique Set Up
The Situation
Rich in untapped mineral wealth and on the cusp of an epic boom, Mongolia is only ~2-3 years into what we believe will be a 10-20 year secular bull market sustained by positive structural change and a diversified set of stable, competitively advantaged mineral based “exponential growth engines.”
Critically, these growth engines are poised to benefit from a multitude of durable multi year tailwinds and an uncommon stability derived through a combination of diversity (gold, oil, copper, uranium, coal, natural gas, rare earth’s, etc.), natural counter-cyclicality (base commodities vs. precious metals), long lives and the spoils of a structural cost advantage, a function of its geographic proximity to China. Together they provide the Mongolian economy with the capability to drive sustained periods of exponential growth in GDP and per capita incomes.
Why Mongolia?
- Tiny population rich in mineral wealth
- Construction of world class mines (on the cusp of commercial production)
- Proximity to China results in a structural cost advantage
- Experiencing a high teens annual GDP growth rate
- Anticipate near-term growth to accelerate
- Hard Working and ambitious pro western culture
Other interesting data points on the question of “why Mongolia” include Mongolia’s Doing Business Ranking: http://www.doingbusiness.org/rankings. Mongolia is #29 in the world in “protecting investors” (ahead of, for example, Australia or France) and #33 in the world in “enforcing contracts” (between Denmark and Japan).
Bottom line, we think the combination of low population density, trillions in “in ground” resource wealth, proximity to China/the Asia Pacific, and the fact that tens of billions are being spent on capital projects in planning, development, and production phases over the next five years – all in a tiny economy with run rate GDP a mere fraction of that size – has created a situation where all the stars are aligning to generate a potentially staggering level of wealth. As mines turn on and the capital that follows tries to squeeze itself into Mongolia’s tiny economy, a doubling if not tripling of GDP over the next 3-5 years is all but certain.
Mongolian Growth Group: Well Positioned on the Eve of the a Historic Boom
Enter Mongolian Growth Group (MNGGF.PK), a Mongolia based diversified investment company run by fellow VIC’ster, adventure capitalist, founder of Praetorian Capital, and CEO, Harris Kupperman. As we mentioned, MGG’s focus is on real estate and financial services or put a bit differently, the two sectors most leveraged to the growth of the economy and GDP.
We think an investment in MGG is a strategy tailor made to optimize the above dynamic, and at approximately 1.25x “true” BV (where that BV is poised to compound at approximately 3x a rapidly growing GDP) investors are getting a highly asymmetric investment opportunity with fairly predictable upside of 5-10x in 5 years and minimal probability of permanent loss. We think paying a small premium to “depressed” TBV or the market clearing (private market) value of its assets today, without any monetization of the redevelopment portfolio – immediately prior to multiple high probability “hard” catalysts offers not only an 1) attractive entry point but 2) a hard floor intrinsic value wise and 3) significant near-term appreciation potential uncorrelated to the movements of the market as a whole.
Clearly we like that risk/reward.
Opportunity Overview
Keenly aware of the short window available to them given 1) poorly functioning capital markets temporarily holding back institutional capital flows and 2) the historic tendency for downtown real estate located in the capital city of countries undergoing historic booms to accrue value to its owners in parabolic fashion, Harris (and co-pilot Jordan Calonego) wisely set about gobbling up as much prime real estate in downtown Ulaanbaatar’s (UB) as possible in anticipation of it closing.
Realizing that 1) an expanding and rapidly growing real estate market causes step change rises in property prices and rents, which acts as a multiplier on valuations – typically to the tune of 3x the growth experienced within the general economy and 2) real estate in a rapidly expanding economy offers arguably the best leveraged risk/reward set up to take advantage of that growth, the two set out building an enviable market position in the heart of downtown and succeeded.
Luckily, MGG managed to get in early enough to compile what is an utterly amazing property and land package that includes an extensive list of city-center real estate located directly on, or immediately adjacent to, Peace Avenue, Mongolia’s main (and only) street. MGG’s property and land package consists of a diversified collection of prime class A/B office property, residential apartments, and retail space. Notably, prime locations are now long gone or very expensive so the timing on this was a thing of beauty.
So why now?
- Recent government election and foreign direct investment related political reforms aimed at welcoming the worlds capital with open arms have removed a material overhang/associated political uncertainty for at least the next 4 years
- Billions in new government related infrastructure spending coming down the pipe
- The receipt of full financing for a game changing, world class mineral asset Oyi Tolgoi (OT) currently on the cusp of commercial production – essentially investors are investing in Mongolia at a major inflection point that will drive rapid growth in GDP and exponential increase in per capita incomes
- Recent announcement of QE to infinity – western central bank money printing and presence of negative real rates across the global financial markets should support hard asset prices and hence ongoing development of Mongolia’s vast natural resource base.
Ultimately we think a better, more unique set of circumstances to get exposure to Mongolian economy than on the eve of the turn is unlikely, given the above factors, rapidly improving fundamentals and the presence of external near-term catalysts set to kick start the second wave of what may very well turn out to be one of the greatest economic growth miracles in history.
As far as MGG specifically, well, basically we have premier real estate assets with massive gearing on the eve of this historic multi-year growth phase in general economic activity, which again provides an ideal set up where investors have a predictable outcome, a hugely asymmetric risk/reward equation, and the chance to front run a tsunami of incoming liquidity. I’m sure all of us can appreciate that getting leverage to an specific outcome at the right time, in the right market, through the right vehicle can be incredibly rewarding. That’s exactly what we have here.
That said, let’s talk about Mongolia. Sparsely populated with only 3m people, Mongolia is a former soviet satellite that is 1) geographically well positioned to benefit from free trade and 2) endowed with bountiful natural resources to the tune of trillions. In fact, Mongolia has enough below ground mineral wealth to make every Mongolian man, women, and child a theoretical millionaire, a data point that in and of itself helps paint a pretty clear picture that Mongolia isn’t your average commodity driven emerging market or secular growth story – but something unique with extraordinary potential over the fullness of time.
To highlight this point, we are talking about a people that could go from half nomad to the wealthiest in the world on a per capita basis within the span of a roughly a decade. I mean holy sh%t!! Perhaps there is a historical precedent, but I’ve certainly never come across a country that has the potential in ~10 years time to go from one of the poorest to the richest simply by unlocking the embedded value beneath their feet through changing a few laws and signing a few JV’s. Clearly that’s an oversimplification but with avg GDP per capita of only ~$3,000 and a present run rate of ~$8.6B in GDP in a country sitting on a trillion + in embedded asset value and the potential to generate GDP of 40B+ over the next 5 years, clearly the runway is massive and the countries present run-rate represents a mere fraction of its ultimate potential.
So we think the seeds are currently being sown for an epic wave of wealth creation unlike any other nation on earth that I’m aware of – a story that’s still in the very early innings and likely to accelerate substantially in the years ahead that should (in all probability) continue pretty much irrespective of global economic conditions or turmoil within the western world. I’m not talking about GDP + type of growth, which while respectable enough in the current environment isn’t it. I’m talking about, is an economy that’s capable of creating EXPONENTIAL increases in the average real earnings power (standard of living) of its people on a sustained, multi-year basis.
For those taking score, exponential is super compounding and if most estimates are to be believed Mongolia is poised to compound GDP by a factor of four over the next 5-10 years – and if things go smoothly near-term, nominal GDP could actually double in just over two.
A Quick Word on OT & TT
With two of the largest development projects in the world in Oyi Tolgoi (OT) and Tavan Tolgoi (TT) commencing production over the next couple of years (TT won’t really get started until next year) its easy to imagine how things could get downright silly on the growth front given the amount of latent, embedded growth in export capacity held within these two assets. It’s nuts, but these two projects alone looking out over the next five years have combined (committed) levels of Cap-ex approximating ~$12B, so close to 2x run rate GDP.
To give a better idea of the scope of these near, medium and long-term growth drivers, these two mines presently sit on ~81 B pounds of copper, ~46M ounces of gold, and ~6B tons of coal (big boys clearly). Initial production capacity is looking at annual production rates of ~1.2B pounds of copper worth an estimated $4.6B, 650,000 ounces of gold worth an estimated $1.1B, and ~3m tons of coal worth an estimated $100m or taken together, ~ $5.7B – and remember this $ amount consists of ongoing (recurring) export capacity and hence stands to be a gift that will keep on giving for an estimated 60-70 years.
Of course none of that discusses any of what I’m sure is a very real, near certain pathway to expand the resource and in turn, to grow OT or TT’s ultimate steady state production levels materially above initial estimates.
So things could get a bit nutty in the blue sky scenario and again, were talking about only two mines, so none of the above includes any additional growth potential that will be driven by the 25 or so additional projects in the pipe, each of which is expected to represent ~5% GDP on average. Nor does it speak to the ripple effects and positive feedback loops that all of this investment will spur throughout the various other facets of the economy.
Real Estate Portfolio (Portfolio Composition, Valuation, & Strategy):
Property Strategy
- Buy top quality properties along Peace Avenue
- Focus on leasable retail and office property
- Focus on redevelopment opportunities with sizable value uplift through redevelopment
Property Portfolio
- 28 Residential Units
- 6,081 meters of Retail Space
- 5,361 meters of Office Space
- 13,800 meters of Redevelopment Opportunities
Portfolio Composition and Valuation
Note: I apologize for the tiny font, it was the only way I could make it format properly…
Brief Primer on Downtown Ulaanbaatar:
MGG currently owns 28 residential units, 6081 meters of retail space, 5,312 meters of office space and the crown jewel, 13,800 meters of redevelopment property all strategically positioned within a prime 3 kilometer stretch in downtown. That said, one of the most important aspects of this thesis is to understand the geography of Ulaanbaatar and the nature of downtown.
UB is landlocked and runs east west as its constrained to the north and south given its wedged directly between two mountains – so its much more comparable to a place like Hong Kong than it is to your average city. Also, and this is equally as critical, there is only 1 main street in downtown UB, the aforementioned Peace Avenue. So when thinking about MGG’s property and land package its important to grasp that there is really only 1 area with a distinct financial and residential presence downtown where everyone wants to be located and its extremely small – which is a function of the fact that UB was originally constructed for only 300k people by the soviets. This is an obvious problem for a city housing 40% of the population of Mongolia or about 1.2m people.
Considering this reality then, its probably no surprise to anyone that downtown UB is currently facing a drastic supply shortage of Class A&B office, residential and retailing frontage and this shortage is getting more acute day be day as more and more of the worlds corporations and various expats are arriving in UB to set up operations. The shortage of residential apartments is particularly large, which are highly desirable to wealthy locals not only for status reasons but because of basic logistics given that traffic getting in and out of downtown is notoriously bad. Commutes on average take about and hour and a half to two hours back and forth.
So, the most important piece of the structural shortage puzzle is it’s a certainty that their is only one way to go downtown to help alleviate these bottlenecks – and that’s up – meaning the construction of office, retail and residential towers. Understanding this inevitable reality is a big part of connecting the dots in our mind as well as the sheer genius of how Kuppy went about acquiring MGG’s existing property (the specifics will become readily apparent shortly), not to mention where a big part of MGG’s ultimate upside will come – and to be clear by upside I mean big time, many many multiples of the current stock price type of upside.
Also, with 40% of Mongolian citizens living in a city built for a population a mere fraction of that, its not surprising that the infrastructure of the city is in dire shape and in critical need of repair and expansion. Why this is relevant to property prices is because any land outside of the city is essentially worthless because it has no infrastructure (so their is no water, sewers, electricity, etc.). This in turn drives up the price of the land within city limits because it’s the only land attached to infrastructure. This dynamic naturally provides a huge tailwind to property investments within the city center.
A Roadmap for the Future: Thinking about Valuation & the Kazakhstan Boom (2002-2008)
In order to better frame the opportunity and the second order effects of what we believe is in store for the Mongolian economy in the years ahead, we wanted to note investors have multiple historical comps where the transition to an open economy results in a large multi-year period marked by vast wealth creation – so there are various road maps but for our purposes here, Kazakhstan seems the most relevant.
While by no means a perfect comparison, in fact we would argue on a variety of levels that the unique nature of the Mongolian situation makes it substantially more attractive, the Kazakhstan example is a useful case study in a multitude of meaningful ways and it makes sense on a high level to use it as a blueprint for thinking about how an investment in MGG will unfold over the next 5 years or so.
As far as the specifics that make Mongolia materially more attractive, the quick and dirty outline includes 1) Almaty isn’t land locked and therefore suffers from no shortage of land with ~200 sq. kilometers (big difference) 2) UB has only one premier shopping street (Peace Avenue) where Almaty has 5, all substantially developed (another huge difference) and 3) while technically a democracy, its been ruled by the same leader for ~20 years and our read is that its generally understood that its a pretty good idea to keep ones business small enough to keep it out of sight from the authority’s. In other words, capital apparently flows out of Kazakhstan like bees to honey when it can (big big difference). After all, in Mongolia and UB, free enterprise is a big part of their national character and property rights are well respected, a point of pride amongst the vast majority of the population, so its very likely that the wealth of the country will stay within its borders and reinvested back in the economy. At the margin all of the above should intuitively make any investor more bullish on Mongolia relative to Almaty.
That being said, there are many critical similarities that make the comparison apt and at the end of the day, a solid roadmap to use for thinking about how all this plays out. Both countries are resource based economies, both came across massive resource discovery’s and grew rapidly due to large step change increases in production derived from those discoveries, both are former soviet satellites, both share similar cultures, architecture, initial infrastructure etc. – and so the primary difference (outside of those already noted), is that Kazakhstan is 10 years farther along in its boom than Mongolia so we think comparing the two helps MGG investors see around the corner of the oncoming mining boom.
As a side note, studying comparable situations of formerly centrally planned economies that have set about making the transition to a free, market based system is instructive. Historically, these booms tend to last approximately 15-20 years before prices normalize within the ballpark of developed nations and the evolution of these situations is broadly predictable as far as the general effects on the economy. These are key insights. What we have here then is textbook Soviet market reform, and the effects on the underlying economy in terms of these reforms are indeed predictable, and because Mongolia’s in the very early innings of this long-term transition, studying Kazakhstan (which is about halfway through) gives us a reasonable template to build of off.
Kazakhstan’s statistics over its 2002-2008 boom can be seen in the chart below (per MGG’s presentation)
Not bad by any means, but its much more interesting to compare present Prices in Ulaanbaatar today to get an idea where they may end up tomorrow. Odds are Mongolians have seen anything yet…
What the above comparison makes clear is that on an apples to apples basis prices per meter in Almaty are about 3-5x those in UB, which for reasons already noted we think is the absolute low end of where they will end up at in UB 5-10 years from today.
That said, if one is willing to factor in cap rate compression over time, a fair assumption we think, then MGG’s existing property will be worth something approximating 5-10x its present value within 5-10 years. Not bad for a small premium to BV today no?
Special Situations
Now for some insight into Kuppy’s value creation strategy, and again, this is just one of many special situations within the larger property portfolio that illustrate the value of a mind set focused on the right things. Of course this is just 1 example but its illustrative we think of the type of value that is accruing to MGG shareholders above and beyond the pricing and rent tailwinds but I digress, back to the point. Another colleague put it like this…
“MGG recently purchased a ground floor retail space that’s tenant was an ethnic restaurant on a side street of Peace Avenue. MGG purchased this property for $1.6m at a mid-teens cap rate from a forced seller. MGG is now beginning construction on an extension to the property that will increase the property’s rentable area by 60% at a cost of about $300k, effectively creating a low 20′s cap rate at today’s yields. In a few years we expect 10 caps or less to be the norm in central UB, and rents to be 2-3x higher than today’s on this property – effectively 5-7x upside on the purchase, not counting the interim yield.”
In a nutshell MGG’s investors are getting paid 20% a year with downside protection and a high probability of making 5x our money in 3-5 years, and all for owning prime downtown real estate in the capital city of one of the most promising economies on the planet looking out the next 10 years. Hard not to like that type of asymmetry all things considered. In fact, Steve over at the excellent Capitalist Exploits had an apt analogy, describing buying into select, high quality Mongolian real estate as akin to buying high dividend paying equities that are set to double every couple of years for a number of years going forward. I think that sums it up rather nicely.
And again, this is only one deal out of many similarly attractive “special situations” within the present property portfolio, and not an instance of “one off” cherry picking. Anyone interested in learning more about other deals should check out the company’s letter to shareholders for a few additional examples.
Resource Conversion – Monetizing the Redevelopment Portfolio
The biggest opportunity for shareholders at this point lies in the redevelopment portfolio. To understand why we think this, lets take a step back a bit and remember the underlying reality in downtown UB and how alleviating the bottleneck as far as supply/demand is concerned is a function of building out office, retail and residential apartment towers. This is the future, that I am all but certain. Remember UB is landlocked (sandwiched) in a valley between two mountains, so think of it like Hong Kong. There is nowhere to build but up. Having a downtown that is nestle between mountains makes is easy to identify the “money zone” and helps mitigate the risk that the city could “grow away from you” as an owner.
Also, the savvy I referred to earlier requires a bit of explanation in that as a former Soviet satellite, most property ownership was a function of the government privatizing its (real estate) assets, and it did it in a way so that all of its citizens participated in said land monetization and hence ended up resulting in lots of tiny land parcels (one for each man, women and child presumably). Well, to put it mildly having ~3m people each own some tiny parcel of land doesn’t do much for property values or for businesses looking to redevelop downtown by adding a new high quality office tower. Therein lies the problem and as always, the opportunity – and that’s exactly the opportunity has MGG capitalized on by exploiting its first mover advantage and quickly aggregating multiple small, adjacent land parcels along Peace Avenue into a handful of large blocks. All in, MGG owns ~7-8% of downtown’s “sweet spot,” which is amazing when you think about it. Anyhow, given the unique history here, we shouldn’t be the least bit surprised that the value uplift through the creation of large land packages in landlocked, deeply spaced constrained downtown UB along its main street is quite substantial.
So, given that and keeping in mind that high rents in downtown UB result in property values that are several times there replacement costs, owners of existing land and property have an attractive opportunity to convert land and existing structures towards their “highest and best use.” As an example, assuming current building costs of 1,200 to 1,500 meters property owners are looking at paybacks on investment of between 2 to 5 years. So ROIC are very attractive. Thanks to MGG’s ownership of multiple large land parcels in prime locations, which again is exceedingly rare given the time, money, and negotiations it took to roll-up multiple parcels into large development ready blocks, to say these assets are valuable or that MGG is in a position to create tremendous value for its shareholders over time is an understatement.
Lets take a look and see just how tremendous by reviewing just 1 of these land packages, which possesses a total size of ~2200 meters. 2200 meters translates into (roughly) 1500 meters of sellable land space per floor if we assume the remainder is used as space for general utility (think recreational area for businesses and residents). If we then assume the tower in question being built has 20 floors (entirely reasonable if not conservative) and use current costs and values for class a residential located in the heart of downtown according to local broker BDSec’s latest report, this development would create an incremental $75m (or ~2.20/share) in value! That’s 2.20/share in value vs. a current stock price of $3.90 and that’s just 1 of MGG’s 6 land parcels. Disclaimer: I had to lay down the first time I realized this.
So the math looks like this: $4000 in sales per square foot * 30, 000 square feet of residential sellable space (1500 square meters per floor * 20 floors) equals $120m less cost of $45m ($1500 meters in cost per square foot * 30,000 square feet) which equals ~$75m in total profit ($120m – $45m = $75m).
Granted, the example above assumes MGG were to do the redeveloping themselves, which isn’t going to happen given the companies preferred strategy of entering into a JV with experienced developers and contributing the land and retaining some % of the building while taking the property management rights, so that $75m in profit wouldn’t accrue solely to MGG but that’s not the point. The point is to illustrate the incredible value creation that MGG can deliver to shareholders over time by entering into select deals on land packages with the right partners – of course its also to illustrate that MGG is dramatically undervalued at today’s quote or said differently, relative to its existing asset base assuming no additional accretion of value through rising rents and property values.
Also, with each monetization MGG would retain a high margin recurring revenue stream approximating ~100k a year. Not game changing by any means but its an asset worth at least a million bucks (i.e. 10x) so a nice little kicker for playing.
We think finding the right JV partners should be a relatively simple and painless process given the extremely high quality of the asset. As far as financing, we’re looking at 50% down payments on construction that is pre-funded – with the JV partner obviously fronting that bill.
In sum, MGG has the ability to unlock value worth several times its present price within the existing asset base and again, this is assuming no additional price increases on property values/rents.
One last recap of the redevelopment strategy before we move on, per the company presentation…
- Partner with experienced developers
- Contribute Land and local experience to a prospective JV
- Manage the property afterwards which leads to high margin, recurring revenues
- Avoid outsized financial commitments
- Avoid completion risk
- Avoid budgeting risk
- Retain high returns on capital with reduced risk
Management Quality:
As I mentioned last time with my write-up on SND and reference to its CEO Nolan Watson, we think Harris also possesses that “…passion, the magic if you will, that is the hallmark of all truly great business leaders and entrepeneurs – “what he does mixes with who he is, which is cooked and propelled by what he believes.” I put it like that not to be promotional but in order to accurately portray that I think we are dealing with something special in terms of managerial quality, particularly in terms of incentive alignment, strategic vision, capital allocation, and sheer dedication to exploiting a very unique opportunity.
Not only has he put the vast majority of his net worth on the line, but unlike the vast majority of the executives I know (or people in general for that matter) Harris was willing to pack up his life and move halfway across the world from the sunny beaches of Miami to a developing, non English speaking country where he knew practically no one, with long -40 degree winters and most of the day to day luxuries all of us have come to rely on, all pursuit of fulfilling his dream. Maybe it just part of my personality, but frankly that’s the type of thing that fires me up. Attempting such a feat takes courage, conviction, and a bold, pioneering spirit – exactly the type of combination necessary to succeed in a frontier environment, and exactly what I would want in the CEO attempting to lay down his mark by building a great, truly enduring business in an emerging market on the far side of the world.
Nonetheless, readers should judge for themselves so in that vein I’ve linked the following profiles and interviews – each of which should help paint the picture as far as sizing up the caliber of the individual leading MGG’s charge.
Lets start with one on compensation and incentive alignment….
“Chris: Mongolia Growth Group is a bit different from most other public companies in terms of compensation. Can you explain?
Harris: the Company started with me asking friends to invest alongside me in Mongolia. I wanted a diversified company that would have adequate exposure to the Mongolian economy. I simply didn’t have the resources to do that myself. I felt funny asking my friends to invest in my company and then tell them that I was going to take a salary and dilute them through stock options or any other scheme like that. Instead, I have decided to take no salary, stock options, performance allocation, bonus or anything else. I’m here in Mongolia because I’ve invested my own money in the company. My Co-Pilot in this venture, Jordan Calonego feels the same way. Besides, we’ve been investors for over a decade now and have been disgusted to learn that the CEO always seems to do better than the shareholders. Now that our roles are reversed and we are management, it would be wrong of us to do what we have always criticized. Investors need to think of this company as a business created by a bunch of very successful hedge fund guys who want to invest their own money in Mongolia. Minority shareholders can come along for the ride if they want without any of the onerous fees normally associated with hedge funds. It is the only company that I know of like this. I hope we can use this as a template for the next time that I complain that some Management team is overpaid, but that’s a different story!”
Shareholder Letters – http://mongoliagrowthgroup.com/?cat=12
Interviews:
http://capitalistexploits.at/2011/06/a-mongolian-capitalist-part-i/
http://capitalistexploits.at/2011/06/a-mongolian-capitalist-part-ii/
http://www.distressed-debt-investing.com/2010/11/hedge-fund-manager-interview-series.html
http://www.distressed-debt-investing.com/2010/11/hedge-fund-manager-interview-series_21.html
http://thedailygold.com/interview-with-harris-kupperman-ceo-of-mongolia-growth-group/
Thoughts on Mongolian Economic Sensitivity: The Rock of the Asian Pacific
For the non-believers out there, evidence of Mongolia’s decoupling from the rest of the world can already be gleamed from its 30% nominal (17% real) growth rate over the first half of this year, and this growth rate (I would add) looking out 6 months to two years will accelerate. That, and with 90% of Mongolia export capacity being Chinese driven one would think that any serious slowdown in its neighbors economic activity would result in a similarly lock-step downward adjustment to Mongolia’s economy, yet this hasn’t happened and given the dynamics at play we don’t expect it will. That’s not to say that its entirely immune, not at all, just that even if near-term weakness eventually shows itself, such weakness will ultimately be overwhelmed (and then some) in the near-term by much stronger countervailing forces.
We should also point out that such growth is unheard off pretty much anywhere else in the world today, which is telling in and of itself but especially remarkable in light of the slow down in emerging markets and China in particular, not to mention the significant recessionary fears in developed markets the world over…and again, this is PRIOR to the substantial acceleration in economic growth that will take place as OT starts to produce over the next 12 months, the $10B IPO of TT takes place, or the government starts putting to work billions towards infrastructure improvements. Candidly, if such durability doesn’t intrigue you it should, as within it are the clues to what lies ahead in my estimation, namely a Mongolia that dances happily through the rain and comes out the other side significantly stronger.
Nonetheless it appears a decoupling has already started and is likely to continue given the commencement of steady state production at OT. Basically, once OT ramps the divergence highlighted in the chart should blow out, as it will single handedly grow the real economy in the high teens and average incomes by even more – not to mention diversify the economy from one that’s primarily coal based, to a dramatically more stable one driven by a diversified, countercyclical mix of coal, copper, and gold pretty much overnight.
Given this reality, it seems pretty certain that the Mongolian economy will be shielded from 1) a reasonable level of economic turmoil within the developed world and 2) a Chinese hard landing. At the very least the implication seems to be that economic conditions (i.e. stability and growth) should hold up substantially better than other more developed economies, both east and west.
The somewhat paradoxical conclusion above is a function of a couple of things…
Mongolia’s proximity and hence sizable cost advantage (transportation costs, labor, etc.) to traditional sources of Chinese supply removes a considerable amount of uncertainty in terms of the big picture. Unlike most resource driven economies, commodity pricing plays second fiddle to the ultimate outcome given Mongolian low cost production is able to feed more and more of China’s existing demand at the expense of higher cost competitors – and we would note that even under a draconian 20-30% drop, its hard to see how that would come close to being of sufficient magnitude to materially effect the baseline demand number that China would require even if it started shrinking. Therefore, as crazy as it sounds, the health of the Chinese economy would seem unlikely to effect Mongolian economic growth prospects materially at this early stage in it’s development.
Put a little differently, the level of demand destruction required for Mongolian production to feel a GDP growth negating hit would need to be staggering – we think one that would imply a depression like scenario globally, so the simple answer is that Chinese coal demand may drop, but not to a level that would destroy demand for its lowest cost producer. Same with copper, gold etc. So we expect Mongolia to hold up as China rationally shifts their needs towards the lowest cost producer and because at the end of the day, Mongolia’s production capacity isn’t big enough (even at maturity, say 10 years down the line) to take the entire share of the commodity needs of the worlds 3rd biggest economy.
After one takes into account the gold byproduct, Oyi Tolgoi actually has NEGATIVE cash costs for its copper production. Hard to believe, but this tier 1 mega mine/multi billion dollar copper producer with a mine life of ~60-70 years literally can’t become uneconomic under most reasonable future scenarios given practically every other copper mine in the world would need to go bankrupt before OT would face material stress. I say that because as a low cost producer of gold and copper with massive scale, high grades, natural counter-cyclicality (gold should do well when copper does poorly and regardless of whether we have inflation or deflation), and a structural cost advantage large enough to drive a truck through makes it extremely unlikely. So a scorched earth scenario where this happens is REALLY difficult to envision barring some type of Yellowstone type event (such as a Chinese or Russian invasion).
Basically given the Mongolian economy’s low base and OT’s contribution, not to mention its scale as the third largest copper mine in the world, or its negative costs on copper production (due to its unusually high level of gold byproduct) etc. it remains difficult to come up with a scenario in our mind where OT’s impact as a growth driver could be negated. We just can’t figure out how to remove any legs from the foundational stool under any scenario worth worrying about given OT’s economics are bulletproof relative to competition. The mine should generate cash regardless of where we are in either commodity’s cycle, so the odds that it would ever get idled over the life of the mine is pretty much nil.
My understanding of the last few years is that much of the of torrid growth has been driven primarily through exporting coal from smaller mines, pretty much by selling it at half market to the Chinese for what is presumably their local power needs. That would seem to imply that all of the rapid growth from foreign investment from these tiny mines over the last few years is very stable and in all probability sustainable indefinitely – after all, presumably these pretty much non-discretionary foreign inflows are a function of necessity, i.e. of ensuring the lowest cost sources of coal possible can be used to keep the lights on in local Chinese cities located close to the Mongolian border (so again, sustainable because its clearly the lowest cost source of power they could possibly utilize). Either way in the long-run, unless China stops powering their cities, homes, etc. the demand for this low cost coal should be more than sufficient to support Mongolia’s present run rate GDP – sure, volatility in volumes and pricing will always be there but production increases from existing mines and/or additional coal derived from new mines should easily overwhelm that cyclicality as export capacity grows.
As an aside, planned infrastructure investments/logistical improvements should buoy run rate coal exports and hence GDP since most of today’s low cost coal is transported by truck ~250 miles to the Chinese border (so not exactly the most efficient method to put it lightly), so its worth highlighting that when the rail currently in planning is built the economics of this portion of the economy (i.e. its core driver at present) will get materially better, further augmenting Mongolia’s already steep cost advantage. Hard to tell if the entirety of the additional margin will accrue to Mongolian producers, but regardless I view any progress on this front is icing on the cake and figured I should mention it, as the positive effects on general economic activity aren’t trivial.
Summing it all up then, all signs point to the Mongolian commodity juggernaut possessing “inevitable” status in Buffett parlance given a high probability of near certain growth looking out 2-3 years from the economy’s present $8.6B base.
Catalysts:
Mining
As Mongolian mines turn on, GDP and per capita incomes will grow and hence the value of MGG’s RE assets will appreciate even faster. As far as specifics, the big near-term catalysts are the commencement of production at OT as well as the upcoming IPO of TT – both of which should result in substantial growth and large windfalls in terms of wealth to Mongolia’s citizenry, catalyzing a substantial re-rate in the value of MGG’s properties. That’s just what happens in an ~8B dollar economy where one mine is set to bring in ~$5B in recurring export revenue within 6 months to a year and another that’s expected to raise ~10B in an IPO – an amount that in and off itself is larger than the entire GDP of the country presently.
Fwiw, these developments are practical certainties in our opinion (OT especially), and as we’ve already mentioned, should come to fruition in the near-term irrespective of cyclical swings in commodity demand/pricing, turmoil within the capital markets, or political grand standing by a small minority of Mongolian politicians dead set on killing the golden goose.
Remember, OT is fully funded and TT is arguably one of the best low cost coal assets in the world in terms of size/scale and proximity to the hungriest coal consuming economy on the planet. Remember, Mongolia’s is starting from a very low basek and its status as a low cost producer with a structural cost advantage relative to other high cost producers such as Australia, Indonesia, etc. practically ensures Mongolian production continues to displace foreign resource demand unabated.
Capital Markets
Mongolia’s capital markets do not function and any improvement on this front will be a major positive for economic growth and per capita incomes given it would unleash an additional source of upside leverage to GDP entirely independent of the mining boom, and would unlock an enormous amount of latent consumer spending power providing an economic growth/average income/real estate pricing tailwind for literally decades.
There is still much to be done but the good news is the wheels are turning. While progress is naturally slow, the positive changes on the horizon are multi-fold, including 1) the continued arrival of foreign banks 2) the passage of legislation related to various capital market related issues next month (such as the creation of laws to regulate credit and create securities markets), 3) the London Stock exchanges successful modernization of the Mongolian Stock Exchange (MSE) and 4) the successful IPO of TT (hopefully on the MSE) etc., all of which will help (at the margin) facilitate the structural changes necessary to create the foundation needed to allow fully functioning capital markets to take hold. So all of the pieces of the puzzle are in motion and coming together but this will take time.
Also, as of today most Mongolian banks generate NIM’s of 8-9%, and are still woefully undercapitalized, which naturally makes credit very expensive and access to long-term debt financing of any kind extremely rare. Something like 80% of loans are turned down, a statistic that in my mind pretty much says it all. I mean it’s an obvious problem when even the best businesses and entrepreneurs (entirely) worthy of capital can’t get. But again, luckily things are changing and when they do, a virtuous feedback loop will start to gain traction and in the process naturally drive down NIM’s, the cost of financing, etc. which will naturally broaden access to capital and help make long-term financing available, etc. and in turn facilitate the creation of a mortgage market and a liquid, fully functioning modern stock and bond market. So all of this is critical to keep in mind in context of the longer-term story here, as today’s headwinds will eventually become very powerful tailwinds.
Lastly, as long-term investors with an eye towards the inevitable, we want to get in before this happens and in truth, hope the window stays open a bit longer given the extreme inefficiencies it creates for a company like MGG run by a pair of opportunistic investors with the willingness, ability, and capital to exploit it on shareholders behalf. Obviously any time interest rates are excessively punitive and loans are short-term in nature, this dynamic will lead to a fairly large amount of financial turmoil and a pretty much continuous flow of forced selling like the situation described in the special situation segment earlier. So to tweak St. Augustine’s famous line on chastity, Lord please give Mongolia functioning capital markets, just not yet.
Exchange Up list(s)
We expect MGG to up list to the TSX-V within the next few months, the Mongolian Stock Exchange in the near-term and eventually the TSX longer term. The up-list to the TSX-V is by far the most consequential in terms of a hard, near-term catalyst and we expect it will drive a material revaluation in the company’s shares. Keep in mind that MGG is currently listed on the Canadian National Stock Exchange (huh?) or the “CNSX” – a tiny exchange for emerging companies. Basically the worst exchange in Canada. This is critical as this listing has heretofore prevented large amounts of capital (read a long list of institutions) from investing in MGG despite their willingness given internal mandate/liquidity restrictions, a barrier that critically will no longer apply once the TSX-V makes those issues mute.
Given all of the pent up demand and assuming an up-list along with a modest increase in MGG’s IFRS book value as those numbers are changed to reflect the substantial increase in Mongolian property prices and rents over the latest twelve months (which again is still substantially below “true” book value), perhaps something approximating $2.25. If we then assume a multiple on those revamped IFRS numbers at or below the lowest end of the comp range, so say 3-4x, both reasonable assumptions given the substantial uplift in Mongolian RE and the relative superiority vs. comps – MGG’s equity would end up somewhere between $6.75 and $9 in the relatively near-term, so upside approximating 2-3x the present quote at some point within the next year. Not bad.
As far as the MSE up listing, it may take a bit longer than the TSX-V up list, but eventually we think this will be a substantial catalyst as MGG is the best positioned and really the only company that will be listed that provides institutions with a conservative vehicle to play the multi year growth wave in Premier downtown UB RE. Fwiw, can’t imagine Asian sovereign wealth funds not wanting exposure once it’s available.
Point being, we see these events, particularly the imminent TSX-V up-list as having a high probability of driving a material re-rate, and in the process pushing MGG’s valuation more in line with intrinsic value and/or that of its global peers.
Risks:
Resource Nationalism/Government Related Issues
Figured we’ll start off with the elephant in the room by noting that additional government regulation/bureaucracy could affect the cost and pace of development in Mongolia going forward. For reasons outlined below it’s a negligible risk in the thesis killing sense. Also, we should probably mention that if the current political grandstanding and melodramatic/western press seeking antics of a small minority of politicians continues, its reasonable to assume some impossible to quantify amount of damage (in terms of lost FDI) will walk away. While powerless to affect change in any real sense, the mere perception of political risk could become self-fulfilling to an extent, but again it would be an immaterial amount and is nothing to lose sleep over in context of the long-term thesis but definitely something to monitor.
That said, lets remember the ambitious, pro western nature of its people and the fact that both major political parties are pro-business and better yet, that the more classically liberal of the two was just elected in the countries quadrennial elections. This is evidenced in the new governments DP plan (and others) that highlights their policies, as well as in their actions, most recently by voting down calls to renegotiate terms of the OT contract twice within the last couple of months. I emphasize it given all of the recent events/press of late that paints a very different picture, so I wanted to reiterate that right out of the gate to highlight that while its true Mongolia has its fair share of myopic, pandering politicians intent on enacting self defeating policies, so do we all, and the “kooks” in the headlines are a small minority with zero power to do anything of material consequence – just like the kooks in our own, or any representative democratic government for that matter.
So while no discussion of this topic would be complete without the above, neither would a discussion that didn’t provide a good idea of the character of the Mongolian people as a whole, particularly in terms of standing up for property rights and the democratic form of government. I mean this is a country that went on a hunger strike (for God sakes) in order to achieve democracy, so the belief in the rightness of a democratic system of government isn’t just a phase, its actually deeply ingrained in who they are as a people. At the risk of sounding hyperbolic, I actually think its fair to say that democracy is in their blood. Evidence of this can be gleamed from a variety of angles, most notably by Mongolia’s multi-decade history of stable democratic governance, a period marked by peaceful, seamless transitions of power. This type of thing is practically unheard of in the prototypical frontier market and really speaks for itself.
Also numerous sources who’ve spent a material amount of time on the ground have told us that the average Mongolian will tell you that property rights are considered sacred and that the government will simply never just take an asset from anyone. The only exception to this rule is when the Chinese are involved as Mongolians harbor a severe mistrust of their larger, more powerful neighbors, and reflexively fear Chinese control of Mongolian assets – but even here, the two countries are for the most part able to work around these differences and somehow manage to make it work. As further evidence of the larger point consider that Mongolia is #29 in the world in “protecting investors” (ahead of both Australia & France) and #33 in the world in terms of “enforcing contracts” (between Denmark and Japan). Interestingly then, as nuts as it seems, capital appears to be relatively safer in Mongolia than in a wide variety of developed western nations – and yet people that wouldn’t think twice about investing in Japan, Australia or France wouldn’t invest in Mongolia with a ten-foot pole. As fact and data driven investors, all in all this makes no sense to us given the empirical and anecdotal evidence points to a large disconnect between perception and reality in terms of the perceived vs. actual risks of investing in Mongolia in terms of the stability of government, property rights and respect for the rule of law. These are critical points for potential investors to internalize.
I should probably also note that as unusual as it may be in terms of the average frontier market, I don’t think it’s at all abnormal for country that underwent decades of oppression and the “cog in a wheel” reality of Soviet rule to have deep-seated preferences for democratic forms of government and a profound respect for property rights amongst the majority of its people (Poland comes to mind). In fact I think its intuitive if anything. So again, my read is that respect for both democracy and the rule of law is deeply ingrained, and both are enduring characteristics that are highly unlikely to change anytime soon.
Again, these are key points and while I fully realize this isn’t orthodox opinion, all things considered I just don’t see Mongolia as particularly risky on an absolute basis or relative to other western developed nations. That’s not to say that Mongolia doesn’t have its owns very real risks and issues, just that the range of outcomes here is relatively predictable and many of the typical pitfalls associated with investing in frontier markets don’t really apply in the traditional sense. As I hope is clear by now, the more you peel back the Mongolian onion the more all of this becomes obvious.
With that foundation established lets get to the point as far as why we don’t feel that governmental/political risk is all that material to the endgame here – at least not significant enough to be amongst the thesis killing variety.
The backbone of this conclusion is derived from…
The fact that Mongolia is a democracy where all existing legislation requires a quorum (or 2/3rds majority) of votes to overturn. In a very real way then handicapping this risk is a basic math problem and an easy one to solve at that.
For example, as far as we can tell the golden goose killing, resource nationalists in the Mongolian parliament (i.e. the ones whose antics get plastered all over the western press) only number in the mid twenties at best – in a government that keep in mind requires a bare minimum of 39 votes in order to affect real change of any consequence. So again, investors need to understand that that this is a small minority in a democratically elected government that frankly doesn’t appear close to having the requisite political muscle to jeopardize the country’s progress (at least for the next 4 years). So the headline risk, while not particularly helpful and a tad unnerving is at the end of the day just that (so pretty much nothing but noise). At minimum I think one can confidently say that because of this structural reality, the political risk is reasonably contained for the near to medium-term future.
Even if we assume by some extraordinary measure the “kooks” in the government managed to garner the requisite 39 votes to do something staggeringly retarded (which again is unlikely for reasons already stated), I would argue we still have an ace up our sleeve in the form of veto by the PM. What the media fails to mention 9x out of 10 is that the PM is on record stating he would veto any such legislation immediately. I mean the guys not dumb given the stakes.
If we want to go one step farther and assume he’s lying (just for the fun of it I suppose), remember that the law is still clearly on Rio’s side and the company is on record stating it wouldn’t stand for it and would fight it if necessary in court. So Rio has made clear that any change in current terms won’t fly and hence under that scenario the case would end up in arbitration within the international court system and hence, any ruling would almost certainly come down in Rio’s favor given what are very clear, mutually beneficial terms that were obviously understood to be legally binding at the time of signing by both parties involved. I’m no lawyer, but this just seems self-evident. So worst, worst, worst-case production gets temporarily delayed 6-12 months as the issue gets settled in court and the economy takes a near-term hit in the meantime.
Lastly, the embedded growth derived from OT & TT “turning on” is a lock regardless of what the future brings on all of the above fronts. I bring it up again because remember that as they “turn on,” these mega mines will in and of themselves fuel substantial gains in GDP and average incomes relative to present run rates – and hence in the value of MGG’s RE portfolio irrespective of the macro. No matter what happens, Oyi Tolgoi ramps up and that is really all that matters in terms of this thesis working. Strictly speaking, the idiocy of politicians is not an impediment to investment success.
Think about it like this, even if we assume the worst-case scenario where the government goes nuts (highly unlikely imo) and rips up OT’s existing agreement and somehow gets away with reinstituting a new contract where Rio is essentially nothing more than a contract miner earning a 10% IRR after it recoups its initial investment (with the rest of the economics going to the government) – and that nonsense stands in court – even then, Mongolian GDP will still roughly double when all is said and done. Meaning OT & TT still get built and hence run rate GDP of $8B becomes “steady state” GDP approximating ~$16B+.
The takeaway is that GDP should approximately double in ~3 years regardless and that this doubling is highly predictable. Put another way, if OT & TT turn on GDP will double and given that our downtown UB RE should appreciate at a rate of 3x that, the value of MGG’s portfolio could easily triple in value even under the most draconian – not to mention improbable – scenarios we can imagine. Again, the above assumes the government does something stupid and most of today’s projects in the works ultimately get nixed as FDI throttles back due to fear surrounding political risk.
Other critical points to internalize is that most of the politicians in power today are amongst the countries wealthiest citizens and therefore they have the most to lose by spooking the international investment community with the specter of sovereign risk. I say that with confidence because in Mongolia the political and business elite are one and the same, and because most of them actually own either 1) large interests in the mines that FDI has been – and will be – developed or 2) if not the mines, certainly any multitude of supply chain related businesses that stand to benefit royally as the country continues to develop/modernize over time. So rest assured the politicians are cognizant of what’s at stake here and any acts of staggering idiocy along these fronts would hit them directly where it hurts (i.e. in their pocketbook).
Also critical is that as Harris has mentioned, the Mongolian people have already “stubbed their toes badly” in this respect with the 2006 excess profits tax, an 85% tax that was partially repealed (almost instantaneously) in 2006 and fully repealed by 2009. From everything we’ve read and/or heard from those in a position to know, the folly of this act was apparent to everyone, everywhere, and pretty much immediately. I mean with the switch of a button, Mongolian FDI and most of the countries mining related jobs/projects ground to a halt and the country was for all intents and purposes plunged into a severe bout of economic distress in the blink of an eye – and again, it took almost 3 years for the damage of that one act to be undone. Maybe it’s just me, but people don’t forget things like that very easily. So its no small point that the memory of what awaits such short sighted decision making is still fresh and/or that the political class stands to lose considerably from a financial standpoint should the minority of the countries politicians somehow succeed in tarnishing the countries reputation as an ideal/safe destination for investment capital. Again, I just don’t see it happening.
Last but not least, consider that the government absolutely needs foreign investors (read the associated tax revenues that these investments will generate) in order for to be able to come up with the billions in requisite funding needed to 1) repair the countries crumbling infrastructure and 2) support economic development in the countries others sectors. For anyone familiar with the situation this is a very big deal as without continued FDI, the Mongolian government would be likely be sh%t out of luck as far as alleviating so many of the infrastructure related issues currently plaguing the country. The cold hard reality is that politicians need this to happen to deliver on their existing promises to their constituents – let alone to deliver on promises relating to a brighter future. In other words, they need it to keep their jobs. That’s the beauty, as unlike most frontier markets and their dictatorial strong men that run the country uncontested (usually with an iron fist) – Mongolian politicians live in fear of losing their jobs just like the politicians in our own or any truly democratic society for that matter, after all, they have two decades of experience watching peers get kicked to the curb which tends to make an impression. Also, none of the political parties or individual politicians have enough power to not fear the reaper, as witnessed by the recent jailing of one of, if not the most, powerful politicians in the country. Because of this, again just like our own politicians, they tend to do what they need to do to ensure they keep their jobs, and not to be a cynic but if there is one thing politicians as a group can be counted on to do, it’s cover their ass and act on an opportunity that ensures their job/advances their own interests. We’re covered on both fronts.
Add it all up and our conclusion is that the majority of Mongolians and the politicians in power are both incentivized and eminently aware that capitalizing on the countries resource wealth is the ONLY way forward. Meaning, they understand that jeopardizing the investments that they depend on by enacting myopic legislation is akin to playing Russian roulette and for what, an extra 15% or whatever of OT’s equity? To say that would be self-defeating, and all around shockingly dumb isn’t the half of it. It’s not like it takes a genius to realize that chasing away the precious capital and investment at this stage in the game would level any hope the government has of achieving its plans, as without the profits from its natural resources, those plans are dead in the water. Everyone loses. Big time. So not only would all Mongolians suffer, the current politicians (read the business elite) would bear the brunt of it, as it’s likely they would not only be out of a job, but vastly poorer.
Now all of the above doesn’t stop western journalists from pasting every scary word they hear from opposition minded Mongolian parliament members every chance they get (and the political circus like press conferences they seem to hold on a bi-weekly basis). We reiterate this point not to beat a dead horse, but to crystalize how this type of thing out of context tends to unnecessarily exacerbate fear/dampen sentiment, and hence leads to overblown concerns regarding political risk when a close examination of the facts and underlying situational dynamics at play strongly suggests it’s just noise. All of this is not to say that that government related risks aren’t real to certain degrees, just that whatever happens we don’t think it will kill the golden goose and that the headlines plastered in the western press typically don’t come close to telling the whole story. Again, perception isn’t necessarily reality, especially in this case, where the members of the MP party are a small minority that happens to be unusually hysterical in their quest to strap what amounts to a stick of nuclear dynamite in the engine of Mongolian progress and economic growth. They will fail miserably, just as they have at every point so far.
We want to close by quickly mentioning that we think this article posted below on the second order effects of rising taxes at OT and other emerging Mongolian copper producers (published a couple weeks back) obviously overstates the risks of the new proposal set to come before Parliament, lacking the balance and context in terms of the larger picture which we’ve tried to synopsize in brief.
http://dealbook.nytimes.com/2012/10/15/tax-proposal-in-mongolia-threatens-rio-tinto-project/
For clarity’s sake, the new proposal set to go before parliament detailed in the article above isn’t OT specific – again, those OT specific proposals have already been voted down twice in the last couple of months – but an entirely new law aimed at the copper industry itself. The proposal, if passed, would add an additional ~300m USD in tax liability (by revoking income tax allowances), not to mention introduce a sliding mine royalty that scales up to 20% depending on the copper price at the time in question, which is considerably higher than the fixed 5% rate guaranteed under OT’s existing agreement.
Bottom line is that (as always) anything can happen, but as we hoped we’ve made clear, 1) passage of this bill wouldn’t kill the thesis and 2) a large amount of caution against reading too much into recent press is more than warranted.
At the end of the day we continue to think all signs point towards a bright road ahead for Mongolia. We’re of the opinion that Mongolia’s history says a lot about its future much like the operational track record of a 20 year old corporation does about its own. Sure the world could be upside down tomorrow we just don’t think its likely for much the same reason. The momentum of the last twenty years of history are on its side. That, and they appear to have take the cheap tuition to of the last decade to heart, and possess all the key ingredients necessary for sustained, long-term success (an exceedingly rare combination we might add) – such as an educated, hard working, entrepreneurial culture, a young population – 60% of the population is under 26, can you say baby boom? Wonder what that will do for property prices given a relatively fixed supply due to structural reasons but I digress. They also have a multi-decade history of stable democracy marked by peaceful transitions, a fully functioning legal system with a long history of respecting property rights and the rule of law, relatively low levels of corruption etc. etc. and so ultimately, we think Mongolia has a very high probability of harnessing its vast potential and becoming the wealth creating juggernaut of a country it was destined to be. We’ve positioned ourselves accordingly and look forward to a long, hugely profitable ride as this transition takes place in the months and years ahead.
Development/Production Delays at OT/TT
Closely related to the above, there is a chance that the final piece of the OT production puzzle, namely the ability of Rio Tinto to hook the mine up to nearby Chinese power lines gets scuffled somehow. Given what’s at stake, various tea leaves, etc. we doubt a mutually acceptable agreement won’t be reached near-term but even in the worst case scenario, all this would do is delay the commencement of commercial production by ~6 months or so as Rio would need to build the power capacity themselves. Like with the specter of an arbitration hearing, this would amount to a slight kick in the balls (i.e. a near-term pullback in the economy) but nothing game changing as it would push production back 6 months to a year max.
Commodity Risk
As with any country where the economy is commodity driven, Mongolia is to a certain degree affected by commodity prices and a sustained collapse in pricing obviously wouldn’t be a great thing. Given the countries structural cost advantage though, prices don’t need to improve or even stay at current levels for the thesis to work.
Also, the macro shock risk is real and while I think MGG weathers the storm much better than most, a systematic financial crisis wouldn’t be a good thing as far as FDI/capital flows are concerned. Capital flight would temporarily delay the day Mongolia realizes its full potential.
Geopolitical Tensions with China and/or Russia (Sovereign Risks)
To paraphrase Harris, there’s always a chance China and/or Russia decide to “bring the tanks in,” and while a highly remote possibility it should be noted as a risk.
Corporate Governance
With 1) a sole mandate to create shareholder value 2) a 33% ownership stake 3) full transparency, accountability to investors and an impressive BOD 4) independent verification that all MGG’s property titles are clean 5) Price Waterhouse Coopers doing the books and 6) Cushman Wakefield taking care of the property appraisals etc. etc., we think we are in good hands. As such a small company, it’s telling in my mind they didn’t skimp on fees (and they usually do, though in the good way) and hired world class auditors and appraisers because it was the right thing to do all things considered.
Let me preempt the equity raise question by noting that the up-raises were accretive to per share value as they were done at a premium to NAV and that capital was deployed at very high rates of return. The second they do a raise that’s dilutive rest assured I’ll be the first one in their ear. Don’t see it happening though given Harris and COO Jordan Calonego are both excellent capital allocators, so rest assured they have a firm understanding of what is and what is not, dilutive – and given inside ownership of 33% and the fact that they have put up millions in capital of their own money. I’m pretty sure they aren’t interested in diluting themselves to go empire building given they don’t even pay themselves a salary (there’s no upside, only downside to doing so). So between that and various other data points, MGG might be one of, if not the most shareholder-friendly I’ve ever invested in and it shows (in so many different ways). For example, as noted above, they hired world class auditors and appraisers in order to give maximum comfort to their shareholders yet they’ve raised ~$51m in capital so far, and every time they did a non-brokered deal because they didn’t want to pay the fees. Notice the pattern of spending money like they would if it was their own (which a large part of it is).
Couple more points. The raises were also done because they were approached by the right type of long-term shareholder that wanted to get in, and MGG wanted to have them, and because increasing the liquidity of the stock adds value. Additionally, in order to up-list the company had to meet minimum # of shareholder requirements. The raises helped out on all those fronts.
All that said, I tend to like the idea of additional capital raises going forward as long as they are done above “true” book value because I believe they would be significantly accretive to an already largely fixed cost base and because the window to deploy capital at these super attractive rates is closing. Operating leverage to having a larger property portfolio spread out over a fixed cost base is significant. Equally as importantly, in real estate having a bigger property portfolio is better, not only because of the substantial fixed cost leverage involved, but because having a broader portfolio gives them more negotiating leverage with tenants, and allows them to more easily gain large prospective clients like a YUM brands, where by having a wider selection of property locations to showcase they are able to meet a wider, more varied set of needs.
In terms of the initial policy on no options, and the seeming flip-flopping in that regard, rest assured it isn’t what it seems. First, its not like they are issuing additional stock to themselves (these guys don’t even pay themselves a salary) and second, the options they’ve issued so far were done solely to attract/retain local talent. Really high quality (smart), enterprising locals are naturally hard to find and so when you hire them you want them to stay and giving them an ownership stake in the company is the best way to do that. Historically, some of their best people were getting poached by large multinationals and so MGG decided it was the right way to go in order to make churn less of an issue. They can be cheap skates with quarterly turnover and have their best in brightest stolen from them or they can issue some options judiciously and try and strike the right balance. I think they are doing the right thing.
Last but not least, just take a quick look at MGG’s board, which consists of Ross Beauty’s right hand man in terms of corporate governance or notable short-seller Bill Fleckenstein (who’s also one of the largest shareholders of the company) to name a few. This is an impressive BOD for such a small, off the radar company. I think that’s telling.
Dutch Disease
In terms of the risks of Mongolia catching a case of “dutch disease,” check out the BDSec overview on the new coalition government’s latest DP plan for some good color. The DP plan is basically the government’s framework for policy decisions going forward and I think its pretty clear that they are going about things in an intelligent way designed to minimize these risks. I believe they are using Chile as a template for how to do things right.
Also important in terms of thinking about Mongolia’s ability to successfully navigate the resource curse, the mongols are/will be getting granted stock in these IPO’s like with TT. So if the mines flourish, so will the average mongolian in terms of wealth. They will certainly be much richer than they are now. That should keep a lid on a lot of the envy. Instead of a “he’s getting rich” and “I’m still poor” it’s more “where did all this free money come and its nice that we are all getting wealthier – I want more of this” if you follow me. Embracing free market capitalist principles will make everyone far far richer in the end…and again, I think they realize that and not just on some superficial level. That said, MGG’s portfolio is actually set up in a way to benefit from “dutch disease” in the near to medium term so keep that in mind as well.
Helpful Documents:
Thesis PDF (just in case the formatting doesn’t come through)
MGG Corporate & Property Presentations
BDSec Report: The Heavy Hand of Government Lightens Up
http://www.scribd.com/doc/110231053/MGG-the-Heavy-Hand-of-Government-Lightens-Up
BDSec Report: New Securities/Market Law Draft A Potential Game Changer for Mongolian Capital Markets
BDSec Report: Mongolian Portfolio Strategy
http://www.scribd.com/doc/110231162/MGG-Mongolia-Portfolio-Strategy
Mongolia Overview:
http://www.scribd.com/doc/110231012/Mongolia-Report
Capitalist Exploits (Mongolia related posts & Kupperman interview)
http://www.capitalistexploits.at/tag/mongolia/
Adventures in Capitalism Mongolia Related Blog Posts:
http://adventuresincapitalism.com/search.aspx?q=Mongolia
Business Week Article
http://www.businessweek.com/magazine/foreign-money-invades-mongolia-0721201
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How do you gain such confidence in an up-list triggering a revaluation to 3-4x book? With all due respect, that seems to be a bit more than optimistic. Also, if I’m not mistaken, you had a similar catalyst as part of your Energold thesis.
Greg, no worries, skepticism is encouraged. The big catalyst with energold at the time of the write-up was improving operating performance.
Regarding MGG, I’m not at all certain where it will trade after the up-list. I’m pretty confident it will trade up materially but that confidence is derived from a combination of
(1) The valuation (~1.25x true BV, not the IFRS numbers). This assumes no value uplift from the monetization of the redevelopment portfolio, which is likely unrealistically conservative given how valuable this property is in UB. Think of it like owning giant chunks of Fifth Avenue in NYC or Michigan Avenue in Chicago 100 years ago. This embedded upside optionality imo is worth multiples of the present price, and were talking about assets that have been compounding at 30-50% a year anyway and should continue to compound at that rate for at least another 5-10 (so that is cheap considering).
(2) Basic supply/demand dynamics, which should catalyze a liquidity unlocking event in the near future. Think of it as front running liquidity. The stock doesn’t have a lot of sellers at this valuation (for good reason, its owners understand what they own) + a substantial amount of sidelined institutional investors that for non-economic reasons have been prohibited from buying. The up-list will change that. I want to get in before that event, and btw the up-list isn’t speculation, it will happen and likely within the next 3 months.
So the dynamics here are actually very similar to the underlying dynamics of the real estate portfolio itself. Because the stock is un-investable (in a similar manner described above), the idea is to purchase the asset before that changes. By “front-running” the liquidity unlocking event (the day it becomes investable) oftentimes you can sit back and enjoy yourself as the price is subject to a sharp upward revaluation due to a massive pool of capital getting put to work in what is a small, very illiquid float with finite supply of sellers. Special sit strategy 101, one of my favorites actually.
Make sense? Where talking about premier assets with a finite supply, very few sellers and high (rapidly growing) demand. When that held back demand can finally invest, as they try it naturally rerates the stock. When you look at it from this lens, the idea that the stock would trade to 3 or 4x IFRS BV (which is really 2-3x true BV, assuming again no value for the embedded optionality and no additional growth in property prices and rents) it isn’t all that unreasonable. Given the ROE, length of the growth runway and embedded optionality through redevelopment, I’d argue 2x “true” BV is reasonable, if not a downright steal. And then there is the fact that every single one of its inferior comps trade at 4-5x. Why? I assume because their is enough capital out there that wants exposure to this type of asset and is willing to pay up. None of them have been able to buy MGG, but again that’s changing. When they can, I think the stock will go up. How much? not sure, but I’m confident it will be meaningful, and justified by the long-term fundamentals.
Thanks for posting this. Your write ups are incredibly detailed and nicely supported with easily accessible linked sources.
MNGGF reminds me of a passage that always stuck with me from John Train’s The Craft of Investing. He talked about how if you really want to get rich, early in your life you need to move to a promising developing nation and try your hand at starting a business (One Way to Get Rich, page 110 – The Craft of Investing). With MNGGF, you can apparently invest beside a couple of investors doing the exact same thing without ever leaving your home!
Your reasoning on why IFRS book value is likely too low makes sense. However, can you provide more color on this passage below or some other way to verify the property values for those of us who don’t have the opportunity to talk with the independent sources?
“We’ve also had talks with a multiple independent sources that have spent significant amounts of time with boots on the ground and who have each crosschecked MGG’s listings with present valuations of comparable assets and built estimates through a property-by-property build-out from the bottom up.”
Congratulations on a meticulous and extensively researched article.
I was very enthusiastic about local real estate, so having done extensive research in this sector I can only speak to this part of MGG’s business.
Judging from only their real estate portfolio, the stock is overpriced. To not be overpriced, its real estate portfolio would have to appreciate very fast very soon. I would agree on your assessment based on a “desktop review” of the company, but it doesn’t quite reflect the reality of their assets’ value or potential. The real estate market has definitely gone through a boom since the Oyu Tolgoi deal was announced, but it beginning to face a potentially sharp cyclical correction. I am also under the impression that MGG’s real estate portfolio in particular will underperform the rest of the market. Most reports on the sector tend to be fairly biased or rely on poor data, so it is difficult to make a perfectly objective evaluation and I can only provide my own subjective opinion:
If you get the chance to look at actual transactions that happened in Ulaanbaatar, you will notice that there is no support for current prices- yes there is high physical demand, but no capacity for the local population to absorb the high asking prices, in fact residential per sqm prices Ulaanbaatar are not terribly far from those in Almaty, for office space Ulaanbaatar far exceeds it. If Mongolia is touted to be the Kazakstan of this decade, how much further can prices really go? I get the impression that the only reason such prices are still being quoted is that there are very few transactions going on, even less in the “soviet” properties that MGG specializes in. However the real problem is that there are many well built new buildings going up in the city, all of which have challenging asking prices. The prices will go down, and second hand properties most likely will not find a whole lot of buyers because they will be competing with hundreds of new residential units. This wouldn’t be a problem in a more populous or wealthier nation, but realistically this real estate will be vying for the same 500 households that are able to transact.
Also, I understand that MGG mainly has a portfolio comprised of 30-50 year old apartments built by Russians. These are difficult to rent at high yields and as a portfolio (not individually) are difficult to transact. While well located, they have serious safety and maintenance issues despite reports of the contrary. Lack of safety in particular is a deal breaker for the type of tenants who are willing to pay good rents (I’m thinking the types to have corporate allowances)- due to this, squeezing good yields out of these apartments is very challenging. When it comes to transacting, I understand that MGG has not been a market player, it has been the market. Therefore there really is no guarantee as to how they would be able to exit their portfolio, and frankly any estimation of its capital gains can only be based on fantasy. What “comparable assets” with comparable transactions would there be?
Of course my assessment is a subjective opinion, but I would sincerely hope that any potential investor would spend a day to understand the local situation independently by talking to competing agents and the type of people who would be tenants.
Thanks for the response and thanks again for the write-up (always very well thought out and detailed). I do like the Mongolia story and long-term potential, but one of my initial concerns when I first came across MNGGF from Kuppy’s blog was the premium to book. After reading this I’m rethinking whether or not I should I should actually wait for a discount and just buy it now and treat it like a LEAP. An uplisting surely won’t help my hopes for a discount to book.
All the best and keep sharing your solid analysis with the rest of us!
Marco,
Thanks for the post, it sounds like you’ve spent some time on the ground and commentary from guys like you was exactly what I was hoping would come about.
That said, my feeling there is a lot about your comments that don’t stack up and my hunch is perhaps you familiarized yourself with MGG within the first couple months of their operation (a lot has changed since then) or you just don’t understand it. Talking about a dearth of buyers in residential that could support present prices without addressing the creation of say 10k + new mining jobs set to come online that pay 10x the current average and how at the margin, this should catapult demand past a fixed supply doesn’t make a lot of sense. And that’s just from OT so your rearview 500 family baseline number is on the cusp of exploding as these mines turn on, the capital market related factors I discussed take hold and the exponentially growing population creates a continuously increasing step change like baseline number. The value of any asset comes from the future not the past and the future supply/demand equation in terms of residential and retail properties is about as bottlenecked as it gets. It’s just simple back of the envelope math, not rocket science. Mongolia has a population that is both rapidly growing and getting wealthier at a rapid pace, so you have a rapidly growing pool of available capital set to chase a fixed supply of land/real estate, and as this money tries to squeeze itself in prices will rocket higher.
As far as spending a day talking to competing agents and the type of people who would be tenants, that’s exactly the people I’ve talked to and their subjective assessment was night and day from your own. Your correct that office space is relatively expensive but prices aren’t likely to drop due to the severe supply deficit for something like another 5-10 years. Where will all the foreign or newly created local businesses go? As far as pricing in the resi and retail market, residential apartments are materially cheaper than other places and retail is phenomenally cheap relativey.
Also, MGG’s he real estate portfolio is appreciating in value very quickly and if you understood what MGG was doing the comment about underperforming the market most likely wouldn’t have been made. There is no comp here as no else really doing what they are doing on any real level. First, MGG has a tiny resi portfolio at this point in its evolution and its focus is on redevelopment – most of the Soviet stuff was built in the 1940’s and 1950’s, so it’s 60-70 years old not 30-50 years old. Second, the residential stuff they have been getting out of for awhile now has been selling at 50% more than they bought it for a year ago.
Ultimately, as another money manager I know put it aptly, “the reason the real estate portfolio is appreciating so fast is because the consumer is becoming much wealthier (Mongolia just downgraded its GDP growth estimate to “only” 11%) very quickly, translating to rental yields going up very fast. Cap rates can stay constant at mid-high teens, and if rents go up 30-40% per year MGG’s portfolio goes up in value by 60% because they create a ton of value along the way via refurbs and buying stuff smart. If cap rates compress…well, you do the math”. I think that’s dead on.
Feel free to push back, I just don’t think your understanding of MGG is all that well informed. Thanks for taking the time and I appreciate the commentary though.
JM, anything in particular you want to know?
Greg, exactly! I waited to make it a big position until after the most recent elections but ultimately, as much as (in a perfect world) I’d like to be able to buy this thing at 1/2 of book I just don’t think its going to happen. That, and I think the mis-pricing is already pretty large, so with the up-list coming its kind of an act now or forever hold your peace type of thing. Hopefully it gets that low though, I’ll just buy more.
Marco, one more thing, just realized that my comments on office pricing might have come of a little to overzealous than I intended. What I mean is that UB office property is expensive and their probably will be a cyclical down turn in pricing/valuations at some point in the next few years, but redevolopment at MGG will be focused on undervalued segments elsewhere and that should create a ton of value over time. Just wanted to clarify.
This seems like a tremendous idea and really enjoy the well-reasoned back and forth on the comments. Know that they seem to be de-emphasizing their insurance business, which also seemed like a great opportunity with many of the same secular trends. Do you like that they are now more of a pure-play on real estate?
Mongolia used to be a province of China. Investor beware…
Chise, thanks for the kind words, I’m blessed with having unusually smart, thoughtful readers that won’t hesitate to hold my feet to the fire when they feel its warranted
. Typically this dynamic results in some pretty good threads.
In terms of the de-emphasis on Insurance, presently the Mandel unit only makes up about 5% of NAV so that was the reason I chose to focus on the property portfolio, as its the primary driver of the business at this point and will continue to be going forward.
As far as my preferences, yes, I prefer they stick to real estate. I think Harris and Jordan realize that when attempting to consolidate/dominate any market they need to take into account local and regional factors in order to successfully handicap the risk/reward of the opportunity, certainly in terms of opportunity cost when capital could be devoted elsewhere. After spending some time on the ground I think it became clear that it’s going to take quite some time before the average Mongolian see’s the utility of insurance, and hence for penetration to really gain a material foothold. The mentality just isn’t there yet and it will take some time before this changes. People apparently run lights and ignore traffic laws with abandon and existing rules are hardly enforced so what does that say about the governments position to really enforce the recent regulatory changes in the first place. That said, gaining a foothold in auto will help the unit roll that market position into other areas with more attractive prospects and I think it will eventually become very successful all things considered – its just that there are better places in the near to medium term future for MGG’s capital.
So as Keynes said, when the facts change, I change my mind. I think that’s whats happened here in terms of the downplaying of insurance vis a vi the property portfolio as the company became more familiar with the reality on the ground. The opportunity in insurance was less attractive then what they initially thought and vice versa in terms of real estate. More evidence in my mind of this team’s capital allocation savvy and optimal risk-adjusted return mindset, two traits that will be critical to successfully navigating and capitalizing on the tremendous long-term opportunity in this one of a kind country. Just my 02 cents.
John, no disrespect but that’s one of the more laugh out loud comments I’ve gotten in quite some time and you may want to familiarize yourself with the country and its history before making comments like that.
You might as well say something like don’t invest in Poland, they used to be controlled by the Soviets. So the comment is ignorant and frankly absurd on its face. I mean seriously, the animosity between the two countries is well known, as are their vastly different cultural, legal/rule of law and political related set ups. Consider just one rather illuminating example…the present Mongolian political leadership has posters of Reagan (literally) in its office. Ya think the two countries might not be all that comparable in the sense you imply?
Anyhow, I just don’t think the legal/rule of law and cultural issues that make China un-investable in my opinion are at all applicable to investing in Mongolia. As they say though, caveat emptor!!
[...] Go long Mongolia? Too esoteric for me, but interesting [...]
What is the source of your conviction that a TSX V listing is imminent (within couple months)? It’s almost inevitable that as the company grows bigger it will uplist, but I see no evidence of even a consideration in any of the company materials, discussion ect to do it in the next few months. Do you have any support or are you speculating?
Thanks,
Management. Paper work has already been filed, could be sooner than that, just depends on how long the back an forth and forth goes on. The company meets the necessary requirements.
Any suggestions on how I can find contact information for independent sources in Ulaanbaatar to confirm MGG’s real estate portfolio value?
Great news! OT has finally reached an agreement on power with the Chinese government. This was the final hurdle before OT could start production so it looks like the critical piston of the Mongolian growth engine should start to fire up sooner rather than later.
Excerpt from the FT article below…
Rio’s Mongolia mine clears major hurdle
(Financial Times)
Oyu Tolgoi, Rio Tinto’s flagship Mongolian copper-gold mine, has cleared a major roadblock as it prepares to start producing after successfully signing an agreement for power supply, a major obstacle that had caused delays to the $5bn project.
Mongolian vice minister for mining Erdenebulgan Oyun told the Financial Times on Monday that the mine, one of the biggest copper mines in the world, inked a deal on Sunday to purchase power from neighbouring China. Two other Mongolian government officials confirmed that the deal had been signed.
“It is great news for us,” said Mr Erdenebulgan.
The agreement, which follows months of negotiations between the mine and the grid company in the Chinese province of Inner Mongolia, paves the way for the copper processing facilities at Oyu Tolgoi to be readied for production.”
Also, Dalio’s latest piece on “the formula for economic success” has some interesting implications as far as thinking about Mongolia and its growth rate over the next 10 years. Enjoy.
http://www.mediafire.com/view/?13wlnqgqb1g6vrp
JM, for us most of our comfort level was derived from talking with three other money managers that have spent a material amount of time on the ground not only talking talking to other property owners, but other business leaders of foreign enterprises and Mongolian politicians – all of whom I personally trust and respect. As far as releasing those names on a public blog, that is obviously problematic and not something I want to do. Basically, there time is worth quite a bit and I don’t want to flood them with inquires.
That said, digging up worthy names to call up shouldn’t be all that difficult after searching the web a bit. I would call the company and ask them if they have any suggestions (no idea what they will say). Might also be worthwhile to contact Nick Cousyn at BDSec, the author of there recent piece on MGG or the guys over at MAD investment solutions (savvy real estate investors who’ve been in Mongolia since 2009 or something like that). Sorry if I couldn’t be more helpful – I trust you understand.
http://www.mining.com/rio-and-turquoise-hill-to-their-oyu-tolgoi-mine-let-there-be-light-88433/
Great piece from SA on the near-term risks (mainly political).
http://seekingalpha.com/article/999591-mongolia-investment-climate-at-the-moment-uh-oh?source=kizur
I’ve been interested in this one for a while. I tried to buy it for my daughter’s education account (she’s only 3… I figure 15 years before College is perfect for Mongolia’s rise) but my broker can’t sell it to me at a decent commission. The TSX listing to gain access will be very welcome. I’m sure there will be more like me waiting.
Craig, love where your heads at – if I’m correct on how all this plays out a 10k investment today should get the job done by the time you have start cutting checks
.
The point on your broker is a good one, as many don’t even allow the option in the first place at this point (like IB for example). The day this business becomes investable vis a vi the vast majority of investors will be a great one.
“Great piece from SA on the near-term risks (mainly political).”
It’s rare and much appreciated that you post links to articles that so clearly highlight the risks with an investment that you recommend
Doesn’t the government passing a budget that includes increased taxation on the OT mine undermine your thesis that the party currently in power is friendly to foreign investment? Maybe the National Security Council saves the day in the end, but that’s far from guaranteed.
Short answer is yes, and while its unfortunate (sad really) it doesn’t effect the long-term thesis and may actually turn out to be a blessing for MGG shareholders given the cascade of forced selling and epic grave dancing that would result. That said, my faith in the Mongolian people (and its government) highlighted within the thesis was ultimately grounded in Mongolia’s youth, not in the existing political regime (and fwiw, would never have invested in the first place if the idea hinged on politicians doing the right thing). Also, if an investor isn’t willing to look out 5+ years and lacks the type of intestinal fortitude necessary to ride out the inevitable ups and downs here, then an investment in Mongolia isn’t for them. Regardless, for some excellent color on a complicated dynamic see Nick Cousyn’s just released piece from local broker BDSec.
http://www.bdsec.mn/files/Vast_market_inefficiencies_create_the_most_compelling_buying_opportunity.pdf
At the end of the day, investors need to remember that OT will still get built. Eventually. Might be a year or so if the current government decides to play an insanely self defeating game of chicken with one of the worlds largest, well capitalized, and most sophisticated mining companies, but if it does, the consequences will be so severe that they won’t have a job very long. Nothing like an severe recession and a cascade of bank failures to highlight what happens when power is given to pandering, prolifrigate politicians who spend well above their means and in a myopic, reactionary reaction move to make up the difference by picking the pocket of the country’s primary benefactor. Just thinking about how short sighted it is makes my head split apart. Politicians will be politicians I guess (sigh). So think of it like the paradoxical truth that over the long run the best cure for high oil prices is high oil prices. The best cure for political insanity is political insanity and I have hope the young recognize this and will ultimately right any temporary governmental wrong turns in time.
More importantly though, and the key to the thesis, is that when OT ramps avg per capita incomes will explode, as 10k+ new jobs paying 10x the present average come online and that newly created wealth begins to flow through the economy. Remember as well, that MGG’s real estate assets were built around the idea that dutch disease is inevitable to some extent and hence has built its property portfolio in a way that isn’t just insulated, but maximally leveraged to it. So again, as this dynamic plays out over the next 5 years premier real estate is likely to at least triple from present values irrespective of the macro and/or the idiocy of politicians. Unless one is willing to believe Rio will pack up, never to return, the investment case for MGG at or around today’s price remains highly attractive.
Lastly, and just for perspective, avg per capita incomes post OT’s ramp are expected to balance out at ~$9k which is just about the avg income of American citizens in the early 1930′s post the great depression. I think that number is on the far side of unreasonable and ultimately a floor for where the average “steady state” standard of living balances out in the long run. If that’s true, MGG’s property portfolio is deeply mis-priced.
Another solid read…
http://copperinvestingnews.com/13079-mongolia-mining-risk-oyu-tolgoi-turquoise-hill-rio-tinto-kincora-copper.html
Thanks for the detailed reply and the link to the BDSec report. You’re right that panic selling will be a boon to MGG, but their share price could very well decline in such a market as well.
What gives you confidence that OT will get done in a year or so? If there is protracted fight with Rio Tinto over the royalty tax, why would they move forward with the mine?
Can you elaborate on how MGG is insulated/leveraged against dutch disease? I’m not following your point on this.
Sure, no argument there but odds are good any significant selloff from present levels would provide an opportunity to average down all things equal. That said, a combination of factors makes this less of a concern than would ordinarily be the case given the present composition of MGG’s shareholder base and a couple other relevant dynamics.
First, this is a closely held stock consisting of strong hands focused on the long-term vision, who I believe are by and large unlikely to be be sellers at or around the present valuation.
Second, with fear of a Chinese slowdown pummeling Canadian equity markets across the board over the last year (resource and non-resource related businesses alike), a large speculative capital driven liquidity vacuum just took place – especially though as it pertains to the CNSX, as the lower down the quality rung in terms of the exchange you go, the worse the wash out was. In other words, the CNSX was hit harder than the TSXV, which was been hit harder than the TSX and so on. So given a relentless sell off already in the rearview, odds seem reasonably good that most of the weak hands are already gone at this point. Of course take that fwiw. And remember, given the current CNSX listing there was really no material institutional or retail shareholder base parked out here in the first place so I don’t imagine there is a large amount of willing sellers in currently in the Q, especially when you take a step back and compare it to the ocean of newly created buyers waiting in the wings that will for the first time be able to invest (post a TSXV up list). Looked at through this angle then, seems were set up to weather any storm in terms of price action relatively well. The incremental demand should outpace the available supply
Third, considering the multitude of bubbles in emerging market real estate around the globe at present, investors shouldn’t be all that surprised to realize these bubbles are a direct function (and classic unintended consequence) of the unprecedented level of synchronized, western central bank money printing we’ve got going on right now. As always, said printing has given birth to a proverbial tsunami of capital zigg zagging across the globe in search of an inflation protected, higher yielding home in a ZIRP world. Which btw is why MGG’s emerging market comps trade between 4-5x BV, as there is billions in institutional capital presently allocated to this asset class.
I mention this because, given the country’s dearth of functioning capital markets Mongolia almost alone in Asia has yet to experience the type of massive foreign liquidity driven property booms we’ve seen unfold across the real estate markets of it’s various neighbors (and in essentially every other emerging market the world over for that matter). I think this is a good thing for both offense and defense related reasons. As far as defense, it makes Mongolia substantially less vulnerable, if not entirely immune to the types of capital flight driven collapse a theoretical unwinding of these property bubbles would entail elsewhere. In terms of offense, perhaps Mongolia would be a beneficiary of said unwinding assuming it was orderly – especially considering it’s superior long-term fundamentals and the drastic relative valuation differential. I’d actually argue that this is likely inevitable once Mongolia becomes “investable” given the enormous amount of invested capital currently parked throughout the emerging world’s real estate markets. When this happens prices should go just nutty as I have to believe any sane pm’s running these funds would be immediately attracted to the idea of trimming their investments in the company’s lower quality, considerably higher priced comps in order to re-cycle said capital into MGG.
All that said, I’d read both pieces below to familiarize yourself with the above dynamic.
http://www.thebubblebubble.com/emerging-markets-bubble/
http://www.bloomberg.com/news/2012-10-04/rio-rents-reaching-9-300-mask-sputtering-real-estate-market.html
My conviction on why the OT issue is likely to get done within a year is based on a couple factors but your right, its possible it could drag out longer in theory. My understanding is that getting a ruling (arbitration wise) should take no longer than 6-12 months and if it takes a little bit longer, say year and half or two, fine – the endgame is still the same except that under that scenario Harris and Jordan get more time to do what they do at hopefully drastically reduced prices (so certainly not the end of the world if that’s how things play out).
Yet all that said I doubt it will go that far given the government’s in a catch 22 and as I see it, really boxed itself into a corner at this point. Keep in mind that the government possesses seemingly ZERO leverage and playing games is not only lose, lose but could quite literally result in the economy coming apart at the seems. For example, if they don’t work it out and force RIO to take it to the courts, there’s not a chance in hell the government will qualify for the billion plus dollar bond offering they need so desperately (last shot to get it closed is by Q1 of next year if memory serves), otherwise not only will the various infrastructure related promises they’ve made not get funded, I’ve been told it wouldn’t be long before we’d see a domino like cascade of bank failures and perhaps an outright government default. From what I’ve been told the average voter does not fully comprehend that these are the consequences of playing populist hardball, and one would presume the government knows this, so the present politicians presumably are rolling the dice with their careers. Not to joke about something that’s not a laughing matter, but geez, talk about an epic example of snatching defeat firmly from the jaws of victory and for what? My best guess is they find a middle way and the project proceeds but again, arguably a positive thing for MGG shareholders over the long run if the worst case scenario unfolds, but again we are talking about pushing out production another year or two.
In term’s of dutch disease, the short answer is A) because inflation is the friend of the premier real estate owner, as it acts as a de facto tailwind that augments both property price and rent increases roughly in line with the underlying rate of inflation and B) because their specific focus/present portfolio positioning is both laser focused on the largest areas of inefficiency and optimally geared towards the high net worth end of the spectrum. As we all know, the problem with dutch disease is it leads to massive disparities between the rich and poor, which induces envy and a myriad of other societal issues that are bad for the countries social fabric, but that said, if you own the premier real estate in the most elite area of the city it doesn’t really matter given its foreign businesses and the top 10% of the nation’s HNW citizenry that MGG serves and honestly, will likely gravitate towards best in class assets like moths to a flame.
Anyhow, from a thought experiment perspective think about it like this…if a country is made up of 25k millionaires and 2m poor people living beneath the poverty line and possesses 2k high end retailers where an informal economy serves the rest and this country only has enough downtown land to construct say 5k high end apartments and 250 premier retail outlets, sure the wealth disparity is huge and a terrible thing but again, its irrelevant as the supply demand bottleneck – and hence multi year pricing tailwinds – for the owners of that retail frontage and related redevelopment land is as good as it gets. The governments ability to navigate the resource curse is not a factor in terms of the value of that real estate. I mean when 25k millionaires are bidding against each other for those 5k apartments and/or the 2k high end retailers are competing for only 250 spots…well I’m sure you get the point. Prices should go absolutely nutty as more and more money chases a fixed amount of goods and to the point, regardless of whether the rest of the country stays mired in poverty over the next ten years or whether it reaches its ultimate potential (think Saudi Arabia or Dubai).
That in mind then, with MGG’s focus at this point on optimizing and accumulating additional ground floor retail locations on the main street of the city center (Peace Ave.), MGG is setting itself up to be the property guys that lease space to the YUM brands, the Gucci’s or the Ferrari dealership’s of the world. Think of it like Michigan Ave. and how attractive it would be owning a significant % of the retail frontage that runs along side it, except in Mongolia the “money spot” is much smaller and geographical limitations ensure there is practically zero risk said sweet spot will ever grow away from you over time. Same idea with the re-development parcels, which will likely be used to build high end modern residential apartment buildings, Class A malls or both (mixed use resi and retail) – it will just depend on the opportunity set and whatever will create the most value shareholders.
The critical point to internalize vis a vi dutch disease is that MGG actually built its property portfolio and strategic vision around servicing the wealthiest element of Mongolia so its naturally a non-issue. When OT is built the equation looks like this – fixed supply of RE + High inflation (read pricing tailwind) + a huge influx of high end luxury retailers entering the country + existing millionaires, wealthy foreign expats, and 10k+ citizens with new jobs and a real standards of living ~10x what it was = a rapidly growing pool of available capital chasing a finite amount of high quality assets = rapidly expanding property prices/rents (and hopefully a some cap rate compression as icing on the cake).
Make sense? Hope that helps
Thanks for the very detailed and educational responses.
Sorry for the continued questions. Just trying to better understand all the nuances of your thesis.
I get what you’re saying about the Mongolian government suffering from a huge decline in foreign investment should they pursue the path to reworking the OT agreement with Rio. In the event they continue down this roead, what gives you confidence an arbitrator’s decision would be reached even in two years? Khan Resources filed for arbitration in January 2011 and only won the jurisdictional phase in July 2012.
No worries, its an idea riddled with nuance so its completely understandable (there are many, many layers to this onion).
With the caveat that something like this is almost impossible to handicap with any significant degree of certainty, I say 1-2 years because of the clear cut nature of the dispute and because Rio has the requisite money, experience and legal team to get this wrapped up as soon as possible. That said, I still think the odds are both parties come together and get something inked out within the next year given the stakes, as even if it proceeds to international arbitration a compromise would likely be reached well before any verdict is actually rendered. So all eyes are on Rio’s next move given the latest quarterly release implies that they are planning on (rightfully) ignoring the recent tax changes. Point being, we have a bit of a mexican stand off going on and for now the ball is in Rio’s court.
That in mind, seems like there is a couple of ways this could play out. The most likely is probably 1) Rio could refuse to pay the additional tax while commencing open pit operations, which would bouy the local economy (particularly real estate) and allow the company to start generating some return on their investment while also buying time for the international courts to render a decision (or for the government to come to their senses and uphold the original agreement), or 2) they could just halt operations entirely in a tactical move to set the right long-term precedent and maximize the pain (twist the knife if you will).
If I put my CEO of Rio hat on its hard to know what the right call is (don’t envy him one bit) as I think its arguable that option 2 is the better long-term move given the message it would send but it’s obviously debatable – it would certainly help highlight the folly, incompetence, bad faith, and sheer belligerence of the new government, perhaps driving a steak through its power and legitimacy in the eyes of the people (keeping my fingers crossed). So option 2 would highlight a lot of key realities in a way that I think while short term painful, would ultimately reduce moral hazard and augment the long-term good in respect to both Rio and Mongolia as a whole. And again, hopefully it would ensure the politicians responsible for all of this are not only out of a job, but out of government all together. I mean while this “foreign raider” meme that these jackass politicians exploit for personal gain is understandable (given the history and cultural sensitivity to the issue, one may say its even smart in a Machevelli type of way) OT is demonstrably anything but, as its acted in a manner that is not only admirable but practically guarantee’s enormously outsized gains for the Mongolian people both in the near, medium and long-term. Ironically then, by brandishing the greatest benefactor the country has ever seen as some cartoon-esque, unscrupulous foreign raider bent on plundering the country’s riches they may ensure that’s what they ultimately get – as it won’t be ethical, well intentioned foreign businesses that would eventually replace OT in the quest to get the country set up firmly on its own two feet in the future, but the Chinese or Russians – the very nations that have ruthlessly exploited the country so despicably in the past (and to add irony on top of irony, who by there actions made this political meme effective in the first place). Oh the irony of it all but I digress.
So Rio by taking option #2 may stand a better chance at getting this issue behind them for good as it would sober up the GOM by making the stakes and consequences of there actions felt immediately, and in the process (I would hope) help them to not only better realize the futility and self defeating nature of its present path, but also to reverse this ill conceived tax law sooner rather than later. For example, instead of the ~$400m in OT related tax revenue they have written into the government’s budget next year vs. the ~$125m that OT is currently expecting/willing to pay, they would walk away with nothing – a big fat goose egg. This is compounded by the fact that the billions in governmental loans the government is counting on will almost certainly not get funded either. Hmm…I’m no professional game theorist but they can get $125m, another $1B+ in development loans and have the economy benefit from this and all the other positive secondary effects that will flow from OT ramping up, plus the hundreds of millions OT is planning on devoting towards building schools and other social related causes over the next year and beyond or they can get 0, go through a deep depression, a banking and perhaps even a currency collapse, all because of ignorance and imagined slights. Choice seems clear to me. I’m no Einstein, but better to get 75% of a growing pie than 100% of nothing no?
While its sad (potentially tragic) given the fact all of this is unnecessary/avoidable (especially because of the needless pain that will be felt by Mongolian citizens as a result) I can’t help but think this tact may be the way to go in the long run as it would serve these politicians right and make a much needed example out of them and the harmful, short sighted politicking they practice. That, and because it may not only better ensure the agreement is eventually upheld, but because it should make the temptation along with this type of reneging by future governments if not a non issue, certainly a lot less likely going forward.
So circling back to the original question, I’m not certain it won’t take longer than 2 years to get a ruling, I just don’t think its likely for the above reasons. One way or another a compromise within the next year appears highly likely.
Nick Cousyn from BDSec shares your optimism on the govt vs. Rio outcome.
“Jon: Let’s get specific about the big elephant in the room. There’s a lot going on with Turquoise Hill Resources’ Oyu Tolgoi project [OT]. The government of Mongolia [GOM] seems to be indicating they are going to tax the Oyu Tolgoi project at rates higher than agreed in 2009, a few other tweaks here and there, and the minister of mining has said he’ll resign if the Oyu Tolgoi Investment Agreement is not renegotiated. What’s your near-term outlook on Turquoise Hill for the next 4 to 6 months?
Nick: For the next 4 to 6 months my outlook is positive on Turquoise Hill, I think it’s the next 30-60 days you have to watch out for. We identified the political risks with OT two months ago and the investors we talk to were well prepared for what’s occurring right now. I read Wall Street research on Turquoise Hills and laugh at how much they write and how little they know. Things will get worked out with the GOM and OT, because it has to. I’m not prepared to speculate exactly how the situation resolves itself, but both sides are looking for a way out of this predicament, which will hopefully put this issue to bed for good. There’s just way too much money to be made by both parties to do anything different than to come to a resolution.”
http://seekingalpha.com/article/1027461-a-positive-outlook-on-mongolia
Yep, thought the article was pretty good and I’ve become a fan of its author Jon Springer and his work generally. While I don’t know him I think he helps people considering an investment in MGG to go in with their “eyes wide open” so to speak in regards to the risks in context of the long-term big picture. Also I tend to agree with Nick and while naturally biased (as we all are to a certain extent) given his role at BDSec, I think his work and overall viewpoints are solid as well.
FYI, amazingly it appears that the GOM was able to raise the debt it had hoped for at frankly ludicrously low yields – gotta love the orgy of central bank money printing no? Funny how it tends to end up in the strangest of places
. Regardless, this is a very good thing imo vis a vi real estate prices and should put additional pressure on the GOM to come to their senses as they are now considerably more dependent than they already were in terms of its reliance on Rio and OT (so while the government was already hopelessly dependent, the magnitude of that dependency has gotten much larger which should further strengthen Rio’s already ridiculously strong bargaining position). That said, who knows though, maybe this will embolden the populist kooks to continue with their hard line stance (one can’t possibly know for sure).
http://seekingalpha.com/currents/post/691111?source=kizur
Btw, in regards to EGD I don’t have a lot to add. I expected the mineral fleets results to be very weak given the results of some of its peers but continue to hold my stake as well as believe that EGD is substantially mis-priced (although I don’t expect a material re-rate to happen in the near-term given the operational headwinds). This one will require patience but that patience should ultimately be well rewarded.
Hi, good write and long-term I agree with your thesis. Near-term, I have a few concerns/questions:
Value: MGG’s current valuation trades at a substantial premium to land values. MGG acquired their property at an average price of ~$1,200/SqM and the current stock price values the portfolio at almost $5,000/SqM. For comparison, Almaty (by Harris’s own research), has average prices in the $7,000 – $8,000/SqM range about 10 years after their commodity boom began. It’s hard to find much value in the stock at these prices unless you think UB is going to quickly blow past Almaty to the top of the world’s “Most Expensive” lists. Does this concern you?
Yields: You mentioned that examples of getting mid-teen and 20% cap rates were not “one off cherry picking”, but based on MGG’s latest presentations, their current yields range from 8.5% to 14% on cost. Why is this? Also, because investors are paying 4x – 5x cost, the yield to shareholders buying today is only 2% – 4%, right? Even if rents eventually reset to market, you’re only getting an 8% – 10% yield.
Development: 30% of the portfolio is redevelopment sites that have not yet been built. Do you have any idea when these will get developed? If residential values are 4x construction cost, and you can pre-sale your residential units, why hasn’t management started any projects? I know APIP and several local developers have projects already in the works; isn’t it time MGG had a tower going up?
RE Cycles Risk: As a corollary to my development question, I think properties trading at multiples of construction cost is unsustainable and will lead to a building boom, oversupply and decline in prices (as it has in every other real estate boom in history). Supply has been constrained by a lack of capital, but once capital can be accessed, won’t everyone start building office and residential towers and risk overbuilding?
Management: I know everyone loves Harris & Co., but who on the MGG team has any real estate experience? These guys are very successful hedge managers, but that is very different from developing property in Ulaanbaatar. Wouldn’t you rather MGG have at least one board member and one manager with experience developing property abroad?
I’m thinking it may be best to wait for someone to start selling (large percentage of early shareholders that have 3x+ profits), and look to pick this up closer to $1/share. Why do you think now is the time to buy?
I am with St. Matt. The valuation is not compelling at this price. If you read their 2011 report, $20M of real estate was purchased that year and appraised at year-end at $26M. Another $10M was purchased this year, giving us $36M in real estate. The only appreciation above that is whatever occurred in 2012 YTD. With some 30M shares you are 3-4 x the real estate cost.
Yes, Mongolia has huge potential and yes the real estate will go up but with such a huge premium over book you have a long way to go just to get your money back.
Doesn’t seem to pass the Warren Buffett test.
St. Matt, appreciate the questions, I’ve editorialized below.
“Value: MGG’s current valuation trades at a substantial premium to land values. MGG acquired their property at an average price of ~$1,200/SqM and the current stock price values the portfolio at almost $5,000/SqM. For comparison, Almaty (by Harris’s own research), has average prices in the $7,000 – $8,000/SqM range about 10 years after their commodity boom began. It’s hard to find much value in the stock at these prices unless you think UB is going to quickly blow past Almaty to the top of the world’s “Most Expensive” lists. Does this concern you?”
Yes, by purchasing MGG at the current quote your paying about a 25% premium to liquidation value at current prices but given the embedded growth in avg incomes I have a hard time understanding the substantial premium comment in light of that. Before you respond, take some time to think about what I’m saying here. In terms of the Almaty heuristic, I used it to frame the situation on a high level but first, there are critical differences between the two that need to be taken into account and second, don’t let it confuse you to the point where you miss the forest through the trees. Mongolia’s RE values are directly correlated to per capita incomes and the growth in overall economic activity, not to prices in Almaty. That’s a crucial distinction to understand.
Anyhow, paying a 25% premium to a property portfolio that should triple in value as GDP roughly doubles over the next 3-5 years is in the long run a significant bargain. An investor purchasing MGG today is simply arbitraging this spread. Of course this doesn’t assign any value to anything that occurs in the meantime through (1) the purchase of additional properties through intelligent means and the value creation that should accrue to MGG as they go about making smart property level improvements or (2) that will be created through the monetization of the redevelopment parcels, which as I showed in the write-up has the potential to be worth more to MGG than its entire EV at present.
“Yields: You mentioned that examples of getting mid-teen and 20% cap rates were not “one off cherry picking”, but based on MGG’s latest presentations, their current yields range from 8.5% to 14% on cost. Why is this? Also, because investors are paying 4x – 5x cost, the yield to shareholders buying today is only 2% – 4%, right? Even if rents eventually reset to market, you’re only getting an 8% – 10% yield.”
Again, you may want to re-read the relevant parts of the thesis much more closely and try and internalize what I said a little better. The example you reference was a special situation where they were able to purchase a property at a mid teens yield from a forced seller, where they where able to spend a little money intelligently to increase the rentable square footage to the point where the pro forma cap rate was ~20%+ (meaning that is the implied yield post construction of the various improvements they are making). So yes, given the high % of redevelopment properties in MGG’s property portfolio the yield to shareholders is low and in the range you state. That said, this isn’t a yield play (yet) and the issue is really irrelevant to the question of whether or not MGG is substantially mis-priced or not.
“Development: 30% of the portfolio is redevelopment sites that have not yet been built. Do you have any idea when these will get developed? If residential values are 4x construction cost, and you can pre-sale your residential units, why hasn’t management started any projects? I know APIP and several local developers have projects already in the works; isn’t it time MGG had a tower going up?”
Not to beat a dead horse (and no disrespect) but please re-read the sections on downtown UB and resource conversion (as well as this comment thread) a little more closely. After you do I think you’ll realize that construction costs have literally nothing to do with present values for structural reasons. I mean would you make an argument that RE values in Hong Kong or say even on Fifth Avenue in NY are overvalued solely because they are above the cost of construction? I doubt it.
In terms of timing on redevelopment its hard to say but they are moving towards that goal in a prudent fashion. In fact, the company’s latest filings actually provide some detail in terms of the types of properties they envision getting built on each of the land parcels the company owns, so I was pleased to see some detail on the endgame in this respect. Also, the company is still very very young, and the redevelopment portfolio as it currently stands is even younger so I’m not sure it makes sense to imply that they’ve been sitting around twiddling their thumbs doing nothing on this front. Bottom line is that they are taking their time to make sure they do it right and don’t make any mistakes which imo is vastly preferable to rushing into a project prematurely.
“RE Cycles Risk: As a corollary to my development question, I think properties trading at multiples of construction cost is unsustainable and will lead to a building boom, oversupply and decline in prices (as it has in every other real estate boom in history). Supply has been constrained by a lack of capital, but once capital can be accessed, won’t everyone start building office and residential towers and risk overbuilding?”
Normally I would agree and rest assured I’m aware of the iron laws of economics but the answer hear requires an understanding of the very nature of downtown UB, which once you understand this issue will cease to be a major concern. With that said, let me be clear and state that I agree that in terms of office properties, prices have gotten a little ahead of themselves and a cyclical correction is a certainty at some point but residential and especially retail is still much cheaper relative to Almaty and other comps. So that in mind, as I said in the write-up, “remember UB is landlocked (sandwiched) in a valley between two mountains, so think of it like Hong Kong. There is nowhere to build but up. Having a downtown that is nestled between mountains makes is easy to identify the “money zone” and helps mitigate the risk that the city could “grow away from you” as an owner.” The issue here then isn’t just one of capital, which as you note is constrained but one of geography, a rapidly growing population, an exponentially growing upper and middle class thanks to OT, and the extreme scarcity of prime land/property in the heart of the UB’s city center.
So to answer your question, no, once capital is more available everyone won’t start building property as you have to own the land in order to build on it and they aren’t creating any more land (sure, the GOM is building bridges and focusing on other infrastructure projects that should at the margin relieve a little bit of what is intense upward pressure on prime RE in the city center but it’s not even close to sufficient to alleviate the structural issues at play).
“Management: I know everyone loves Harris & Co., but who on the MGG team has any real estate experience? These guys are very successful hedge managers, but that is very different from developing property in Ulaanbaatar. Wouldn’t you rather MGG have at least one board member and one manager with experience developing property abroad?”
Yes, I would like to see that and will mention it to Harris. Ideally they could recruit someone like Sam Zell to the BOD, who is notably on record stating that Mongolian RE offers up a generational type of opportunity given the underlying dynamics at play. Maybe this is pie in the sky but nonetheless, I agree that getting some experienced RE players on MGG’s BOD would be a great thing.
Fwiw, here is a somewhat dated article where Zell mentions his thoughts on Mongolia…
http://whartonmagazine.com/blogs/when-sam-zell-talks/
“I’m thinking it may be best to wait for someone to start selling (large percentage of early shareholders that have 3x+ profits), and look to pick this up closer to $1/share. Why do you think now is the time to buy?”
Reread the beginning of this comment thread for my thoughts on this. In terms of waiting for shareholders sitting on gains to exit good luck with that (I think they are focused more on value than they are anchored to what they paid but you never know, it might happen) – so while I agree it would be wonderful to be able to add to the position at $1 I seriously doubt that’s going to happen, again though I hope I’m wrong and I’m able to get another bite at the apple.
Bob, appreciate your point of view but disagree…
“I am with St. Matt. The valuation is not compelling at this price. If you read their 2011 report, $20M of real estate was purchased that year and appraised at year-end at $26M. Another $10M was purchased this year, giving us $36M in real estate. The only appreciation above that is whatever occurred in 2012 YTD. With some 30M shares you are 3-4 x the real estate cost.”
While I understand where your coming from I think its important to really put your mind into the reality of the situation and the unique situational dynamics that have lead up to where we are today. Looking at the cost of acquisition will lead you astray with certainty.
First, as I mentioned in my response to St. Matt cost isn’t the issue and is really irrelevant to the value of MGG’s property portfolio at this point.
Second, re-read the sections of the thesis where I talk about resource conversion and the massive arbitrage the company exploited (and the associated massive value uplift that was derived from) having the capital and brains to aggregate what where previously dozens of small land parcels into six large blocks available for redevelopment purposes. When you really think about it, I think its pretty easy to understand why the value of these large, aggregated land packages is much much greater today than the cost of any of the individual pieces, as prior to MGG’s aggregation of said properties redevelopment on the scale that MGG is engineering was impossible. This is a critical point to understand.
In terms of passing the Buffett test, we can agree to disagree. Fwiw, I’m certain Buffett would agree with me that value and statistical cheapness based on the rearview are not one and the same thing. I could name example after example, but when Buffett put 25% of BRK into KO at roughly a mid teens multiple it wasn’t exactly cheap in the statistical sense and yet it was massively mis-priced and one of the better investment opportunities in terms of upside and risk/reward of his career. Not trying to imply that MGG is similar to KO, just that just because it’s not cheap in the statistical sense doesn’t mean its not a tremendous long-term value.
[...] A long write-up of a Mongolian investment with a CEO who says: “The Company started with me asking friends to invest alongside me in Mongolia… Instead, I have decided to take no salary, stock options, performance allocation, bonus or anything else. I’m here in Mongolia because I’ve invested my own money in the company. My Co-Pilot in this venture, Jordan Calonego feels the same way. Besides, we’ve been investors for over a decade now and have been disgusted to learn that the CEO always seems to do better than the shareholders. Now that our roles are reversed and we are management, it would be wrong of us to do what we have always criticized. Investors need to think of this company as a business created by a bunch of very successful hedge fund guys who want to invest their own money in Mongolia. Minority shareholders can come along for the ride if they want without any of the onerous fees normally associated with hedge funds.” (Above Average Odds) [...]
Dear Author,
I have to say, I feel your analysis is light in one area and that is numbers. For example, St Matt raised good questions about the implied sq ft value of the property and the current yields and your answers site optimistic views on the future of Mongolia but provide absolutely no numerical backing to your thesis. This stock is simply not cheap by any normal measure. It’s all about growth here, and you provide no quantification of this growth. If you’re a growth investors, then fair enough, but a value investment this is not. Having said that, I am long the stock, but only as a really long term play, and I don’t believe there is any way to quantify the upside.
Matt – at the end of the day its a simple thesis vis a vi the numbers I outlined in the write-up – perhaps you haven’t pulled up the word doc with the relevant graphs/numbers (charts don’t appear on the posted version for some reason) but my underlying assumptions are laid out very clearly. There is absolutely zero reason to fire up the spreadsheets here.
Your correct that I’m paying for growth on a certain level (which admittedly I practically never do as a rule of thumb) but what I don’t think you quite understand is that said growth is quite literally banked into the cake assuming OT ramps as planned. While this is an oversimplification, if OT ramps per capita incomes grow exponentially and if per capita incomes grow exponentially, so does the value of MGG’s prime RE. At ~1.25x true BV the stock is grossly mis-priced if things work out as I expect. Fwiw, the GOM’s latest bond offering further buoys this dynamic.
Also, I fully answered St. Matt’s questions related to implied square footage and yields, I just didn’t re-post the numbers that are already discussed within the write-up in a spoon fed way. So what about my valuation isn’t clear to you? Also, not sure I understand the quanitification of growth argument, especially because you turn around immediately after and claim it can’t be quantified. Your correct that precision is impossible but at the same time its not necessary, a rough approximation will do just fine. Do you disagree that there is a direct correlation between per capita income and growth in GDP and RE values? Or is it that you feel the multiplier I use is incorrect? Guess I’m just having a hard time understanding what your getting at.
Highly recommend Harris’s latest interview, great stuff as far as keeping things in perspective and really firmly rooted in a long-term view.
http://microcapclub.com/2012/12/microcapclub-interview-with-harris-kupperman-ceo-of-mongolia-growth-group/
Also, with $1.5B just raised by the GOM (primarily) for near-term infrastructure related projects (thanks Ben!), investors should take note, as for comparison sake its akin to the U.S. government spending $3T – and yes, that’s with a T – on infrastructure related projects within a 2 year time frame.
So given the absolute size of this investment relative to the economy, odd’s seem high that all of that spending will set off another massive boom, one that is unrelated to mining but that should ultimately reinforce it as OT ramps up over the course of the next 6-12 months. Safe to say that’s a scenario where I see prime RE on Peace Ave. doing very very well.
Thanks for posting the interview. It was encouraging to hear the CEO talk about wanting someone with more real estate expertise take over. I didn’t care for how he blew off the question about Mongolian politics. The royalty tax being included in the budget can hardly be described as fringe politicians making public statements that won’t become policy.
JM,
Yes, completely agree with the new management sentiment. Its only natural I think, as Harris knows (more than anyone) that the value creation that a crack RE executive suite would bring at the margin is substantial, especially as the company transitions from what is really a land bank at this point – so its a no brainer imo as the company starts to develop its land parcels and a different skill set is needed.
Which by the way I think is another benefit to having owner operators with substantial equity stakes and all the right incentives (no salary etc.) running the company, as you can rest assured that they will act in the best interest of shareholders even if it means moving on themselves.
Regarding the commentary vis a vi the GOM, I hear you and agree but knowing Harris I didn’t take it that way (but again, I totally see where you are coming from in retrospect). I should re listen to that segment but my take was that he was trying to steer the emphasis to a larger point which is that its impossible to get a feeling for whats actually going on through the lens of the western press and that at the end of the day he is confident that the government will not be a large enough impediment to thwart the countries vast growth potential over time, at least not enough to matter given today’s low base. I think that stance is justified. As evidence of the crazy unpredictable (and really inexplicable, at least from the outside looking in) nature of the GOM’s its rumored that the GOM is in the midst of re-write the recently passed mining laws as we speak in an effort to undue a lot of the damage that’s been done and reverse the optics. Feels like crazy town given the mixed signals but presumably there is a method behind the madness.
Yet whatever happens I believe it’s ultimately impossible for me to have any real edge on the topic without actually living there and/or having the right contacts (both of which seem critical to accurately handicapping the difference between perception and reality on what is a complex and nuanced issue). Regardless, the country is growing off such a low base that even if the GOM tries with all it’s might to self destruct its own immense potential, in the long run normalized GDP and per capita income is still highly likely to end up at roughly 2x the present level. If that’s the case MGG’s property and land parcels will be worth considerably more than what they are worth today, the upside being measured in multiples – if they can successfully monetize the redevelopment properties the upside in the starts to get silly. So I understand where your coming from but I don’t think Harris is cavelier regarding this risk at all as much as it may have come off that way.
I think we could use a little more data on the real estate market and economy.
I emailed MGG c/o Harris to ask if they could share some data on the re market there.
Sanity returns at the GOM (at least for now)!!!
Pasted below are a couple of solid reads that discuss the latest data points related to Rio (TRQ) and the GOM’s standoff. Basically I think the tides are really turning at this point (fingers crossed) and if this is followed up with an intelligently rewritten foreign investment law then look out, Mongolia’s off to the races and perhaps in an even bigger way then I thought was likely to materialize after all the recent shenanigans.
Between the removal of this key piece of uncertainty and the potential for a “new” investment law, OT ramping, the tidal wave of infrastructure spending scheduled to be spent over the next two years, and (hopefully) a full tilt re-ignition of FDI related confidence etc., I don’t think its unreasonable to conclude that the signposts point towards a country that is overcoming its recent challenges/the insanity of some of its short sighted politicians. In other words, the center appears to have held and growth in economic activity set to go gangbusters, likely gaining strength as it grows and again, irrespective of the macro.
http://seekingalpha.com/article/1083721-doubling-down-on-turquoise-hill-s-buy-signal
http://seekingalpha.com/article/1088691-turquoise-hill-resources-reason-and-reality-buy-and-monitor-closely
Also, while I wholeheartedly agree with the “reason and reality” sentiment of the latter article, I think a critical insight here from the get go was to paraphrase Milton Friedman – not in waiting for the right politicians to get elected per se, but in waiting until the point in time where the conditions were in place whereby even the wrong people would ultimately be forced to do the right thing. Politicians will be politicians after all.
Kevin – while I hear you remember how early in the development curve Mongolia is at the moment. Meaning, I’m not sure what type of info they could provide outside of what they already have, as there simply isn’t the type of data available like you have in a more developed market. What particular info do you have in mind?
All one can do is try and verify that stated prices are indeed what they say they are both absolute and relative to the appropriate comparisons – how an investor achieves that goal to their personal satisfaction is up to them. Regardless, at the end of the day if GDP and per capita income doubles over the next 3-5 years its all a mute point (as having more granular data at the margin won’t make a bit of difference relative to the ultimate outcome). That said, the more information the better so if there is pricing data or other relevant info out there that they could provide shareholders with they should.
i’m having enough problems finding any real estate to buy in the bay area. i can’t imagine what’s going to happen in mongolia. i think the main risks are downward movement in commodity prices and also the remote possibility of some kind of a bloody coupe and expropriation of the land. outside of that, i think most of these issues will resolve themselves within three years. for those that can’t handle the volatility, averaging in may not be a bad way to go. also, tsx venture exchange listing yesterday in case anyone’s interested. happy new year to all!
Ak – appreciate the commentary and while totally ignorant on the particulars of bay area real estate, it’s not all that hard to imagine that being the case (ha). I want to go where the puck is going to be though and that imo continues to be in Mongolia.
In terms of the risks, I stand by my belief that given the economy’s low base (relative to OT, TT, infrastructure spending etc.) and the country’s geographic proximity to China – and the massive structural cost advantage that proximity imparts relative to its largest customers primary sources of high cost supply – falling commodity prices are basically a non issue, as GDP gains from production volumes ramping (market share gains) should vastly overwhelm any offsetting weakness in GDP from pricing weakness. Also remember the unique nature of OT and its negative cash costs on copper production (thanks to its unusually abundant amounts of gold byproduct), which ensures it will generate gobs of cash regardless of where we are in either copper or golds respective cycles (which I would note are countercyclical to each other). Imo this is a CRITICAL point to internalize when thinking about the future. I mean the term low cost producer doesn’t really do justice to OT in a very real way when you really think about. Most haven’t.
Point being, GDP gains and the associated gains in standards of living and hence in prime RE prices, are almost entirely dependent on volumes as opposed to pricing per se. So infrastructure spending aside, we don’t need prices to be high or even at the level they are today to make a killing on prime UB RE, we just need the government to spend the recent bond proceeds and these low cost “mega” mines to “turn on” – that’s it. So not only is that it, but on an $8B economy, that’s borderline overkill if you know what I mean.
Turning towards the cat risk, that’s obviously correct in regards to the risk of the tanks rolling in etc. yet for cultural, geopolitical and various other reasons I’m not going to delve into at the moment, I put the odds of this risk coming to fruition (at least at any point in the next 5-10 years) at basically nil. Sure its possible, but incredibly unlikely (less than a 5% chance imo) and fwiw, its not something that causes me to lose a minute of sleep, and its not something one can predict anyway.
Agree on your next point as well – think its a great idea that for the majority of investors, averaging into a position over time as they become more familiar (and hence comfortable) with the situation, the risks, etc. is the way to go. I know it was for me. That said, that’s really true with any investment and with the convergence of events re the government receding to a material extent (for now), the train leaving the station in terms of the Mongolian economy (OT ramping, 1.5B in infrastructure spending over the next 2 years etc.), a Chinese economy that appears to be reaccelerating, the up-list to the venture exchange imminent (so the point in time where MGG becomes “investable” to what is a simply massive pool of new money) etc. etc. the stars really do seem to be aligning. Candidly then, its hard to imagine a better set up to gain some initial exposure to MGG and the Mongolian economy. Obviously I’m talking my book so take it for what its worth, but personally, I just doubt investors will get a better chance than the hear and now to do so and tend to think that looking back five years from today it will be crystal clear that the easiest money (the proverbial $100 bill on the ground) was made by those investors with exposure prior to all of these events taking place. As with pretty much any investment, by the time all of the uncertainty is gone, so is the mis-pricing. I doubt this time will be any different.
Well gents the uplist is upon us.
MGG starts trading tomorrow on the TSX-V and Harris and co. will be ringing the opening bell on the 23rd (my birthday no less). Very nice and right on time!
http://bit.ly/U1rguN
You were certainly correct on the timing of the up listing. Congrats. Just a note. I emailed the company about their lack of a November shareholder letter and they promptly responded that the Dec letter would be released shortly giving some color on the political developments and explanation of why the Nov letter was not published.
I’m looking to add to my holdings tomorrow as the political situation seems to be easing.
Matt, thanks and agree that the political situation is easing and am definitely looking forward to the new letter.
But yeah, by all measures it appears it’s game on in Mongolia again. Of course that uplist appears to be helping things along as well
Hi,
I haven’t heard back from them so maybe the email got ignored.
Just basic information, enough to be able to estimate what’s going on in the RE market there. The whole value in their portfolio is land appreciation (limited cash flow etc). So to me, that makes it a potential tradable company vs compounder.
Historical data if possible for these:
Per capita income
house prices and interest rates
rental yields
historical residential and office occupancy rates
property launches and take up rates
RNAV
norminal GDP (again tied to copper)
currency
rental increases
supply of office space
what’s going on in the industry, insiders buying etc
I can see how Harris probably sees things. For eg, Russian style housing won’t stay Soviet chic given time and opportunity. Some of the best RE deals were run down residential properties once the property boom got going. As for land value, their plan is to build upwards because I guess geographically you can have sprawl development (eg LA) in Ulaanbaatar.
Even 30 story buildings (apartments/office space etc) with 4 tenants (point block) over their buildable area (let’s say 40% of their sq m size) works out to pretty good profit. Even considering the approximate values given in some of the posts above, the potential for per sq ft appreciation is high.
I just want to know what could kick start things again (ie. resolution of political wranglings and indication of demand from China).
The attraction for now is copper and coal, at least until the commodity boom busts (if 200 year cycles are anything to go by, maybe within the next 5 years). Then it’s dependent on how else Mongolia develops its economy. The government’s already indicated it wants to follow Chile’s development trajectory, so we’ll see.
Kevin, great thoughts and all of those data points sound good in terms of suggestions for the future but I still have my doubts that many of them are even possible to compile at this point, at least without doing the DD yourself on the ground or at least by talking with people that have tried to build up similar metrics themselves (so I have doubts that such data can be compiled in a manner where it’s all that meaningful). Of course its also backward looking which given the situational dynamics at play makes it not all that relevant either. So while in this case I’m not saying having more information isn’t better – I’m saying that I think the data points we do have are plenty sufficient to be approximately correct in terms of approximating the value of MGG’s present and future property portfolio (as I’ve outlined in the thesis/thread).
That, and personally I look to the underlying drivers that drive those historical data points first anyway, and frankly they couldn’t be stronger. I mean Mongolia has what is basically a very young, exponentially growing population and better yet, that populations average per capita income is growing exponentially and this is in a landlocked city with incredibly severe supply constraints and very cheap resi and retail property relative to appropriate comparables. Then there is the fact that Mongolia lacks a fully functioning credit and mortgage market, so as the capital markets modernize and become available (driving down the cost of capital and in turn its availability) the demand tailwinds for MGG’s premier property portfolio will grow even stronger which (on top of everything else) will make an already severely bottlenecked supply/demand situation even worse than it already is. So of all the risks in an investment like MGG, getting more info of this nature doesn’t keep me up at night nor worry me all that much.
The long and short of it on this issue is that as the Mongolian economy normalizes investors should make quite a lot of money arbitraging property values and even more when the redevelopment portfolio is eventually developed to its highest and best use. While the level of historical data isn’t as granular as I’d like it’s also not necessary all things considered. As Buffett so pithily put it, you don’t need a scale to know a man is fat and imo that is the case here.
Amazing read by MAD Mongolia
http://www.mad-mongolia.com/news/mongolia-news/mongolias-state-of-the-macro-14240/
FYI:
http://www.bloomberg.com/news/2013-02-04/mongolia-1-25-day-labor-amid-4k-purses-stirs-discontent.html
I’ll post this on SND but I just wanted to officially welcome NW and the Sandstorm team to Mongolia and OT!
More thoughts to come but this is just awesome.
http://www.sandstormgold.com/news/release/index.php?&content_id=271
http://sandstormmetalsandenergy.com/news/release/index.php?&content_id=248
Oh yeah, take a look at those terms!!!
MGG’s book value fell in the 2012 annual report based primarily on lower real estate appraisals made in 4Q 2012, the time of a down turn in Ulaanbaatar property values. The comments note that by 1Q 2013, valuations had recovered and then some.
A longer term investment thesis keeps the company cash flow negative. The stock price may churn at these levels for a bit.
The liquidity provided by the TSX listing has the COO selling small lots of stock. Are cars heavily taxed in Mongolia?
The large pools of newly investable capital seem to be waiting on the sidelines.
At least the sparring over OT mining royalties was settled.
The comments here are so few for such a fine report.