With an official population of nearly 14 million, and straddling both sides of the picturesque Bosphorus waterway, Istanbul is Europe's largest city, nearly twice the size of London. Yet unlike London, Istanbul has only two bridges crossing its main waterway, and no tunnels. In addition, during our visit one of these bridges was partly closed for maintenance, so getting around this great city by car was not an easy task. We are pleased to report, though, that we did successfully complete our busy schedule of company visits.
This was our second research trip to Turkey in three years. Following our last visit in April 2010, we shared our thoughts about the investment opportunity in Exploring Global Small Caps: Politics, Trade and Growth in Turkey. We outlined why, from a macroeconomic standpoint, we were attracted to the idea of investing in Turkey: principally, its young and socially mobile population, important strategic position bridging Asia and Europe, enviable growth rates, and low indebtedness of its government, consumers and banks.1
Turkey's macroeconomics remain attractive, in our view, especially when compared with much of the rest of Europe. Real GDP grew by 8.5% in 2011, following a 9.6% advance in 2010, the best performance in the entire G20.2 By contrast, 2012 has so far seen a significant slowdown, with a first-quarter advance of 3.2%, and it looks as though the economy should achieve a soft landing; the IMF forecasts 2.3% growth this year and 3.2% for 2013. With 74 million people, Turkey's GDP per capita has tripled in the last decade to $10,000 ($14,600 on a purchasing-power parity basis), and we believe still has room for upside.3
Turkey's strategic importance continues to evolve, with the country becoming a bona-fide play on the dynamic MENA region(Middle East and North Africa), while simultaneously losing its historic dependence on Europe. The European Union as a portion of Turkish exports has dropped to just 36% versus a longer-term average of 57% dating back to the mid-1990's. This is in line with the Middle East, including Iraq, which is now 31%, versus the 10% or so it had been for nearly 20 years, as depicted below.
Turkish Airlines, which has emerged as one of the world's premier carriers, now flies about 17 million people to 150 cities each year, and should benefit from plans for a third airport in Istanbul, solidifying the city as one of the globe's key transportation hubs. We flew from Istanbul's second airport for an intra-Turkey trip, and like much infrastructure in the emerging markets, its quality and ease of use easily surpass what we are accustomed to in the U.S. and UK.Imbalances that had built up in the economy during the 2010-2011 period of accelerated growth have recently improved as GDP growth has moderated. Most notably, both inflation and the current account deficit (CAD) were around 10% last year. However, helped by a weaker Turkish Lira, during 2012 a rebalancing seems to be taking shape, as domestic demand has cooled while export growth has been resilient. The 12-month CAD contracted to $67 billion, or 8.7%, as of April.4
Inflation has also gone from boil to simmer, last reported at 8.3% in May, despite high oil prices. (More than a third of the current account deficit is caused by energy imports; Turkey is energy poor and relies heavily on imported natural gas from Russia and Iran). Unemployment is running at 8.2%, almost as high as the U.S., although Turkey's rate is perhaps less surprising given the country's young median age of 26. Industrial production per worker has advanced at an admirable rate of 3% or greater for the past 10 years.5
Reflecting some of this progress, Moody's upgraded Turkey's credit rating in June from Ba2 to Ba1, one notch below investment grade and in line with Fitch's rating.6
However, at Royce it is not macroeconomics per se that excite us, but rather corporate quality. We stick steadfastly to our search for quality, making only the slightest refinements to fit the business landscape of the countries we visit. There are many facets to quality, of course. Two of the most critical for us, particularly when researching non-U.S. companies, are corporate governance and strategic focus. Most often we like companies to focus on one product or service and to do that exceptionally well.
Unfortunately, many of the Turkish companies we met fell short of these requirements. We found companies that a decade ago were operating in sectors entirely unconnected to their current activities, with plans to enter additional new businesses. We found companies where the major customer or supplier was a parent or sibling company and others where cash balances or cash flows are absorbed by its parent company to use in other group enterprises. We also met companies that vertically integrated into their supply chain with no apparent logic.
As disappointing as these discoveries can be when you have high hopes for a market, that is exactly why we take the time and effort to see companies on their own turf—to interview management, to see how they think about and view the business franchises they run, and to tour and evaluate facilities. No amount of office-based work, or "armchair research," can come close to the value-added insight gleaned from the on-site approach.
Moreover, not every meeting we had in Turkey led us to a dead end. We found some well-managed, focused businesses with none of the complications of a dominant corporate parent to derail them. These expanded further our knowledge of European corporate quality, and we may expand by one or two our small number of investments in Turkey.
Over lunches and dinners, we also discussed many other issues with our Turkish hosts. From a perceived gradual creep of religion into Turkey's secular society, to the armed conflicts affecting Syria and the wider region as seen through the eyes of a cement producer, to Istanbul's hopes to stage the 2020 Olympics.
We will certainly return to Turkey at some point to further explore its corporate landscape. By 2013, a new rail tunnel under the Bosphorus is due for completion, which we hope will help to ease Istanbul's traffic problems. Unfortunately, we suspect that Turkey's corporate governance issues may take longer to resolve.
1HSBC, The Economist (http://www.economist.com/node/21552216,"Istanbuls and Bears")
2 The Economist (http://www.economist.com/node/21552216,"Istanbuls and Bears"), EFG Istanbul Securities
3 The Economist (http://www.economist.com/node/21552216,"Istanbuls and Bears")
4 EFG Istanbul Securities
5 The Economist (http://www.economist.com/node/21552216,"Istanbuls and Bears")