The strategy has a strong bias towards ‘value’, one that has increased over the last year and a half. However, we believe that it is right to have a balanced strategy and continue to have significant exposure to profitable tech/internet stocks, as well as more defensive areas such as consumer staples.
We believe in the importance of having a balanced strategy. Our valuation driven approach means that the strategy currently has a strong bias towards ‘value’, there are several themes that can be identified. Some have made a strong contribution to performance in recent years, some have not.
That should be expected, given that the strategy contains a variety of ideas that are at different stages in their transition from being contrarian to popular.
Some are secular growth stories at a reasonable price; others benefit when the cycle turns; some have re-rating potential without implying aggressive assumptions; and we own high yielders. All are trading at what we believe to be a discount to fair value.
Asian technology companies were significant beneficiaries of pandemic trends, such as working and studying from home. US-China tensions have also seen Taiwanese tech companies take market share from US competitors.
However, the market was quick to recognise the improved earnings prospects of these companies and we steadily took profits from outperformers, as share prices moved close to our estimate of fair value.
The strategy currently has a slight underweight position in the tech sector relative to the MSCI Asia Pacific ex Japan index. We’ve retained exposure in some of Asia’s world-leading technology companies that we would argue justify their re-rating given improvements we have seen in their competitive positioning.
Companies such as Taiwan Semiconductor Manufacturing and MediaTek have remained beneficiaries of strong structural trends such as 5G proliferation, the ‘Internet of Things’ and the development of areas such as the metaverse.
We have also found opportunities to add to selected tech hardware manufacturers that have fallen out of favour, and yet have scope for improvement, supported by net cash balance sheets and compelling dividend yields.
Largan is one of the leading designers and manufacturers of smartphone camera lenses. It’s a high quality, innovative company that has benefitted from flagship phones continuing to adopt higher spec cameras.
However, the shares fell out of favour when US sanctions against Huawei meant the loss of its largest customer, with the resulting gap in orders proving difficult to fill. Underperformance presented us with an opportunity to invest.
Unfortunately, chip shortages meant that camera spec upgrades were postponed, while other component prices have been going up. Being contrarian means we are sometimes early to invest, focusing more on building conviction in our estimate of fair value than identifying potential positive catalysts for the share price.
The cause hasn’t been helped by an ultra-conservative management team, who communicate very little to the market. However, judging them by their actions rather than their words gives ground for optimism, given the company launched its first ever share buyback in 2021 and increased the dividend payout ratio.
As we reduced exposure in tech/internet names that had outperformed, we added more to cyclical businesses given the discounts available in these areas, and the potential for earnings to recover quicker than the market expects.
Autos are a current theme evident in this section of the strategy. While chip shortages have been disruptive for auto manufacturers’ supply chains, there are attractive opportunities to hold selected stocks in the sector, which offer exposure to underpenetrated auto markets and EV growth potential.
One of the strategy’s largest active positions is in Astra International, a leading Indonesian conglomerate with interests in market leading auto-related businesses. While the pandemic has proved disruptive to the Indonesian economy, we believe auto demand should eventually grow as GDP per capita rises.
Larsen & Toubro (L&T) is another good example of the kind of stock we added to in mid-2020, as we increased the tilt towards quality cyclicals with underappreciated growth recovery potential. L&T is a conglomerate whose engineering & construction (E&C) business is India's largest.
Although the pandemic impacted profitability, with disruption to existing projects and new orders, we felt that the business was primed to gain market share as construction activity improved after several years of underinvestment in India.
The shares have recovered strongly, with the Indian government placing greater emphasis on public investment to kickstart the economic cycle, while L&T management are bullish on the prospects for a recovery in private capex, with its bid pipeline improving domestically and internationally.
The strategy has significant exposure in financials but holds none of the index heavyweight Chinese and Australian banks, preferring to hold banks and insurers that we consider to be of higher quality, undervalued and which have strong capital positions. Various secular themes are represented.
As mentioned previously, we remain positive in our long-term view of India, which is at an early stage in the credit cycle.
Private banks, such as ICICI Bank, which have strong competitive advantages. They also have strong balance sheets and positive medium-term earnings growth outlooks, with positive sensitivity to rising US rates for the likes of UOB.
Other significant themes within financials include long-term positive prospects for the life insurance industry in China (AIA and Ping An Insurance), and a turnaround in profitability for general insurers such as QBE Insurance and Samsung Fire & Marine.
China was the worst performing Asian market in 2021 by some margin, with indices that cover the rest of EM universe generating a double-digit return for the year (as can be seen in the chart below).
While the recovery in China’s economy was showing signs of slowing all year, market weakness has been exaggerated by the large index weighting of Chinese tech/internet companies.
These have been significantly impacted by regulatory tightening, and concerns that policy tightening for over-leveraged property developers such as Evergrande might have a spill over effect on the broader economy (our 3Q21 report covered both topics in depth).
Source: Bloomberg, (price only, US$) rebased to 100 as at 31 December 2021.
The strategy started 2021 with an underweight position in China, but this has been gradually reduced as we believe that investment risk is now being far better rewarded. Fiscal and monetary policies are becoming more supportive as authorities focus on supporting growth.
While the business climate may remain challenging, there are still many very good businesses we can consider for investment.
Gree is a relatively new holding, one of China’s largest home appliance manufacturers, with a leading position in the air conditioner (AC). The slowdown in China’s housing market has depressed growth for Gree and led to a large de-rating for the stock, which now trades on less than 10X PE, with a net cash balance sheet and a 6% dividend yield.[1]
We consider this an ex-growth valuation for a company that we do not believe to be ex-growth.
The Chinese AC market has grown rapidly as disposable incomes have risen, with sales growth of 14% CAGR over the last 15 years. The average urban household in China has 1.5 air conditioners, while only 8 in 10 rural households have an air conditioner.[2]
This compares with an average of 3 per household in Japan, a market that is still growing at 4% per annum. So, despite rapid penetration growth, we believe there is plenty of room for the trend to continue as China’s GDP/capita increases.
Other growth drivers include premiumisation and market share gains in international markets, where Gree have lagged major competitor Midea. Finally, there is potential for distribution channel reform to improve margins, albeit that this has had a short-term negative impact on sales growth.
Ming Yang Smart Energy is a leading wind turbine manufacturer in China and was one of the biggest contributors to relative performance in 2021. We bought Ming Yang following fears about new order pricing and higher commodity prices.
But ultimately, we think that for China to reach its ambitious target of peak carbon emissions by 2030 and carbon neutrality by 2060, profitability in renewable sectors – such as wind – will need to be attractive.
Indeed, following years of dramatic cost reductions, wind power has now reached grid parity in China, leading to the imminent removal of subsidies for both onshore and offshore projects.
We believe this will help remove investor perception that the sector is heavily dependent on supportive government policies, allowing investors to focus more clearly on the long-term growth opportunity available.
Source: Bloomberg LP, as at 31 January 2022.
Last year saw President Xi place an increased emphasis on the need for more inclusive economic growth in China and ‘common prosperity’. This, in turn, led to a focus on combating anti-trust practices, ensuring data security as well as safeguarding employees and families.
The strategy’s holdings in large internet companies such as Tencent and Alibaba were negatively impacted, with share prices and valuations correcting from relatively high levels amidst a flurry of headlines surrounding the issuance of fines and new regulatory measures.
When we examine the absolute earnings impact from these changes, it appears small relative to the decline in company share prices. We were happy to trim positions in these holdings when valuations were high, but now they are available at historically low levels, below those we think are reasonable.
True to our principles, we have been adding on weakness, reflecting the fact that we know these companies very well and we don’t require aggressive assumptions on growth and valuations looking 3 years out to justify the investment case.
Longer-term, while there was merit in addressing some of the excesses in corporate behaviour it does not seem logical to us for the government to continually undermine one of the more vibrant sectors of the economy, particularly one so potentially instrumental in narrowing the technology gap with the US (a key government aim).
Therefore, it seems likely that the intensity of regulatory scrutiny will eventually fade, allowing share prices to recover as the risk premium declines. It is also worth noting that these events may eventually have a positive impact on the well-capitalised, as access to capital is reduced for the sector, the fuel that drove intense competition.
Finally, we should address the risks. The biggest risk is always going to be the one that no one has thought of yet, but two that are getting plenty of airtime are the prospect of higher inflation and US tightening.
Inflationary pressures are likely to remain a focus for investors. We feel that the best way to mitigate against a more adverse inflation outcome is to avoid stocks, whose current market valuations cannot be justified by their future cashflows – even at current low interest rates.
We believe that this is an environment that suits our investment approach, with a laser focus on valuation, seeking to find out where the market has failed to correctly price the multi speed nature of the recovery.
Rising US treasury yields have historically made it tough for Asian markets to perform, with concerns that financial conditions may tighten. However, we remain sanguine.
Policy in Asia remains orthodox, with real yields still reasonable, while a few central banks have pre-emptively tightened, providing a cushion against US policy tightening. Also, yields in the US are rising from a very low base and its cyclical recovery remains strong, which should support demand.
While this period of high growth is unlikely to last, our base case is that economic activity this decade can trend higher than the decade post-GFC. Banking systems are healthy, and the investment required to decarbonize economies is significant. In our view, Asian equities could benefit from this environment, given the reasonable valuations on offer.
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
As a large portion of the strategy is invested in less developed countries, you should be prepared to accept significantly large fluctuations in value.
The strategy may use derivatives (complex instruments) in an attempt to reduce the overall risk of its investments, reduce the costs of investing and/or generate additional capital or income, although this may not be achieved. The use of such complex instruments may result in greater fluctuations of the value of a portfolio. The Manager, however, will ensure that the use of derivatives does not materially alter the overall risk profile of the strategy.
Investment in certain securities listed in China can involve significant regulatory constraints that may affect liquidity and/or investment performance.
This is marketing material and not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication.
Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals, they are subject to change without notice and are not to be construed as investment advice.
