Back on track?
A landmass five times the size of Europe, Asia is the largest and most populous continent, yet its stock markets account for only 5.08% of global equity market capitalisation. Leaving aside Japan, Asian investment straddles the developed markets of Australia, Hong Kong and Singapore, through Korea and Taiwan and on to the emerging markets of the China and the Indian sub-continent. Lower production costs have meant that these markets have been beneficiaries of cost-cutting in the west. From being highly export-led, domestic demand has become the more important driver of performance, with increasing disposable incomes and credit more widely available. The valuation premium demanded for first world accounting and corporate governance is being eroded as a result of recent scandals. These dynamics have caused Asia to outperform in these torrid times, with a fall of just 5.7% since the beginning of the year for the MSCI Asia Pacific Free ex Japan index against a negative 18.7% result for the MSCI All Countries World index, in dollar terms.
The Asia-Pacific corporate landscape has changed greatly since the 1997 currency crisis and much of the systemic risk has been removed. Companies have deleveraged, conglomerates have been broken up and profitability has improved. Foreign corporate investment in the region is rocketing, with $80bn (E00bn) of inflows into China this year, and a forecast $130bn next year. As margin pressure forces Western companies to outsource manufacturing to Asia, employment in this sector continues to increase. The region is better able to withstand external shocks, as head of Asia/Japan regional specialist at JP Morgan Fleming Asset Management in London, Richard Cardiff, explains, “Asian economies are far more robust, thanks to reduced debt, large trade surpluses, the removal of foreign exchange controls, and the build-up of foreign exchange reserves. However, the growth prospects in the region still stem from the fact that most Asian countries are emerging market status.”
In the opinion of Chris Palmer, a senior fund manager at Gartmore in London, the most powerful trend in Asia is for US and European companies to outsource all of their manufacturing operations to Asia, focusing their attention on maintaining the brand and research and development. Now companies such as Compal Electronics, who build laptop computers for companies like Dell and Hewlett Packard, not only assemble but also source components and capital equipment from other Asian companies. Designs for new products are sent straight to the Far East for manufacture, whereas in the past a western company would have set up its own production line first before considering outsourcing. Palmer sees this as a win:win for companies and consumers in both regions, as it improves the margins of the western company, leads to lower prices in the shops for western consumers, creating more demand, and acting as a spur to the Far Eastern market’s development. To remain competitive large Japanese electronic goods companies like Sony and Sharp are also starting to outsource manufacturing to Asia. The skill level of Asian workers is improving to the extent that they can handle complex manufacturing processes such as in the pharmaceutical, biotech and software industries.
The experience of steady employment at increasing rates fosters consumer confidence and spending and fuels domestic demand. Once incomes exceed what is necessary to survive, spending increases to larger items, like cars and houses, and becomes aspirational. As Palmer comments, “The younger generation have far higher expectations than their parents, and nothing at all in common with the experience of their grandparents”. There is increasing trade between the various Asian countries and capital is shifting towards where it can be most efficiently used providing, in Palmer’s view “many good investing opportunities for decades to come”.
Peter Soo, Asian regional investment director at AIG in Hong Kong, suggests that the idea of investing long term in emerging markets is a myth, because of the high volatility, but he is extremely positive on Asian market performance for the next 24 months. Looking back over the long bull market in US equities, Soo suggests the baby boom generation, through an explosion in consumption, prolonged its length beyond the typical 18-24 months to longer than six years. Demographics are similarly positive for the Asian markets, although the peak in 30 to 55 year olds will not occur until 2025. Statistics show that Asian households are being formed with fewer and fewer people, the average moving from 4.8 to 3.9 persons per household, and this is a further spur to consumption. More and more people in Asia have an income above the critical World Bank threshold of $5,000 per capita per annum. Besides having greater income, Asian households are showing an increasing propensity to spend, savings rates peaking some years ago. Domestic consumption is now by far the biggest proportion of GDP, at 84% in Korea and 98% in China, with headline rates of GDP growth in those countries 5% and 8% respectively.
As Asian consumers experience greater job security, their expectations of future income are reinforced, leading to more use of credit. But Jason McCay, Asian regional manager at Martin Currie in Edinburgh, sees Asian consumer credit growth as a by-product of reduced corporate debt and lower interest rates. Say McCay “the banks’ role in the past was to fund corporates, but without that requirement they are flush with liquidity and offering favourable terms to consumers.” McCay continues, “For the first time since 1997 a new credit cycle appears to be underway, and the power of consumer spending will increase asset prices and economic activity, resulting in a virtuous circle of more spending. This could continue for the next five to 10 years.” However, Gerald Smith, manager of the Baillie Gifford Asia Pacific funds, feels that Asian consumer spending is susceptible to weakening external demand.
With the growth of the domestic consumption, the bias of the Asia-Pacific markets towards technology stocks and exporters is diminishing, in favour of domestic retail operations and banks. Market returns are becoming more diversified and so the behaviour of Asian markets will be less volatile and cyclical, forecasts McCay. A lower risk premium on Asian equities should result in a rerating, underpinning the market in the longer term. But McCay concedes that Asia could not decouple completely from the difficult equity markets of the last two years, although levels of volatility in the Asian markets are now broadly half that of US and Europe.
Whereas Asian companies’ returns on equity have converged to comparable levels with the US, on price to book value terms, Asia trades at a 39% discount. Arguably the most established Asian market, Hong Kong, trades on a huge discount to the US, with a price/book value of the MSCI Hong Kong index at 1.1, versus 2.9 for the US. The dividend yield on the Hong Kong index is 4.2%, some 250 bps over Hong Kong dollar interest rates, implying a negative equity risk premium. The undervaluation prevalent in Asian markets is exemplified by this clear anomaly is pointed out by Soo. The dividend yield on Hang Seng Bank is 5.7% against rates on Hang Seng Bank deposit accounts of 1.1%. Since arguably one is taking equivalent risk as an investor as a depositor, the size of the yield differential is astounding.
To some extent the Asian markets are victims of their own success. Massive overcapacity in many industries has led to little pricing power and whereas they are seeing big volume gains, there is no pricing power, indeed product prices continue to fall. Smith points to continuing political instability in the region, particularly the influence of North Korea, spillover of troubles in Indonesia, and investors can be tripped up by governmental interference in the management of companies in key sectors like telecoms. Says Smith, “In Asia there is always the problem of regulatory uncertainty and sometimes arbitrary change, which impedes long term investment.”
Fidelity, one of the top four investment houses in the region, has $10.4bn in Asian equities, of which 60% are institutional mandates. Of these 60% are Hong Kong based institutions, generally smaller portfolios than those coming from European and US clients, but more numerous. Managing director of Fidelity Hong Kong, Doug Naismith, reports a high level of enquiry, with improving performance from the region, a reversal of the trend since 1997, when many withdrew funds. Because it has become such a small part of the global benchmark, pure South East Asian mandates are unusual. Some Asian mandates bring in Japan, to make for a more meaningful sized allocation. Australia is now considered part of the region, whereas before it might have been excluded. Often US plans will select the most developed markets, and have a combined benchmark of MSCI Australia, New Zealand, Hong Kong and Singapore. A slightly broader mandate would be the MSCI Far East Free, but increasingly Naismith reports interest in Asia Pacific ex-Japan, and Pacific Basin ex-Japan mandates, which exclude India. Equivalent combinations of FT benchmarks are seen and other constraints may be set on portfolios as a function of the investor’s attitude to foreign exchange controls and status as a qualifying investor in the local market.
Gartmore runs $1.3bn of money in Asia, taking in all quoted markets ex-Japan, although some mandates exclude Australia, the largest market in the region. As Palmer, comments, “the challenge confronting clients is how to bundle the Asian region. A client might want to put Asia together with Japan, and provided a house has both capabilities that can work well. Typically Asia Pacific and the Indian sub-continent makes up a sizeable proportion of a global emerging markets mandate, and clients must be ensure that they do not allocate twice to the same underlying markets. Unless a client is specifically allocating only to the developed markets in the region, emerging market capabilities should be a key element in manager selection.”
Naismith also suggests that, as the allocation to Asia has shrunk, investors have increased the amount of active risk that they are prepared to take in the region, to make the expected returns more meaningful. Says Naismith, “There are fewer core mandates and greater demand for active management.” Cardiff comments, “The inefficiencies that abound in emerging markets can be better exploited by a specialist manager than a generalist, and although foreign investor limits have been raised in many markets, the influence of the local investor creates pricing anomalies less common in developed markets.” A specialist manager will be able to pick his way through dissimilarities in accounting treatment and how Asian companies deal with their shareholders. As Palmer avers, “Lower levels of research and smaller trading volumes means that it can take longer for fundamental changes in the outlook for companies to translate through to prices.” Much of this know-how comes from a local presence and fund managers with a global sector approach struggle to enforce this discipline in Asia, because of the influence of local investors. Otherwise the universe splits neatly into bottom-up stock pickers, whose stock bets drive country weightings, or top-down asset allocators, whose stock decisions come after imposing the country view.
As far as the investment process is concerned, Fidelity picks stocks in Asia in much the same way it does elsewhere, taking a bottom-up approach on the basis of fundamental valuation of stocks, as opposed to being top-down or sector-driven. Given the markets’ inefficiency and lack of development, Naismith supports the stock-picking approach and stresses the teams’ local presence, with 16 investment professionals spread over more than 12 countries, with a diversity of nationality and culture. Having people on the ground is more important in Asia than other regions, as Naismith points out: “Asian companies do not tend to travel to meet investors.” The resources allocated to research are biased towards countries that make up the greater proportion of the benchmark, so Hong Kong, Australia, Korea and Taiwan. Uniquely, Fidelity devotes as much time researching stocks in which it is not invested as those it is, and Naismith suggests that this enables the firm to calibrate current holdings and know the history of a stock before investing.
Cardiff stresses that the JP Morgan Fleming process has been specifically designed for the region, borne from the company’s 30 years of experience of Asian markets. The team of 48 JP Morgan Fleming fund managers in the Pacific region run $15bn of Asian money, and each are country or regional specialists responsible for making investment decisions, not just recommendations. On average each has over 11 years of relevant experience, more than six of which with JP Morgan Fleming. Staff are spread over seven offices in the region and conduct more than 1,000 company visits per year. Companies are segmented into four internal classifications according to their competitive advantage, quality of earnings, and potential for restructuring. Stocks are then ranked by value and with reference to the current market conditions. Core overweights within portfolios are companies ranked as premium or quality, offering superior returns and/or being in attractive industries, operating in favoured countries, according to the macro house view.
Although Martin Currie, with $899m invested in Asia, of which $333m is in specialist mandates, run a global sector approach across all other regions, Asia is still run along country lines, because the correlations between stock and sector are not strong enough. Also, as McCay explains, if Asian stocks were included in global sectors, too little time would be spent looking at them, because of the disproportionate size of US and European stocks. Even sectors like telecoms, which elsewhere are strongly correlated, are barely correlated in Asia. Hence the six Martin Currie Asian fund managers are country specialists and make inputs into the asset allocation process, bearing in mind the firm’s global strategy, enforcing a top down country view. As McCay suggests, “in simple terms, having the right stocks, but the wrong markets, leads to poor performance”. As regards to stock-picking, the Asian team at Martin Currie screen stocks according to the same principles as other regions, broadly looking for stocks on cheap valuations with positive earnings momentum and improving fundamentals. Risk systems allow McCay to determine which positions are driving risk, and, as active managers, Martin Currie tends to have significant flexibility to deviate from the benchmark, both on a stock and country level, with a typical tracking error of 7% to 12%. Its mandates tend to be quite broad, the most popular being the MSCI All Countries Asian Pacific ex-Japan.
Baillie Gifford operates a bottom-up stock picking approach on individual stocks, but is conscious of the influence of global trends on certain sectors, for example the demand for DRAM will affect prospects for companies like Samsung Electronics, whereas utility stocks will be driven by internal domestic issues alone. Overall its portfolios tend to have a slight growth bias, as its research suggests that future growth prospects are being underpriced. The largest single position in the portfolio is Hutchison Whampoa and its associate Chung Kong, which is trading on less than a sum of the parts valuation, even ignoring its European 3G interests. Smith also considers that BAT Malaysia, a separately quoted subsidiary of BAT Industries, offers a good total return, with a yield of 7% and modest but stable profits growth of 10% pa.
Within Gartmore’s Asian team, each of the five equity analysts are market specialists with some sector specialism, and these analysts have direct contact with companies and make recommendations. Portfolio constructors match the risk and return profiles of client mandates to the analysts’ views, and decide whether to tactically over or underweight markets relative to the benchmark. Gartmore’s philosophy is to invest in the unexpected and its analysts look for early indicators of positive or negative change in the prospects for a stock.
AIG runs $39.3bn in Asia and has probably the largest and most diverse teams in the region, with 20 investment professionals spread across offices in seven countries, including on the ground analysts in far-flung outposts like the Philippines, Thailand and South Korea. AIG uses a standardised approach to investment across the globe, segmenting stocks according to their lifecycle and growth profile and then taking value into consideration. It employs top-down asset allocation and risk analysis to determine portfolio construction favouring companies with either exceptional growth or established stable growth, who have a clear competitive advantage.