with Andrew Clifford
The last 12 months have been a tough period for markets in the Asia region. Only two markets in the region delivered a positive return – India and Indonesia. There are a range of reasons for this, but it largely boils down to the tightening of global liquidity, with rising interest rates and major central banks starting to shrink their balance sheets. There are also questions arising around the strength, breadth, and sustainability of the current global economic expansion.
Looking at the specific holdings that have been impacting our Asia ex-Japan strategy’s performance, the three largest positive contributors over the past 12 months to 30 September 2022 were Jardine Cycle & Carriage, a holding company for automotive and commodity operations predominantly in Indonesia, Indian bank ICICI, and Chinese property developer China Overseas Land & Investment.
The largest detractors from performance over the same period were Samsung Electronics, Taiwan Semiconductor Manufacturing, and Tencent.
It’s worth reflecting on those top contributors and detractors. To reiterate, one of our top three contributors was a Chinese property developer, in fact, two of our top 10 contributors were Chinese property developers. While on the negative side, the two positions that hurt performance the most were Korean and Taiwanese tech companies, which were both sold off on concerns around softening global demand.
The reason for reinforcing this point is because there can be a tendency to assume that given all the negative headlines in the media, that China must be the cause of the strategy’s decline. However, the sell-off has been fairly broad-based across the region. If we compare the performance of the Chinese share market with other manufacturing and export powerhouses around the world, like Korea or Germany, we can see relatively similar trends in terms of their stock market performance.[1] So, despite all the headlines, it seems that markets have still largely been driven by normal economic forces.
There are some exceptions, though. One place where we can clearly see weak international sentiment towards China is in the widening gap between the prices of Chinese assets listed on both the mainland (known as “A-shares”) and in Hong Kong (known as “H-shares”). This “AH Premium”, as it’s known, reached decade highs on Monday 24 October. This means that the exact same asset was, on average, trading at a more than 50% premium on mainland Chinese markets compared to the Hong Kong market – a market significantly more influenced by international investors.
This AH premium has been widening over the past couple of years for a range of reasons. We have touched on a few of these in our regular investor communications, including the regulatory environment, defaults in the property sector, geopolitics, and China’s COVID-zero policy. Many of these topics are complex and difficult to address thoroughly. We don’t always agree with the direction that the government has taken, and there are certainly aspects of the situation that we wish were different, but in general, we’ve tended to be more sanguine than the views that are commonly expressed in the media.
The 20th National Congress of the Chinese Communist Party (CCP), which wrapped up on 23 October, and the subsequent sell-off in markets on Monday has raised concerns for some of our clients. At this event, the new senior political lineup for the next five years was announced. Politics is hard at the best of times, and Chinese politics is particularly opaque, so we would caution against drawing any really strong conclusions at this stage about the implications of the new leadership. The only thing that can be said with much certainty is that it shows President Xi Jinping has a strong political position. But this has been evident for a number of years now. Nevertheless, clearly some international investors decided they didn’t like what they saw, hence the Monday sell-off.
When we step back and look at the broader market reaction, it’s hard to draw a coherent narrative. On the Monday following the Congress, HK and US-listed Chinese assets declined sharply, but mainland Chinese markets experienced far less dramatic declines. This suggests that the domestic audience doesn’t share the same fears that many international investors have about China’s outlook. Commodity markets like copper and oil also barely moved, so seemingly, participants in those markets also didn’t see the weekend’s events as impacting the outlook for economic activity dramatically. Even more unusually, investors in Western companies that earn significant profits in China, like Nike or BMW, also didn’t seem at all perturbed by the latest political theatre. So, whatever the specific concern is, whether that be economic or geopolitical, we can observe that these different groups of assets didn’t incorporate the same assumptions about the world’s outlook. What that means is that at least one of these groups of assets is mispriced. Given that Hong Kong and US-listed Chinese stocks fell sharply, it’s reasonable to assume that either they need to go up, or the other group of assets needs to adjust lower.
Our view is that it’s more likely that HK and US-listed Chinese assets will close the gap upwards, rather than the others coming down – but only time will tell. As it stands today, not only is this AH Premium still near decade highs, but the valuation of Hong Kong-listed stocks – when looking at measures like Price-to-Book, or Price-to-Earnings ratios – are around the lows reached during periods of dramatic dislocations such as the global financial crisis or even the Asian crisis of the late 1990s.
We feel that many of the discussions around China are at risk of being a little emotional and counterproductive for investors. It takes people away from the basics of focusing on companies and industries. A year ago, the common wisdom was that Chinese property developers were a train wreck in the making, and while we’re not completely out of the woods yet, over the subsequent 12 months, the developers in our portfolios have been among our better-performing holdings. It’s a great reminder of why we do what we do. We try to find opportunities that other investors are unreasonably fearful of, or that are being overlooked or misunderstood.
China is a large market and is frequently in the media, but there are other markets across the region that the Asia ex-Japan strategy is investing in. As the world is getting used to COVID, we have the opportunity to get back on the road and meet companies face-to-face again. Members of our investment team were in Vietnam a couple of weeks ago, and we are heading to Indonesia and Thailand next month.
Last month, a couple of us spent some time in South Korea, which is proving to be a really fruitful market for us. In recent months, we’ve added four new Korean companies to the portfolio. Korea is obviously a relatively wealthy and technologically advanced country, and it has a strong export sector, not to mention it’s a geopolitical ally, which helps to remove some of the noise around news flow. The Korean market has sold off sharply from its highs of mid-last year, it’s down by a third, and the currency has been weak. It’s also worth noting that many of the historic challenges facing investors in Korea have also started to be addressed in recent years. There’s been a raft of new pieces of legislation constraining controlling shareholders, as well as helping to protect minority investors.
One of our newer holdings, Coway, is an example of some of the opportunities we are seeing in this market. Coway is a consumer products company, their main products are water filters and air purifiers. They also sell bidets and mattresses. Korea is their largest market, but they also have sizeable operations in Malaysia and more nascent (but potentially quite interesting) positions in Thailand, Indonesia, and the US. In recent years, they’ve been growing revenue and earnings at around 10% p.a.,[2] as they’ve been expanding their geographic footprint as well as broadening their product suite. However, if you look at the stock over the past six years, it has declined more than 40%,[3] despite delivering healthy growth. That leaves the business trading on 8x consensus earnings for this year. The company has a conservative balance sheet, with only a modest amount of debt, and generates great returns on capital. Investors have seemingly become bored with the company, as the domestic Korean market is now quite mature for them and the international markets, while growing nicely and now accounting for a third of the business, have been a bit slower to develop than people had hoped for five years ago. We think the company still looks really prospective, with a solid (if maturing) core business, promising geographic growth opportunities (with which they are actually seeing some really good traction; Thailand grew almost 100% last quarter, albeit off a small base), and a valuation that is really quite undemanding and should provide a great margin of safety. That’s just one of the newer holdings, but hopefully it provides a sense of the opportunities that we’re finding in the region outside of China.
Looking at how the region and strategy are positioned, in the near term, ongoing economic headwinds could well continue as the world tries to adjust to the inflationary environment and rates continue rising. However, as we’ve detailed above, sentiment towards the region seems to be at a fairly low point and valuations appear depressed. These are the kinds of things that should lay the groundwork for future returns. As at the end of September, the strategy was around 90% net invested, so it is nearly fully invested and we remain enthusiastic about the medium-term outlook.
[1] MSCI China, MSCI Germany, MSCI Korea in local currency terms. Source: MSCI.
[2] Source: Company reports.
[3] Source: FactSet Research Systems.
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