Cautious approach to growth

Any discussion of the global economy now always incorporates a mention of India and China. They have not only been two of the fastest growing economies over the past few years, but Goldman Sachs, among others, has predicted they will continue to expand for many years to come. In its analysis of the Brics economies, which comprises Brazil, Russia, India and China, Goldman Sachs said India’s economy could exceed Japan’s by 2032 while China’s could be larger than the US by 2041 and any other country’s by 2016. Rapid expansion The rest of Asia has benefited from the growth in China and the global economic expansion of the past three years. China’s economy has been expanding at a rate of around 10 per cent a year and grew by an annualised 10.7 per cent in the first three quarters of 2006. Asian stock markets have also benefited from increased risk tolerance by investors and attractive valuations, as well as the regional and global economic growth. The MSCI AC Asia Pac ex Japan index, for example, returned 72 per cent over three years to 9 October 2006 while it rose 133.54 per cent over the past five years. Naturally, the global correction in the spring did impact on Asian markets. Over the past year, the Asian index has returned a lower 16.67 per cent. Mark Mobius, manager of the Templeton Asian Growth fund, which has distributor status in the UK, has outperformed the index over the past year by returning 18.60 per cent. He does not believe valuations in Asia are looking stretched following their strong returns of the past few years. “Market fundamentals continue to support the long-term upward trend of emerging markets,” says Mr Mobius. “While Asian companies have recorded significant share price appreciation, corporate earnings have also increased. This has made valuations still look attractive. “Many companies are experiencing strong growth and there are many upcoming IPOs in Asian markets. The key is to find undervalued companies that are well capitalised and have a unique and competitive product range. Companies that are paying solid and sustainable dividends are especially attractive. Despite their rapid growth, many Asian companies are undervalued when compared to their peers in developed markets.” Mr Mobius adds that the correction in the spring provided investment opportunities because “stocks were oversold due to poor market sentiment and not poor fundamentals”. He highlights South Korea, China H and Red-chip shares and Taiwan as presenting particularly attractive investment opportunities. “South Korean and Taiwanese companies offer an attractive combination of good technological and production expertise while China stands to benefit from its accession into the World Trade Organisation, greater foreign interest and strong consumer spending. “For some time, we have been emphasising four major C themes in our investments. These are: consumer, commodities, convergence and corporate governance. Sectors that are geared towards direct consumption will continue to benefit from the higher disposable income per capita in emerging markets. With commodity prices at relatively high levels, there will be many opportunities for good profits for companies supplying them. “Convergence between Asia and China will continue to provide good opportunities for companies. Finally, corporate governance is very important in investing. We want to invest in companies that treat investors fairly.” Slow turnover The Aberdeen GI-Asia Pacific fund has outperformed the index over the past one, three and five years. The manager, Hugh Young, says he takes a bottom up approach to running the fund. Mr Young looks for stocks that can generate growth over at least the next five years. “We have a turnover of stocks within the portfolio of only 15 per cent,” he says. “We have held some stocks for more than 10 years. We try to identify good quality companies with good businesses run by good management that look after the interests of shareholders.” Mr Young says the consistent performance of the fund is down to the process used and the experience and longevity of the team. “We try not to get caught up in the noise of the market and news channels, such as the fact, for example, that the rate of inflation is moving up. We focus on stock picking based on company fundamentals.” The fund is ranked sixth over three years and fourth over five years. Over one year, it has slipped to 69th. “There will be short periods of underperformance,” says Mr Young. “But this is for reasons we can explain. This year performance has picked up in the second quarter.” Mr Young has seen few reasons to change the portfolio over the past three years. “The underlying stocks in the portfolio have been performing well although the valuations have been rising. We have trimmed positions where stocks have risen in value and added to positions where companies are out of favour. “For example, we reduced our exposure to India in April and May just before the market wobble although we only cut our position by 1 per cent out of our exposure of 15 per cent.” Given the strong performance of stock markets in Asia, Mr Young says that with the exception of Thailand none of the markets are now looking cheap. “There are, however, plenty of investment opportunities. We have been adding to Siam Cement. This is an industrial company that is regarded as a bellweather stock.” The fund has also topped up its position in Singapore Telecoms. “I would say many stocks are at full valuations now rather than stretched valuations,” says Mr Young. “Stocks are on average valuations of 16 times earnings for this calendar year compared to 12 times four years ago. But earnings have been growing over this time as well. Companies are better managed than five years ago, balance sheets have improved and greater attention is focused on shareholders. Countries also have current account surpluses.” The rise in markets is reflected in the fact that small cap stocks were on a 30 per cent discount to the main market 10 years ago. Now they are on a par to the main market. Exports have driven the growth of Asia but Mr Young says the region is now less dependent on these industries. “There are opportunities in the domestic economy. You only need to look at the penetration rates of credit cards to see the potential.” Mr Young says recent events in Asia serve a purpose in reminding investors of the political risks of the region. These include the political coup in Thailand and the nuclear test in North Korea. Bubble bursting Millicent Lai took over management of the Schroder ISF Pacific Equity fund just over one and a half years ago. The fund has returned 21.93 per cent over the past year compared to 16.67 per cent by the MSCI AC Asia Pac ex Japan index. Ms Lai says the fund was detrimentally affected by the bursting of the technology bubble six years ago, which has affected three to five-year performance numbers. Ms Lai says she uses a bottom up approach with a focus on shareholder returns and valuations. “We are looking at the return on equity from companies,” says Ms Lai. “We seek stocks where there is a rising trend in returns on equity that will provide attractive long-term share price returns.” Ms Lai adds that there is a valuation overlay on this analysis. “We will not pay any price for stocks with rising returns on equity. Valuations may be a trigger for when we sell stocks despite a growth in shareholder returns. “We also want to make sure we are not in stocks when valuations are okay but shareholder returns are declining. Equally, if a stock is cheap there will be a reason for this if the return on equity is not rising.” Ms Lai says analysts build their own models to evaluate where shareholder returns are heading. She admits Asian stock markets have been on a strong run and that absolute valuations are at the high end of their historical range. Nevertheless, says Ms Lai, this is balanced by the growth in Asian earnings and economies. “The region has benefited from restructuring since the Asian crisis and the cyclical development of global growth. “The discount in valuations of Asia and developed markets has narrowed as well. We are cautious because of valuations rather than the fundamentals.” The fact that Asia has benefited from the growth in the global economy means it can also suffer from any downturn. The fund has been increasing its focus on stocks that benefit from the growth in the domestic economy. While Ms Lai says Asia is less dependent on exports than in the past, a significant slow down in the US and global economy will impact on Asia. “If there is a soft landing for the global economy, Asia’s restructuring will lessen the impact. Asia will be badly impacted by a hard landing for the global economy. This will be particularly the case for cyclical stocks in the region.” She adds that the fund has been finding investment opportunities in particular in Thailand, Indonesia and Singapore. “Thailand has been hit by a number of events. These include the Tsunami, the coup and the rising oil price. If you believe the oil price has reached its peak, however, then there is room for improvement. We have been focusing on domestic consumption companies, particularly banks and financial services stocks.” Ms Lai also likes domestic consumption companies in China. “We feel there are lots of opportunities for growth in the domestic economy.” Allan Liu, manager of the Fidelity Funds South East Asia fund, which has out-performed the index over the past one and three years, says his stock research, including visiting companies and their suppliers and competitors, is supported by 20 portfolio managers and 32 research professionals in Asia.

‘Asian markets have since rebounded from the correction, in some cases to higher levels and much quicker than was expected’ - Allan Liu, Fidelity Funds South East Asia Fund

“I tend to favour companies that exhibit above average earnings growth relative to their sector and the broader market at attractive valuations,” said Mr Liu. “I typically invest in mid to large cap companies although I will consider opportunities among smaller companies where liquidity is sufficient. “I look for companies with a high quality management team, globally competitive edge and positive cash flow, all of which I believe provide a good indication of long-term growth potential. As such, geographic and sector allocation is primarily the result of my stock selection.” At the end of September 2006, China became the fund’s second largest country over-weight. This reflects the investment opportunities Mr Liu has been finding across various sectors, including metals and mining, oil and gas, telecommunication services and banking. Mr Liu is also overweight energy despite the recent reduction in oil prices. He remains overweight because of the “secular increase in energy demand coming from emerging countries like China and India”. The fund is underweight Taiwan. “Outside the technology and financial sectors, there are limited investment opportunities in terms of the core competencies of its companies or its relative valuations.” The sell off in stocks in May and June, which Mr Liu said was caused by investors’ growing risk aversion to emerging markets, led to valuations trading at a discount to global markets. This produced attractive investment opportunities in Asian stocks, says Mr Liu. “Surprisingly, Asian markets have since rebounded, in some cases to higher levels and much quicker than was expected,” says Mr Liu. “I am optimistic Asian markets will be driven by a recovery in domestic consumption and strong export demand. The likelihood of expansion in China remains strong even though the government has been implementing monetary tightening to slow down the over-heated economy.” Mr Liu says that despite recent market movements, Asian economies have generally become more resilient to external shocks because of their internal growth, budget and trade surpluses and higher foreign exchange reserves. “At the corporate level, capital discipline has improved significantly and companies have largely been able to generate strong free cash flows and lower debt levels, making them more resilient to any sudden rise in interest rates or input costs,” says Mr Liu. “The average earnings growth and dividend yields of Asian companies remain the highest in the world.”