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Investment views

Time to rethink Asia

21 May 2018
Author(s): Charlie LintonPortfolio Manager

By Charlie Linton, Portfolio Manager

The drive for innovation is such that Asian firms are set to spend more on R&D in 2018 than anywhere else in the world

 

Key insights

After years of promise and scant delivery, Asian equities finally found their stride in 2017. Keen Asia watchers will be quick to point out that a disproportionate part of the advance was delivered by just four stocks – Samsung Electronics, Alibaba, Tencent and Taiwan Semiconductor. However, we would argue that the rally was symptomatic of a much larger trend that will force investors to radically rethink many of their long-held Asian views.

Striving for the innovation crown

Firstly, we will look back at what so enthused investors about last year’s success stories: Asian companies gaining a seat at the global innovation table. While Asian firms have historically been criticised for spending a lot and delivering little, last year saw the emerging Asian tech giants secure large global market shares in the hypercompetitive sectors – thanks in large part to years of heavy R&D spend. This speaks to a wider trend in which Asia is looking to realign itself away from its legacy roles as a low-cost manufacturing base.

The drive for innovation is such that Asian firms are set to spend more on R&D in 2018 than anywhere else in the world. While this may have raised alarm bells in the past, 2017 has demonstrated that the region’s firms are no longer reckless with their investments. We also note that Asian companies have played a much more active role in developing emerging technologies, as was the case recently when Asia-based LG Chemical, Panasonic and Samsung inked a US$25 billion deal with German carmaker Volkswagen to power the world’s largest carmaker’s shift into electric cars.

Figure 1: R&D expenditure (US$bn)

Figure 1: R&D expenditure (US$bn)

Source: OECD, September 2017.

 

We also see similar dynamics among renewable energy sectors in the solar and wind energy space, where Asian firms already count themselves among established market leaders. Although not the sole catalyst, all three of these sectors have disproportionally benefited from the ongoing efforts to stamp out pollution in the region.

Figure 2: Solar equipment maker - revenue (US$m)

Figure 2: Solar equipment maker - revenue (US$m)

Source: Bloomberg Intelligence, 2016

 

Riding the green revolution

Indeed pollution control is one leg of the key tenets of the recently announced ‘Beautiful China’ policy which will see Asia’s largest economy strive for a better quality of life for the country’s residents by delivering cleaner air, more sustainable investments and renewable energy. These goals may seem woolly or overly aspirational for investors more used to dealing with western institutions. Nevertheless, Chinese policy-makers are already well underway in their efforts to change from a ‘growth-at-any-price’ model to one where quality is favoured over quantity.

One area currently being disrupted by these developments is China’s chronically indebted and poorly run state-owned enterprises (SOEs) which have suffered from excessive leverage, poor capital discipline and oversupply under the old growth paradigm. The ‘Beautiful China’ framework has seen the least efficient, highest polluting lossmaking operators lose access to capital. The upshot of this policy being a shuttering of heavily polluting plants, which has in turn reduced the oversupply burden that dogged even the most efficient operators.

Policy-makers are already well underway in their efforts to change from a ‘growth-at-anyprice’ model to one where quality is favoured over quantity

 

Figure 3: Asia ex-Japan capex growth

Figure 3: Asia ex-Japan capex growth

Source: USB analyst estimates, April 2017.

 

Although draconian by Western standards, the reforms are starting to have a tangible impact on profitability across the sector. For example, only 5% of Chinese steel companies used to turn a profit five years ago, whereas today fully 90% of these firms now trade in the black. We’ve also seen similar developments across the aluminium and cement sectors.

In the past firms would have used these profits to fund capacity expansion; however, we take heart that the recent windfall has been used to pay down debt. This should make the sector even more sustainable in the future.

Capital discipline, attractive valuation

We also note that capital discipline isn’t unique to Chinese SOEs, since every sector across the Asia Pacific region has seen an improvement in free cashflow, with the exception of the telecoms sector.

While margin expansion dictated by wiser capital allocation has played its role in the recent profits growth, a large part of the region’s surging profits can be directly attributed to improvements in top line revenue growth underpinned by solid and steady economic expansion. Indeed, sales growth has played a much larger part in the recent annualised earnings-per-share (EPS) improvement registered by Asian firms compared to their global equities peers. This comparison is especially stark with US firms, which have relied on buybacks to fuel the majority of their recent EPS growth.

Every sector across the Asia Pacific region has seen an improvement in free cashflow, with the exception of the telecoms sector

 

Figure 4: Earnings growth breakdown by region

Figure 4: Earnings growth breakdown by region

Source: S&P Dow Jones Indices, Factset, CLSA, 25 October 2017.

 

We feel that this greater reliance on revenue growth has the potential to make Asian equities more immune to short term shocks than other regions, such as the US and Europe, who have already wrung out most of their operational efficiencies.

Valuations still attractive

In light of the improved operational and strategy track record delivered by Asian firms, the conversation generally turns to whether the region’s current valuation offers an attractive entry point for investors. A quick review of valuations currently offered by the MSCI Asia Pacific ex Japan index shows the region’s multiples have yet to reflect the improving earnings and strategy outlook. In fact the index now trades within its long term valuation average. Were we to strip out the technology sector from the index – home to the majority of richly-valued firms– we find that the index actually trades below its historical average valuation, which would indicate that fears of an overheated Asia are largely overblown.

Positioned to take advantage of the changing Asia

We have re-aligned our Asian portfolios in light of the region’s shifting valuations. Our portfolios are now much less exposed to technology stocks – after benefiting from an overweight position over the last 18 months – to focus on more attractively valued parts of the market. We currently favour the relatively less crowded financials, materials and real estate sectors. In financials, we particularly like Chinese banks due to their exposure to the region’s growth, as well as the improving bad debt provisions from China’s recent deleveraging.

Our process isn’t predicated on forward-looking judgement calls on commodity levels. However, our steer into the commodity stocks is driven by the sector’s recent deleveraging and the previously mentioned Chinese capacity cuts, which we believe has made the sector much more resilient on a through-cycle basis.

On a more tactical level, we continue to be overweight Chinese A-shares as the asset class has been especially suited to our disciplined 4Factor investment process. Additionally, we believe that the asset class also has the potential to benefit from additional inflows from both Chinese savers and overseas investors, especially as international index providers include the asset class in global benchmarks over the coming years.

General risks: All investments carry the risk of capital loss and past performance is not a reliable indicator of future results.

Specific risks: Geographic/ Sector: Investments may be primarily concentrated in specific countries, geographical regions and/or industry sectors. This may mean that the resulting value may decrease whilst portfolios more broadly invested might grow. Developing market (Inc. China): Some countries may have less developed legal, political, economic and/or other systems. These markets carry a higher risk of financial loss than those in countries generally regarded as being more developed. Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. bankruptcy), the owners of their equity rank last in terms of any financial payment from that company.

 


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Charlie Linton
Charlie Linton Portfolio Manager

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