10th December 2014
Jonathan Pines, manager of the Elite Rated Hermes Asia ex Japan Equity fund.
Since inception, Elite Rated fund manager Jonathan Pines has seen stellar returns with his Hermes Asia ex Japan fund versus the sector average and benchmark. In the following Q&A, Jonathan analyses the region, identifying where some of the compelling opportunities lie, and as well as some of the areas to avoid.
FundCalibre in conversation with Jonathan Pines, fund manager, Hermes Asia Ex Japan Equity fund:
China has been a laggard in Asia for some time, what are your expectations for the country’s equity markets?
A big theme in the portfolio is our positive view on cyclical stocks. The anomaly in Asia is the cheapness of cyclical stocks relative to defensives. Cyclical stocks are trading at record-low valuations relative to their fundamentals, while defensives are trading at record highs.
What makes this a compelling investment case is the rareness of the extent of this disparity – to find similar disparate valuations one needs to go back to the heart of the global financial crisis in 2008 or the Asian Financial Crisis 1998. In both cases, cyclical stocks went on to rebound sharply relative to defensives. China has a large number of cyclicals – a number of which have seen their share prices fall. Therefore, we see significant opportunities in selected Chinese cyclical stocks.
Another attractive feature of China is the liberalising of its stock markets. Most international investors until now have been limited to the H-share market, the stocks listed in Hong Kong. However, the domestic A-share market is now opening up to international investors. This is the second most liquid market after the US and is also very inefficient, as it has been completely dominated by relatively unsophisticated local investors.
Looking at the price disparity theme, the broader trend towards liberalisation, and the market inefficiencies in the A-share market, we see plenty of opportunity in China for bottom-up stock-pickers such as ourselves.
Many consumer stocks, particularly in the smaller ASEAN markets, have performed strongly in recent years, how sustainable is this?
This part of the market is exactly where investors should not be. Many of these stocks are trading at record-high level valuations following a sharp re-rating over the past half-decade. We believe that those investing in these types of stocks are setting themselves up to underperform over the next five years. While the companies are high quality there is no margin of safety: the current prices render the stocks unsafe. Even the shiniest, reddest Ferrari is not a good deal if it costs a million dollars.
You have a large contrarian overweight position in Korea, why is this?
We are finding many beaten-up stocks in Korea. For example, we like the Korean brokers. Generally, Korean stockbrokers are not high quality businesses and do not generate a good return on equity. However, these companies have been beaten up so badly that some trade at a third of net asset value. When you get this extent of cheapness, the cheapness can be a catalyst for a re-rating.
We also like the petrochemicals because many of these companies are trading at record low valuations: the market is pricing in no growth over any time horizon. Electronic component makers are also attractively priced after sharp falls. Firstly, they have been hurt by falling competitiveness relative to Japanese (yen-based) competitors. Secondly, in some cases, these companies form part of the Samsung Electronics supply chain and have come under pressure as Samsung reins in costs. Despite these real challenges, we think the valuations of certain electronic component manufacturers are too low given their long-term prospects.
India has experienced a sharp rally over the past year; do you still see opportunities in this market?
We are always looking for opportunities in India as we believe it is the best long-term investment story in the region given its stage of development, democracy, decentralized economic growth model and massive population. However, I would temper enthusiasm in the short-term as we believe stock prices have gone up too quickly.
Share prices are broadly a function of a company’s cost of capital and future earnings. In India, the improving cost of capital part of the argument is easy – with Modi, a reformer, coming in and reducing the cost of doing business and improving confidence. However, the future earnings story is less obvious. We expect that when reforms do not immediately translate into improved earnings, stocks will not be able to sustain their recent rallies.
From a bottom-up perspective, it is necessary to analyse which particular companies will be beneficiaries from these reforms. Some will certainly do well, but other companies, particularly those with already high returns on equity, might face more competition when the reforms remove barriers to competitors’ entry. The cost of capital benefit is clear, but the earnings effect must be assessed on a company-by-company basis.
Chinese internet has been a high profile area of late, particularly with the Alibaba IPO. How are you playing this?
We have a big position in Baidu. This is a great company growing its top line at just under 50%. While its earnings are currently growing at a slower rate, we believe they will catch up. It is good value at a P/E multiple below 30x.
As for Alibaba, it is another great company. The nice thing about this IPO was the main owner of the company, Jack Ma, was not incentivised to list the company at the maximum possible price as he was not selling his shares. Of course, the main reason that share prices often perform poorly after IPOs is because the people selling the shares are the same people telling investors how great it is and are the same people that want to sell their own shares the highest possible price.
Even though this stock has gone up 50%, the price does not appear unreasonable. The way we have chosen to play Alibaba is through Hong Kong listed China Dongxiang. Around half of China Dongxiang’s value comes from its position in Alibaba, but it is trading at a sharp discount to the sum of its parts. We thus gain exposure to Alibaba but at a discount.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Jonathan's views are his own and do not constitute financial advice.