257. Generating an income by investing in Asia

18 May 2023 (pre-recorded 2 May 2023)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Staci West (SW): Welcome back to the ‘Investing on the go’ podcast brought to you by FundCalibre. Listeners looking to construct an investment portfolio that produces an income may want to consider looking towards Asian equities. Today’s guest tells us more about the ripe dividend landscape in the region and discusses investment opportunities ranging from technology to insurance.

Chris Salih (CS): I am Chris Salih, and today we’re joined by Jochen Breuer, manager of the Elite Rated Fidelity Asian Dividend fund. Thanks for joining us today, Jochen.

Jochen Breuer (JB): Hi Chris. Thanks for having me.

CS: Let’s start with the fund itself. It aims to provide what’s called a cross-cycle performance, which in a nutshell, means it aims to do well no matter what’s going on in the sort of wider Asian or indeed global economy. For the listeners, maybe just explain how you go about this and what sort of companies fit this sort of stereotypical mould for this.

JB: Yeah, I think that’s a great starting point. So, when I took over stewardship of the fund around six and a half years ago, really we set out to achieve three key outcomes for our clients. The first being, as you mentioned, outperformance of the index through the cycle. Secondly, to deliver an attractive headline dividend yield, which at the moment is around 4% on the fund, and dividend growth over time. And thirdly, to achieve this with lower risk characteristics than the market. And with that, I mean a relatively lower drawdown in falling markets. So, the focus is really to deliver an attractive risk-adjusted total return, where the dividend is an important part of that total return over time. And the fund itself is fairly concentrated in nature, so around 30 to 50 names over time, and it’s managed without any reference to the benchmark. And the average holding period I would say is three to four years of the companies we own so, it’s very much a patient approach to investing.

Now, as one would expect for a dividend strategy such as ours, the fund does exhibit certain style characteristics. So, because of the type of companies we invest in and our focus on downside protections through the focus on valuation, the fund tends to behave more defensively. So, it tends to outperform in falling markets, but it lags in strongly rising markets. And for example, 2020 was such a difficult year for us, as sectors such as Chinese internet companies strongly outperformed and those tend to pay limited dividends and therefore are not really featured much in our investible universe. But we managed to recover the performance and some more in 2021 and 2022.

Now our investment approach is very much bottom-up focused, and we have more than 50 analysts here on the ground in Asia which are constantly meeting and analysing companies, and with their help and through strong stock picking, we can hopefully deliver against those three outcomes that are mentioned at the outset. And I’m glad to say that we have delivered against those over the last six and a half years.

You also asked me obviously what type of companies more specifically we are looking for and there are a number of characteristics I would highlight, the first being that the companies we invest in tend to have strong business models and therefore can generate attractive and resilience through-cycle returns. They tend to have conservatively managed balance sheets and good cash generation. And we are looking for good governance frameworks. And on top of that, management teams that have shown good capital allocation in their businesses, where the dividend is an important part of that capital allocation framework. And management that manage these companies in a sustainable manner.

The final point I would make is on valuation. So, it’s not quality at any price, but we’re very valuation conscious. So, the focus is really on protecting the downside to achieve attractive risk-adjusted returns for our fundholders.

CS: Okay. I’m going to touch on a couple of themes on the back of that. Firstly, technology, you know, you mentioned that you think technology can enter a recovery phase in the second half of this year. Why do you think that is and what impact [does that] have on your portfolio? And I ask that in the wider context of, you mentioned that defensive positioning, I think you’ve got about just shy 20% in technology or you had about that sort of number. I mean, does tech sort of become a … is tech a defensive investment now? Or how do you maybe … just give us a view on that please.

JB: Yeah, no, absolutely. So, as I mentioned, technology stocks are around 18% of the fund today, but we have been adding to those holdings over the last few months. And I would classify that part of the portfolio certainly more within the cyclical bucket within the portfolio. And if we kind of go back and think about what has happened, I guess listeners will be aware that the wider technology space benefited from increased customer demand during Covid while supply chains were impacted, and therefore we’ve seen those disruptions, but really over the last 12 months some of those trends have reversed. So, while supply chain issues have largely been resolved I would say, demand, for example, for PCs, notebooks and mobile phones has weakened, and hence we have seen kind of inventory levels of components and also of end products increase.

But I think crucially, we believe that we are past the worst here, and have, for example, started to see those inventory levels starting to come down. And hence we think from a cyclical backdrop, this is supportive and at the same time valuations for a lot of these hardware technology names, which are really leaders in the industry here in Asia, those names look attractive.

And if I could maybe talk about one stock that we like, it would be Samsung Electronics [Group]. Many will probably know Samsung’s consumer products such as TVs or fridges, but by far the biggest profit contributor is Samsung’s memory division, in particular d-ram memory, which goes into notebooks, mobile phones, servers and so on.

So, why do we like Samsung? I guess the first point would be from a structural perspective. So, memory is an industry that has consolidated over time. And today there are really only three scale players left in the industry in the form of Samsung Electronics and SK hynix [Inc.] in Korea, and then you have Micron [Technology, Inc.] in the US. And that makes for a much, much more rational market than used to be the case. And I think we are seeing that playing out right now. So, as a result of the weakness in demand that I talked about and the depressed profitability, these three industry players have now started to reduce capacity utilisation and capacity expansions. And we think this is really the last step that is required for an ultimate kind of cyclical recovery in that industry.

And Samsung – kind of coming back to your point about cyclical versus defensive – we think Samsung is in a very good position to weather the storm here, as it’s really the lowest cost producer within the industry and it also has a very strong balance sheet. In fact, almost a quarter of its market cap is currently sitting in cash. And for an income investor like myself, what’s important really is that they have an absolute dividend policy. So, despite the cyclical weakness, they’re paying a stable dividend, and that obviously is very important for me as an investor. And lastly, and I think I mentioned it before, is really on valuations, which we think are very attractive and provide a very positive risk/reward profile for the stock.

CS: Just quickly, does that mean a group like Samsung might almost be considered cyclical and defensive, if you see what I mean? Because it’s in such a strong position?

JB: Yeah, absolutely. I think, I mean, cyclicality comes obviously from the underlying industry they operate in, which is a cyclical industry. But then when you look at the strengths of the company in terms of its balance sheet strengths and, for example, also the shareholder return profile, and lastly also the valuation that the stock is trading on, makes it very attractive from that perspective and gives a very attractive risk/reward profile, which we see.

CS: I’m going to turn to a sector which perhaps has not been seen as very attractive for the best part of 15 years, so, banks. Let’s talk about a couple of Asian banks – have the banking issues that have sort of been reverberating in the US and Europe, been felt in Asia? I assume you are confident there won’t be contagion because you’ve added, I think it’s HSBC has just been added to the portfolio. Maybe just give us a bit of an outlook on that and you know, what you would be watching for if you’re not concerned?

JB: Yes, absolutely. So, again, financials are roughly 20% of the fund. But when looking at the exposure within that, one thing that I would highlight is that, historically and also today, the majority of our holdings are non-bank financials. So, these would be, for example, leasing companies, exchanges, or also selective insurers that we like. Why do we prefer those type of companies over banks? Really the reason is that they tend to operate in attractive niches of the market, which have less competition and therefore the potential to grow faster and generate very attractive returns on capital.

An example of such a company would be, for example, Chailease [Holding Co., Ltd.] in Taiwan, which provides leasing companies for SMEs or small and medium sized companies, in Taiwan, in China, and also in Southeast Asia. And this is a market that’s not really being served by the large banks as the business model is too specialised and too labour intensive for those larger banks to compete. And as a result, Chailease can generate attractive returns and grow at very decent rates.

So, when it then comes to the banks and to your question, I would say the first thing I’d say is that those issues that we’ve seen in the regional banks in the US and also around Credit Suisse in Europe, have really only limited read across for Asian banks, I would say. And the reason being that most banks in Asia have very strong capital positions. They are subject to strong regulations. Plus, they have a very large stable deposit franchise in most cases. There are obviously other drawbacks, such as the fact that a large part of the bank’s universe in Asia are state-owned enterprises and hence not necessarily only managed for the benefit of minority shareholders. And this is why we are very selective when investing in banks in the region.

The one bank you mentioned obviously that we have been adding over the last few months is HSBC. And there are a number of characteristics that we like here. The first being the restructuring of the business that management has done over the last few years, selling a number of underperforming non-core assets and geographies, which we believe will lead to stronger and improved return profiles of the group. And because of those restructurings, the other thing is that Asia now is more than 50% of the business and it’s obviously a higher growth kind of market. And lastly, I would say the capital position attracts us, which is very strong and allows management to return significant funds to shareholders through dividends and buybacks. In fact, they announced a 2 billion US dollar buyback today. And we believe 30% of the current market capitalisation will come back to shareholders over the next three to four years.

CS: Just on the landscape, obviously your focus is on individual companies, but you also have to take a look at the macro environment they operate in, it can’t be ignored. So, given that in mind, we’ve had a challenging couple of years with China and the ripples that they cause and the discussion about how big those ripples are perhaps changes, obviously, there’s a lot of divergence between US and Chinese monetary policies. And I just wonder how that and China in general impacts the wider holdings. Could you maybe explain the … are the ripples as big as perhaps they may have been seen to be 15, 20 years ago? You know, just how much do you have to batten down the hatches every time China sort of really kicks off <laugh>?

JB: Yeah, maybe a little bit of kind of backdrop. I’d say probably listeners know that China has been in a very restrictive kind of zero-Covid policy for almost two years, which only really ended at the end of last year. And since then, we’ve seen a rapid reopening of the economy supported really by monetary easing, but also by fiscal policies. And crucially, I think China is not seeing the inflationary pressures that we experience in the West. And that makes those policies really feasible in the first place.

On top of that, we’ve seen [a] much more supportive regulatory backdrop over the last few months. So, we’ve seen policy support when it comes to, for example, the property sector. And clearly, I think we are seeing that the government is supporting the economy wherever it can. While the recovery really has not been all that smooth and partly behind initial expectations, I think the direction of travel for the Chinese economy and the intention of the government really has become clear.

Now, compare that to the backdrop of Western economies – and I would include Australia for example here as well – where monetary policies are restrictive to fight inflation and hence we are really seeing a slowing consumer and corporate environment.

From a fund perspective what I would say, how it has impacted… Since last year, we’ve really been looking for more companies that benefit from the reopening of China, not only in China, but also within the wider region as China obviously remains by far the largest economic force in Asia. And an example would, for example, be regional companies that benefit from an increase in Chinese tourism because one of the trends we have clearly been seeing I think over the last few months, is that the Chinese consumer has strong pent-up demand for services, for example, tourism, while demand for goods, especially those larger ticket items, is still somewhat lagging behind.

CS: Let’s turn to dividends, obviously you are seeing dividend increases this year. What’s your outlook  for the rest of 2023 and beyond that? Are you confident [or] pensive? Just give us a view on that as well, please.

JB: Yeah, sure. So, I think one aspect that makes Asia an attractive hunting ground for income investors really is that it offers attractive headline yields, but it also has good prospects for dividend growth over time. And on the one hand side, for example, you have countries such as Australia or Taiwan, which are more mature in nature and also have certain tax advantages or tax incentives for companies to pay higher dividends. But on the other hand, you have some of those more emerging markets where payout ratios are still relatively low, and you should see higher dividend growth over time from the companies operating in those countries. So, another aspect I think we have seen over time is that different governments have encouraged companies to return more cash to shareholders. And that is something we definitely are seeing at the moment with respect to the Chinese state-owned enterprises.

When I look at the fund and the dividend announcements of the companies in the fund year to date, I would broadly say that they have been in line to slightly better than expected. And I think that reflects really kind of the improving fundamentals in Asia with the Chinese reopening, and which also results in higher confidence of management teams. And to give an example, Swire Pacific [Ltd] is a top five holding in the fund and they have not only decided to initiate a sizable share buyback program of funds a few months ago, but also increase their dividend by around 15%. And we believe there’s ample room for more dividend growth going forward as the business recovers.

CS: Jochen, can we just finish with a couple of companies and a couple of areas of the market you might be excited about? Just, you know, you’re very company focused, let’s maybe just get a couple more beyond the ones you’ve talked about already that you are particularly excited about at the moment.

JB: Yes, absolutely. So, let me talk about maybe Singapore Exchange [Ltd] which has been a holding for a number of years and this falls into this bucket, which I talked about earlier of non-bank financials. So, exchanges we think are attractive businesses because they tend to have very strong business modes in the form of certain network effects, as clients tend to choose the highest liquidity pools and the lowest cost operators to execute their trades. And Singapore Exchange in particular has very dominant positions in a number of derivative and foreign exchange products within the region. Another reason we like it is that it’s a business that generates high margins, is fairly capital light in nature and therefore generates a significant amount of cash. And this allows management to grow the business at attractive rates and, at the same time, return cash back to shareholders in the form of dividends.

Another maybe a little bit more underappreciated aspect we think, is that the exchanges benefit from rising interest rates, as they can invest the flow that they keep for their clients at higher rates in the current environment. And finally, from a portfolio perspective, I think what’s also interesting is that the exchanges tend to benefit from increased market volatility. So, it’s also a very attractive stock to own from a portfolio diversification benefit perspective, as it makes an attractive defensive holding within the fund.

CS: Jochen, once again, thank you very much for joining us today.

JB: Thank you, Chris.

SW: The Asian market is one of increasing relevance and importance for equity income investors, and this fund is well placed to capture that trend. The fund generates not just an above-market yield, but also one that can grow, offering attractive total returns. To learn more about the Fidelity Asian Dividend fund visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.