329. Contrarian investing in Asia: hidden opportunities in China and Korea

5 September 2024 (pre-recorded 2 September 2024)

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. This week exploring a contrarian strategy that capitalises on undervalued opportunities across Asia, focusing on key markets like China and South Korea.

Darius McDermott (DM): I’m Darius McDermott, today I’m with James Cook, who’s an investment director at Federated Hermes associated to the emerging market and today’s subject, the Asia ex Japan Equity fund. Good afternoon, James.

James Cook (JC): Good afternoon, Darius.

[INTERVIEW]

DM: So, look, let’s dive straight into the fund. This is a different Asia fund than lots of the growthy ones that we see. You know, you will look for attractive opportunities across the market cap, which is a bit more differentiated to some of your peers, but also that you are contrarian investor. Maybe tell us what that means in layman’s terms and tell us how you go about doing Asia extra pound investing.

JC: Thank you, Darius. Yes. We are bottom up contrarian investors. And I guess the first way that makes us different is we don’t mind what quality we get in terms of the companies we’re investing in, as long as we get it at a good price. If I can use an analogy, we are happy to own a $50,000 Ferrari. We think that’s a great price for a Ferrari, but equally, if we cannot find a Ferrari at that price, we’re happy to own a Ford at $5,000. And that makes us different because many fund managers are only interested or focused in high quality and fast growing companies. And that focus on quality and growth can limit their universe of opportunity and we think opens them to a potential mistake to overpay for or fair value for a Ferrari or even a million dollars for a Ferrari.

And you only have to go back to 2020, the year of go-go growth when you could see managers were indeed prepared to pay an ever higher price for the quality. We are not gonna pay, you know, $200,000 for a Ferrari. And certainly for a while now, the very high quality companies in our market have been extremely expensive. And we’ve held an overweight to Fords because that’s where we found the most attractive opportunities, and that’s resulted in our historic value bias, which still holds today.

But importantly, we’ve survived what has been a very hostile environment for value investors precisely because we’ve never been pure value or deep value. We’ve had a mix of Fords and Ferraris, but definitely more Fords, which as I say remains the case today. So the first way that we are different is we don’t mind buying lower quality. If we are getting a good deal, we have the flexibility to go up and down the quality spectrum, depending on where we see the most attractive price relative to quality opportunities.

And the second way that we are different is we are demonstrably contrarian. Now I can’t show you any evidence, but when you look at what happens to the share prices of companies after we bought them, and we don’t always get it right, but you will see that they have gone on to outperform over various time periods. And that’s evidence that we of our ability to generate alpha. But before we buy them, they have been underperformers. We buy stocks that have been underperforming, where we assess the fall in their shares is for a temporary reason. And that might be a cyclical company which has enjoyed fast earnings growth in the past and then has consecutive quarters of slower earnings growth. And this isn’t unusual when you consider in the last decade, most outperforming managers have bought stocks which have already been outperforming the earnings have started to recover. And that has been reflected in the share price movements. So the two ways that we are different is we don’t mind buying lower quality and we don’t mind buying companies which are outta favour.

DM: And you will do that up and down the market cap spectrum as well, wherever that opportunity may lie?

JC: Yes. And that’s another dynamic. And, if you like, another area where we’ve been wrong, I think, you know, a lot of managers have tended to concentrate into the larger mega cap part of the market. And for many years that was a good strategy to have. So we invest across the market capitalisation spectrum, but I would characterise that we’ve been lower than, you know, certainly lower than mega cap within the portfolio.

DM: So we’ve used the word contrarian a couple of times already and I think that brings us nicely to talk about China, which I think most people would say is a contrarian investment at the moment. I note you have considerable allocation to China. What catalyst do you see for the recovery in the region and hence in their companies and their share prices?

JC: Yeah I mean, I agree with you. I think China has been the ultimate contrarian place certainly for the last several years. And it’s been a very easy and comfortable trade for a lot of investors to be short China. It’s been so out of favour and particularly with foreign investors. And that has resulted in the record low evaluations that you see today relative to the rest of the world.

Now we’ve never, as I’ve just said, been afraid of bad news. You don’t tend to have good news and good valuations and, you know, the Chinese economy is clearly going through a tough period. And that is reflected in the discount that you see today. You know, the risks are well known in terms of the ongoing tensions with the United States, the poor consumer sentiment, which has in turn been caused by the property market weakness.

And until, well, I would maybe still argue that the government’s response has been unimpressive to date with no major fiscal or monetary stimulus having been launched. The government’s approach has been to take a sort of incremental approach to support the economy. And so far that hasn’t been successful. I mean, the greater part of the government’s efforts has been around the promotion of technology and higher quality growth and important industries like EV, solar batteries. But it remains our view that the longer the market stays weak, the higher the chance will be that we will see an increased response. Whether that’s a major fiscal or monetary stimulus, which ultimately will help the property market to recover and maybe mark a turning point in equities. But what you have is a market that is extremely cheap.

Hong Kong is now trading at nine times PE with positive earnings growth, offering more than 4% dividend yield, which when you compare to less than the 2% return for savings in the bank, it it starts to make perfect sense for Chinese households who are sitting on large savings to invest in the equity market. And, you know, there are thousands of listed companies in China, and historically it’s been the case that we’ve had to look in the brambles to find the most attractive opportunities. Today, you have high quality companies, or companies we assess to be high quality, trading at the same multiples as perhaps the more cyclical older economy. Companies of old you know, some stock prices have simply fallen too much. And you’ve got companies like Baidu, which is China’s equivalent of Google trading on a core PE of under three times if you adjust for the non-core investments.

And Tencent at the beginning of this year, got to a low team multiple of just 12 times for arguably one of China’s highest quality companies. And from a bottom up perspective, that has resulted in an increased overweight to China. And, we don’t know what will happen.

Your question what’s the catalyst? I think a lot of investors can see that the market is cheap and indeed are asking that question. We don’t know what will happen Darius from here, but we do believe the property issues will eventually be resolved. It may take a prolonged period of time and it’s going to be hard as we’re seeing but ultimately it will recover and consumer confidence will recover with that. We are less confident in terms of the geopolitical outlook, but we do assess today that it’s a risk worth taking given the record low valuation that we see.

And I think support in one common feature that we see today in Chinese stocks is the buyback and dividend support that government has been very focused on mandating state entity state enterprises to increase their repurchase of shares and their dividend payments. And listed companies have followed similarly very profit focused been very focused on their, you know, operating costs and operating efficiency. And many are sitting with decent surpluses of cash, and they’ve started to buy back their shares at very depressed levels.

So for these reasons, we believe the market has found a flaw and the upside from any reasonable re-rating or even, you know, investors covering off their short China could be significant from here.

DM: Yeah, there’s nothing like, you know, if companies know their shares are cheap, then of course if they have surplus capital, they can buy them back. Reducing the share count and potentially the increase the earnings per share. So little bit of extra government stimulus coupled with that valuation that I think is reasonably well known from most investors could in itself just be a fairly simple catalyst, couldn’t it?

So, look, we’ve talked about China, and I’m sure we could talk about China all day, but also you have a big overweight to South Korea, about a third of your portfolio. Is there something going on? Is this a sort of hidden growth story in the region, or is it again, just a bottom up set of opportunities? What sort of sectors are looking interesting in Korea?

JS: So you know, again, if we just step back and look what’s happened in the last decade within the Asia markets and the four major markets of India, Taiwan, Korea, and China, then the first two, India and Taiwan have done reasonably well for investors and have delivered not quite the record levels you’ve seen in the S&P 500, but decent returns over that time period. What hasn’t done well has been China as we’ve just been discussing, and also Korea.

So Korea is a another market where we find exceptionally attractive valuations. It is a market with many high quality companies from a business perspective, global leaders in their own fields. Many of them are in technology in the auto space and other growth sectors, but they are trading at a discount certainly to their US peers and also within the region to Taiwan peers.

So, Korea has long been a value market, and a lot of the Korean discount is due to poor corporate governance. This is a cause that we’ve taken on and something we’ve been passionate about in terms of engaging with the companies that we own in Korea and at a government level, and to some success, I think. Maybe you can’t directly trace it to the work we’ve been doing, but now is talking about its own value up program similar to what you saw last year in Japan where the Tokyo Stock Exchange you know, focused on Japanese companies trading below their book value and, you know, pushing management of those companies to adopt strategies to improve value and shareholder returns. And in Korea you have a burgeoning activist class.

It’s something we’ve seen through the Covid period, a growing participation from retail investors. And in Korea today, more than a third of the electorate participate in the stock market, which has one of the lowest payout ratios in the world. And hence that discount that you see and things are starting to change. And there is a lot more focus for companies on shareholder returns there. There’s a long way to go and we firmly believe that you need to see the law change in terms of tackling some of the ways the founding families that control a lot of Korea’s largest companies have mistreated minority shareholders in the past. But what we’ve seen this year is certainly those companies that do have excess cash on their balance sheet and particularly ones not controlled by founding families, have sought to increase their payouts. So there’s green shoots of change underway, which gives us hope.

But Korea, going back to your what sector’s [question] – Korea is a technology powerhouse. And, I guess a good example of very high quality companies would be Samsung electronics. That is one of our largest positions in within the strategy. It dominates in memory, it also operates as you know, in smartphones and consumer electronics. We like it because of the asymmetric asymmetry in risk and return from it diversified business.

But in the context of AI, which has been the front of a lot of investors focus this year a lot of companies in Samsung’s sphere have done very well. But Samsung hasn’t you know, where Samsung dominates in memory, TSMC dominates in the logic part of CHIP manufacturing. And TSMC has really gone to the races it supplies a lot of the chipmakers and Nvidia and Samsung’s competitors in memory micron, which is listed in the US and SK Hynek, which is listed in the Korea, have also done incredibly well this year. So all, all the other companies around Samsung already have an AI premium built in.

Samsung has fallen a little bit behind in terms of high bandwidth memory but it’s rapidly catching up. And, you know, we do believe it will do that and attract an AI premium. But today, you have a high quality company, a long history of generating you know, high return on equities, significant percentage of its market cap in cash, some of the best talent in career, very professional management trading on just 1.3 times book value, and that compares to TSMC on six to seven times. So for us, that is certainly a $50,000 Ferrari. And that’s really what the Korea market gives, you know, some really high quality companies at very attractive valuations and lower quality companies at exceptional valuation levels.

DM: Thank you. So you did touch briefly, and I’m pretty sure I know what your answer’s gonna be based on when we come to talk about the other major country in Asia, which of course is India, which is a noticeable underweight. Is there no good, or are there no Fords or cheap Ferraris in India?

JC: It’s a real struggle for us Darius, it is really difficult to find value in that market. And it isn’t just that we have some contrarian view, you know, if we were top down investors then maybe our first decision would be to choose India as the market we’d like the most. It’s got a large democracy, a business friendly government, good relations with the West, and certainly companies that have delivered decent earnings, but we don’t like the price. And on a current multiple, at 25 times price earnings, it’s the most expensive major market in the world. And that goes across the quality spectrum. You have perhaps lower quality companies like a cement or port operators trading on 30 times multiples, consumer staple companies with little growth on 70 times.

So although the macro story is good we cannot justify paying those kinds of prices. And of course, it has been painful as I touched before, over the last 10 years and continuing this year, India has gone up almost every day. And China more often than not has been going down. But but I think eventually we believe we’ll be proven, right? You know, either because the India stock market doesn’t do anything for a long time and valuations catch up or the market suffers a sell off where the valuations have been too high. And maybe just a last point to note is most of the rerating, sorry, most of India’s performance has come from a rerating not from earnings.

DM: So look, let’s finish off with hopefully an opportunity to just talk about the asset class. We know not all countries are on the same valuations, but Asia is cheaper than Asian level versus its history. And we know the AI story in the States and the continued rise of the S&P. What’s the bright spots? Is it just the valuation as the potential for the region? Do you have sort of some greater confidence and hope that after a number of years of underperforming developed markets, that this may turn around?

JC: Well you know, I think maybe the last few years, understandably, investors are questioning because of the underperformance relative to markets. And let’s not forget that the S&P has been very has been led by a narrow band of, you know, the Mag 7. Maybe just now we’re starting to see a broadening out.

But what you do get within Asia, Japan, as we just touched on, is an enormous divergence in returns and some extremes in valuations as you say. So certainly, yeah, I mean, look, parts of the market are, we would argue expensive. Other parts are extremely cheap and in our view more than discounting the risks. We’re not saying markets like China doesn’t have any risks, but we think that those risks at these price prices today are more than discounted.

Looking out, if we went through individually, China is going through a tough transition but one that may well deliver a more stable more modest growth outlook than it has recorded historically, but one that’s sustainable and one that’s fitting for an $18 trillion economy. Of course, you have India going through the same kind of growth acceleration that you saw in China a couple of decades ago. And in Korea and Taiwan, you do have some technology powerhouses. You know, it is very difficult for America’s leading multinationals and technology companies to do what they do without their Korean and Taiwanese suppliers.

But from our bottom up contrarian perspective you know, we are very excited about the prospects for the Chinese stocks that we own, that are trading at near record valuations and the Korean companies that we see exceptional value. So, you know, we are positive about the prospect of both countries. Our portfolio reflects that value in its trading at an extreme level today at nine times PE and less than book value at 0.9. You know, that is even for us as the value guys, a cheap level and maybe the price you pay for being so cheap is to be lower quality, and we are a little bit lower quality in the fund, but not by much in terms of quality metrics like return on assets and return on equity.

So, I think one last thing I’d leave you with is, you know, humans tend to sell low and buy high, and in those moments, they believe it’s for a good reason. The longer a market trends lower or higher, the more confident people become that tomorrow will look like today. And what they forget is the most important, the single most important consideration investing is your starting point. And for us, that’s the price you pay. And I’ll leave it there Darius.

DM: James, thank you very much for talking about Asia as a region, but also your differentiated approach at Federated Hermes.

SW: Federated Hermes Asia ex Japan Equity is a concentrated fund investing in emerging markets within the Asia ex-Japan region. The contrarian philosophy makes it refreshingly different to many of its peers. The process has historically worked very well, with the fund delivering excellent long-term performance. To learn more about the  Federated Hermes Asia ex Japan Equity fund please visit fundcalibre.com