Optimism and long-term themes in Asian equity markets

Below is a transcript of the video, modified for your reading pleasure. Please check the corresponding video before quoting in print, as it may contain small errors.

So, for much of the last couple of months, a lot of the focus has been on the US and the UK stock markets, and what’s been going on. How have markets in Asia been faring?

[00:23] I think there’s a bit of a division within the region from market performance. North Asia has been the weaker area. South and Southeast Asia have done rather better. North Asia consisting largely of China, Taiwan and Korea, have been facing some quite significant headwinds. China, domestically-driven. From the Taiwan and Korean perspective, they are more exposed to the export markets and demand in Europe and the US. And there is clearly a colder wind blowing.

But some of the companies have actually been reporting their earnings recently, haven’t they? Have they been more encouraging than you might have expected or are there worrying signs there as well?

[1:12] Well, I think that’s where I take a good deal of encouragement. And when we think about what we’re investing in, and in fact, the key tenants of investment are firstly, how companies themselves are operating, what they’re actually doing and what they’re producing. And then considering how the markets are valuing those.

And when we have gone through company results for our fund for the first six months of the year, operational strengths in terms of profits and dividends have been very encouraging – around three quarters of our companies grew their sales. There was around half of them saw margin expansion, so, the other half have seen some contraction, and overall earnings growth has been very positive. So, if we’re looking into averages, the median company produced just shy of 7% growth in sales, a little over 7% in earnings, and the median market margin contraction was less than a half a percent. So, our focus therefore is on any company that is seeing both the sales contraction and margin contraction, but for the fund overall I think it’s been a very encouraging set of results.

And furthermore, when we consider reported earnings, we attach a great deal of importance to the dividend. Not only because we’re an income fund, but also the dividend is the clear evidence of profitability being delivered in cash-based terms. And the dividend results were also very encouraging: 20 companies out of the 36 we hold have declared dividends so far since the middle of the year. 13 of those rose, six of those were unchanged, only one has registered any decline. And that was about 11% decline. So, the overall operating picture, I think it’s very encouraging.

So, when we switch across and think, well how are markets doing? And how are markets varying? We’re aware that stock markets have been weaker. And we are certainly aware that on macro considerations China particularly has not performed well. But if the underlying companies are doing what they need to do, then it becomes a little bit more likely that when the macro picture clears, those companies are going to be left looking cheap.

And just to sort of round off this comment, cheap companies are not ones where the share price has fallen. A cheap company is where the share price has fallen, but the earnings and the dividends have held up and continue to deliver growth. And that’s what we would hope to see in a sort of quality company type of portfolio that we’re seeking to produce.

And you mentioned China briefly there, how concerned are you about the geopolitical risk with China and Taiwan, et cetera?

[4:37] Yeah, that is a difficult one to answer with a high degree of certainty, because we can all express opinions and we can all construct a very rational argument as to why maintaining the status quo makes sense for everybody. But you could have made precisely the same arguments for Russia and the disadvantages to them of their recent act to invade Ukraine.

So, the question still stands. Does China want to forcibly reunify with Taiwan? I think the answer still has to be, no. I think that there is a key difference between the political setup in China versus that of Russia. And the key difference being Russia is led by a single person who makes his own decisions. If he is down in the depths of the Kremlin dreaming dreams of empire, he still has the power and authority to act unilaterally. That is not the way the Chinese political system is set up. Although Xi Jinping is a very powerful figure, he is still part of a collective – he’s still, in fact, a good deal more constrained, than one might realise. And so, while there is certainly pressure to deliver unification with Taiwan at some point, the appetite and the will of the collective, I think, does not lead one to believe that a forceable reunification is on the cards.

So, I think for the present, that the geopolitical risk is there, and it will remain, and tensions will certainly continue to be evident. But I think as a practical consideration, that is not part of our investment case. So, really our focus much more is how the collective government in China is dealing with the domestic issues that it currently faces, because these, I think, have to be the priority. Further disruption of the type, which would be profound if military action would be pursued is, I think, antithetical to everything that they are trying to achieve at the moment.

And this view’s obviously gone through into the portfolio in that you are obviously still happy to invest in Chinese companies. I think there’s about a third of the portfolio invested there. But in one of your recent reports, you mentioned sort of concerns around the property sector and mortgage boycotts, I believe you put in there, which is interesting. So, whereabouts in China, are you investing? What kind of companies do you like?

[7:33] Well, we are primarily invested in domestic Chinese companies. We have one that is involved in export manufacturing, which is Shenzhou International, a textile maker with operations in China and Southeast Asia, particularly Vietnam and Cambodia, that has a very strong client base and also has a very modern set of production facilities. So, they’ve invested heavily in capital equipment. So, they have in fact done very well, even though they’ve seen margin compression of around 6% this year. Sales growth of around 20% has vastly exceeded that, and so therefore the results have been positive.

But our domestic exposure is made up of communication services, video games, financial services – both banks and insurance – of retailing, of utilities, and particularly domestic gas distribution to households. We’ve also got some healthcare as well.

And if you take a view, as we do, that when you’re going into an investment, you’re taking a three-year horizon at the very least. Because when we’re forecasting companies, we look at expectations for next year, year after that, year three’s little bit hazier. But we’re taking at least a three-year view and that will continue to roll, but China’s not about to fall apart. I mean, it’s still doing enormous quantities of trade, cash is flowing through. You’re getting velocity of transactions. You’ve got a quite a clearly delineated set of problems, which although complex, are not insoluble.

And one of the other things you’ve been doing is looking sort of over a three- to five-year view for some structural changes that are happening and opportunities that you might be able to take advantage of there. Hyundai and Kia came up as the progress they’ve been making in electric vehicles, for example, and the supply chain opportunities there. Perhaps you could tell us a little bit more about that and maybe other trends that you have identified?

[10:01] Sure, the electric vehicle market in Asia, and particularly China, is expected to be substantial. When BMW were making their dispositions and their plans for electrifying their fleet and the market they’re looking to sell into, by around 2030, I think they’re working on the basis of a 42 million strong EV fleet of around 19 million or so in Europe, but they’re expecting around 12 million or so in China by that point. Now, there are a number of companies that are quite well advanced. We’ve got the Chinese companies like BYD, like Geely, who are doing pretty well, but Hyundai and Kia have probably been the most successful, or one of the most successful now, amongst the big car makers in producing electric vehicles and generating stronger sales.

I was particularly struck by the fact that, in the first five months of the year, Hyundai and Kia were out-selling pretty much everybody in the United States, with the exception of Tesla. And the Koreans have form in this, they produce good quality cars. And the story of Hyundai and Kia is an interesting one, which we don’t have the time to go into now, but they were one of the first vehicle manufacturers to provide seven-year warranties. They were that confident in their engineering. So, they’re quite forward looking, and they are producing a wide range of models for markets in the US and in Europe. So, when we’re having a look at these opportunities in Asia, the electric vehicle theme, and its supply chain, is pretty important.

We might not make a bet, as it were, on an individual car maker, but we’re more interested in those companies that are supplying things that all electric car makers will need. In the case of the portfolio, we have a position in Hanon Systems, which makes cooling systems both for internal combustion engines, but also for electric vehicles. The cooling system around the battery is all about energy efficiency. And, you know, the order book is growing particularly quickly for that company. Right now, it is facing significant margin pressure on costs, is also seeing, because car makers themselves are still seeing disruptions to production. That also means that they’re operating sub-scale at the moment, but that will change.

And so, I think, you know, when we are looking at this sort of three-to-five year horizon, and certainly from here to 2025, the company is well on track to achieving that. So, I think the electric vehicle space, battery makers, battery equipment makers and component parts are a good long term structural theme.