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Positioning for Reflation: Asia Pacific Fund Manager Q&A

Thoughts on equities versus bonds

amid rising inflationary pressure and increasing bond yields?

One of the things that surprised us was how much bond yields have fallen over the last few years. If we look at the black line on the top chart, which indicates Asian interest rates, it has been falling pretty much in a straight line. The US 10-year Treasury, which is the black line on the bottom chart, has been trending downwards as well.

We are no experts when it comes to inflation or bond yields, but after talking to companies that we have invested in, we can see that there is more inflationary pressure, driven by Covid, money printing and the fiscal stimulus rolled out by central banks around the world.

From the perspective of bond yields, even though it has bounced from the bottom, current yields are still considered very low in a historical context. If we look at the bond yields of the US 10-year Treasury, it is at approximately 1.6% in June, compared with 3% in 2018. As such, we think it is dangerous to assume that current bond yields will stay low forever. We should expect rising bond yields to cause ramifications on equity valuations. 

Equities vs. bonds – “what is least expensive?”

Asian equities vs. bonds
US equities vs. bonds

Source: Bloomberg, Datastream, Factset, MSCI, Macquarie, as at 29 August 2020.

That said, we don’t believe bond yields affect the fundamentals of the companies that we invest in, in terms of cash flow and profitability. However, it could affect market sentiment. Last year, investors believed that interest rates might never go up, but now investors have started to pay more attention to the potential rise in interest rates and how it could impact highly-valued stocks (such as technology companies). I see this as a healthy phenomenon, that the market is focusing on this risk.

In terms of equities versus bonds, we think equities look relatively more attractive. As of today, deposits from banks and investment grade bonds provide very low yields, if anything at all. Hence, although equities might look more expensive from a valuation perspective, from a yield perspective, we believe equities are still quite attractive compared to bonds.

In terms of our portfolio in this kind of environment, we would say it is well-positioned. We do not invest in companies that do not generate profits or cash flow, such as some of the highly-valued technology companies. They have been particularly vulnerable to a hike in long-term interest rates. Having said that, we are open to technology companies with high profitability and a good track record, such as Tencent, where we have been invested since it listed in 2004.

How has Covid affected your investment decisions?

Identifying high-quality companies that should be resilient during crises like Covid

Every crisis provides an opportunity for investors and companies alike. As bottom-up investors, we like to observe how companies navigate through crises, as high-quality companies usually emerge from them stronger than before. For example, we look at whether they are adopting new technologies or deploying marketing dollars more wisely. We believe this tells us a lot about the company culture and the management team.

In the current climate, we are seeing a big shift in terms of consumption from offline to online, which likely won’t revert to pre-pandemic levels after the pandemic is over. The challenges ahead for bricks-and-mortar retailers are clear, and as a team, we have started to turn more cautious on some of them. However, for those with higher brand equity, I think the impact would be minimal.

Whether you are shopping online or offline, you are probably going to buy the same cosmetic brands, and the same household appliances or household products as before. Moving online could actually help companies save costs in the long term.

However, there is less excitement over consumption-driven companies compared to a few years ago, due to concerns about cost inflation. If you think about a tissue paper company, a shampoo company, or a snack confectionery company, with raw material costs going up, there could be increasing pressure on margins.

That said, we see this as a short-term issue. If we look past the potential cost inflation and look at the improving demographics and market growth potential — particularly in some markets in Southeast Asia — there could still be opportunities for some consumer companies in the region to continue to grow.

Is your investment conviction on India still intact?

The current situation in India is worrying.

India has always had issues over the past decade. About a year and a half ago, there was a housing finance crisis in India and before that, there was the demonetisation crisis. India has rarely looked as good as China from a top-down perspective. It has always run a fiscal and current account deficit, with a weak currency and unstable politics.

India has seen several disruptions over the last decade

Source: FSSA Investment Managers, BusinessToday.com, Financial Times, Outlook India, February 2021.

However, it is exactly for these reasons that we have historically found India to be an attractive market from a bottom-up perspective. It is almost the opposite of China. Because top-down has been challenging, companies need to be competitive and well-managed in order to survive. We see the current situation as an opportunity to identify high-quality companies that are able to emerge from the pandemic stronger then before, although from a social perspective, it is clearly very worrying.

One of our main investment themes in the India market — which we have had for many years and remains intact today — is the high-quality private sector Indian banks. In China, banks are 100% state-owned, whereas in India, about 70% of banks are state-owned and 30% are private. HDFC Bank, which has been one of our top 10 holdings for many years, has a market share of approximately 5% to 6%, and has been gaining market share over the years. The ratio of credit to GDP in India is about 50% or 60%, whereas in China it is around 200% or 300%, depending on your definition of credit. Hence, from a credit penetration and market growth perspective, we believe there is a huge opportunity for quality private banks in India.

Besides that, we also like Indian consumer companies — another major investment theme for us. In our view, India today is like China 10-15 years ago in terms of consumer penetration. Of course, you could argue that India might never get to where China is today, but if you look at demographics, income growth or the sheer size of the population, we believe there are good opportunities with some of these consumer companies.

As such, although one could argue that there is more macro risk in India compared to China, if we look beyond the near term and take a longer-term view, we believe there are still plenty of attractive investment opportunities in India.

How is the portfolio positioned?

Our portfolios are reasonably balanced. We do not believe that we should position our portfolios towards a certain theme whenever that theme becomes popular.

As of today, we have approximately 21.1% allocation towards banks. Until recently, many people questioned our rationale for investing in banks due to low interest rates, but we find this overly simplistic. We have a meaningful allocation to Indian, Indonesian and Singaporean banks, all for different reasons. We believe Singaporean banks will be beneficiaries of rising rates, even though until recently people were expecting rates to fall. Also, banks such as Oversea-Chinese Banking Corporation (OCBC) have exposure to different Asian countries, including China. They have a 20% stake in Bank of Ningbo, for example. As for Indonesia, India and the Philippines, we see these markets as attractive from a credit penetration perspective.

We also have about 20.9% allocation to technology, mostly to hardware. We have stakes in Taiwan Semiconductor (TSMC) in Taiwan, Samsung Electronics in Korea and Keyence in Japan. We believe technology is a major secular trend and we do not mind holding technology companies for an extended period, especially those that are competitive and reasonably valued.

Historically, we have preferred to own consumer names. We have a high exposure to consumer companies in India and Southeast Asia because of their cash flow generation and high predictability. We do not have any exposure to energy or commodities. It is just too difficult to take a long-term view on commodity prices, or how much steel prices are going to rise and fall, or even oil prices for that matter. Historically, we have always been quite light in commodities.

Sector breakdown

as at 31 May 2021

Source: First Sentier Investors. Numbers may not add up to 100% due to rounding.

From a geographical perspective, we have a large exposure to India at about 18.5%, and a 45.2% allocation to Greater China (including China, Taiwan and Hong Kong; or about 24% if just China). We also have a meaningful allocation to Japan (6.2%), as we like certain automation and consumer names there, and Southeast Asia (10.4%), as we believe it will continue to provide an attractive domestic consumption story in the long term, primarily because of favourable demographics — which is the opposite to China or North Asia.

Regional breakdown

as at 31 May 2021

Source: First Sentier Investors. Numbers may not add up due to rounding.

Thoughts on the Sino-US trade tensions?

Has it affected China’s manufacturing edge?

We believe trade tensions will be an ongoing issue.

Over the years, China has become a rather large part of the global economy. In terms of the percentage of GDP to the US, China is where Japan was in the late ‘80s. From a political standpoint, we believe there will be more conflicts between China and the US, whether that be on exports and trade or other geopolitical issues. That said, we believe it affects market sentiment, rather than having an actual impact on the economy. China has a very domestically-driven economy; its exports contribute only a tiny part to GDP.

US-China ‘Phase 1’ trade deal a temporary respite

But there is no quick solution to the dispute between the two largest economies

China’s surplus with the US has been rising
China GDP now 67% of US GDP – similar to Japan in mid-90s
China’s GDP growth, contribution breakdown

Source: US Department of Commerce, China’s Ministry of Commerce, Bloomberg, FactSet, National Bureau of Statistics, World Bank, FSSA Investment Managers. As at 30 June 2020.

Not only that, but despite various trade barriers imposed by the US, China’s export numbers continue to beat expectations. In fact, the pandemic has affected non-Chinese manufacturing bases more than those in China. As global demand recovers, China has become a reliable manufacturing source for most markets around the world. Before the pandemic, there were concerns that China might lose their manufacturing edge due to labour shortages. However, that concern is slowly diminishing. Tesla for example, built its largest factory in the world in Shanghai last year and it now manages to export cars from China to Europe1 — this reflects China’s high manufacturing competitiveness.

Geopolitical tensions between China and Taiwan; and China and the US–

What should investors pay attention to?

You could say that these events occurred because of China’s increased strength, and China has become even stronger after Covid. So, this will be an ongoing issue.

When the US-China trade war first started, Chinese exporters were sold off heavily, because people believed there would be 20%, 30% or 40% tariffs on different kinds of products. However, today if you look at some of the exporters that we have in our portfolio, their profit has not really been affected, despite the introduction of tariffs. The reason for this is quite simple: good companies can manoeuvre around this kind of trade barrier.

The more geopolitical issues there are, the more beneficial it is for the stronger, bigger companies. Take Techtronics as an example. In the past, their manufacturing base was only in China, but now they are developing in Southeast Asia — Vietnam, in particular — and they are also looking to expand in the US. Smaller companies cannot do this. If the bar has been raised, in some ways it can be better for the more competitive companies.

In terms of Taiwan, there have been times when everyone worried about the potential for war between China and Taiwan. Historically, those times turned out to be good buying opportunities. The important thing, for us at least, is to stick to the companies that we like. Depending on how the geopolitics actually turns out, then good opportunities may actually arise from these periods.

Thoughts on the commodity sector?

As a team, we had a long debate on this topic at the end of last year. The whole world was negative on commodities and, generally speaking, when people say that there is no future for something, it is usually the right time to buy. However, despite that rule of thumb, we decided not to invest in the sector mainly for two reasons.

The first reason relates to sustainability. BHP Billiton, for example, derives a percentage of its revenue from coal mining2. Although we think it is a high-quality company, we believe there are structural headwinds facing these types of companies. After applying our environmental, social, and governance (ESG) lens, we find we are misaligned with coal-mining companies.

The second reason is confidence. Only in hindsight, do we see the copper price going up. As a team, we have never had the confidence to invest in the commodity area; we just do not see this as within our area of expertise. We did look into some oil companies in China, but many of the Chinese oil companies are on the US sanctions list3, thus adding another layer of complexity.

Thoughts on Australia?

Are there any investment opportunities?

In our view, there are three main sectors in Australia — banks, resources and industrials or exporters.

Historically, we have been more focused on the exporters, such as medical equipment or pharmaceutical companies. One of the largest holdings we have in Australia is CSL, a leading plasma company. Besides CSL, we are also shareholders of ResMed, a sleep apnea equipment manufacturer. In that sense, we think Australia has done pretty well in terms of medical innovation.

We have always been quite nervous about Australian banks because of their size. Commonwealth Bank of Australia for example, has a similar market cap to some of the Chinese banks. We struggle with this concept from a population perspective: how can a bank in a country with 25 million people (Australia’s population) have a similar market cap to a bank in a country with approximately 1.4 billion people (China)? So, on that notion we have never invested into Australian banks.

Although there are some Australian commodity companies that are high quality, as mentioned earlier we have decided not to invest in that sector after applying an ESG lens.

How do you see the tightening regulation in China playing a part in the investment universe?

The government is clearly trying to exert a stronger influence on different aspects of the economy. Apart from the traditional industries such as banks, property and utilities, now internet and technology firms are under the spotlight, and for good reason. We believe companies will adapt to the new regulations and learn how to grow more responsibly and more sustainably.

We think it is positive that the market is now focused on risks as regulation, as well as competition. This is a healthy development.

Are things improving in Asia from an ESG perspective?

ESG has always been a part of what we do — not because it drives performance, but because it is what we stand for. We write many letters to the companies that we invest in, to gauge their feedback — this is an important part of our research process. Companies say only good things in their annual reports and meetings, so there is limited information you can glean from these formal channels. We have to challenge them on the specifics of issues like labour and tax in order to understand their level of commitment to ESG.

I think it has come a long way. For example, 10 years ago in Japan, if you talk to companies about dividend pay-out, gender diversity or board composition, you might be asked: “Where are you from?” and whether you understand Japan as a market. As of today, there is a shortage of female directors because every company is trying to diversify their board.

Same goes for China. You would probably get thrown some snarky remarks if you asked Chinese companies to explain their board composition. Today, things are changing with increasing foreign participation in the equity market and foreign investors’ influence on companies’ behaviour. Chinese companies are increasingly focused on reporting structures and remuneration and how they can demonstrate their ESG capabilities. We see this as a positive trend.

That said, we see ESG as a journey. There are no perfect companies. On the one hand, we do not want to invest in a company that is too imperfect, but at the same time we find it very rewarding to engage with companies, steer them in the right direction and have an impact on their evolution.

 
1 https://www.bloomberg.com/news/articles/2020-09-11/tesla-plans-to-start-shipping-china-built-cars-to-europe-asia

2 BHP Billiton 2020 company report

3 A sanction list is a compilation of individual sanctions that can be applied to individuals, countries, groups or companies. Sanctions list are often collated by governments and international bodies.

Source: Company data retrieved from company annual reports or other such investor reports. Financial metrics and valuations are from FactSet and Bloomberg. As at 30 June 2021 or otherwise noted.

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