The Japan equity market underwent significant volatility in the first quarter due to the coronavirus pandemic and concerns about its impact on the global economy. The sell-off was indiscriminate and across all sectors, with little differentiation between the higher quality, well-managed companies that we own and their less attractive peers. Although it was frustrating to see the widespread market carnage and the impact on our short-term performance, the panic-selling created an opportunity for us to add to our conviction stocks at attractive valuations. Since then, some of our holdings have subsequently rebounded (although it is too early to call an end to the coronavirus market panic).

After every crisis in Japan’s history – including the Global Financial Crisis (GFC) in 2008 and the Tōhoku earthquake and tsunami in 2011 – the behaviours of consumers and corporations fundamentally changed. In light of the current global health crisis, we tried to envision any positive developments that might arise from the situation and sought to identify companies that could benefit.

For example, the percentage of workers equipped with remote-working capabilities in Japan is currently below 20%1. We believe this will inevitably rise, leading to higher expenditure on technology-related goods and services. As we adapt to the new norms of social distancing measures and travel restrictions, the use of e-commerce, digital payments, telemedicine, cloud services, virtual and online entertainment, and online education platforms have accelerated – and are likely here to stay.

In the midst of such uncertainty, we believe our Japan portfolio is well-positioned. Our investment approach is inherently conservative and more than 80% of our portfolio companies have a secure net cash position. In a world awash in high levels of debt, we believe these companies should offer a reasonable amount of downside protection.

A large portion of the portfolio is invested in purely domestic companies with higher visibility with regards to demand. This includes drugstores and discount food retailers offering daily necessities, software and technology solutions providers operating a recurring revenue model, and online platforms in e-commerce and digital payments. We believe they should remain resilient in the event of a global recession.

Among our portfolio holdings with high overseas exposure, we have invested in leading Asian consumer franchises, global medical equipment manufacturers, factory automation companies, and other technology leaders. They are all high-quality companies with dominant market share in their respective niche industries and reinforced by solid balance sheets.

Despite shorter-term disruptions, we remain confident that our portfolio companies can bounce back from adversity and become even stronger after the crisis.

Adding to high conviction companies

Earlier this year and in anticipation of a sharp slowdown, we evaluated our portfolio holdings, looking for companies that we believe should remain relatively defensive. We took advantage of the market volatility to consolidate the portfolio into higher conviction ideas and purchase companies on our watch list that had become more reasonably valued.

Among the companies we added to were Welcia, Japan’s largest drugstore operator, and MonotaRO, Japan’s largest maintenance, repair and operations (MRO) e-commerce platform. Both companies proved to be highly defensive and benefited from increased demand for hygiene and healthcare products amid coronavirus concerns. Notwithstanding the temporary sales boost, we believe the long-term investment case for both companies – as the leading players in their respective industries – remains intact.

Welcia’s business model is bearing fruit and its performance is starting to diverge from competitors. Welcia offers one-stop solutions for consumers, with a particular focus on dispensary/ pharmacy services (a sizeable market worth JPY7.5 trillion2). While its drugstore peers dismissed the idea of dispensing prescriptions due to high initial costs, Welcia made upfront investments and has become one of the largest dispensaries in the country.

Although Welcia’s market share of the prescription drug market by revenue is still 2%, it has only recently started to benefit from the change in consumer behaviour and the increased use of dispensaries near their homes. This trend is in accordance with government policies to promote the use of community-based healthcare (as opposed to hospitals and clinics); therefore, we believe there is still room to grow. Around 7% of the JPY6.5 trillion3 drugstore market is prescription sales, of which Welcia already takes a 31% share. We believe Welcia should continue to gain share in a consolidating market, due to its strong brand and established infrastructure.

At MonotaRO, we believe there is still a long runway of growth ahead, as it continues to gain market share in the fragmented MRO industry. Compared to 30% e-commerce penetration in the overall business-to-business (B2B) market, e-commerce penetration in the MRO segment is only 10%4. We believe the pandemic will likely accelerate the shift towards online purchases, particularly when factoring in economies of scale and the benefit of lower procurement costs. Amazon has proven to be less of a competitive threat than previously anticipated, as MonotaRO holds a stronger presence in the B2B sector.

We also topped up our position in OBIC, Japan’s largest enterprise resource planning (ERP) systems provider, which we wrote about in detail in a previous note. OBIC has been resilient in the current market environment and has performed steadily in previous downturns. Operating profit has grown consistently for the last 22 years, including the GFC and the Tōhoku earthquake periods.

Recurring revenue businesses have continued to grow, with cloud services and on-premises support accounting for 39% of sales and 48% of operating profit. With more people working from home, we expect cloud-based services to become an increasingly larger business.

Similarly, we took advantage of market weakness to add to Benefit One, which provides membership benefits (such as travel management and healthcare) to corporate clients. The majority of Benefit One’s revenue is recurring and has grown by around 11% a year for the last five years.

Despite the short-term sell-off, we believe the longer-term investment case for Benefit One remains solid and the company could become much bigger in five years’ time. While Japanese companies and government entities have traditionally provided welfare services for their employees in-house, Benefit One has become a major outsourced supplier of value-add services to the employee, while also saving costs for the employer. In addition to fringe benefits, the CEO has communicated his vision for newer platform businesses, such as payment settlements and healthcare.

We also added to GMO Payment Gateway, the largest online payment processing company in Japan. GMO Payment’s driven and capable management team is headed by President Mr Ainoura and Vice President Mr Muramatsu, former CEOs of Card Call Service and Payment One – the two companies that merged 14 years ago to form GMO Payment. As a growth-oriented company focused on sustainable growth over the medium to long term, the management are committed to delivering 25% compounded annual profit growth over the next five years.

One of the key risks for GMO Payment is if its biggest clients start to process payments in-house after reaching a certain scale. This was the main reason behind GMO Payment’s revenue slowdown in 2019, as companies like Rakuten and Mercari shifted some of the services previously provided by GMO to an internal division.

However, we believe there is still plenty of room for GMO Payment to grow, as e-commerce penetration in Japan is only 7%5 of retail sales. With more offline retailers and consumer brand companies launching e-commerce portals, we believe GMO Payment is well-positioned to capture the market, due to its extensive experience and track record in the payments industry.

The emergence of cashless payment transactions could be another growth driver for GMO Payment. Japan’s cashless payment penetration is relatively low at 18%5 compared to countries such as South Korea (95%), the UK (67%) and the US (44%). Recent policies, such as merchant subsidies and consumer rewards programs (which have been primary catalysts in other nations), are expected to accelerate the pace of transition. This could open doors to larger addressable markets, such as the offline cashless payment (JPY300 trillion) and the public tax/ utilities market (JPY100 trillion).

New positions

As bottom-up investors, we do not rely on benchmark indices or sectors to construct portfolios. Investment ideas are generated by meetings with company management, followed by detailed fundamental research and analysis on companies we might want to invest in. The recent market volatility allowed us to buy high quality stocks on our watch list that we had followed for some time, but were too expensively valued in the past.

Among the new positions was Hoya, a leading manufacturer of lenses and related optical products. Having observed its performance over time, we increasingly appreciated its corporate philosophy of being a “big fish in a small pond” and its strong focus on corporate governance and shareholder returns. Unusual in a Japan context, Hoya has a strong profit-centric culture and its track record has been consistently good.

Over the past 10 years, total shareholder return was 78% of free cash flow after acquisitions (Hoya’s policy is to return all excess free cash flow to shareholders after budgeting for capital expenditures and acquisitions), or 73% as a proportion of net income. On top of that, Hoya has JPY290 billion net cash on its balance sheet (or 9% of market cap). The board believes this is too high, which means we should probably expect to see share buybacks in future.

Hoya’s business can be categorised into two major divisions: Life Care and Information Technology (IT). In the IT segment, which focuses on glass-related products used in the technology manufacturing process, Hoya has developed a near monopoly in certain materials, such as Extreme Ultraviolet (EUV) mask blanks used in the production of semiconductors, and glass substrates used in Hard Disk Drives (HDD). Hoya generates 40-50% operating profit margin (OPM) on these products, as there is virtually no competition. As semiconductor leaders Taiwan Semiconductor (TSMC) and Samsung start to migrate their chip production to more advanced and smaller nodes, we believe that average selling prices (ASPs) for Hoya’s EUV products should rise. Hoya expects to double the capacity of both products over the next few years.

We also purchased Olympus, the largest medical equipment company in Japan with 70% global market share in gastrointestinal endoscopes6. Despite its strong franchise, we have been concerned in the past with its complacent culture and low profitability. However, we believe there are positive changes underway: Olympus has replaced the majority of its senior leadership team with externally-hired managers, which should bring fresh new perspectives, as well as the ability to make drastic changes where it is needed.

The executive management team now consists of five key people in CxO7 leadership positions, thus streamlining the decision-making process. In addition, the core Medical business has been restructured and simplified from five divisions into two, with Endoscopic Solutions managed from Japan and Therapeutic Solutions to be managed from the US.

After the reorganisation, Olympus’ strategy has refocused on strengthening its leadership in gastrointestinal endoscopes. It is investing in China, where the overall penetration of gastrointestinal endoscopy is low, by increasing its training programs to resolve the bottleneck of insufficiently qualified doctors (China has only 22 endoscopists per million people, compared to 250 per million in Japan8). Chinese government policies to promote endoscopic diagnosis support its penetration into mid-tier hospitals, which should increase demand for

Olympus’ products exponentially.

In addition, Olympus has committed to controlling costs in order to improve margins and profitability. The majority of Olympus’ consolidated profit comes from its Endoscopic Solutions segment, which generates around 29% OPM. However, Olympus’ consolidated OPM is only 9% - much lower than global peers (Medtronic, Stryker and Johnson & Johnson all generate OPM above 20%). Olympus aims to improve its OPM to 20% by fiscal year (FY) 2023. We continue to monitor the progress, as we believe that there could be considerable upside if Olympus can execute its transformation plan. While it is early days and there is still much to be done, we believe the direction of travel is encouraging. The position is a relatively modest one, though we have been adding on weakness.

What we sold and lessons learned

We sold Relo Group and BeNEXT to make room in the portfolio for the companies mentioned above. Both companies had been pursuing lower quality growth, in our view, with overseas acquisitions diluting earnings and distracting management from the main local business.

Relo Group is a leading corporate services company, providing leased housing, global relocation services and fringe benefits. We initially bought Relo for its recurring revenue model, which offers stable earnings growth and downside protection during economic downturns, as demonstrated during the GFC.

However, we started to question the investment case amid signs that the company had bigger ambitions for its global relocation services. In particular, Relo’s large overseas acquisition in 2019 of a global relocation business caught our eye. The purchase price was expensive at 139x price-to-earnings ratio (PER) and it led to a spike in Relo’s financial leverage. Like many Japanese companies who remain passive investors of their overseas purchases, Relo’s culture did not seem globally-savvy enough to transform the acquired business.

As such, we had been reducing our position in Relo since last year, in favour of Benefit One. As the coronavirus started to spread, our portfolio review led us to completely sell out of Relo as we considered the impact of a recession on its global relocation business – and, given that better-quality companies could be purchased at bargain prices amid the market sell-off.

Similarly, BeNEXT’s overseas acquisitions have been a major concern on profitability. We initially believed that BeNEXT, which primarily dispatches engineers in Japan (88% of operating profit), should benefit from increasing labour shortages in this particular sector.

In hindsight, we should have exited this position when we noticed BeNEXT’s longer-term ambitions on making overseas acquisitions. Instead, we held on to it because of its cheap relative valuation, even though we increasingly had concerns about the quality of its business. Similar to Relo, Covid-19 aggravated the risks of BeNEXT’s overseas exposure (Nissan Motor in the UK) and its manufacturing staff dispatching business, both of which are macro-sensitive.

Among engineering dispatch companies, we have greater conviction in TechnoPro, with its longer-term mindset (the company trains its engineers in more advanced skills) and its higher exposure to IT engineers (50% in headcount terms, compared to BeNEXT’s 20% mix), where demand has been resilient and growing rapidly.

Both Relo Group and BeNEXT seemed to be cheaper than peers, which initially gave us comfort as lower valuations provide a greater ‘margin of safety’. However, as we subsequently realised, optically-cheap companies do not necessarily protect capital.

Most investors look at companies in a much too simplistic way: growth vs value. However, in reality, all investors should be looking for value; that is, to buy companies where the market value is below intrinsic value. But, a lower price-to-earnings ratio (PER) or price-to-book (P/B) valuation, based on 12-month earnings or book value, does not mean that a company is cheap, nor that there is more value to realise compared to companies at a higher PER or P/B. The issue with these ratios is that they cannot capture a company’s long-term profit/cash flow growth, nor its resilience during economic recessions.

We look at valuations from a more holistic perspective and believe that quality companies can justifiably command a premium – particularly those that have these three qualities concurrently: 1) high return on invested capital; 2) strong and sustainable growth; and 3) high earnings visibility, supported by a strong franchise and management team.

Our portfolio holdings generate 37% weighted average ROIC, indicating that these companies have higher profits that can either be reinvested for long-term growth or be returned to shareholders. We also believe companies with a high-calibre franchise or management team warrant a lower discount rate (cost of capital) because earnings visibility is higher. As such, the best-performing companies in the current down-market have typically had higher valuations relative to the market – which is what we have experienced in our Japan portfolio.

Interestingly, for some of our high-conviction holdings, it is difficult to pinpoint a single numerical value based on today’s business. These companies evolve over time, as the management invent new business lines to grow earnings. For example, M3 started by offering pharmaceutical marketing services (information on drugs that is emailed to doctors). However, 20 years later, its services include contract research, job placement and medical records software. The pharmaceutical marketing segment now accounts for only 16% of M3’s consolidated sales.

As part of our investment approach, we are disciplined in conducting regular fair market valuation reviews; however, our conviction in a company’s franchise, management and sustainability of growth plays an equally important role in our holistic investment decision-making process.

Performance review

The top contributors to performance year-to-date are the same companies that we had added to during the sell-off – MonotaRO, GMO, Welcia, OBIC and M3. Though they were sold off along with the market, they subsequently rebounded, as investors realised there should be little negative fallout from the coronavirus.

Out of the companies that performed poorly – BeNEXT, Fast Retailing, Recruit Holdings, SMS and Workman – we sold BeNEXT, as mentioned earlier, but we remain long-term owners of the rest and have been adding on weakness. Workman and Fast Retailing (UNIQLO) specialise in selling quality, affordable clothing. They were highly defensive during previous economic recessions as their stores attracted price-conscious customers. However, Covid-19 has particularly affected discretionary retailers due to a weaker consumer appetite and widespread store closures. Even so, while these short-term disruptions undoubtedly affect earnings, they are temporary in nature and, in our view, do not affect the long-term investment case.

We believe the Workman Plus brand should continue to strengthen, as affordable, functional apparel continues to grow in popularity among deflationary-minded Japanese consumers.

Fast Retailing, led by a passionate and visionary founder, has a strong franchise supported by solid brand equity and a decent growth outlook both domestically and overseas. Both companies generate the highest ROIC among industry peers – Workman’s ROIC is 34%, while Fast Retailing yields 38% ROIC, indicating a strong foundation for sustainable growth.

Despite being recruitment-related businesses, Recruit Holdings and SMS proved to be resilient in previous economic downturns relative to competitors. SMS only hires nurses and careworkers – roles that enjoy strong demand irrespective of the economic cycle, due to Japan’s ageing population and labour shortages in the care sector.

Recruit Holdings is not only a recruitment company, it also runs various online media portals – the equivalent of Yelp (online local business reviews) and Expedia (online travel agency) in Japan. The marketing media business accounts for 38% of earnings before interest, tax, depreciation and amortisation (EBITDA), online job advertising and recruitment accounts for another 38%, and the general staffing business is around 24%.

Due to Covid-19, most job interviews have been delayed or cancelled – companies do not want to host face-to-face meetings and they have been reluctant to shift the process completely online. In addition, restaurants and the travel industry were hard hit, which affected Recruit’s business as well. However, SMS and Recruit are both leading franchises operated by capable management. We believe SMS will likely remain a key beneficiary of structural labour shortages in the niche care sector; and Recruit’s asset-light model, entrepreneurial culture and track record of achieving a leading market share in its domain bodes well for future growth. As consolidation in each industry accelerates due to Covid-19, we believe stronger companies such as SMS and Recruit should increase their leadership over peers.

Last words

In the throes of a downturn, pessimism is abound, which is understandable and expected. But the Chinese word for “crisis” (危機), which consists of two letters with opposite meanings – danger and opportunity – suggests that we should look at the status quo from another perspective. Likewise, great investors in history exploited market volatility in a downturn, which ultimately generated superior returns.

We have two observations on the companies that have been resilient (so far) during Covid-19. The first type are those that have already built a dominant franchise and are best positioned in a Darwinian world, where survival of the fittest is the name of the game. The other type are those leading the disruption in their respective industries, either by innovating or helping others adopt better business processes. Regardless of the type, capable management, whether charismatic or visionary, is indispensable to creating successful companies.

It is the darkest nights that produce the brightest stars; and our findings remind us that our investment philosophy of focusing on high-quality companies with strong franchises, financials and management is for the benefit of long-term returns and in the best interest of our clients, especially during times of turmoil. As we stay true to our colours, we will continue to invest in companies that we believe can spot and grasp opportunities in the midst of a crisis.

China's real GDP growth over last 40 years

Nevertheless, companies in China are still growing – albeit some at more sustainable levels than others. Pinduoduo, a Chinese online platform which combines value-for-money goods with social e-commerce, grew revenues by 650% in 2018. Sales more than doubled in 2019. However, the company has been burning through its cash with coupons, incentives and promotions to acquire users. It also has only a short track record, having listed in 2018. We found it difficult to put a value on such a business; and with no sign of profitability in the near term, we deemed the company uninvestible.

On the other hand, TAL Education is a market leader in after-school tutoring services. In 2019, TAL’s revenues and profits grew by 49% and 64% respectively. We believe there is still considerable potential for TAL to continue to expand. Their teachers are top-tier university graduates and there is a strong research and development team on the back-end to standardise teaching materials. But, TAL has always been too expensively-valued – 3-year trough price-to-earnings (P/E) is 40x – which means there is little room for disappointment on earnings. We prefer to buy companies with a greater margin of safety, where the potential upside is sufficient compensation for the risk.

We have not invested in Pinduoduo (irrational business model) or TAL Education (too expensive). Our investment philosophy remains unchanged and we continue to focus on identifying well-managed businesses with dominant franchises and conservative balance sheets. Many companies in our China universe have become more attractively-valued amid the market volatility, although we have been surprised at how well some of them have held up.

Technology and innovation

Despite the slowdown, there are still pockets of investment opportunity to be found in China. We find similarities with the experience in Japan where, despite more than two decades of stagflation, the best companies managed to innovate and find new markets for growth. We expect high quality companies in China to do the same. We see evidence of this in the rise in research and development (R&D) expenditure, as Chinese companies move away from being “low-cost manufacturers” and start to climb the value chain.

There are now a number of market-leading companies in China with innovative products and the ability to compete globally. In 2018, China received more than 1.5 million patent applications – the highest number globally and more than the United States, Japan, Korea and Europe combined4. As China’s technology manufacturers produce higher value and more technologically-advanced products, average selling prices (ASP) have risen and margins have improved. This should contribute to more sustainable earnings growth over the long term.

We have been adding to companies that have been able to demonstrate this innovation trend. One example is Sunny Optical, which makes optical components such as camera modules and lenses. Sunny has grown its R&D expenditure by 40% CAGR5 since listing on the Hong Kong Stock Exchange in 2007. There are more than 2,000 R&D staff, whose job is to explore and enhance new technologies for cameras in smartphones (the majority of its business), automobiles (advanced driver assistance systems and autonomous or driverless vehicles), as well as newer areas such as Augmented Reality, Virtual Reality and robotics – all of which use some form of camera sensor as inputs.

Sunny’s optical design capabilities have been developed over many years and the company is one of few which can produce both camera lens sets and camera modules. They invest across the whole value chain and aim to become a fully-fledged optical systems solutions provider, including optical lens, cameras, image sensors and smart eyes.

As a result of improved product specifications, Sunny has consistently increased its market share. The company’s capex plan suggests confidence in the medium term. In addition, the broad adoption of 5G in China could provide a cyclical tailwind as smartphone sales return to growth. Camera upgrading in smartphones (higher resolution, dual-cam to tri- and quad-cam, 3D sensing, and better lens quality) is a structural growth trend, in our view, which helps to cushion Sunny’s blended product ASP against annual price declines.

However, there are many moving parts. Major uncertainties include Huawei, which accounts for around 25% of sales (there is the risk of reduced orders due to Huawei’s ban in the US6), as well as increased competition, potential for yield improvement and foreign exchange volatility – all of which could affect earnings in the near term. Reassuringly, Sunny’s track record has been outstanding among its peers in China, particularly with its focused strategy and vertical integration business model. In addition,

Sunny’s management team are young and diligent, and there is strong alignment with shareholders as 35% of the company is owned by management and ex-employees.

Expansion into new markets

Hongfa Technology is the largest relay manufacturer in China and the third-largest globally (relays are electrical switches used in a variety of products, such as automobiles, home appliances, telecommunications and industrial automation). In the past, Hongfa had enjoyed strong growth in the domestic market, driven by rising incomes and urbanisation (people were buying more cars and home appliances). However, in recent years, the volume of auto and home appliance sales has slowed due to high penetration levels and a slowing economy.

Hongfa has taken steps to expand into new product areas and grow its overseas business. Firstly, as a leading supplier of auto relays for traditional vehicles, Hongfa has leveraged its relationships with both domestic and global car manufacturers to expand into the high-voltage supply chain for electric vehicles (also called “New Energy Vehicles” – NEV). Compared to traditional auto relays, high-voltage relays for electric vehicles are around 5x more expensive, which implies much higher revenue contribution.

Since 2018, Hongfa has been the exclusive relay supplier to Volkswagen’s full electric “MEB” platform, while Daimler’s Mercedes BEV models and Tesla’s Model 3 also use Hongfa’s high-voltage relay technology. Hongfa only makes relays and related components, which means that they can respond quickly to client-specific demands and increase capacity as needed. They are especially nimble when compared to global industrial competitors where relay is only a small part of the overall business.

We believe demand for high-voltage relays is likely to accelerate as the major auto manufacturers roll out new electric vehicles in response to stricter regulations on emissions. Indeed, Hongfa expects this division to grow significantly – targeting RMB 3 billion revenue from both domestic and overseas customers by 2023.

Secondly, Hongfa has started to break into the low-voltage market, which has a much larger market potential (around 5x bigger) than the niche relay market. This is a new and still-developing business area for Hongfa. Its low-voltage product range is still small; but, they believe they are able to differentiate by offering better-quality products. We have been impressed by the strong performance-driven culture at Hongfa. Their standard defects rate is below “one ppm” (parts per million) – which is incredibly low – and they have a solid reputation of manufacturing high-precision, high-quality products.

Rising health awareness

Companies that tap into Chinese consumers’ spending behaviour form another key segment where we believe there are good investment opportunities amid a slowing economy. China’s per capita income has reached a level where people are starting to spend more on discretionary items and premium goods and services, evident in the sales breakdown of home appliances, automobiles, food and beverages, and domestic and international travel. However, consumers are becoming increasingly savvy about their choices – this is a highly competitive market and growth is likely to be bumpy.

As long-term investors, we believe that taking a bottom-up and selective approach – and carrying out detailed fundamental company research – is the best way to identify dominant franchises with long-term earnings growth potential. We have owned Vitasoy International, a plant-based food and beverages business, for many years. Vitasoy, which was established in Hong Kong in 1940 by Mr Lo Kwee-Seong, produces soy-based drinks, ready-to-drink teas and tofu food products. Having studied the health benefits of soy beans, Lo developed a fortified soymilk drink in response to the malnutrition he saw in Chinese refugees fleeing to Hong Kong to escape the civil war. By the 1960s, Vitasoy had over 25% market share of the total Hong Kong beverages market, second only to Coca Cola.

Vitasoy is still a tightly-controlled family company, although it has been professionally managed since 2008 – Larry Eisentrager, ex-Nestle and Dairy Farm, was CEO from 2008-13, followed by Roberto Giudetti, formerly Procter & Gamble and Coca Cola, from 2013 to present. Both have helped to steer the company towards significant earnings growth and improved profitability.

Vitasoy has benefitted from the increasing level of health consciousness in China and growth on the mainland has accelerated. Around two-thirds of Vitasoy’s revenue is now generated in China and it is growing at a much faster pace than the rest of the business. Its mainland China plants are operating at a 100% utility rate, as they struggle to keep up with demand. In 2018, the company announced that it would invest RMB1 billion to build a new plant in Dongguan (in Guangdong, Southern China), which should be fully operational by 2021.

Vitasoy aims to grow at more than 20% per year, which would mean growing faster than the industry. However, in a recent meeting with Giudetti, we were reassured by his comments about “making the right decisions rather than chasing growth”, which suggests that the company understands the competitive landscape and the challenges of expanding into new markets. We expect quality and sustainable growth from Vitasoy in the future.

Our investment process remains unchanged

We continue to believe that China equities should be able to deliver attractive shareholder returns over the long term. Against the backdrop of heightened market anxiety and uncertainty surrounding the coronavirus, we believe it is more important than ever to maintain a steady hand and focus on the long-term opportunities. Our portfolio holdings – high quality companies supported by fundamental growth drivers – will undoubtedly be rocked by market sentiment. However, our investment style is generally suited to these uncertain times, as “quality” tends to hold up relatively well amid volatile markets.

We continue to adhere to our long-established investment process, focusing on quality of management, franchise and financials. A key part of our investment process is meeting with management teams of the companies we own or might wish to own. We conduct around 1,600 meetings each year, of which 300-400 are in China. We have been investing in these markets since the establishment of the team in 1988 and have owned some portfolio companies for decades. We believe these long-standing relationships have provided us with a better level of access to management than we would otherwise experience.

As long-term shareholders, we look for management teams that are well-aligned with minority investors and respect all stakeholders, both in good times and bad. This is especially important in emerging markets, where corporate governance standards are still evolving. Boards are usually dominated by insiders, which can make it difficult to challenge executives or influence behaviour to achieve better outcomes.

In China, we rely on the integrity of founder-managers and their stewardship of these businesses. Many privately-owned companies are largely owned by the founders, who remain actively involved in operations and decision-making. As an example, during a recent research trip to China, we visited a zoo that the founder had built in front of the company’s office building; elsewhere, another founder had constructed an educational academy the size of a factory.

However, we do not have to own any company (or sector, or country) that does not meet our quality criteria, as we construct portfolios on a bottom-up basis and without regard to benchmark weightings. Our portfolios tend to be relatively concentrated, which allows us to focus on identifying companies with capable management teams and evidence of strong corporate governance. Once we are satisfied with management quality, we assess the quality of franchise (barriers to entry, pricing power, competitive advantages) and analyse the financials (how solid are the balance sheet, cash flow and earnings?).

Other than Governance, we are also mindful of Environmental and Social issues that make up the ESG trinity. China has introduced a number of policies to encourage a more sustainable level of growth. In cities, residential coal-power is being phased out in favour of cleaner, natural gas. Wind and solar power and “green energy” industries such as New Energy Vehicle (NEV) batteries have been boosted by subsidies and favourable government policies. Water conservation is also high on the agenda, as companies and citizens look for ways to reduce wastage. This has thrown up a number of investment opportunities (as well as challenges).

Due to China’s geographical size and large population, its economic growth can have a huge impact on the environment and climate change. As long-term, responsible investors, we view it as part of our responsibility to guide our clients’ capital towards more sustainable outcomes.


1 Source: As of 13 March 2020

2 “Helicopter money” refers to monetary expansion designed to stimulate the economy

3 Source: Reuters, January 2020 despite-easing-trade-tension-idUSKBN1ZL0EA

4 Source: World Intellectual Property Organisation

5 “CAGR” refers to compound annual growth rate

6 Source: Company reports, March 2020


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