Schroder Asian Total Return not expecting major stimulus from China


Over Schroder Asian Total Return’s (ATR) annual results period to 31 December 2019, it delivered a total NAV return of 15.7% (by comparison, the reference index increased by 14.6%).

Clearly, the landscape has changed monumentally since the period-end. In what is his final note to investors as chairman, David Brief, said: “The sudden outbreak of COVID-19 has completely transformed the economic environment. Investors had been expecting another year of improving economic activity, few inflationary pressures, low interest rates and ample credit. Equity markets were selling on rich valuations reflecting this benign environment. They are now facing a range of outcomes where the extent of the disruption to the global economy is unknown. We can only hope for all our sakes that the most pessimistic predictions are wide of the mark. Meanwhile, our managers are not virologists and can only continue to concentrate on the longer term fundamentals of companies and seek opportunities that may present themselves during this period of market turbulence.”

In the following sectors, ATR’s managers,Robin Parbrook, Lee King Fuei, offer views on some macro themes.

China outlook

“Our views on the China economy are, broadly speaking, for more of the same (assuming the covid-19 impact is limited). We do not see the economy accelerating and expect no major stimulus measures. This is based on the assumption that the People’s Bank of China (PBOC) keeps the upper hand and continues to work on dealing with the excesses of the past – the huge credit bubble and subsequent bad debts created by the monetary largesse following the global financial crisis (GFC).

China now appears to have contained the credit bubble and credit is growing at a more sustainable level. To give credit to the authorities, they have also started to deal with bankrupt banks and bad debts, and we are also seeing some defaults, as well as smaller bad banks being merged with larger banks. In our view this process is likely to be gradual and ongoing. While we would, perhaps, prefer a shorter, sharper shock (which might throw up volatility and opportunities), this is clearly not the way of the world in China, or elsewhere, these days. The PBOC clearly wants to deal with the mess gradually without risking panic, deposit flight, and a potential capital account and/or currency crisis. With the better banks likely to remain part of the solution, and interest rates likely to stay very low as the workout continues, we continue to avoid Chinese financials despite their apparent low valuations.

So, what does this mean for the Chinese economy and profitability? Deleveraging and excessive debt levels are disinflationary (i.e. lowering inflation) and this, combined with ageing demographics and current trends in industrial disruption (which we believe are also disinflationary), are likely to mean that growth in China will slow further. We see no reason to expect a pick-up in growth over the medium term and, despite the optimism in the stock market, we do not expect to see a rapid improvement in profitability; instead, we expect the trend in chart 5 (of the annual report document) to continue, albeit with a material variation across sectors in China.

Why then is about half the portfolio still in China stocks? There are some structural trends in China which we think are very supportive of growth; as a result, while old China – the banking, property, heavy industrial, oil, and cyclical sectors – may struggle, new China can still grow. While we are often critical of the Chinese authorities, sometimes command economies can quickly get good outcomes. The education system has rapidly improved over the last 20 years – whether measured by university rankings or the numbers of well-qualified graduates (Chart 6). A smaller but better educated and hungry workforce should mean productivity growth continues and entrepreneurship remains strong in China.

This, when combined with infrastructure that is superefficient and a rapid move to a more efficient, mobile-based economy, provides a further boost to productivity growth in China in both the industrial and service sectors. On our trips to China, we continue to be amazed by how rapidly key parts of the economy are progressing – large Chinese cities look and feel much more like first world cities than a typical city in a middle income Asian country.

The other facet of China we continue to be surprised by is the upgrading of product quality in the industrial and service sectors. China now spends as much as the Eurozone on research and development  and is increasingly a leader in many technologies; the days of China just being the low-cost factory of the world are passing. We believe Chinese companies to be key players/leaders in areas such as telecoms infrastructure, electric vehicles, white goods, electronic products, renewable power, internet gaming, and e-commerce (where Amazon is rapidly losing out in most Asian markets to competitors backed by Alibaba and Tencent). Our focus within the portfolio is, therefore, not to fixate on Chinese growth and politics but to focus on the major structural changes and the companies that are likely to benefit from this.”

Why we have little exposure to ASEAN and India

“Despite the main stock markets in ASEAN – Malaysia, Thailand, Indonesia, and the Philippines – posting relatively poor performance over the last 12 months, the portfolio continues to have effectively zero exposure to ASEAN (except for Singapore). The portfolio also has only 6% exposure to India as we struggle to justify the high valuations that Indian blue chip stocks trade on. 

The more we look at ASEAN, the more we believe the region is stuck in a classic middle-income trap. Measures of corruption and the ease of doing business remain poor across ASEAN and India (see Chart 8). Politics appears to be deteriorating, with vested interests and questionable elements increasingly prevalent in Thailand, Indonesia and the Philippines. Populism in ASEAN is on the rise, as in much of the world. As shown in Chart 9, the rule of commercial law, whether it be the ease of paying taxes or enforcing property rights, is poor in much of ASEAN (especially the Philippines and Indonesia); India however comes right at the bottom of the heap, particularly in terms of the ease of paying taxes.

The consequences are disappointing investment rates, poor productivity growth and sluggish economic growth (Chart 10 on page 15 of the 2019 annual report).

Our conclusion, therefore, is that, without change, the middle-income ASEAN countries and India will continue to experience disappointing growth and will end up in middle income traps similar to those of much of Latin America. The current sluggishness of many Asian economies is in our view primarily due to structural factors, not cyclical issues.

What does this mean for ASEAN stock markets? Given that most markets have been weak, are these issues at least partly reflected in prices? We are not convinced. Markets in ASEAN are heavily weighted towards banks, property and energy stocks and have almost no exposure to new economy or growth stocks such as technology and internet stocks, that is, the disruptors. Given the subdued growth outlook, and the structurally poor positioning of many companies to disruption and technological change, we find ASEAN markets expensive. We are not saying that we will not invest in ASEAN – there are some very well run companies there – but we need stock prices to reflect the more challenging domestic outlook.

India raises more debate. Ignoring the increasingly questionable ‘edge’ to Mr Modi’s policies, we would accept that he has undertaken some sensible policy initiatives and that India is at a different, and earlier, stage of development to ASEAN. The country should, therefore, be able to produce reasonable growth. 

We are not sure if the weakness in the economy is all cyclical (given the problems in the banking system) or partly structural. The consensus, especially among the Indian stockbroking community, is it is primarily cyclical and we will see a strong rebound this year. We are less convinced – playing nationalist cards and controlling the press does not engender business confidence – and it is clear that, while the Prime Minister may be doing some things right (increasing infrastructure spending, cutting taxes and reducing red tape), he has not addressed many of the key issues to create a vibrant economy.

The market, however, has made decision-making easier. India is the most expensive market in Asia despite the challenging backdrop and the deterioration in returns on equity. Profits have, in the main, consistently disappointed over the last five years and we see little prospect of a sustained turnaround. Unless we see a significant correction in our favoured bluechip stocks, exposure to India is likely to remain below 10%.”

Value stocks, internet stocks and disruption

“Prior to the covid-19 pandemic the biggest point of debate among the Asian investors at Schroders was whether 2020 would be the year when value investing finally came back after a decade of underperformance?

We do not expect the trends around disruption to reverse; indeed, we think quite the opposite in many areas of Asia, particularly finance and retail, where we forecast an acceleration in disruptive trends. Hence, we worry much of the value universe is a ‘trap’. In particular, we are cautious on traditional automobile companies in Asia. When we visit them, the perception remains that car ownership will follow historic trends (Chart 14 on page 17 of the 2019 annual report) despite evidence to the contrary and dreadful traffic jams. We would not be surprised if we are close to peak car ownership globally. Also, we struggle to see how most of the manufacturers will make money from electric vehicles and we expect margins on traditional internal combustion engine cars to remain under severe pressure. This is a sector we continue to avoid.

Asian banks are more interesting. Yields are attractive and the better banks are trying to adapt and roll out digital banks while addressing legacy cost issues. We have some exposure to banks in India (namely, the best private sector banks) and Singapore (which will benefit from Hong Kong’s woes); however, in general, we think banking in Asia will be a tough place. We expect margins to remain under pressure as interest rates stay low and digital banks take market share Consumers are perhaps more open and trusting of digital banks than incumbents think). In much of emerging Asia, we think consumers who are often unbanked will skip directly to digital banks, foregoing traditional banking which often offers a poor legacy service. Therefore, we are not giving up on traditional banks but seemingly cheap valuations cannot be the only criteria to own them – they also need a niche and the ability to adapt. Well-funded digital banks and fintech start-ups may not make much money but they have the potential to be very disruptive.

Does this mean the portfolio is just full of ‘sexy’ internet stocks? Definitely not, as it is becoming clear that not all internet stocks are winners. Some internet stocks – such as Uber, Trip Advisor and WeWork) have not yet seen the benefits of scale drop to the bottom line.

Perhaps this is not surprising; as Chart 16 says, “did travel agents and taxis ever make great returns?” Could low barrier to- entry industries in the bricks-and-mortar world remain low barrier to entry in the internet universe? This means we want to focus on internet stocks that can get scale and high user stickiness. For the moment, the company is sticking with its core positions in Tencent Holdings, whose social media and gaming platforms have high, and sticky, market shares and, like terrestrial TV in the old days, being the industry leader, garners all the revenue share; and Alibaba which has done well, and is well positioned given its stakes in key growth assets such as Alibaba Web Services (in cloud computing) and Ant Financial.”

Where do we see the best investment opportunities in the region?

“There is a mix of stocks using their comparative advantages to gain market share – stocks such as Resmed, one of the world’s leading sleep apnea companies that has used new technologies to improve product effectiveness and grow revenues. Another example is Techtronics, a key holding for many years, which has benefited from rapid improvements in motor, and particularly battery technology, enabling the company to hugely expand its product range and the quality of its power tools. Techtronics’ latest battery advances have enabled the company to move into the heavy industrial segment, introducing battery-power saws, jackhammers and pile drivers which can replace dirty, unreliable petrol tools. A visit to the company’s main R&D and manufacturing hub in Guangdong is always one of the year’s most insightful visits.

Other areas of focus are Asian companies with strong entrenched niches in areas of growth. These includes companies such as Chroma ATE, which has a strong niche in specialised semiconductor inspection and testing equipment. It should benefit from the capital equipment upgrade required for 5G chip fabrication, as well as higher capital expenditure as China tries to develop its semiconductor industry. In China, we like companies such as Wuxi Biologics which has proved it can be a global leader in a very high barrier-to-entry, high-growth industry (Chart 20, page 21 of the 2019 annual report). With Chinese pharmaceutical companies massively increasing R&D spending, we think the biologics industry will grow rapidly.

We expect Wuxi Biologics to be the partner of choice in China and one of the three largest global players in biologics outsourcing.

The portfolio’s other focus is stocks that play off domestic demand growth in Asia. This primarily revolves around domestic demand and upgrading in China. As highlighted in the China section earlier, we are confident the Chinese economy can continue to grow at a modest rate. We expect much of this to come from productivity gains, which should fuel consumer wealth growth via salary gains. We see recent structural trends continuing so have kept the long-term holdings in stocks such as Midea (which operates in the white goods industry), Ping An Insurance and AIA (health insurance and savings plans), Galaxy Entertainment (Macau gaming), and TAL Education (tutoring and online education).

Holdings in the growth areas of the Company are balanced by more ‘value’-based stocks, and stocks where we anticipate the bulk of returns will come from dividends (assuming covid-19’s impact on corporate cash flows is not prolonged). This includes the two remaining Hong Kong-listed property companies – Hang Lung and Swire Properties. Both are trading close to their all-time low discounts to NAV and offer attractive yields. The stocks are deeply out of favour due to worries about their Hong Kong retail exposure. We think the market is missing the fact that both have assets in China that are doing very well; in Hang Lung’s case, its properties there are now over half of NAV. Moreover, for Swire Properties, the key Hong Kong office portfolio is proving resilient, particularly the new non-central business district development in Island East.

Governance, in particular, has always been at the heart of our research process: in Asia, we are nearly always minority investors, either to governments or founding families, and the protection of minority investors’ rights in most countries is poor.

Environmental factors, and the sustainability of business models have also long been considered in our investment thinking and are now getting increasing prominence, particularly as we expect political and policy pressure on emissions standards to ratchet up in Asia. The portfolio has never had much exposure to carbon-intensive industries and given rising risks of an even greater backlash, we are unlikely to invest in them. However, the company is not an ESG fund so we do not have specific exclusions to sectors such as oil & gas and mining.”

ATR: Schroder Asian Total Return not expecting major stimulus from China

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