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Aberdeen Asian Income benefits from tech and Chinese consumption

AAIF

Aberdeen Asian Income (AAIF) has announced its annual results for the year ended 31 December 2019, during which it benefited from exposure to tech companies and businesses that rely on Chinese consumption growth. During 2019, AAIF provided an NAV total return of 10.5%, which was broadly in line with the MSCI All Countries Asia Pacific ex Japan High Dividend Yield Index’s 10.6% gain over the same period, but behind the 14.9% return on the MSCI All Countries Asia Pacific ex Japan Index. The share price rose by 14.2%, on a total return basis to 214.0p, reflecting a narrowing of the discount over the period. As noted above, the best performing stocks were a combination of technology companies and businesses that rely on Chinese consumption growth, while banking stocks have been the worst performers. The investment manager’s report is provided as a Q&A, which has been reproduced below.

Q: How did Aberdeen Asian Income Fund perform in 2019?

The Company returned a positive 10.5% in Sterling NAV terms (total returns) over the year coupled with a dividend yield of 4.3%. As a fellow investor in the Company, this return was particularly pleasing during a time when markets were driven by rising risk appetite on hopes of softening trade tensions and stimulus measures. Although our quality and income-focused investment style was not in favour last year, the portfolio holdings were able to capture some of the growth rally while maintaining an attractive payout for shareholders. The Company has declared an 11th consecutive year of dividend increase, which has been wholly paid out of the dividend collected from the underlying stocks. The higher return comes despite the British pound strengthening against Asian currencies towards the end of the year as fears of a hard Brexit receded.

Q: Which stocks were the top contributors to performance?

Our top five stocks in 2019 were a combination of technology companies and businesses that rely on Chinese consumption growth.

The Asian technology sector has a long tail of companies and we have been able to add value by picking the industry leaders which can outperform over the business cycle thanks to their scale advantages. Taiwan-based TSMC is the world’s largest foundry, producing the raw material that feeds into the memory chip industry where Samsung Electronics enjoys the lion’s share of the global market. Thanks to continued investments to stay at the forefront of new technology, both companies generate strong free cash flows and boast significant cash piles which are supportive of shareholder distributions. Looking forward, we expect both TSMC and Samsung Electronics to benefit from demand growth coming from the roll-out of 5G networks globally, artificial intelligence and cloud computing.

Although China’s growth has moderated from prior levels, the government’s effort to prop up the economy provided downside protection to equities. Yum China, Rio Tinto and China Resources Land were all beneficiaries of Chinese consumption, providing exposure across industrial production and consumer spending on the mainland. As you can see, not all of these companies are listed on the Chinese stock exchange but their share prices are nonetheless driven by the health of the Chinese economy.  As volatility looks set to persist into 2020 with subsequent phases of the trade agreement to be hammered out and consumers curtailed by Covid-19, we will continue to monitor the markets and make use of any valuation opportunities that uncertainty throws up for the patient investor.

Q: Which stocks performed the worst?

As central banks across Asia acted alongside global peers to ease monetary policy and support domestic growth, the lower interest-rate environment reduced profit margins for the banking sector. This was particularly true for the international banks that had to reprice loans at a lower level and manage a reduction in trade flows across the region. Both HSBC and Singapore’s OCBC are in the top 10 largest positions within the portfolio and have been detractors over the year. With well-capitalised balance sheets, both banks have been among the top dividend payers for the Company historically.  Unfortunately, the banking sector has been particularly affected by the Covid-19 pandemic as one of the key conduits of government policy to the real economy. We have seen regulatory intervention on banks’ dividend decisions in the UK and the US, and similar discussions were underway in Australia at the time of writing. The temporary dividend holiday enforced on UK banks is very different to a dividend cut driven by financial distress, overleveraged balance sheets or poor quality management.

LG Chem shares performed below our expectations as the company implemented protective measures to counter and prevent future safety issues on its large-scale energy storage batteries. This is an important step ahead of its overseas expansion plans to benefit from the growing regulatory trend for alternative energy sources that require storage solutions. Furthermore, we believe that electric vehicle production is fast approaching a tipping point that  bodes well for LG Chem’s EV batteries business, which is used by global car manufacturers including GM, Ford and Volkswagen.

Elsewhere, we have been reducing our position in Giordano throughout the year as we believe the dividend yield will not be sustainable against the backdrop of a challenging Hong Kong retail environment. As indicated by the Chairman in his statement, we have also prudently impaired our holding in G3 Exploration bonds to reflect the complex nature of the sales process required to obtain a fair value for the underlying coalbed methane gas assets. We are working with the joint provisional liquidators and other institutional investors to recover the fullest possible value for these producing assets.

Q: How do we pick stocks for the portfolio?

Our investment philosophy is to find good quality companies that offer both capital growth and an attractive dividend story over the long term. We have a team of more than 40 analysts based on the ground across Asia meeting companies and uncovering often-mispriced opportunities. Our in-house investment process based on fundamental analysis enables us to identify businesses that are easy to understand, with a clear earnings growth trajectory that underpins the sustainability of their dividends. Our holdings are typically industry leaders with strong balance sheets and a focus on profitability that stems from their competitive advantage on factors including, but not limited to, costs, brands, distribution, supply chain or knowhow. Through this bottom-up stock selection process, we have constructed a diversified portfolio that shows lower gearing and higher returns compared to the Asian benchmark, whilst still providing exposure to longer term growth trends.

For example, we identified electric vehicles as a critical component of the global shift away from fossil fueled internal combustion engines as the predominant driver of transportation. As electric vehicles were still only a small proportion of vehicle fleet production for the large OEMs, we began to look further up the supply chain to find key component suppliers which would be core to the electrification of transport globally. Two years ago we initiated a position in LG Chem, a Korean company with a cash cow chemicals business that had steadily invested in large battery technology to be a one of the leaders in batteries for power storage and electric vehicles globally. Our due diligence on the company included discussions around LG Chem’s Environmental, Social and Governance (ESG) frameworks and its efforts over time to advocate international environmental and safety standards within its own operations as well as to raise standards through its supply chain. At the time of writing, LG Chem is investigating the cause of a gas leak at its subsidiary plant in India and the remedial measures necessary with all stakeholders, which includes the local community. LG Chem’s actions and communication efforts on the social and environmental impact have been quick and open, and we are in active engagement with the company.

Our presence in the region for over 25 years has enabled us to build a cumulative understanding of corporate management in Asia. Over this time we have developed and enhanced our ESG framework to reflect emerging themes that impact our holdings on a financial basis.

Q: What have been the most significant portfolio changes in 2019?

Australia and Singapore are the highest dividend paying markets, which explains why we have chosen to have our highest exposures to these markets. However, we are increasingly finding new companies in faster growth countries and sectors which are improving their shareholder returns policies and offering attractive total returns. A natural result has been to reduce our positions in Australia and Singapore in order to fund these new ideas. We sold down our Australian banks holdings following a strong first half share-price performance as valuations looked stretched heading into a lower rate environment. We also exited Hong Leong Finance, a mid-sized bank in Singapore, given that the fund already owns the three large Singapore banks that offer better returns and higher dividend yields.

We also initiated Ascendas India Trust, which owns a portfolio of business parks and logistics properties across India. The Trust itself is listed in Singapore which offers cheaper financing for property transactions and better disclosures for investors. Rental growth is well supported as its quality assets have attracted a diversified range of tenants with an end-customer skew towards IT services – a sector that continues to generate attractive growth and employment opportunities. This provides a good dividend yield for shareholders as well as opportunity for further capital appreciation alongside Acendas India Trust’s property pipeline. We believe there is further mileage over the longer term from their expansion into the modern warehouse sector, property acquisitions and positive rental reversions, which is supportive of shareholder returns in the future.

Q: Why is everyone talking about ESG?

Growing global concerns about ESG issues have  propelled ESG from the fringes of the asset management industry to its mainstream. As long-term investors, we have long held the belief that ESG information and analysis should be explicitly embedded into our due diligence and portfolio construction process. In our opinion, ESG assessment and integration enhances returns as corporates with robust ESG practices tend to enjoy long term financial benefits. Informed and constructive engagement helps foster better corporate practices, protecting and enhancing the value of your Company’s investments.

We actively engage with your Company’s holdings to share and encourage better governance practices. This includes discussions around AGM agenda items as we instruct all proxy votes across all holdings within the portfolio as well as targeted engagements on specific issues. Last year, for example,  we spoke to the management of Yum China, which operates restaurant chains across China, about various supply chain issues around food and packaging quality. The company has since blacklisted suppliers known to be engaged in illegal deforestation and remains receptive to shareholder feedback that promotes further ESG improvements.

Q: What is the outlook for dividends in Asia?

The sharp rally in growth stocks over the past year has resulted in quality and income stocks underperforming the broader market. This means that good quality dividend-paying companies are trading at relatively attractive levels, providing us with an opportunity to add to the portfolio at compelling valuations.

However, no one could have prepared for the Covid-19 pandemic and its far reaching repercussions across the world. As manufacturing closures and sweeping lock down measures feed through to lower revenues and profits, companies are facing the difficult decision of whether to pay or not pay dividends. In normal circumstances, a dividend cut is considered a negative signal that reflects poorly on capital management and treatment of minority shareholders. However, we are far from normal today and the decision to not pay dividends can help pay wages and protect the balance sheet from what could still be a long and arduous journey.

We have already seen a reduction in travel and leisure activities and if the spread of Covid-19 is not contained, companies could take a more prudent approach to new capital expenditures and increasingly hoard cash on the balance sheet which could have a further negative effect on growth and dividends. Global mobility restrictions are forcing companies to postpone Annual General Meetings (AGMs) to comply with quarantine laws. AGMs are where shareholders vote to approve dividends so this is having a knock on effect which will shift dividend collection in 2020 towards the latter end of the year.

Although nobody can accurately predict when the world will return to normal, what remains consistent is our investment philosophy that targets sustainable growth, both in capital and in dividends, over the long term. Our holdings are cash-generative businesses with exposure to structural growth trends and strong financial positions that give us confidence that they can stay resilient if conditions deteriorate.

[QD comment: No major surprises here. 2019 offered a number of challenges but Asian equities generally performed well, benefiting from an easing of China-US trade tensions, particularly towards the end of the year.]

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