Poor year for Scottish Oriental Smaller Companies as large India weight weighs

Scottish Oriental Smaller Companies (SST) had a poor year to 31 August 2020, delivering total NAV and market returns of -13.2% and -14.2%. In the announcement, SST notes that the MSCI AC Asia ex Japan and MSCI Asia Ex Japan Small Cap indices returned 10.9% and 7.1%, respectively. We note that at the financial year-end, India accounted for 39.4% of SST’s portfolio.

‘Large weightings in India, Indonesia, and the Philippines detract’

Vinay Agarwal and Scott McNab, SST’s managers, noted: “During the year ending 31 August 2020, Asian equity markets’ performance was strong. This strength is not fully reflected when measured in sterling, as a result of the appreciating pound. The US-China trade war had been the biggest driver of stock market performance for some time with the pattern continuing at the start of the period but the outbreak of COVID-19 in 2020 impacted stock markets significantly. Initially, only Chinese markets suffered but a strong government response prompted a swift rebound. As it became apparent that the pandemic would not be contained, global stock markets then sold off sharply in March. This selloff led to significant fiscal stimulus and money printing from developed market governments and central bankers. The resulting easy monetary conditions then led to a sharp rally in global stock markets with Asian markets also rebounding, many ending the period at a similar level to that before the pandemic and some even higher.

Growth weakened notably over the period and a global recession in 2020 is almost inevitable. Earnings forecasts for Asian companies have been cut significantly, particularly in sectors exposed to domestic consumption. Asia’s stock markets were mixed. The Chinese and Taiwanese markets rose sharply which was reflective of their respective governments’ handling of the crisis and also the performance of a few behemoth technology companies. South-East Asian stock markets performed very poorly. Indonesia, the Philippines, Singapore, Thailand and Vietnam all fell sharply. These countries’ dependence on Chinese trade and tourism was highlighted by the pandemic. The Indian stock market also underperformed. Its economy had been slowing before the pandemic took hold. A hastily introduced lockdown then led to a massive contraction in economic activity.

Small companies performed in line with the broader Asian market over the year. Within individual countries, performance was much more varied. Smaller companies in China and Taiwan were weaker than their larger counterparts whereas smaller companies in Malaysia and Korea were very strong, predominantly as a result of exceptional share price performance from a number of smaller companies in the health care sector.

SST’s investment performance over the year was poor. The biggest detractors from performance were the large weightings in India, Indonesia and the Philippines. It is mainly in these countries that we have found smaller companies we believe will be the winners in their respective markets with strong growth prospects in the long run. Unfortunately the company’s holdings in each of these countries performed in line with local stock markets which in all cases was disappointing, particularly so in Indonesia and the Philippines. We added to SST’s positions in all of these markets during the year as share prices fell to very attractive levels. By contrast, SST owns relatively few companies in China which was one of the best performing stock markets.

The biggest contributor to performance was stock selection in Taiwan with the company’s Taiwanese holdings continuing to perform strongly. We significantly reduced SST’s exposure to Taiwan during the period as this strong share price performance led to expensive valuations.”

Food and beverage holdings largely performed well

  1. “Tata Consumer Products (formerly Tata Global Beverages) benefited from pantry stocking in its core tea business in India as well as in its Tetley operations globally. Its new chief executive’s focus on gaining market share in its core Indian tea business, while also scaling up its operations across categories such as branded salt, pulses and beverages has borne fruit and the company has reported strong results during the year.
  2. Nissin Foods’ instant noodle sales also benefited from pantry stocking in both its major markets of China and Hong Kong and it raised prices for its products in China. Higher prices and strong volume growth led to an improvement in its profitability. The company has been using the tailwind of higher customer demand to launch several new products with an emphasis on premium products in China. It also improved its distribution in China, where Nissin’s business is growing faster and earns higher margins than Hong Kong.
  3. Emami Limited was impacted by the lockdown in India with its manufacturing plants and the bulk of its distribution channels closing. Its share price fell significantly as concerns over the coronavirus mounted. We had been looking closely at the company and purchased shares for Scottish Oriental after this fall. Management disclosed a sharp rebound in sales as India’s lockdown eased and its share price subsequently recovered.
  4. Sinbon Electronics reported strong operating performance with its profits rising on volume growth and an improvement in its product mix towards higher-margin segments, with the company benefiting from increased demand for cables for ventilators and other medical equipment. The share price rose much more rapidly than profits, resulting in expensive valuations. Therefore we reduced the Company’s exposure.
  5. Gujarat Gas reported strong operating performance with profits boosted by growth in its industrial gas volumes. The introduction of a new regulation in its key operating region of Morbi has led to a shift among its industrial customers towards natural gas from more polluting fuel sources such as coal. However, the natural gas regulatory authority has stated its intention to introduce competition in major markets, which could affect Gujarat Gas’ future profitability. Therefore, we sold the Company’s position.”

Max’s Group suffered greatly with all of its restaurants closed at one point

  1. “Max’s Group was severely impacted by COVID-19 with all of its restaurants closed at one point. As activity gradually normalised, initial signs of customer demand were strong. Management are using this disruption to accelerate changes including consolidation of its restaurant formats by eliminating less profitable brands, increasing supply chain efficiencies, and encouraging a shift to a franchised model which we believe will lead to a significant improvement in profitability. We added to the Company’s holding during the year. 
  2. Mahindra & Mahindra Financial Services declined as a result of the expectation that the disruption caused to the Indian economy by Covid-19 would lead to an increase in credit losses across its vehicle and housing finance businesses. We were particularly concerned about a six-month moratorium on loan repayments mandated by the Reserve bank of India. Customers may use this period of forbearance to divert their cash flows towards other uses leaving them unable to make loan repayments at the end of the loan moratorium. Therefore we sold Scottish Oriental’s position.
  3. Concepcion Industrial was badly impacted by the lockdown in the Philippines which significantly impacted sales of its refrigerators and air conditioners during its busiest quarter of the year. We remain positive about the company’s prospects and believe that the disruption to the sector will likely favour Concepcion in the long run as the impact on weaker competitors will have been even more severe. Recent months have witnessed an encouraging improvement in demand in both its consumer and commercial segments.
  4. Sarimelati Kencana saw its Pizza Hut restaurants suffer as a result of the impact of Covid-19. However, its delivery operations have thrived. The company has renegotiated terms with its landlords and Yum! Brands, owner of Pizza Hut, has accepted a reduction in royalty payments all of which has mitigated the impact of Covid-19 for the company. We have been very impressed at management’s handling of this crisis. We added to Scottish Oriental’s position during the year.
  5. Haw Par owns a large stake in Singapore’s UOB Group, the value of which fell in the market selloff. In addition, sales of Haw Par’s Tiger Balm fell sharply during the period as travel outlets such as duty-free retailers represent one of its largest distribution channels. We reduced the company’s holding in Haw Par during the period as we concluded that management are less dynamic than we believed them to be given Tiger’s dependence on traditional distribution”

‘North Asia’s wealthier, more industrialised economies have performed better than those in South and South-East Asia’

In their outlook notes, Vinay and Scott added: “It is no understatement to say that the outlook is cloudier than it has been at any time we can remember. The economic impact of the coronavirus pandemic has been acute. The numerous lockdowns that were introduced to try and contain it have stifled economies. Even without these lockdowns, consumers’ behaviour would have changed. There has been a massive dislocation and there is no knowing how long this will last. Many Asian countries have largely contained the pandemic yet have still suffered severely. North Asia’s wealthier, more industrialised economies have performed better than those in South and South East Asia, partly because of better containment of the virus, partly because their economies are more export-focused with manufacturing less impacted than consumption, and partly because their wealthier governments have more tools at their disposal. The domestic-focused economies of India, Indonesia and the Philippines where we have invested most of SST‘s capital have suffered much sharper contractions and this has been reflected in corporate earnings and share prices. Expectations are for equally sharp rebounds in these economies as normality returns but, even if this is the case, there may be some bad scarring. Asia’s central bankers have followed their counterparts in the West and Japan in cutting interest rates with further cuts forecast. Should economies rebound there will be a large disconnect between interest rates and growth that would normally be expected to lead to inflation but there is a near-universal consensus that inflation is not a worry. This worries us. Things that are not expected to happen tend to lead to bad outcomes if they do happen.

Despite the pandemic’s impact, India, Indonesia and the Philippines continue to represent the bulk of SST’s investment ideas. The countries’ attractive demographics and burgeoning middle classes provide an opportunity to invest in small companies that are leaders in these respective markets which have decades of structural growth ahead of them. We cannot forecast when a rebound in demand will happen but we are confident that consumption will return and restaurants will again be busy in these countries. Max’s Group has not been a successful investment for the Company so far. We built up the position as we were impressed at the controlling families’ willingness to professionalise management with the appointment of Ariel Fermin as chief operating officer. There were a number of changes that needed to be made with too many formats and a lack of central sourcing leading to inefficiencies and it was easier for an outsider to identify these issues. On speaking to members of the controlling families and management it became apparent that despite his chief operating officer title, Ariel Fermin is de facto chief executive and is fully empowered to make all changes he sees fit. The disruption caused by the lockdown in the Philippines has impacted Max’s heavily with revenues in the second quarter of 2020 falling by more than 70 per cent compared to the same period in 2019 and the company booked a large loss for this period. Management have responded by cutting costs, enhancing takeout and delivery offerings and shutting some weaker stores permanently. When the Philippines recovers, Max’s will be very well positioned to take advantage with its leaner cost structure and greater focus on its core brands. The market value of Max’s is now not much more than US$ 100 million. It operates almost 750 restaurants, the majority directly owned with the rest franchised. Its average restaurant generates more than US$ 500,000 of revenues yet the current stock market valuation ascribes less than US$ 200,000 for each directly owned restaurant and less than US$ 100,000 for each franchised restaurant. Should earnings return to prior levels, Max’s will be on a price to earnings ratio of six times. However we expect profitability to improve with the operational changes made and there is still plenty scope for growth. We cannot forecast when things will get better but there is significant upside when they do. It seems unlikely to us that eating out will not be popular again as humans are by their nature a social creature. As a species we are impatient but patience is important when investing. We believe, if we are patient, Max’s will generate strong returns for the Company over the coming years.

Another restaurant company that has performed poorly for SST this year has been Sarimelati Kencana. With more than 500 Pizza Hut outlets in Indonesia and by far the dominant operator in the country, the company’s restaurants were impacted by declining confidence and various local lockdowns. However, approximately half of its outlets are exclusively for delivery and delivery sales increased significantly during the period. As a result, in the second quarter of 2020 revenues fell by only 17 per cent and the company still generated a profit albeit a very modest one. 2020 profits will be significantly down on last year’s. But the demand for eating out has not gone away and comparing the current share price with 2019’s profits shows Srimelati Kencana as being on a “normalised” price to earnings ratio of less than 10 times. The growth in pizza delivery may not have cannibalised dine-in as they serve two different purposes. Therefore as life returns to normal, the crisis may well turn out to have accelerated Sarimelati Kencana’s growth by drawing customers’ attention to its delivery operations. To give an indication of the potential, Domino’s Pizza, the leader in the UK delivery market, has more than 1,000 outlets serving a population that is only one-quarter of Indonesia’s population. Sarimelati Kencana is now valued at only 0.5 times its revenues compared to Domino’s in the UK at 4 times revenues and Domino’s Indian franchisee on 9 times revenues. We believe that Sarimelati Kencana should prosper even if Indonesians never venture out to restaurants again. This seems unlikely and we expect its restaurants to be as busy as its delivery operations once confidence returns. We do not know if this will take months or years but the return available is well worth waiting for.

Another industry that has seen a temporary setback has been air conditioners. SST owns the leading manufacturers in India (Voltas and Blue Star) and also the Philippines (Concepcion Industrial). Unfortunately, both countries went into lockdown during the peak sales period leading into summer and all three companies saw revenues in the second quarter of 2020 more than halve from the same period the prior year. We do not believe that demand for air conditioning in either country has been reduced. Annual air conditioner sales in India are approximately five million for a population of 1.38 billion, compared to approximately 45 million in China for a similar population size. In the Philippines, annual sales of air conditioners are less than one million for a population of 110 million. Although India and the Philippines both have lower levels of per capita income than China, our analysis of demand trends across emerging markets suggests that per capita incomes in both India and Philippines are nearing levels at which demand for discretionary products such as air conditioners typically accelerates. Therefore we expect revenues for all three companies to resume growth in due course. One other observation worth highlighting is when compared to share prices at the end of February i.e. before fear of the coronavirus took hold, Voltas’ share price has almost recovered, and Blue Star’s share price is well on its way to recovering, whereas Concepcion’s share price is still down significantly. The relative competitive positions of these companies are unchanged yet share price performance has been very different. Voltas’ market capitalisation is a multiple of Blue Star’s which is a multiple of Concepcion Industrial’s. And the difference in the value of shares traded in each company is even more exacerbated. Therefore we believe the biggest driver of share price performance here has been liquidity rather than fundamentals. This is reflective of what we are seeing in stock markets everywhere. Money printing has driven flows into stock markets. These flows are directed towards larger more liquid companies. We believe that fundamentals will be reflected in time with patience rewarded as the Company’s quality companies grow and produce outsized returns for shareholders. This was the case for Scottish Oriental’s portfolio after both the Asian Financial Crisis and the Global Financial Crisis and we expect this pattern to repeat.

The company’s portfolio trades on a historic price-earnings ratio of 20 times, with an expected earnings decline of 11 per cent in the current year. On these metrics, the company’s portfolio is as expensive as it has ever been. Earnings growth for the following year is forecast at 28 per cent which would take the portfolio back to a more reasonable valuation. Forecasting earnings is not our strength, particularly in times as uncertain as these. We do not know which way markets will go next and are comfortable with SST holding eight per cent cash meaning the portfolio is 92 per cent invested and should capture most upside if markets continue to rally. If markets fall again we will look to deploy this cash into our favourite companies. We have also been using the company’s cash to buy back shares in Scottish Oriental, effectively adding to the entire portfolio on behalf of shareholders.”

SST: Poor year for Scottish Oriental Smaller Companies as large India weight weighs

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