FSS Asia Investor Update (Jan ’17)

First State Stewart (FSS) Asia is an independent investment management team within First State Investments. The team manages ~US$21bn across a range of Asia Pacific equity strategies on behalf of both institutional and wholesale clients. One of their fund offerings is the listed Scottish Oriental Smaller Companies Trust, which I have profiled previously.

The group recently published a detailed Asia Pacific equities update, available on their website. The note includes a review of the second half of 2016, positioning updates across the fund as well as commentary on realised and unrealised mistakes. Below are some highlights / insights:

  • Market update & outlook:
    • Regretful about recent period of underperformance but think it’s not that surprising. The team has gone out of the way in the past to point out that they are likely to do less well in more ebullient market conditions.
    • No significant rotation or top-down sector reallocation – focus remains on finding high-quality businesses & management teams and holding them for as long as they are able to. Some concern from the fact that everyone seems to be a “quality investor” recently – some parallels with the US nifty fifty environment of the 1960s and 1970s.
    • This herding behavior has been compounded by passive strategies, particularly evident in high quality consumer franchises. Valuations matters more than ever.
    • Macro has become more important, but they prefer to spend their time focusing on businesses and management teams. Look for teams with the ability to generate ROE consistently in excess of cost of capital as well as a “proven track-record of dealing with the vicissitudes of what the world has to throw at [them].”
    • Next season in the markets is more likely to be winter than spring – “the coming primacy of politics over economics, inspire [little] confidence in sustained high valuations. In the meantime, it seems likely and perhaps even probable that markets may well have a last hurrah blow-off bull market created by our prior monetary profligacy.”
  • Asia Pacific positioning:
    • Generally cautious stance and positioning across Asia-Pacific portfolios – given Asia’s high debt load and the transition underway in the Chinese economy, focus is more on capital preservation vs. swinging for the fences.
    • Geographically, they have a preference for North over Southeast Asia. India remains the largest single country exposure while they are less exposed to the more localised ASEAN economies.
    • Continue to have healthy appetite for exporters and US-dollar earners, played largely through investments in technology and Taiwan. Unfortunately, Trumpian view of the world would suggest rising risk around trade, technology and Taiwan.
    • Bigger problem is that much of Asia (with the possible exception of the Philippines and India) “lives mostly off trade with America.” They don’t believe that domestic companies will provide a hiding place.
    • Philippines: De-rating risks seem quite high and the country has historically been unable to withstand reverse outflows of capital. Governance risks also exist given the weakness of underlying institutions. Recently bought Universal Robina following the company de-rating to more reasonable levels.
    • India: Longer term effects of demonetisation, alongside other structural reforms, should be positive. The country also offers the “broadest mix of family-owned but professionally managed companies,” a combination that often leads to superior results. Thesis for private sector banks has strengthened with a sharp increase in the banked percentage of population and growth of digital banking. Have positions in HDFC Bank and Kotak Mahindra.
    • IT service companies: Thesis is that Digital and IT intensity across industries is likely to increase over the next 10 years and the best companies will find a way to service that growth. Recent pressure on the BFI sector (which is a big client for these companies) might also finally begin to reverse this year, providing some tailwinds for the sector. Have added to positions in TCS, Tech Mahindra and Infosys.
    • South Korea: Many Korean companies are amongst the most impressive and competitive in the world. Challenge is to find companies with this drive for excellence coupled with an alignment with shareholders and a focus on returns. Potential candidates who fit this mould include the LG group companies, AmorePacific and Naver.
    • Singapore / SEA: Added to a number of holdings across the Jardine Group including Cycle & Carriage, Dairy Farm and Jardine Matheson. The group has a growing presence in Vietnam, where it has already been operating for 20+ years. Singapore Telecom and OCBC remain significant holdings. 75% of Singtel’s profits are generated from outside Singapore and the shares trade at a forward PER of 15x, with a dividend yield of ~5%.
  • Mistakes:
    • Li & Fung: Perfect storm for the company in recent times. They are trying to insert themselves into the e-commerce supply chain but have been unable to do so quickly enough to offset the decline of current core customers (such as Kohl’s and Macy’s). Rising costs (labour and currency) on the supply side in China alongside lack of pricing power on the demand side have impacted both top line and profit margins. Some signs that these trends are now reversing. The controlling family has been buying back shares, focusing on costs and willing to adjust its business model to remain relevant.
    • Idea Cellular: The entry of Reliance (Jio) into the market with a US$25bn investment and initial offer of free telecom / data services has seen the company’s shares halve. Today’s valuation (enterprise value) is roughly equal to that of Idea’s spectrum and towers, so you get future profits and cash flow for free. Question is what is it worth. Unlikely that Reliance will continue to offer their services for free given the need to be financially disciplined and repay debt. If Reliance does eventually start charging, Idea may have an advantage in terms of customer service and billing – choice of provider is not a decision driven only by price.