The 2016 annual letter for Overseas Asset Management’s Asian Recovery Fund is out. You can access and download it directly from their website. The fund of funds vehicle was founded in 1998 by Desmond Kinch and its NAV has compounded at 13.5% per annum since inception (vs. 5.2% per annum for the MSCI Asia ex-Japan). OAM has been an early investor in a number of successful value-oriented funds in the region, including Overlook Investments and Arisaig Partners.
Desmond Kinch’s annual letters are always a priority read for me as they contain lots of interesting insights. I actually wrote a short note on last year’s letter, which you can find here if interested. Anyway, below are some highlights / excerpts from this year’s letter combined with my own commentary:
Active vs. passive investing in an Asian context: The proportion of assets that are managed passively (via ETFs or index funds) is growing rapidly. Active managers, as well as their fee structures, are coming under increasing pressure. However, there are some challenges with passive investing in an Asian context because many of the available indices do not accurately capture the region’s growth.
The MSCI index, for example, is heavily weighted towards China and more mature markets such as Hong Kong, Taiwan and South Korea. OAM’s fund, by comparison, has a greater portion of its assets invested in the Indian sub-continent and ASEAN markets relative to the index. On a similar note, the index also includes a number of large cap, state-controlled companies and therefore relatively less exposure to the underlying consumer growth story in the region.
Two big sources of gains for the fund in recent years have been investments in Vietnam and Indonesia. In Vietnam, the fund made several investments in closed-end funds that were trading at large discounts to NAV at the end of 2011. Those gaps have narrowed since then but are still trading at attractive discounts. Indonesia has low levels of debt (government, corporate and household) as a percentage of GDP relative to many economies. As a result, potential for large increases in consumer spending and infrastructure investment over time is high. Much of the fund’s exposure to Indonesia is via banks, financial services companies, retailers and high quality companies such as the Jardine subsidiaries (see here).
Asian currencies are undervalued: This is a recurring theme from recent letters. Over time, Kinch expects real effective exchange rates (that is, rates adjusted for inflation) to appreciate in Asia. According to a detailed study carried out by Research Affiliates, Asian currencies might in fact be amongst the most undervalued in the world. Just to illustrate with a small sample, the Indonesian rupiah, Indian rupee and Vietnamese dong have depreciated by about a third in the past five years. There is some indication they are now stabilising at that level. Another study by GMO suggests that emerging market currencies are undervalued by approximately 1 standard deviation.
Valuations: Emerging market equities (and their associated indices) have mostly traded sideways since 2009. Over the same period, US equity markets have more than doubled and now look expensive across a range of valuation metrics, including cyclically adjusted P/E and P/B. When combined with potentially undervalued currencies, Asian equities currently look a better bet relative to US or developed market equities.
Asian consumption theme: Dominant consumer companies in Asia have seen a significant upward re-rating in recent years. There are now a number of long-only funds that invest almost exclusively in the consumer theme (see Arisaig, Albizia, Coupland Cardiff’s Asian Evolution for examples) and almost every regionally focused fund seems to include some mention of it. While the quality of these franchises are not in question, valuations do look expensive. It makes sense for long-term investors to retain some exposure but I agree with Kinch that there are probably better opportunities outside of this theme at this point in time.
HK small caps: One pocket of the market that looks interesting is small cap companies in Hong Kong. Current sentiment towards China is extremely negative and, as a result, many companies are trading cheaply – low P/Es, high dividend yields and net cash balance sheets. The HK small cap index, in particular, has diverged sharply from the broader market index and is now trading at its cheapest valuation in over 20 years (refer to the graph in his letter).
Portfolio updates: Major investments or additions over the year include China Yangtze Power (CYP), DWS Vietnam Fund and the Scottish Oriental Smaller Companies Trust (SST). Below is some additional commentary on CYP directly from the letter. I believe Overlook is (or at least was) also an investor in the company.
“[CYP] owns the Three Gorges Dam in China as well as other large hydroelectric dams in the country. In essence, its hydroelectric dams are 100-150 year infrastructure assets that should be able to increase pricing roughly in line with inflation over time. CYP has 22 billion shares outstanding so at its current share price, it has a market capitalisation of roughly RMB 280 billion. This year, CYP should generate about RMB 32 billion in free cash flow. About RMB 14 billion of that will be used to pay dividends – they said that the dividend on this year’s earnings will be RMB 0.65/share which is equivalent to a more than 5% yield, subject to only 10% withholding tax. About RMB 8-10 billion will be used for debt repayment and about RMB 8-10 billion will go to retained earnings which over time will likely be used to make acquisitions of other renewable energy generation assets. We think that the shares are far too cheap at a more than 11% free cash flow yield for what is a very high quality collection of assets.”
Finally, SST is a name I have mentioned a number of times on this website. You can find my original write-up here. My thesis back then was very similar to OAM’s thesis as outlined in the letter. Despite the trust’s impressive long term track record and a lower fee structure versus its competitors, it has regularly traded close to a ~15% discount to NAV over the past year. What is most relevant for investors is that management is committed to actively capping the discount at around these levels, even though no formal policy is in place. I therefore think that an entry point at a greater than 15% discount to cum-income NAV should work out well for medium to long term investors.