Adding value in Asian equities
Asian equities are a highly attractive long-term allocation -- a chance to own the upside of the region’s structural growth story. Yet Asia also challenges investors with its fragmented nature, often-expensive valuations, and the frequent paradox of a surging economy and sluggish stock market.
Simon Rudolph, who manages more than $5 billion of institutional Asia-Pacific equity mandates for Franklin Templeton Investments, stresses that active strategies are required to add value to Asian equity portfolios, be they Asia-Pacific or Asia ex-Japan.
Franklin Templeton is known for its value-oriented investment approach, which it pursues in Asia as well as North America, Europe and emerging markets. “Our underlying philosophy is about value and fundamental stock selection,” notes Rudolph.
However, Asian markets have their own characteristics and Franklin Templeton takes a different slant in this region, based on its belief that value and growth are not mutually exclusive. For various structural reasons, many growth companies in Asia are inexpensive relative to their long-term earnings potential. “That’s why this is such a great region for investing,” Rudolph adds.
Such characteristics, combining value and growth, are most commonly found in Asia’s large – and largely unexplored – universe of small and mid-sized companies.
Small is beautiful
The team’s preference is to avoid mainstream names in most sectors unless it has a strong conviction that shares are mispriced. This tends to happen only in extremes when excessive pessimism or optimism prevails
It leads Rudolph and his analysts to seek smaller companies, although some may be too small to give exposure required to capture a particular story. “We may need to find three or four companies to meet our goals,” says Rudolph. “Liquidity issues, therefore, require us to adopt something of a basket approach.”
Liquidity is a challenge in Asia, even for large-cap stocks in some markets and especially so for a value strategy. It leads to important differences in how Franklin Templeton constructs a portfolio compared with a global equities mandate.
In particular it keeps turnover in its portfolios low, on average about 30-35% per annum. As a result, the average holding period for Templeton is much longer than most dedicated Asia equity funds available in the market.
Typically benchmark indices for Asian equities will have big weightings for the top 20 stocks in the universe compared with a global benchmark. For example, Samsung Electronics may be 6% of an Asia ex-Japan index, while Chinese banks will comprise another big chunk. These stocks are heavily covered by 20 or 30 brokers.
“Except in extreme circumstances, I am not going to add much value by owning those stocks,” says Rudolph. “For such names it’s about getting on the right side of the fence for any given period: I should be overweight, underweight or neutral.” The goal is avoid making big mistakes.
The team adds value by identifying an arbitrage in the quality of investment research that leads to stock mispricing. That happens a lot with small and mid-sized companies because they are not well covered by investment banks.
“A bank does not put a junior analyst on Samsung Electronics, so we look at stocks where there’s less sophisticated analysis, where it doesn’t matter for the bank if the analyst gets it wrong. I know how this works because 25 years ago I was a junior sell-side analyst in Europe and I understand the opportunity that mistakes can provide to careful investors,” Rudolph notes.
Actively adding value
Rudolph has a secular bet on crude palm oil (CPO), which is used in cooking and is in increasing demand as incomes rise in places such as China, India and Indonesia. So what kind of company should an active manager look to invest in to take advantage of this secular trend?
Two things tend to affect the share price of palm-oil producers: price of palm oil, and production volumes. In Asia, due to geographic realities, producers are only found in Malaysia and Indonesia. Many established companies have already reached production capacity, so their share prices are influenced mainly by the price of palm oil.
That is not where Franklin Templeton prefers to invest, however. “We seek out upstream producers that still have plenty of land yet to be planted out,” Rudolph says. “These are immature companies whose production won’t peak for years.”
Homework is required, in this case learning all about the lifecycle of palm oil trees. These trees don’t do much during their first four years and only begin to yield oil in years four to eight. They are most productive during years eight to 20, after which yields taper off.
The trick is to find companies that continue to plant young, immature trees. That safeguards the fund’s investment over the next decade or more, and gives managers two ways to evaluate the company’s share price, by palm-oil price and production potential.
“Companies in Malaysia don’t have much unplanted land, but there are plenty of families in Indonesia that went into this business after the Asian financial crisis and are just now ramping up,” Rudolph explains.
Regional take-off
Such stories are increasingly common across Asia as more families list assets and new sectors take off. It takes Rudolph back to when he started as an analyst in Europe in the 1980s: “That was an exciting time, when we saw the emergence of new businesses and entire new sectors.”
The luxury goods sector, for example, emerged with the creation of firms such as Bulgari and LVMH. Today a similar transformation is taking place across Asia, creating new ways for equity investors to access the region’s growth story – such as Reits.
“Another great thing about Asia is its diversity among developed and emerging markets,” adds Rudolph. “It’s a good mix, and there are countries that offer the best of both worlds.”
Korea and Taiwan are classified as emerging markets, yet are highly developed and sophisticated places with companies and brands to rival anything in Japan or the US. This is reflected in their growth rates.
There is a good balance between exporters in North Asia, a different set of companies in Asean, and the tremendous consumer growth stories both in Asean and the subcontinent.
Looking for bargains
Yet the region’s stock markets can look expensive at times, posing a challenge to value investors. “Certain areas have definitely over-run themselves,” Rudolph agrees. “This is often because investors face lack of choice.
“If you want a domestic health-care company, you may be asked to buy it at 30-times expected earnings. What that means, for most fund managers, is that to buy that stock means you are confident the company’s earnings growth will continue uninterrupted for the foreseeable future. That may happen, but it also increases the potential downside if the company hits a speed bump.”
On the other hand, global issues are impacting companies in the region. China is tied to the West by exports, and many Asian countries are similarly tied to China. While foreign investment inflow can boost a country’s stock market and currency, in periods of risk aversion outflows have the opposite effect. The Philippines, for one, is impacted by the “risk-on/risk-off” decision.
“We only add a company to our portfolio if it is fundamentally undervalued,” stresses Rudolph.
Valuation also depends on a portfolio manager’s confidence about how companies are being managed. Occasions when active managers run into problems can be related to issues around corporate governance, when the best thing may be to sell and walk away.
But Rudolph says he is grateful to have a trading team that can find liquidity and has the heft to secure excellent service from sell-side brokers. “Never underestimate the importance of that,” he says.
But he is sanguine about the state of corporate governance in Asia: he believes managements worldwide choose whether to be ethical or not. It’s up to fund managers to assess a locale’s legal system or a corporate’s friendliness to minority shareholders, and factor that into the stock price.
“We follow a disciplined, principled process based on where we think we can add value and where we can manage risk,” Rudolph adds. “We remember that we are handling pension money, so we take our jobs seriously. And we stick with common sense: don’t overcomplicate things, don’t trade too much, and leverage what we know well.”
Consistency of investment beliefs is something that Franklin Templeton investors continue to benefit from.