The big risk for Asian equities

First State Investments, the funds unit of Commonwealth Bank of Australia, acquired Edinburgh-based Stewart Ivory in 2000, but in terms of fund management practices, it was more like a reverse-takeover, since First State has since organized its investment process around the Scots' style. Alistair Thompson is the Singapore-based deputy head of Asian-Pacific equities. First State manages $5.6 billion in Asia Pacific ex-Japan and global emerging markets money.

How would you describe your investment philosophy?

Thompson: I head the Hong Kong and Singapore investment teams and I report to Angus Tulloch in Edinburgh, which we've done to align things along how money is managed there. So you could say our investment philosophy is 'GASP' - growth at a Scottish price.

Seriously now, we invest with an absolute return mindset. We're not interested in benchmarks. We're benchmark-aware, but it doesn't enter into our discussion about stocks.

That's a fashionable thing to say these days.

We haven't changed our investment process since Angus joined Stewart Ivory in 1988. Our criticism of the industry is that there are too many benchmark-huggers. We're absolute return investors because, one, we have our own money in the funds, and two, because the benchmark doesn't represent the best opportunities in Asia.

We invest on a three-to-five year horizon, and we only buy good-quality companies. Of course no fund manager says he buys crap, but you only need to look at his portfolio. None of us is under pressure to invest in the short term. We can turn away new business. Our funds that invest in all-cap stocks are mainly closed. We own 20% of the free float of AsiaSat, for example, and we can't buy any more.

What do you look for when you buy a stock?

It's not rocket science. We look for quality, growth and price. We allocate 50% of our brokerage commissions for access to company managements. CLSA is easily our top broker. At the CLSA Forum, we got back-to-back, one-on-one meetings all week, and we were able to avoid the scrum of the circus.

We like managements with equity in the business, and a sensible approach to risk. We like to ask them about their China strategy and see just how gung-ho they are. And we like pricing power, so we're not skewed toward companies in tech or materials.

What is your cash balance tolerance?

We're always fully invested. We don't hedge currencies and we don't run cash balances. You can still make money in falling markets by buying good companies.

Of your three criteria, quality, growth and price, which is most important?
Quality is paramount. Poor quality doesn't get into the portfolio, although 'quality' is open to interpretation. There is not a price for everything. Take LG Corporation in Korea. Its corporate governance record is shocking. Even if it fell to a fraction of replacement cost, that stock would never make it into our portfolio.

We like growth but don't like paying for it. We don't think most companies can grow 15% in real terms over five years. A number have done it, but it's quite rare. We look for real earnings growth of 5-10%.

What sectors, then, are attractive?

We're always drawn to the consumer sector in Asia. These companies consistently deliver in excess of expectations. Companies like Amore Pacific, China Resources, Hite Brewery, Shinsegae Department Stores. Forget tech. And because these are consumer staples and not consumer discretionary stocks, they are somewhat immune to our cautionary view on developed economies.

Breweries are definitely providing staples. At least for journalists. What valuation methods do you favour?

We look at price-to-book. Book-value growth and dividend growth are usually good assessments of a management's performance. We also look at non-financial measurements, more physical ones. For example, for banks, we're positive on asset reflation in the region, so market cap-to-deposits is a good measure of what the market thinks a bank's franchise is worth. Few investors look at this.

Is all of your information derived in-house, or do you use external sources?

As I said, 50% of our commission allocations are for access to management, while 20% is for research, 15% for execution and the rest for things like access to IPOs. We do use research and some analysts are essential reading for us. But most analysts are too short-term or benchmark-focused.

A few weeks ago a broker we know met with a leading Asian corporation and downgraded it to underperform. This isn't a sell, and the analyst wasn't critical of the company's management, but merely noting the share price was expensive. Well, the CEO responded by saying that anyone who criticizes the company, he would find them and crush them. That's what he said - find them and crush them. It illustrates how the entire investment banking business is still beholden to managements.

But CLSA puts out corporate governance reports, and is the most independent broker. We'd like it if every research report had at least a paragraph on corporate governance and the company's attitude toward socially responsible investment. But there are some seriously good analysts at other firms, who provide the kind of thought-provoking research we like.

How has corporate governance evolved here?

The most impressive gains have been in Singapore and it's reflected in their share price performances. I admit that in 1999 I thought groups like Keppel Corporation were just paying it lip service. But they've done a wonderful job with things like independent directors and selling non-core assets. The quality of management in India is among the highest anywhere.

Does that reflect India's long history of equity markets?

Perhaps. Managers there are very well educated and entrepreneurial in industries where the government hasn't meddled.

What themes are you following?

Asset reflation, domestic consumption and outsourcing.

And the big macro picture?

We can see oil prices easily hit $60/barrel. I think the market consensus is now way off the mark. Consider the demand in India and China. The market has consistently underestimated demand from China, but the listing of its petrol companies has made it easier to see their demand. There is a lack of investment in exploration and production; one example is Indonesia, which has become a net importer of oil because investment in its oil facilities has declined since the Asian financial crisis. We also worry about terrorist activity and the potential collapse of the Saud political dynasty, which really throw out questions about supply.

This is why we're cautious about developed markets, which have not priced in this risk.

So do you favour Asian oil firms?

We like companies like CNOOC, as well as Australian names like Woodside Petroleum and BHP. But there are risks. The biggest risk in China is that the government imposes a windfall tax on oil companies. The government needs the revenue and these companies are making extraordinary profits. But I'm comfortable with that risk, because of CNOOC's production growth.

We're excited by the Asian consumer story. Aside from in Korea, consumers aren't overleveraged. I look at so many of my friends in the UK and it scares me, the indebtedness. Add to that the pension deficits in developed countries. American companies can't sack workers because it would automatically crystallize those pension losses. And demographics favour the Asian consumer story.

This bullishness on Asia: how sustainable is it, given your worries about developed markets?

We think next year could be a critical one for developed markets. We think developed markets are in for a long bear market, and face a debt binge that must be corrected and property bubbles that are beginning to burst, like in Australia. Can Asia perform in absolute terms in such an environment? Asia has decoupled in the past. It could be even easier this time if Japan's economy continues to get healthier.