Stellar year for Pacific Horizon – In the year to 31 July 2017, Pacific Horizon’s NAV total return was 38.5%. During the same period, the total return of the comparative index, the MSCI All Country Asia ex Japan Index, was 28.6% in sterling terms. The share price total return was 42.5%, and the discount narrowed from 10.1% to 7.5%.
The chairman’s statement says that “The strong relative and absolute performance over the course of the year was largely a consequence of good stock selection, particularly in Hong Kong and China where exposure to certain Consumer Discretionary and Information Technology names proved beneficial. Three of the Company’s holdings more than doubled their share price over the period: Sunny Optical Technology, which specialises in optical lenses and has a leading market share in the fast growing car camera market; Geely Automobile, whose parent owns Volvo, a Chinese car manufacturer targeting the mass-market sedan and Sports Utility Vehicle markets; and JD.com, one of the leading e-commerce companies in China. The shares of a further ten holdings appreciated by more than 50%. The use of gearing also helped performance.”
Technology and weak US dollar
The manager, Ewan Macpherson, elaborates on this in some detail: “Two factors in particular underpinned this improvement. First, the increased penetration and disruption that technology is bringing to society and the consequent increased focus by investors on the growing technology companies; second, the fall in the US Dollar, particularly in the latter half of the company’s financial year, which provided focus to the improving economic fundamentals across the Asia Pacific region, especially in China. The company’s entire relative returns, and most of its absolute gains, occurred from December 2016, when the USD peaked and the market gradually realised that China’s economy was recovering rather than being exposed to the threat of a hard landing, as many commentators, especially those in the USA, were predicting.
We believe that the rapid development of technology is creating a tectonic shift in society, with digitalisation driving profound changes in economic and political systems, businesses, consumer habits and behaviours. Many winners and losers are emerging and there is a growing awareness of these changes. Artificial Intelligence (‘AI’) is now taken for granted and the concept of electric rather than gasoline powered cars is considered to be an inevitable commercial development rather than a vision of the future.
Nevertheless, the cascade of these potential ground-breaking changes into broader society is only just being felt and negativity still abounds: Brexit, Trump, low productivity concerns, anti-globalisation, anti-capitalist sentiments, environmental risks, to name but a few. It is our belief, however, that the underlying global economy is improving and societies in aggregate are getting richer at a much greater pace than people realise. In retrospect, this era may well be seen as generating the largest improvement in living standards for the greatest number of people in history. The majority of those people live in the Asia Ex-Japan region.
The number of sectors and industries that are becoming digitalised and connected is increasing rapidly. Previously, when a customer went into a shop to buy an item and paid with cash, there would have been no digital imprint of this purchase; the data inherent in this transaction would only have been available to the shopkeeper. Today, every transaction online and its place in the entire supply chain leaves a data imprint which can be used to improve customer service and efficiency. In the retail industry, e-commerce continues to grow rapidly and has led to an explosion of data which captures what people buy and when, and how choices change over time. This results in both better targeted sales and an improvement in logistics, in products and in customer service; as well as an overall fall in cost for the consumer. In the US, this trend is leading to the rapid closure of shopping malls and offline businesses. In China, it is fuelling the growth of two large retail platforms, Alibaba and JD.com, with a resulting fall in more traditional offline activity.
When an industry moves towards a digital model, the resultant explosion in the quantum of data leads to a profound change to that industry’s dynamics: traditional competition theory breaks down. Rather than encouraging the involvement of many firms and a form of perfect competition, digitalisation tends to produce increasing, rather than decreasing, returns for scale. We have witnessed this in the chip and software industries for two decades, with the dominance of Intel and Microsoft, and now Samsung Electronics and Taiwan Semiconductor Manufacturing (‘TSMC’). As a more immediate example, JD.com is today the largest retailer in China, with no offline stores; a marginal cost of every additional order through its platform that is close to zero; no shops, no salesmen and fixed overheads. JD.com has recently announced its first 100% automated sorting warehouse and is testing the use of drones to deliver parcels, replacing delivery workers with machines and software. Scale leads to marginal cost being below average cost and thus, importantly for shareholders, to significant financial returns. In a world of digitalisation and increasing returns based on scale, we may expect more oligopolies and monopolies to be sustainable in the longer term. The competitive threats to these new monopolies are not to be found within their industries but without, from adjacent sectors, or from totally new disruptive technologies.
In China, the use of mobile phones and the acceptance of new technology are leading to a faster rate of adoption of online shopping than in the developed world. An example of this is online grocery shopping. This is a market worth more than $1 trillion and ripe for disruption by the likes of JD.com and Alibaba. These two companies account for 12.3% of our portfolio and were significant contributors to returns last year. JD.com rose 109% and Alibaba 88%, as the market took note of the longevity of their growth profiles. We believe that both stocks remain significantly undervalued.
Humans are intensely visual. Sight is the leading sense by which we analyse and interact with the world. Our contention is that machines, as they increasingly take over human tasks, will initially use reproduction of the visual ‘sense’ to help them understand the world. Sunny Optical Technology is China’s leading camera module maker, the second largest producer of camera lenses for mobile phones globally and the largest producer of lenses for the automotive market. The stock rose over 200% in the year, making it the second best performing holding in the portfolio. It is set to deliver an estimated 80% increase in earnings per share (‘EPS’) for 2017 after a 60% increase in 2016. With the company’s leading position and technological research and development (‘R&D’) in module assembly and design, it is gaining increased traction in the nascent camera market for cars. Whereas a new car used to have on average less than one camera, a modern advanced driver assistance system (‘ADAS’) enabled car has 8 to 12 cameras; and, in future, a fully autonomous car may need up to 20 cameras or more. Sunny Optical has an approximate 40% market share in this rapidly evolving market. It also has emerging businesses in camera production for drones, optical instruments and robots. Given its products are at the forefront of delivering digitalisation to a large portion of the world’s economy, we believe the company is still at an early stage in its growth cycle. It currently represents 5.4% of the portfolio.
The global automobile sector is an area where we see significant disruption occurring in the medium term. We believe that the end of the gasoline engine is in sight and that electric vehicles will increasingly dominate new car sales of the future; especially in China as the government tackles the problem of pollution, which has become the most pressing social issue for the emerging middle class. Samsung SDI, in South Korea, up 60% year-on-year, is one of the world’s leading makers of electric vehicle (‘EV’) batteries, a business where we believe that volumes could grow five to ten fold over the next decade. In China, our investment in Geely Automobile, a company that we have held for many years on the basis that we thought its investments in R&D would eventually propel it from a low-end domestic car manufacturer to a global original equipment manufacturer (‘OEM’), has started to pay off. The stock rose 250% in the year, after delivering a 78% increase in sales in 2016 and consequent 112% EPS growth. It also expects 62% revenue growth and 73% profit growth in 2017. Through improvement in products, brand image and scale, Geely is positioning itself to become a leading domestic brand OEM, in the first instance in China and then globally. The management team, led by a visionary founder, is launching the new Lynck and Co brand later this year in a tie-up with Volvo. We believe that Geely has the potential to become one of the leading EV manufacturing OEMs globally in the next decade.
The growth in the amount of data being produced by social media, commerce, gaming and machines requires a significant jump in both computing power and the associated hardware capabilities in order to run, manipulate and take full advantage of the data generated. This is leading to a rise in technology prices and what we would characterise as the largest technology hardware cycle since the 1990s boom. Companies such as SK Hynix and Samsung Electronics, which produce the majority of the world’s memory chips in South Korea, and TSMC (which has the largest global foundry) and Hon Hai Precision Industries (the largest global technology manufacturer) have all benefited from this trend. We believe that these stocks are still under-priced and do not fully reflect the potential growth opportunities ahead.
In the first half of the year, markets worried over Brexit, Trump and a potential reduction in world trade. This supported the USD and hid the nascent recovery in Chinese economic growth which, having slowed sequentially since 2011, reached its nadir in 2015; since then, it has been recovering. It is likely that 2016 will prove to be the second year of a Chinese cyclical economic expansion; we are seeing this in the rising Chinese Producer Price Index (‘PPI’), increasing imports, rising commodity prices and a stabilisation in the exchange rate. Over the 12 months to 31 July 2017, the Chinese MSCI Index rose 38% in sterling terms and our Chinese holdings appreciated 72%, in aggregate. Free cash flow, the money left after costs and capital expenditure, is, on average, increasing for Chinese companies, and we would therefore expect growth and probably earnings to continue to surprise on the upside.
Outside China, Vietnam was a strong contributor to the portfolio’s performance. Dragon Capital Vietnam Enterprise Investments rose 43% during the year. In addition, our first direct holding in Vietnam, Military Commercial Joint Stock Bank, rose 59%, as the company’s turnaround from a sleepy corporate bank to a retail lender gradually continues. We still see the Vietnamese economy as a whole as an underappreciated growth story.
On the negative side, stock selection in South Korea was the largest detractor to the portfolio’s relative performance. Not owning enough of Samsung Electronics had a negative impact as the stock rose 57% over the year. Our holding in SK Hynix, also a manufacturer of memory chips, was up 92% and mitigated some of the negative attribution. A number of our smaller companies fell, including some of the biotech holdings, although there was a significant divergence in returns. For example, Medy-Tox, the leading Botox innovator, rose 36%, whilst Bioneer, a biotech company, fell 62%. In this specialist sector, it is our intention to continue with our overall philosophy of supporting our winners and being circumspect about adding to our losers.”
PHI : Stellar year for Pacific Horizon