Scottish Oriental Smaller Companies held back by domestic companies in Philippines

Scottish Oriental Smaller Companies held back by domestic companies in Philippines

Scottish Oriental Smaller Companies (SST) has released its results for the twelve months to 31st August 2018

Performance

The company’s NAV per share fell by 2.4% in total return terms over the report period, while the reference indices, the MSCI AC Asia ex Japan Index and the MSCI AC Asia ex Japan Small Cap Index, rose by 2.2% and 1.3%.

Performance was held back by domestic companies in the Philippines, Indonesia, Pakistan and Sri Lanka. These countries’ currencies weakened over the year creating a difficult operating environment and negatively impacting returns when measured in sterling.

Performance commentary

Scottish Oriental Smaller Companies held back by domestic companies in Philippines

The biggest detractor from performance was the company’s relatively large exposure to domestic companies in the Philippines, where declining consumer confidence made revenue growth hard to find and it was difficult for companies to pass on increased costs resulting from the weakening currency, the peso. However, the cheaper valuations resulting from the fall in share prices gave the investment manager the opportunity to increased Scottish Oriental’s exposure to the Philippines over the period.  Existing portfolio holdings were added to and the manager took new positions in companies it believes have pricing power and strong long-term prospects.

The company was also hurt by stock selection in Indonesia, Malaysia, Pakistan and Sri Lanka where domestically focused companies also struggled.

Investment managers’ outlook, Vinay Agarwal, Wee-Li Hee and Scott McNab

“In the last year, the outlook has become cloudier and most economic commentators are less positive. There are reasons to be negative. Corporate debt levels in Asia are high by historical standards and much of this debt has been taken on in US dollars by companies with no obvious form of US dollar earnings. With interest rates rising and the US dollar strengthening, this is an uncomfortable position to be in. Politics is messy, to say the least, with an increasing cadre of strongmen presidents competing globally to demonstrate the largest ego. The current result of this is the commencement of a trade war, which, from our perspective, does not appear to be in anybody’s best interests. Turkey and Argentina have shown the dangers of poor fiscal management and this has focused recent attention on the vulnerability of Asian countries with current account deficits, namely Bangladesh, India, Indonesia, Pakistan, the Philippines and Sri Lanka. Counterintuitively, these concerns make us more positive as they are well understood and, therefore, we believe are more likely now to be priced into valuations.

There is potential for a trade war to lower growth and impact margins for Asia’s exporters. If the worst comes to the worst, there will be few beneficiaries and much dislocation. The exporters Scottish Oriental owns, however, have relatively high margins, which should allow them to continue operating successfully, albeit at reduced levels of profitability. One of Scottish Oriental’s investments that has been hit by the trade altercation between the US and China is automobile body part manufacturer Minth. At first glance, a Chinese company with significant sales to the US is vulnerable. However, Minth has manufacturing operations in China, the US, Mexico, Japan, Thailand and Germany, giving it plenty of flexibility. Its operating margins in recent years have been in the high teens, which is impressive. With approximately 20 per cent. of sales generated in its North American operations, a full-on trade war will be unpleasant but not fatal. And as Minth’s Chairman recently pointed out to us, his biggest competition comes from German and Japanese companies which are more expensive so there is limited potential for damage – even from any further escalation.

A number of Asian countries have belatedly raised interest rates in an attempt to defend their currencies, with a flurry of interest rate rises over the summer in India, Indonesia, Pakistan and the Philippines. It is probable that further rises will be necessary. This is likely to lead to a cooling of these economies. However, any temporary cooling does not change the long-term case for investing in well-run companies in these markets. Indus Motorsand Pak Suzuki Motor Company in Pakistan have suffered this year both from a volatile political outlook and a sharp depreciation of the rupee. However, both have demonstrated their ability to pass on costs, growing their businesses severalfold in US dollar terms over the last two decades, albeit with bumps along the way from economic and political turbulence and a currency that lost 60 per cent. of its value. In addition, Pakistan’s 2016 automotive development policy will give a fillip to the industry, with increased localisation; a reduction of second-hand imports; and increased demand as quality and pricing improves. This is not dissimilar to India twenty years ago when the incumbents were initially written off, given the expectation of increased competition, but actually thrived in the new environment. Both companies have net cash balance sheets and trade on highly attractive valuations.

The (examples given in the full report) show that whilst we don’t know what the coming months may bring for Scottish Oriental’s companies, we have every confidence they will be able to prosper over the coming years. The portfolio trades on a historic price earnings ratio of 19 times with expected earnings growth in the current year of 14 per cent. Whilst this is more expensive than for most of the Trust’s history it offers better value and faster growth than at the same point last year. The recent market weakness has created opportunities for us to add to the Trust’s positions in some of our favourite companies at more reasonable valuations than we have seen for some time. Despite the cloudy outlook we are cautiously optimistic.”

SST : Scottish Oriental Smaller Companies held back by domestic companies in Philippines