Fidelity Asian Values (FAS) has announced its final results for the year ended 31 July 2022, during which its NAV increased by 3.9%, compared to the MSCI All Countries Asia ex Japan Small Cap Index (net) total return (in Sterling terms) which returned -5.6% over the same period. The chairman, Kate Bolsover, says that Nitin Bajaj and his team should be commended for their diligence and persistence in sticking to their style, in what has been an especially challenging time for value investors, and that FAV’s directors are delighted that the approach is beginning to pay off. The managers say that they outperformed the benchmark primarily because they avoided speculative investments, expensive stocks, and blue-sky business models. They comment that, investing in companies on very rich valuations had been the market norm during the pandemic, so a pull-back was somewhat expected.
Managers review Q&A
The investment managers’ review is provided in the form of a Q&A, which has been reproduced below.
Question
How has the Company performed in the year under review?
Answer
In the year to 31 July 2022, the NAV of the company increased by 3.9%. The MSCI All Countries Asia ex Japan Small Cap Index (net) total return (in Sterling terms) returned -5.6% over the same period. The share price total return was -3.4%.
The Company generated positive absolute returns in a falling market primarily because we avoided speculative investments, expensive stocks, and blue-sky business models. Investing in companies on very rich valuations had been the market norm during the pandemic so a pull-back was somewhat expected.
This approach reflects our investment philosophy of investing in good quality businesses which are run by competent and honest management, and only buying them when valuations provide a good margin of safety.
Question
Asian stocks have lost value over the period under review. Has the sell-off been consistent across the market cap spectrum? What have been the drivers for your outperformance?
Answer
The sell-off in Asian equities this year has certainly not been even. Losses have been lower in small cap stocks than their large cap counterparts primarily due to the reversal of the crowded ‘large cap growth’ trading bias that occurred in 2019 and 2020. In addition, small and large cap indices are further skewed by their geographic mix, with the large cap index having a significantly higher weight in China.
Stylistically, Value stocks have done better than Growth stocks during this period. In our opinion, we are in the early stages of a long-term style rotation out of Growth equities as the valuation gap between Growth and Value is still at a twenty-year extreme in favour of Value stocks. Given our significant bias towards small cap Value, we think a period of sustained outperformance is possible over the coming years.
While this market environment provided a positive backdrop for our style, our focus on bottom-up fundamental research meant that stock selection has been the biggest contributor to the Company’s relative performance. During the financial year, our stock selection was particularly positive in China, India, Korea, Australia and Indonesia. From a sector perspective, positive returns were posted in industrials, health care, financials and materials.
In terms of small/mid cap names, Indonesia’s largest yet lowest cost producer of ceramic tiles Arwana Citramulia benefited from a favourable demand-supply environment, while India’s fourth largest cables and wires maker KEI Industries was aided by a recovery in capital expenditure and its increased focus on higher margin retail and exports segments. In China, the Company’s exposure to a large cap state-owned property developer China Overseas Land & Investment added to performance after the company, which is operating in a consolidated industry, gained market share, driven by the flight to quality amongst developers. Companies which can demonstrate more disciplined operations and have both good balance sheets and access to land sales are better able to successfully complete construction projects.
QUESTION
With slightly over 35% of your investments in either China or Hong Kong, are you worried about single country exposure? What do you consider to be the main risks of investing in China?
Answer
From a risk management perspective, while country positions are an outcome of underlying stock selection, we restrict our exposure to any particular country to within Board set guidelines. Of course, the Board can change such limits, should it so decide, to suit market dynamics as well as the opportunity set. Given the macro-economic concerns around China, it comes as no surprise that Chinese stocks have been sold off; but in our view, there are many interesting companies that are now trading significantly below intrinsic value and are being overlooked by the broader investment community. You could almost compare the current Chinese multiples and sentiment to what happened in the Indian market crash in 2012/13 or in the sub-prime credit crisis in the US in 2008/09.
We look at the situation differently. While we are very conscious of the macro risks of investing in China due to geopolitical tensions, regulatory interventions and economic cycles, based on our analysis, the prices of the businesses we own reflect these risks. Furthermore, we believe that these companies are providing products or services that are beneficial to society – either through improving household products or providing essential infrastructure services – both of which are critical to the smooth functioning of the economy.
However, we would like to share some high-level thoughts regarding the two biggest risks that are being flagged when it comes to China – the demise of the property sector and the impact of the country’s zero-COVID policy.
The various lockdowns have taken a heavy toll on industrial activities and consumption given the lack of movement of citizens. Yes, we have seen some tweaks to policy requirements (such as allowing the ongoing operation of manufacturing activities during a city lockdown), but the government still measures its success in overcoming the pandemic as the number of lives saved and keeping fatalities low. We are monitoring any policy changes, or indeed fiscal or monetary support aimed at improving sentiment and underpinning growth. It is critical to note that the country’s zero-COVID policy can impact corporate earnings so it’s something that we consider when assessing a company’s earnings visibility.
The other risk associated with China is the health of the property sector. For years, China had seen a surge in property development, with many developers benefiting from growing demand. However, like any prolonged investment cycle, the property market in China has seen severe misallocation of capital and excessive risk taking by many private sector developers. In our opinion, quite a few of these “aggressive” developers will not survive the downturn. This will have a knock-on impact on the overall economy; but it will also create significant opportunities for well-managed companies to increase market share. We believe that the businesses we own fall in the category of market share gainers in a number of different sectors in China. Given the current macro backdrop and pessimism, we believe these businesses are quite significantly mispriced compared to their long-term potential.
Given this positive risk/return outlook, and importantly, the underlying stock opportunities, our combined exposure to China and Hong Kong is around 35% as at the end of July (see Charts in the Annual Report) – this is close to the highest it’s been during my tenure.
Question
Large cap stocks make up nearly 20% of your portfolio. How do you choose these stocks and why do you hold them?
Answer
Although the Company has a small cap bias, the investment policy is unrestricted, and we are therefore able to consider large companies for the portfolio where we believe they demonstrate the value characteristics that we seek for shareholders’ portfolios.
In order to be considered as investments, these large companies should demonstrate the same returns profile that we expect from any small cap holding in the portfolio. We like to think of them as adding some diversification benefits from the small cap companies in the portfolio and from the Company’s peer group.
Question
How do you approach shorting companies? Where do you see opportunities in this space?
Answer
The approach to shorting companies is the exact opposite of what we do when creating our long positions. Here we are looking for fragile business models, excessive leverage, management with poor reputations and/or stretched valuations.
That said, shorting is a specialised skill where risk/reward metrics can turn against you because your short position increases if the price increases. Theoretically, a stock’s price can increase to an infinite amount, but its lowest value can only ever be zero. We try to keep the short book well diversified and take smaller sized positions.
Question
Last year you invested in a pre-IPO holding – Tuhu Car. Can you provide an update on this company and will we see more investments like this in the future?
Answer
We continue to hold a position in Tuhu Car that we established in June 2021. It remains an attractive business due to its market dominance in the unique online-to-offline auto parts retailing space. In essence, succeeding in making customers shift online to buy spare parts and then collect them from physical stores. The long-term structural growth opportunity is very attractive, and we have seen similar companies in the US and Australia do very well in this space over a long period of time. China is still at an early stage in its development of auto parts retailing and Tuhu Car is the clear market leader.
Unlisted investments are different from our traditional value investments as these companies are in an early stage in their development. We are very careful about such investments, and I do not foresee the Company increasing unlisted holdings in a significant way.
Question
Can you explain to us how you integrate ESG considerations into your portfolio?
Answer
The Company’s primary objective for shareholders is to achieve capital growth. In order to achieve the best possible returns, we have always sought to invest in businesses which respect laws, their employees, customers, the environment and shareholders as well managing their businesses properly. ESG considerations have therefore always been at the heart of our investment thinking.
Investing in smaller companies in Asia using the strength of Fidelity’s research team here has always offered us the opportunity to identify companies ahead of other investors. Regulations are constantly evolving and ESG is no exception to this. We believe this presents us with opportunities. The development of ESG ratings covered the rating agencies (MSCI/Sustainalytics) has not yet evolved to cover many of the smaller companies which we invest in. This provides an exciting opportunity as the ESG credentials of many of the smaller companies (as you will see in the examples in the Annual Report) are best in class. They are in fact ‘double gems’: companies with good prospects, strong management and well-priced alongside their strong ESG credentials.
We have also included a summary of Fidelity’s house approach to ESG in the Annual Report. This is important as Fidelity covers 85% of the portfolio and is therefore able to give us evidence that my approach is working.
Question
What do you view as the biggest risks and opportunities for the next twelve months?
Answer
We believe that the biggest risks are always things we do not know yet or “unknown unknowns”.
Of the things that are known, in our opinion, the biggest risk continues to be the medium-term impact of experimental monetary policy of the last decade. The world has never had free money the way it did in the last ten years and neither has the world lived with this quantum of debt before. Consequently, it is very hard to have a playbook to figure out how things will pan out. This is something that we keep a close eye on and continue to learn about.
Having said that, we believe our strength is stock picking rather than macro analysis. Peter Lynch, the renowned and highly successful US portfolio manager, used to say, “if you spent thirteen minutes a year on economic (macro) analysis, you wasted ten”. We are of the same school of thought.
We are very happy with the current shape of the portfolio comprising businesses that are dominant in their industries, earn good returns on capital and are available at attractive valuations. The current vital statistics of the Company’s portfolio of investee companies are as follows:
· Return on Equity at 15.4% versus 11.2% for the Comparative Index;
· A stronger Balance Sheet than the Comparative Index;
· Price to earnings: 8.5x versus 11.2x for the Comparative Index; and
· Dividend yield at 4.6% versus 2.9% for the Comparative Index.
Our skills lie in business analysis, finding best in class management teams and mispriced stocks. We are known to repeat the phrase below often and it’s fair to say that it has become known as something of a mantra for the Company:
Find good businesses run by good management and buy them at prices with a good margin of safety.
We continue to focus on this.
Nitin Bajaj
Portfolio Manager
Ajinkya Dhavale
Assistant Portfolio Manager
11 October 2022