Asia Dragon Trust (DGN) has announced its annual results for the year ended 31 August 2023. During the year, DGN provided NAV and share price total returns of -16.7% and -19.5% respectively while its benchmark, the MSCI Asia ex Japan Index, returned -8.4% on a comparable basis (all in sterling terms). Much of DGN’s underperformance can be attributed to its exposure to China, which was a particularly challenging and volatile market during the year. There was also a significant style shift towards value stocks both in China and the broader Asia Pacific ex Japan region, which weighed on DGN’s performance as businesses with quality characteristics, which its manager focuses on, were not as favoured. Nonetheless, DGN’s board and manager remain optimistic about the long-term investment opportunity in China – as well as Asia more broadly – and believe that its combination with abrdn New Dawn, which is subject to shareholder approval on 8 November 2023, strongly positions the new enlarged company for when investors start to allocate back to Asia.
Management arrangements
Keen eyed observers noted that, when plans for the merger abrdn New Dawn were announced, DGN’s lead manager, Adrian Lim, did not feature in the manager line up. Adrian has since confirmed his plans to retire from abrdn. Pruksa Iamthongthong will continue as joint lead portfolio manager and has been joined as co-manager by James Thom, who is currently co-manager of New Dawn.
Investment managers’ comments on performance
“The MSCI AC Asia ex Japan benchmark index decreased by 8.4% in sterling terms over the year while the Company’s net asset value (NAV) fell by 16.7%, in total return terms.
“Contrary to some predictions of a recession at the end of 2022, the US economy remained strong in 2023 with continued economic and employment growth. Concerns over rising price pressures led to the Federal Reserve (“Fed”) increasing interest rates to their highest levels in more than 22 years. In Asia, on the other hand, China’s macroeconomic recovery was slower than expected, as the weakness of the property market weighed on the broader economy and consumer confidence. The weak macroeconomic data raised expectations of a major policy stimulus – the lack of which has meant that investors were disappointed and raised questions on China’s commitment to economic growth. As shown in Chart 1 in the Annual Report and financial statements for the year ended 31 August 2023, this led to underperformance of the Chinese and Hong Kong markets over the past year.
“Elsewhere in Asia, markets in India, Taiwan and South Korea outperformed the region. India’s earnings growth underpinned some rich equity valuations and it benefited from substantial foreign capital inflows, given that it is one of the few countries around the world still seeing solid growth in its economy and corporate sector. The technology-heavy markets of Taiwan and South Korea made strong gains as investors judged that the semiconductor cycle was nearing its trough and responded to rapid developments made in artificial intelligence (AI).
“As shown in Chart 2 in the Annual Report and financial statements for the year ended 31 August 2023, most of the Company’s underperformance arose at the start of 2023 and has continued since then:
“China and Hong Kong were the main detractors from the Company’s performance, as shown in Chart 3 in the Annual Report and financial statements for the year ended 31 August 2023. Mainland markets rose in the final quarter of 2022 on hopes that consumption would recover after the country’s post-Covid reopening. However, the beginning of 2023 saw an inflection point with a reversal in sentiment as the consumption recovery, which our portfolio was positioned for, proved much weaker than anticipated. Accordingly, we suffered in terms of stock selection, where our positioning in what we deemed to be long term structural growth areas such as the consumer discretionary (China Tourism Group Duty Free), technology (GDS, JD.com) and healthcare (Aier Eye Hospital Group) sectors failed to perform. These were a function of a slower than expected pace of consumer spending recovery, the high savings rate as well as weak sentiment resulting from the anti-corruption drive. Investor flows have followed the theme of reforms to State Owned Enterprises (“SOE”) – this in turn has benefited the more value-based sectors, such as telecommunications, energy and financials (where SOEs are a significant influence). We remain sceptical about whether such reform is bringing about real and lasting impact. It is also worth highlighting that many companies in these sectors are on the entity/sanction lists of the US Government, hindering the ability of most Western based institutions to invest in them.
“But Asia is more than China (see chart 4 in the Annual Report and financial statements for the year ended 31 August 2023) and outside of China, the rest of the region is benefiting from supply-chain diversification, as more and more companies look to diversify their supply chains. India and Vietnam are well positioned to benefit from these trends. The Made in India initiative has started to gain traction after 10 years, post a series of reforms that help to improve the ease of doing business in India. For those that have visited India, it is hardly surprising that India needs more power and infrastructure to cater to rising supply chain needs. The higher demand for power, and a rising mix of renewable power, is driving demand for grid upgrades. This, in turn, provides multi year earnings growth visibility for our utility holding in Power Grid. Similarly, improving prospects from the long-awaited property sector recovery have translated into higher demand for cement, which benefited our holding in leading industry cement manufacturer, UltraTech Cement.
“Indonesia has not received as much attention as India but it is also an exciting market from our perspective. The country benefits from a demographic advantage, being the world’s fourth-largest population, with most of its population aged between 15 and 64. It is also undergoing a structural transformation up the commodity value chain, from selling raw ore to producing value-added commodities. Global battery makers and electric vehicle producers are investing in Indonesia to secure a part of the nickel supply chain; this is especially beneficial when the world is moving towards renewables and electrification. All of these trends should prove supportive of economic growth and we believe our holding in Bank Central Asia, Indonesia’s largest private sector bank, should continue to be a key beneficiary of this.
“Turning to South Korea and Taiwan, we see them as key nodes in Asia’s technology supply chains, which are well positioned for structural growth related to the rollout of 5G, big data and digital interconnectivity. Although our holdings here contributed to our underperformance against the index, the rapid advances in artificial intelligence are expected to be a major driver of demand for semiconductors over the coming years and many of Asia’s companies, including several of our holdings, should be key beneficiaries of this over the medium term. We view generative AI as a game changer. When it comes to generative AI applications, ChatGPT is just the tip of the iceberg and demand for AI has accelerated much faster than expected, with the server and networking supply chain among the winners in this rapidly growing market. We see the content upgrade and architecture redesign as a multi-year process, going hand in hand with the growth of generative AI applications, with ChatGPT among the first of many more to come. Our core holdings in both Samsung Electronics and Taiwan Semiconductor Manufacturing Corp (TSMC), are well positioned to benefit from this trend. In the case of the former we see particular value in the preference shares, where their discount to the ordinary shares has widened sharply.”
Investment managers’ comments on the portfolio
“When reviewing the portfolio, and given the uncertain outlook, we focused, firstly, on adding to companies with higher near-term earnings visibility. We added to Larsen & Toubro, the leading infrastructure conglomerate in India whose order book has benefited from capital expenditure spending in India. As mentioned, we continue to back Power Grid as well as TSMC, where we have strong visibility over future earnings.
“Secondly, we focussed on our highest “quality” positions. We have increased our semiconductor and technology hardware exposure as the inventory cycle reached a bottom. For example, we initiated a position in ASM International, the global leader in advanced deposition semiconductor equipment (more details in the case study). The aforementioned TSMC would also fall into this category, as would Samsung Electronics, both trading on attractive valuations.
“Thirdly, while consumer confidence remains low in China overall, the end of Covid-related restrictions is nonetheless boosting businesses with inelastic demand and valuations have substantially de-rated in some cases. For example, we have initiated a position in Aier Eye Hospital Group, China’s leading eyecare specialist chain, where we expect patient traffic to normalise after the disruptions caused by the pandemic. We have added to our highest conviction holdings in the China internet space. In this sector Tencent stands out on recovering advertising spending despite the weak macroeconomic backdrop. Its gaming business also showed signs of recovery as games approvals resumed. Similarly we have built up the position in the online food delivery and platform business, Meituan.
“There were some holdings that we exited on fundamental concerns, such as Longi Green Energy. Despite retaining their cost advantage, Longi’s technological edge has been eroded due to technological transition and we see evidence of oversupply in the solar value chain that we expect to persist in the medium term. Another was Foshan Haitian, where, although the soy sauce maker retains a strong brand and good long-term potential, we see better prospects elsewhere. As a result of this, our holdings in China have become fewer and more focused on those companies where we see the highest quality and best earnings visibility.”
Investment managers’ comments on outlook
“We have seen a material sell-off in China equity markets this year, sentiment towards China remains weak, and there are certainly reasons for caution. Some important areas of the Chinese economy are still seeing persistent weakness, particularly the real estate sector, and consumer sentiment remains soft. That said, we are seeing some improvement in the services sector with encouraging demand trends, for example, in restaurant services, automotive sales and online goods sales. As another indicator, domestic travel spending during the Golden Week holiday in October was only marginally lower than pre-Covid levels. Domestic savings rates also remain unusually high pointing to significant pent-up demand across Chinese households, see Chart 5 in the Annual Report and financial statements for the year ended 31 August 2023.
“Whilst major 2008-style stimulus measures have been absent, since July we have seen the Chinese authorities selectively intervene in the economy with supportive policy measures and financial conditions have also been accommodative. This points to a willingness and desire by the government to bring stability to the property market and to ensure moderate growth is maintained. If successful, this should help bolster consumer sentiment and ultimately convert some of that pent-up demand into spending. The timing of all this is unclear and rising geopolitical tensions add further complexity, but what is clear is that there has been a material de-rating in the Chinese market and possible over-shooting, and for long term investors this is creating opportunities to invest in some very high quality businesses with still healthy medium term growth prospects at very attractive valuations.
“While accepting cloudy macro-economic conditions, rising geopolitical tensions and conflicts in many parts of the world, in Asia we have more cause to be optimistic:
- earnings growth is expected to improve into 2024 with consensus forecasts of 18% earnings growth for the region, following a flattish year in 2023;
- as mentioned, valuations are attractive; and
- most Asian countries have relatively low levels of borrowing and more benign inflationary conditions.
Over the long term, we particularly favour attractive opportunities around these structural themes:
- Aspiration: Rising affluence in Asia is leading to fast growth in premium consumption in areas including personal care products, financial services and food and beverage;
- Building Asia: Urbanisation and an infrastructure boom is set to benefit property developers and mortgage providers among others;
- Digital Future: Growing integration amid the widespread adoption of technology means a bright future for plays on gaming, internet, fintech and tech services like the cloud;
- Going Green: Policy makers globally are committing to a greener and lower carbon future and Asia is in the driver’s seat. Plays on renewable energy, batteries, electric vehicles, related infrastructure, and environmental management all have a bright future. Grid parity will be game-changing;
- Health & Wellness: Asia is home to a diverse range of companies leading advancements in biotech and medical device technology. Our holdings include plays on contract research, vaccinations, pharmaceuticals and diagnostic products; and
- Tech Enablers: Asia tech supply chains are well positioned for structural growth related to the rollout of 5G, big data and digital interconnectivity.”