Chinese stock selection and India underweight weigh on Invesco Asia

Invesco Asia (IAT) has published its annual report for the year ended 30 April 2024 during which it provided an NAV total return of 2.7% and share price total return of 2.2%, both markedly underperforming its benchmark, which returned 7.9%. The underperformance came mainly from stock selection within China and the underweight allocation to India. Despite underperforming during the last financial year, the long term performance record is good with outperformance over three, five and ten years. In addition, performance over four years from 30 April 2020, which is relevant to IAT’s conditional tender offer which will be assessed on five-year performance from 30 April 2020 is comfortably ahead of the benchmark (an NAV total return of 11.0% annualised versus 4.5% from the benchmark). The discount widened a little over the course of the year from 12.4% at 30 April 2023 to 13.4% at 30 April 2024 and averaged 11.3% over the year.

IAT’s chairman Neil Rogan says that not much has changed over the last six months. Trade friction between the US and China remains, with the US presidential election adding noise and uncertainty. He adds that China has taken further steps to stabilise its residential property sector, where overdevelopment has led to a loss of consumer confidence and also some bank instability. Asian technology companies such as Taiwan Semiconductor Manufacturing and Samsung Electronics have performed well on the coattails of the “Magnificent Seven” tech stocks that have led the US stockmarket rally, he notes. India’s economy has continued to grow without so far threatening the high rating of its stockmarket. Domestic consumer spending growth is healthy across Asia; for example 4.8% in China, 5.7% in India, 5.1% in Indonesia and 2.2% in Taiwan (Morgan Stanley 2024 forecasts). And with overall forecast 2024 economic growth rates including 4.8% in China, 6.8% in India, 2.7% in South Korea, 5.1% in Indonesia, 3.7% in Taiwan and 2.2% in Singapore comparing favourably with the US at 2.2% and the Eurozone at 1.3%, he says that there continues to be grounds for optimism and that Asian stock market valuations are cheap relative to the world and cheap relative to their own history.

Investment managers’ report

The investment managers’ report 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: The Company’s net asset value grew by 2.7% (total return, in sterling terms) over the twelve months to 30 April 2024, which compares to the benchmark MSCI AC Asia ex Japan Index return of 7.9%.

The year began with a degree of optimism surrounding the prospects for Asian markets as China’s economy reopened post-Covid. However, the strength of China’s recovery has disappointed while markets have also had to contend with shifting expectations around the trajectory of US interest rates. Against this backdrop, the portfolio has benefitted from the positive impact of our stock selection in markets such as South Korea, Taiwan, Singapore and Thailand, with enthusiasm for AI having generated strong returns for chip stocks in particular. This has helped offset the impact of stock selection in China, where consumer-related stocks that rallied strongly in the prior period gave back some of that outperformance. Looking at markets more broadly, performance over the last twelve months has been mixed (as can be seen from the chart below), and it is frustrating to report that the impact of being underweight India and overweight markets such as China, Hong Kong and Indonesia has also counted against us.

What gives us grounds for optimism is that the degree of divergence we have seen in terms of performance and valuation between the best and worst performing markets is extreme. This is the kind of backdrop that usually presents us with great opportunities. Conditions can change, sometimes rapidly, and although recent performance has disappointed, we are increasingly confident in the prospects for the portfolio over our investment time horizon.

Question: What have been the biggest detractors?

Answer: Chinese consumer stocks were amongst the best performers in the prior reporting period, amidst optimism surrounding post-Covid reopening. However, some of those gains have been reversed as the strength of China’s recovery has disappointed. China Meidong Auto was the biggest single detractor, with weak demand and increased competition from the electric vehicle (‘EV’) segment being headwinds for the luxury auto dealership, although business operations appear to be faring better than feared. Beijing Capital International Airport has struggled as international routes have been slow to re-start, especially from the US, while restaurant operator Jiumaojiu faces pricing pressures in a slower-than-expected recovery. Ming Yang Smart Energy has also faced competitive pressures, leading to concern over the wind turbine manufacturers decision to move into wind farm development, a more capital-intensive business – a development that prompted us to sell. Exposure to life insurers Ping An Insurance and AIA also detracted, as did auto parts manufacturer MINTH.

Elsewhere, LG Chemical felt the effect of slowing EV sales as government subsidies have been reduced in several key markets. Indonesia’s economy has also been going through a softer patch of growth, which negatively impacted cement manufacturer Semen Indonesia and auto conglomerate Astra International.

Question: And contributors?

Answer: Shriram Transport Finance was the biggest single contributor, as India’s leading lender for buyers of second-hand commercial vehicles, it continued to deliver strong earnings growth and improved margins, with evidence of its extensive branch network being used to good effect with growth in cross-selling products. Aurobindo Pharma has also added significant value on the back of an improvement in generics pricing in the US (their largest market) and strong execution in their injectables business, but we have taken profits and sold, with the stock appearing fully valued, in our view.

Tech stocks with exposure to the AI server supply-chain have been strong contributors, with the likes of South Korean chip manufacturer SK Hynix, Taiwan Semiconductor Manufacturing (‘TSMC’) and Chroma ATE in Taiwan all making strong gains. More broadly speaking, stock selection in South Korea has added value, with some excitement over the unveiling of a ‘Corporate Value-Up’ programme, intended to drive improvements in shareholder returns and corporate governance. Samsung Fire & Marine is already setting a good example in this regard, with the insurer’s strong operating performance being matched by a more progressive dividend policy. Hyundai Motor also advanced with sales in the US, Europe and India complementing increased distribution of higher margin vehicles.

Other notable contributions came from South-East Asian gaming and e-commerce company Sea and Anglo American, after the mining group received a takeover bid from BHP. We have also started to see selected Chinese companies, like Tencent Music Entertainment and the digital freight platform Full Truck Alliance, being well rewarded for demonstrating an ability to grow.

Question: Are you able to find any pockets of value in India?

Answer: India appears to be in a macro sweet spot, with a bull market supported by a strong capital expenditure cycle and robust domestic demand. Our Indian holdings have generally performed very well, but we have now sold outperformers like Aurobindo Pharma, Larsen & Toubro and Mahindra & Mahindra, with valuations appearing increasingly full, implying long term growth rates we struggle to justify.

The challenge has been to find new ideas that appear undervalued, with the market trading at 4.0x Price-to-book ratio (‘P/B’), a level last breached nearly two decades ago (see chart above), at a time when other Asian markets attracted a similar premium. As the increased underweight position in India suggests, we have been finding more attractive opportunities elsewhere.

That said, we still have some exposure and have been adding to HDFC Bank, which has recently merged with its parent, a bumpier journey than the market expected. Looking through the near-term issues, we have no concerns on their ability to integrate the two businesses and have been happy to add at trough valuations. We have also introduced: Delhivery, which is India’s largest third-party logistics company, making it well positioned to benefit from growth in e-commerce; and Power Grid of India, the nation’s central transmission utility, a company with what we consider to be stable, long-term growth potential and an attractive dividend yield.

Question: Has your positioning in Hong Kong/China changed, are green shoots emerging?

Answer: The portfolio continues to have a small overweight position in China and Hong Kong. Market sentiment for much of the year has been weak, reflecting concerns over escalating geopolitical tensions, poor consumer confidence and a troubled property market. We witnessed a degree of capitulation towards the end of 2023, with indiscriminate markets weakness suggesting little hope for a recovery and a feeling that the policy response was underwhelming. Our view has not changed, with a belief that coordinated measures have been put in place to support the economy, with valuations still deeply discounted, and equities likely to prove sensitive to signs of improvement in the fundamentals, which we have started to see.

Against a challenging backdrop, we have been thoroughly reviewing the portfolio, seeking to upgrade on quality where possible. As already discussed, we sold wind turbine manufacturer Ming Yang Smart Energy given a change in strategy that compromised our original investment thesis. We also sold China BlueChemical and Will Semiconductor, which have performed well in a weak market, and looked to consolidate the portfolio, exiting some smaller holdings. In turn, we have sought to introduce or add to stocks that offered what we consider to be better quality, stable growth potential at discounted valuations. Names introduced include digital freight platform Full Truck Alliance, baijiu distiller Wuliangye, China Resources Beer and Tencent Music Entertainment.

Meanwhile, markets have rebounded nicely from their January lows. Geopolitical tensions linger, but we have seen signs of stabilisation in the economy and policy support measures that signal a more determined attempt to support the property market.

Question: What are your thoughts on AI developments and related opportunities?

Answer: There has been a bit of a buying frenzy around any company in NVIDIA’s supply chain, given how they have raised their guidance on AI-related chip growth, with their new AI chips being multiple times more powerful than the previous generation, enabling the launch of awe-inspiring AI applications such as Sora from OpenAI.

What we have noticed is that AI enthusiasm has started to move into nascent or niche adopters and beneficiaries. For example, MediaTek, which is a portfolio holding, announced the launch of a new mobile chip in November 2023 which facilitates the use of generative AI on smartphones. This is part of a trend known as ‘edge-AI’ with other high-end Android smartphones having adopted the chip.

For the tech companies we hold, the current contribution to earnings from new AI components or devices is negligible, but the market has been placing higher multiples on these new earnings with the expectation of significant, structural growth from these products in future years. While these AI beneficiaries are clearly in-favour, arguably the biggest and most important change in their fundamentals has been an improvement in the cycle for legacy semiconductors that go into everyday PCs, smartphones and servers, with inventory being drawn down and shipments starting to grow, which is helping drive earnings and margin improvement. We do not need to place high multiples on AI-related earnings to justify double-digit expected returns for these stocks.

Question: Are you convinced by South Korea’s ‘Corporate Value-Up’ programme?

Answer: It is great to see politicians and regulators co-ordinating on measures to help narrow the ‘Korea discount’, but this is not a new trend. Initiatives introduced in 2014 promised similar improvement, since when we have identified signs of gradual improvement in corporate governance, particularly in the growth of dividends from South Korean companies.

The recent measures target companies trading on a low P/B, suggesting management should be accountable for improving governance, that boards should measure P/B and return-on-equity (‘ROE’) and actively explain to investors why they are underperforming. Publishing these metrics and creating premium indices of companies succeeding on that basis (tracked by ETFs) follows the approach taken in Japan, where the strategy has enjoyed success and continues to build momentum.

Other reasons for optimism include: the support of South Korea’s National Pension Service, the world’s third-largest pension fund; and retail share ownership that continues to climb. There has also been recognition that the tax system has been hindering stock market development and is in need of reform, albeit that the election result in April 2024 makes progressive reform less likely.

Lastly, we should add that our overweight position in South Korea reflects the strength of the bottom-up opportunities that we can find, rather than any top-down view or belief in ‘Value-Up’ being a catalyst. That said, we expect more announcements in the coming months, and that South Korean corporates will start making more of an effort to improve appearances when it comes to dividend pay-outs and balance sheets.

Question: Are there any other significant portfolio changes to report?

Answer: We have introduced two Singapore listed internet companies, both of which have market leading positions in the Association of Southeast Asian Nations (‘ASEAN’) markets they focus on: Sea, the region’s largest e-commerce company that also owns a gaming studio; and Grab, which is focussed on ride hailing and food delivery. Both had seen big de-ratings with bearish consensus narratives, but have compelling long-term fundamentals, strong balance sheets and underappreciated hidden value.

Overall exposure to financials has increased as we introduced KB Financial in South Korea and added to ASEAN financials such as Singapore-listed United Overseas Bank (‘UOB’), PT Bank Negara Indonesia Persero and Thai lender Kasikornbank. We also introduced Telkom Indonesia, with recent share price weakness on competition concerns being overdone, in our view.

Lastly there are a few off benchmark-introductions to flag. Anglo American (‘AA’) is global diversified miner of copper, diamonds, iron ore, platinum group metals (‘PGMs’), nickel, manganese and met coal. After a near death experience during the commodity slump of 2015, AA has been through a cycle of selling high-cost assets, moving down the cost curve, and strengthening the balance sheet. With the share price down by more than 40% from its 2022 peak, we felt the balance sheet was in good shape while the valuation was the cheapest of its peer group on a P/B basis.

Swatch is a Swiss luxury goods company, but more than 50% of sales (and a higher proportion of profits) are to countries in Asia, led by China. We believe the shares are excessively discounted, with the company having a very strong balance sheet and encouraging growth initiatives involving brand collaborations. Incitec Pivot is an Australian company with two main businesses, explosives, which has high barriers to entry and intellectual property protection; and fertilisers, which have low margins and low barriers to entry, and recently faced profitability pressure due to rising costs and falling revenues. We believe these issues are reflected in the price and that the underlying business is strong, with a A$1.4 billion shareholder return policy giving us further confidence.

Question: Final thoughts?

Answer: Since peaking in early 2021, Asian equity markets have struggled amidst a liquidity tightening cycle and a crescendo of negativity surrounding China. Valuations for regional indices trade below long-term historic averages, both in terms of price earnings and price to book ratios, and at a significant discount to developed markets, particularly the US. We believe there is scope for this to narrow, with continued divergence in performance and valuations between different countries and sectors also providing opportunity.

Asian equities are also well placed to benefit from an improvement in liquidity conditions, as we approach the peak in rate expectations, with US dollar strength likely to cease being a headwind. Furthermore, inflation in Asia is less of a concern than in developed markets and economies enjoy relatively solid fundamentals, suggesting greater monetary policy flexibility should growth headwinds start to build.

Finally, consensus earnings growth expectations for 2024 are around 20% and we believe that Asian corporates may see less earnings vulnerability from a global slowdown relative to what is being implied in valuations, although India appears to be the exception given elevated expectations.