We have been investing in Asian equities (excluding Japan) for many years and believe that there are multiple reasons to invest in the region. In this article, I will refer to Asia when discussing the Asia ex Japan region.
Firstly, the developed world is likely to see a combination of consumer de-leveraging, an increase in tax rates, pressures on government spending and ageing demographics. In contrast, savings rates in Asia are high and expected to decline, thereby boosting consumer spending. Furthermore, government debt in Asia is relatively low and there are not the pressures on tax rates or government budgets due to huge unfunded pension and healthcare liabilities that are evident in the developed world. Whereas the US government relies on foreign investors to buy its debt, this is not the case for Asian governments.
Secondly, the US faces serious structural issues: a growing budget deficit and large current account deficit, the risk that China will continue to reduce its portfolio of US Treasury securities, potential for pressure on the US Dollar to cause interest rates to rise, to name but a few. These structural problems may result in slower growth being accompanied by higher interest rates. This would prove a toxic brew for US equity (and debt) markets.
Thirdly, Asian currencies are very cheap on a purchasing power parity basis. Given the global trade imbalances and the current path of the US administration and Federal Reserve, the long-term decline of the Dollar is likely to continue. In January 2007, the McKinsey Global Institute found that the US Dollar would need to depreciate (on a trade-weighted basis) by 30 per cent if the US current account deficit were to close by 2012. Since that report, the US Dollar has declined by less than 10 per cent on a trade-weighted basis. We believe that investors in Asia will see their future returns boosted by currency appreciation.
Fourthly, China is currently at the epicentre of a powerful structural shift in political, economic and financial power from the West to the East. China, India, South Korea, Taiwan, Hong Kong and the other investable ASEAN countries are home to nearly half the world’s population. Their total combined population is ten times greater than the population of the US.
Warren Buffett, the world’s greatest investor over the past 50 years, famously said, “I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over.” Based on these arguments, and assuming the price is right, it makes more sense to invest in Asia than in the world’s most developed markets.
Is the price right?
The most common measure for valuing equity markets is the Price/Earnings (P/E) ratio. The table below shows the P/E ratios of the world’s major markets.
You will see from the table that investors in Asian equities are paying approximately the same valuation as investors in US and European equities.
The average P/E for the US equity market over the past 50 years is about 16. Asian valuations therefore look reasonable, both relative to other markets and in absolute terms. However, one of the problems with using current year earnings in the P/E ratio is that it does not adjust for the cyclicality of earnings. One of Warren Buffett’s favourite indicators is total market capitalisation as a percentage of GDP. This measure has one flaw: over time, there is a structural upwards bias to the ratio as a greater proportion of companies become listed as an economy develops. We prefer to use the market’s Price/Sales ratio as a good “sanity check” on whether a market is cheap or expensive. It provides a similar measure but without the structural upward bias over time. As shown below, since 1997 the Price/Sales ratio of the MSCI Asia free ex Japan index (the most commonly used benchmark for the region) generally fluctuated between 0.8 and 1.6. The current ratio of about 1.2 suggests that Asia ex Japan equities trade at fair value – they are neither particularly cheap nor particularly expensive. (See Figure 1)
Is China a bubble?
Greater China markets (China, Hong Kong and Taiwan) comprise more than half the MSCI Asia free ex Japan index. It is therefore imperative that an investor in Asian equities gets China “right”.
Several well know investors (including James Chanos and Pivot Capital) have recently argued that China’s economy is a bubble on the verge of bursting. Their arguments are the rapid growth in credit and the overbuilding in property markets and infrastructure. While we believe there is a bubble in China’s real estate market, the contagion effects on the banking system and economy are likely to be limited. According to the Economist, the average mortgage in China covers 50% of a property’s value and a quarter of real estate buyers pay cash. Loans to homebuyers and developers account for 17% of Chinese bank loans versus 56% for US banks. Bad loans at China’s state-owned banks are therefore likely to be smaller than feared. China has raised bank reserve requirements twice so far this year. If China’s banks, which are largely state-owned, need shoring up, China is likely to sell some of its US Treasuries and repatriate these funds back to China. That would likely put downward pressure on the US Dollar versus the renminbi.
While some of the recent infrastructure spending is likely to be wasteful, such as expressways that have been built parallel to existing toll roads and half-empty airports in China’s sparsely populated western provinces, much of it has, and will, improve productivity, leading to economic growth. China is currently investing heavily in high-speed railways linking cities and subways within its cities. It needs both.
Our Asian investment strategy
We have little exposure to Chinese real estate, banks, toll roads or steel or cement businesses where there is huge overcapacity. Whilst we see over-production in China and much of the rest of Asia we also see under-consumption. Savings rates are too high and correspondingly consumption is too low (see chart below). Asian governments are therefore trying to shift their economies from an export-driven model to a more service-based model and are implementing policies to lower savings rates and boost consumption. Even with high savings rates, retail sales in China are growing at about 15 per cent per annum in China and at 10 per cent per annum or more in most of the region. (See Figure 2)
We have huge exposure to companies that serve Asian consumers. These companies typically have relatively small market capitalisations but are dominant in their markets. We have over 40 per cent of the assets of OAM Asian Recovery Fund invested in companies that serve Asian consumers. Anthony Bolton, one of London’s most successful fund managers moved to Hong Kong and recently came out of retirement to run a Greater China equity fund. On his return to managing money, he said:
“The most exciting argument in favour of investing in China today is its position on the so-called S-curve. China is at the investment “sweet spot” for developing markets which occurs when incomes per head of population rise steadily but consumption increases rapidly, the retail sector develops and the service sector begins to take off.”
The other sector of Asian markets that we think has bright prospects is technology. We have 15-20 per cent of the Fund’s equity investments invested in Asian technology companies. Asia has a global competitive advantage in technology from several vantage points: cost of production, education (particularly in electrical engineering), willingness to adopt new technology and clustering of expertise. Unlike most other sectors of Asian manufacturing, there is fairly tight capacity in technology production, due partly to the bursting of the technology bubble ten years ago. Meanwhile, more than half of global demand for many technology products already comes from emerging markets which are growing far more rapidly than Western markets.
How can we manage funds from Cayman?
We have proven that there is no need to be located in London, New York, Tokyo, Hong Kong or Singapore to successfully manage an investment portfolio. OAM Asian Recovery Fund was launched 11 years ago. As shown below, the Fund has returned 503 per cent (18 per cent per annum) from launch to the end of 2009. This compares with 136 per cent (8 per cent per annum) for the MSCI Asia free ex Japan (US$) index and 42 per cent (3 per cent per annum) for Berkshire Hathaway, Warren Buffett’s investment vehicle. Investors in our European equity fund have reaped similar absolute and relative returns. (See Figure 3)
We have been managing equity investments for clients from Cayman for the past 20 years using a value-based, bottom-up investment process. Sir John Templeton did much the same from the Bahamas for a much longer period and on a larger scale and Allan Gray does the same with the Orbis funds from Bermuda. There is growing interest from fund managers who are considering moving all or part of their business to Cayman. Recently, I met with such a fund manager who remarked on Cayman’s wonderful quality of life. The fund manager commented on how much easier it is to “decompress” from the performance pressures that accompany fund management when you are in Cayman rather than in a big city. The Cayman government has put in place directives and a policy that will roll out the red carpet to investment management firms considering moving to Cayman. Given the pressures of rising tax rates in the developed world, Cayman ought to be in a strong position to attract good fund managers to relocate here and build another pillar to the financial sector.