Introduction
The Asian stock markets have enjoyed a strong run this calendar year. Does this support the theory that the Continent has strengthened its economies and will continue to enjoy its strong run or have the opaque stock markets peaked and do they now look vulnerable to rising US interest rates and the threat of over supply from China? As with all the most interesting debates, opinion is divided. Having just returned from eight days visiting our investments in Asia, talking to company management and Unit and Investment Trust managers, I believe investments in these markets offer significant upside potential although we don’t anticipate that it will be a smooth ride.
Singapore
The positive shift in sentiment in Singapore is most obvious in their primary newspaper, The Straits Times. The passage of time has healed wounds such as the SARS virus and disappointing stock market performance and the headlines point to surprise profit increases, blue skies in the Singapore market, beating official growth forecasts and retail property booms.
Walter Womersley, who works in the Financial Markets division at Rabobank, provided an insight into the Government and people’s understanding of the need for new skills to further the development of their economy. Singapore is embarking on a number of innovative and design based education courses to prepare the next generation for the challenges of the 21st Century and the people are embracing these opportunities.
Although the economic outlook is bright, it remains a challenge to encourage local investors back into the stock market. Alistair Thompson, co-manager of the successful First State Asia Pacific Leaders Fund, said that the risk appetite for equities has improved in the last two years. Due to the increase in value of Asian markets during 2005 the fund is practicing caution in the short term but named several themes it aims to exploit in the medium to long term: the rise of the consumer; the high savings rate; the demographics and; the dividend yield pay out. It was interesting to note that whilst Avian Flu did not register as a big concern to share values or stock market performance First State are certainly aware of its potential impact.
In terms of geographic allocation, Vietnam featured in several discussions with fund managers. Consensus opinion is that the country is looking increasingly attractive as an investment opportunity: it is due to enter the World Trade Organisation, the economy is growing at 7.5% per annum and the Government recently raised money via the International Debt Markets for the first time in many years.
Hugh Young, head of Asian Equities at Aberdeen Asset Management, has presided over a superb period of performance, most notably in the Aberdeen New Dawn Investment Trust. He is excited about the economic development in Asia although he believes China is a difficult country to invest in directly. Instead, he invests in Chinese companies listed in Hong Kong or Hong Kong companies with a base in China.
Of the companies I saw in Singapore both Singapore Telecom and United Overseas Bank were equally impressive.
United Overseas Bank (S$14, pros p/e Dec 2005 13x) has moved against the market trend to increase the size of their loan book and, like Lloyds TSB and Barclays, has focussed on asset quality. The lack of asset growth has caused the analysts to put a low valuation on the shares despite the fact that UOB argues that they are deploying their capital more efficiently than a number of their more highly rated rivals. We also believe the shares are discounted for potential ‘bad debts’ despite the more sober approach to lending. UOB has started to expand out of its Singapore base into Thailand and Malaysia but analysts believe it is moving too slowly to accrue the potential benefits of the rapid growth in consumer incomes in these countries.
As with all the companies I saw, we spoke at length about the prospects for China. UOB has romanced a number of banks outside the big three cities for many years but has not found a partner that fits its criteria in valuation terms. Even with its intimate knowledge of China - UOB was formed by five Chinese families – it finds the valuations placed on these banks difficult to justify and questions whether they will ever be allowed to take full control. (World Trade Organisation rules say the Chinese will soon have to allow foreign institutions to raise their holdings in Chinese banks from 19% to 49%, albeit in tiered moves.) UOB has been surprised by the appetite of Western financial institutions for stakes in Chinese banks. (The less than inspiring performance since mid August of Bank of Communications, the first of the big four Chinese banks to float in Hong Kong, should be a warning to over excited Western bankers.) It is likely that within the next two years UOB will be a target rather than a predator as the founding family seek to extract value and as larger Western Banks seek to acquire assets in Asia.
Singapore Telecom (S$2.44, pros p/e March 2006 12x, yield 4%). The company has a range of activities in fixed line and wireless in Singapore which sit alongside a number of associate companies elsewhere in Asia and a 100% stake in Australian mobile operator, Optus.
Like almost all previously nationalised telecoms companies, SingTel has faced stiff competition following the introduction of domestic rivals in both the fixed and mobile markets and the outlook for its domestic market is relatively unexciting. Optus has also suffered an earnings short fall due to competition from Hutchison and Vodafone. It disappointed investors when it announced that price cutting during the roll out of 3G had hurt margins and that in future it would not compete for customers with its bigger rivals. Both Singtel and UOB have listened to the Western investment banker’s mantra of ‘caution at all costs’, using the free cash flow to reward investors with significant dividend increases. This has so far failed to move the stock price. The more discerning investors may have noticed that the Singtel CEO increased his exposure to the company by a factor of five in July, using the proceeds from the sale of existing shares and borrowed cash to exercise options six years earlier than planned.
Hong Kong
Hong Kong presented the opportunity for several more interesting meetings. The most exciting was with the management of Crosby Capital (75p, pros yield 3%) an investment bank and wealth management business operating primarily in the Asian market. The investment banking team have invested in a number of profitable situations in the year to date and the deal flow shows no signs of abating. Courtesy of some of the pricing inefficiencies in Asian markets due to investor misperceptions, the team see no reason why they should not be able to repeat recent successes in the years ahead. On the wealth management side, the company has made a number of successful new hires, simultaneously growing the asset base and has benefited from the trend among aspiring young business people to appoint a wealth manager.
Other companies I saw were Lee & Man Paper (HK$7.35, pros p/e March 2006 12X, - a paperboard and carton manufacturer) and Giordano (HK$4.50, pros p/e Dec 2005 15X – a fashion retailer). The consensus opinion among Hong Kong businessmen is that, within a relatively short time period, many Hong Kong companies will make greater profits in China than they do in Hong Kong. These two companies have been among the first to adapt their business models to benefit from this belief. Although they are making good progress they are yet to reap the full potential benefits.
I also saw Jonathan Brooke, manager of the East of Suez fund, a hedge fund focusing on Asian markets. Jonathan explained how emerging markets enjoyed a good run up to 1993 but, in the wake of Mexico in 1994, the Asian crisis in 1997, the Russian crisis in 1998, the end of the run in technology shares in 2000 and the impact of SARS in 2002, has been neglected by investors for the last nine years. He believes investors are now beginning to look favourably on the region again but opinion is divided on the near term prospects for the markets given the strong run so far in 2005. However, Jonathan was encouraged to see that, despite all the talk of over-optimism, the South Korean market recently recorded its largest ever short position. He believes that the Asian stock markets will continue to rally and points to the low volume of shares traded in a single day in Asia and the fact that the Korean stock market has only just passed its peak of 1994 as signs of how far they could yet progress. Jonathan noted that recently the total value of bargains in Google in New York exceeded the value of stocks traded in Asia as a whole on the same day: $8bln versus $7.8bln. He also identified that there has not been a proper bull market in Asia post the development of the internet. Considering this and the attractive demographics and desire for self-improvement, there is every chance this geography will surprise in a major way.
China
It is difficult to form a clear opinion about the prospects for the Chinese stock market because of the lack of transparency in the way the economy is managed. This was confirmed in my mind as I learned that the economy is micro managed by Government officials who fear the consequences of over production to a degree far beyond my previous understanding and almost to a degree that is difficult to comprehend given the huge scale they are operating on. Government officials know that over production can slow economic growth and remember how slowing economies led to the removal of the military regime in Taiwan in the early 1990s and the dictator Suharto in Indonesia later in the decade.
On my return to England I was fortunate enough to be invited to see the Chinese Ambassador to the UK speak about the prospects for the Tianjin Binhai New Area, where the Chinese Government is keen foster growth. I was surprised by almost everything that the Chinese delegation said publicly. Not only did they speak like they were Capitalists but they advised the EU to reform the Common Agricultural Policy before lecturing China on subsidies and tariffs and passed comment on the current state of the Chinese legal system saying: “what would you prefer, the American version?”
China currently faces opposition from the West regarding the value of its currency. Western opinion is that the Chinese are purposefully undervaluing their currency to increase (and maintain) the attractiveness of their exports. In doing this the Chinese have amassed a huge foreign exchange reserve which is expected to exceed US$1 trillion, the largest foreign exchange reserve ever recorded.
They are acutely aware of the enormous sums of money invested by Taiwanese and Korean companies in China in the last ten years and the mutual benefits derived from this. If the Chinese revalue their currency upwards the Country will immediately become less attractive to foreign companies as a cheap manufacturing area, exports will fall and it will grow at a slower rate. They also know that the long term planning that has paid off so handsomely for these overseas companies may well now be leaning towards investing in additional countries and that it is overseas capital expenditure which has largely been responsible for the rise in the standard of living of the Chinese population. This Chinese must weigh up the advantages and disadvantages arising from such a move and decide what is best for their country in the long run. It is not certain what they will choose to do. The potential for a surprise revaluation to act as a boost to equity markets globally should not however be underestimated.
Having met and heard the senior Government officials speak, there is no doubt in my mind that the Chinese will adhere to their own policies and act in the best interests of their country and people, resisting pressure to conform to Western policies. They are playing an extremely long-term game in their bid to become rich and powerful. The difficulty for Western investors will be in understanding their methods of achieving these aims.
Conclusion
Having talked to fund managers and company management and experienced the excitement and great feeling of opportunity, I believe I now have a much better understanding of the prospects for Asian economies and stock markets. I also have a better understanding of the complexities governing the direction of their stock markets.
The emerging markets face many of the same challenges in terms of their development. The Chinese must move away from rote learning and basic assembly work to innovation and research - the requirement to ‘think out of the box’. It is encouraging to see signs that this evolution is underway. For example, China is home to some of the most highly rated Universities in the World and has invested heavily in new areas of interest such as nanotechnology and stem cell research and Singapore is introducing team sports to encourage spontaneity and team thinking.
While we recognise the risks associated with investments in the emerging markets, stemming from the lack of transparency in the stock markets and difficulty in understanding their economies, we believe the potential rewards outweigh the risks. Although such an investment is not suitable for all clients we will look to provide exposure to the Asian markets where appropriate. I would be delighted to discuss my thoughts with you in more detail.
27 October 2005
