China stocks are ‘cheap’ and are your biggest overweight, yet many investors are shunning the region. What will lead to a sustained rally in Chinese equities?
If you’re looking for a sustained rally, a lot of people are waiting for two things to happen. One is signs of the bottoming out of the property market, and the second is a reduction in tensions with the US and the West. A lot of investors say that that will be the bottom of the bear market – when those things turn around. But sometimes when stocks are as cheap as they are, and we believe that the negatives have already been factored in, all you need is that. So, all you need is extraordinarily cheap stocks and things at the bottom-up level, going in line with expectations or even a little bit better than expectations.
Can Asia perform as an asset class in the absence of a strong China?
Asia can perform as an asset class in the absence of a strong China. We’ve seen it already. Korea has performed poorly, but Taiwan and India, the other two components of our Asia benchmark, have performed very strongly, even in the context of a weak China. So those economies can do well. Taiwan is tied to the semiconductor cycle. India has got a strong domestic economy. Korea and China do have some of the same drivers. But even if you look at the reasons why they’ve both underperformed, they’re different. China’s property market has performed poorly, which has spread negative consumer confidence. Its relationship with the West has deteriorated. Korea has performed poorly, we think, because of poor corporate governance. So, there are common drivers, but there’s also enough difference between each of the key countries in our Asia Ex-Japan benchmark that can cause their performance to diverge.
Asia can perform as an asset class in the absence of a strong China. We've seen it already.
South Korean authorities are looking at measures to address the ‘Korea discount’. What might the impact be on investments?
The Korea discount is something that’s close to our heart. We’ve been quite active in trying to advise regulators as to what measures they can adopt to close the discount. I think the Korea discount will be reduced if effective measures are put in place, and that means measures that have regulatory effects that address the key reasons for it – things like a lack of fiduciary duty for directors of companies, and the current lack of need for minority approval for related party transactions. Those things need to be put in place.
Absent that, I think there is still opportunity in Korea for stock pickers. So, the kind of companies that can do well are those companies that are not controlled, and a very small number of companies are not controlled in Korea. Those companies can do well because there’s no incentive not to improve their governance. There are also some companies that have shown a commitment to improved corporate governance, despite the fact that it won’t necessarily be in the interests of the controlling shareholders. So those kinds of companies can do well too, even in the absence of a firm regulatory response.
If regulators do not take action, how will this impact your investment strategy?
If regulators don’t come up with a firm response, then we need to be bottom up. So, we’re concentrating on three areas:
- Companies that are not controlled by controlling shareholders. In Korea, about 90% of companies are, and the companies that aren’t would be the banks. Uh, so those companies, we think there will be a long term, positive response to an improved corporate governance zeitgeist.
- There will be some companies that improve their governance despite the fact that they are controlled. We think those will be few and far between. But there are examples of those.
- And then the third area is we’ll look for situations where controlling shareholders can throw minorities a bone, but in a way that won’t cost them anything. So, one area that we are looking at is Korean preferred stock, essentially nonvoting common stock trading at very significant discounts. In Korea, companies can easily reduce their discount by making tender offers to buy those shares at a significant premium. It will improve the cost of capital for the company, but importantly, because the preferred shares outstanding are so small, it won’t affect the control structure in the vast majority of cases. And that’s something that we think controlling shareholders will be prepared to do because it shows that they’re doing the right thing, but it doesn’t really change anything for them.
What is driving your substantive underweight to India, and what would it take for you to reduce the underweight?
Well. India is the most expensive market in the world, it trades at around 24 times earnings. We would classify the market as expensive, but in the mid-cap space we think there are elements of a bubble. We like the top-down story for India, it’s got a lot going for it, but we can’t get our head around those valuations on a bottom-up basis. So essentially what it would take for us to invest in India, which we would love to do, is for valuations to come down. So, stock prices to fall or earnings to catch up with the valuations. We don’t mind which way it happens, but that’s what it would take for us to invest.
To find out more about our Asia ex-Japan Strategy, please click here.
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