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Passive rise in Asia creating distortions for active managers to exploit

To the casual observer, the emerging Asia region has witnessed a powerful return to investor favour over the past three years1. However, beneath the surface of the broad market’s strong overall return of 33% over this period are some significant performance disparities – most notably across the capitalisation spectrum, according to Jonathan Pines, Asia Ex-Japan Portfolio Manager at Hermes Investment Management. The ten largest stocks in the region have seen an 88% share price spike2, far exceeding the 16% rise for mid-caps and 11% rise for small caps.

While the sharp rise of some mega-cap stocks, such as Alibaba, is justified by fundamentals – the broader outperformance of this segment of stocks, and even more particularly the underperformance of the mid cap segment, has been powered in part by a substantial net flow of passive investment into the region. While active managers need to sell across the market cap spectrum to meet redemption requests, the passive manager finds that she only needs to buy the larger cap names to efficiently achieve an acceptable degree of index replication. This is particularly the case for those Asian stocks that also form part of broader global indices.

Although the impact of passive investment has challenged active investors in Asian equities recently, it also offers opportunities. While passive flows can influence markets in the short term, they cannot do so in the long term. Ultimately, price discovery relies on active managers who will eventually buy what is cheap and sell what is expensive. To quote value investing luminary Benjamin Graham, “in the short run, the market is a voting machine but in the long run it is a weighing machine”. The active to passive flows are certainly now strongly favouring the larger cap stocks that dominate the benchmark. In the end, the intrinsic value of the company behind each stock must determine its price.

The opportunity in unloved Korea
The Korean mid-cap space is an area of the market that has been a particular underperformer, rising a mere 6% over the past three years (compared to a 52% rise in Korean large caps), and is a segment of our benchmark that is now attractively priced. The South Korean economy is remarkably robust, growing at its fastest quarterly rate in seven years in the third quarter of 2017, despite the obvious headwind of the increasing tensions on its border. While the threat of North Korea and its nuclear armament is real, there is enough understanding of the potential nuclear devastation on both sides to prevent further military escalation – barring an accident. We are finding a number of opportunities in the Korean mid cap space, particularly among ‘value’ and cyclical companies.

One example is Hyundai Steel. Steel company investors have been focused on the dynamics of the iron ore industry based on the presumption that there is strong correlation between iron ore prices and steel company margins. Hyundai Steel’s stock price has also been hurt by particular concerns about production and profitability of group company and main buyer Hyundai Motors. However, despite weakness in the iron ore market and Hyundai Motor’s problems, Hyundai Steel’s profits have remained remarkably consistent over much of the past decade. Yet the stock is trading near a record low multiple relative to book value. Cuts in Chinese steel production in response to the country’s pollution concerns might too help Hyundai Steel’s profitability.

We are also finding opportunities in the supply chain of the Hyundai Motor Group. Sentiment across the automotive industry has been negative on concerns surrounding Korea’s relationship with China, driverless cars, private hire services like Uber and electric vehicles. While some of these concerns are real in terms of their impact on Hyundai’s prospects, we believe that the business model of Hyundai Motors will evolve and if we are right, it implies that many companies within the Hyundai supply chain are far too cheap.

Lastly, we are finding that there are opportunities in companies fuelling these competitive emerging technologies. For example, we have recently added electric vehicle (EV) battery manufacturers Samsung SDI and LG Chem. In both cases, when we initiated positions we considered the market to be underestimating the value of the EV segment of the companies. Indeed, we were surprised that despite the growing hype around Electric, the fast growing EV battery businesses seemed in both cases to be ascribed very little value at all. It is clear that there is going to be very substantial revenue growth of EV battery manufacturers and the market is getting excited. It is admittedly less clear if this growth will be sufficiently profitable to generate a good return on investment. In the context of increasing interest in the EV names, we will continue to size our positions in the space based on an evolving consideration of the likelihood and extent of the companies’ ability to turn the strong growth in revenue into profits.

  1. 1To 7 November 2017, in US dollars
  2. 2Weighted by market capitalization of the top 10 names, with the rise mainly attributable to the strong performance of Tencent (up 220% in US dollars), Samsung Electronics (146%), TSMC (106%) and Alibaba (64%).

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