Jonathan Pines, Hermes Asia ex-Japan Equity Portfolio Manager at Hermes Investment Management, looks at driving forces behind the winners and losers of 2017 and what will likely drive performance in the year ahead.
Last year was a strong one for our MSCI Asia ex Japan benchmark, which rose 40%. Despite this strength, its longer term performance lags most other global indices (as well as medium term earnings and net asset growth) and we consider it to remain attractively priced.
What worked – and what didn’t for – for Asia ex-Japan stock pickers over the last year
For many years, we have identified stable-earnings, dividend-paying quality companies as generally overvalued, because yield-starved investors chose them in preference to bonds offering miserly rates of interest, while paying inadequate attention to equity risk when valuing these types of companies. In the last year, these types of quality companies got so crushed on a relative basis that many former high-flying income funds are now underperforming – even on a three-year basis. Indeed, half of the 10 worst-performing Asia Pacific ex-Japan Funds in 2017 have the words ‘income’ or ‘yield’ in their name 1. We believe that all narrowly focused, thematic and smart beta investment strategies will eventually suffer periods of underperformance – and should an adherent to such strategies outperform over the long-term, this would be purely fortuitous, with the strategy having had at least as great a chance of long-term underperformance.
In our view, the more popular an investment theme becomes, the more certain its eventual underperformance. Thematic and factor investing strategies inevitably self-destruct because markets, though occasionally inefficient, are not consistently so. Thematic and formulaic investment strategies – particularly non-dynamic ones – almost always have short shelf lives. In the last year Asian income stocks had their relative comeuppance. Even now, after a year of underperformance, there are numerous stable-earnings, dividend-paying companies (often found among telecommunications and consumer staples companies) offering little or no growth while trading on price-to-earnings (PE) multiples north of 30 times. We expect them to continue to underperform.
But quality comes in different guises. In the form of stable-earnings, dividend-paying stocks, quality was overpriced. In contrast, a range of high return-on-equity, high-growth, oligopolistic companies were attractively priced last year. So, while 2017 penalised investors in stable dividend-paying stocks, it showered rewards on the new-media technology and semiconductor giants. Mega-cap and dominant Chinese new-media companies Tencent and Alibaba, both approximately doubled in price. Semiconductor and phone giant Samsung Electronics rose 59%. Taiwan Semiconductor Manufacturing Company also performed strongly. These big four ‘high-quality’ Asian tech companies, together comprise 20% of our benchmark. Any active manager who was underweight these stocks in aggregate, had a tough task in 2017. Their holdings – drawn from the remaining universe of relative losers – needed to run just to stand still, in relative terms.
This last year was also one in which investing in big companies in and of itself was enough to outperform. As shown in figure 1, the largest companies had the largest gains. It is no coincidence that three of the 10 worst-performing Asia ex-Japan Funds in 2017 had ‘Small’ or ‘Mid Cap’ in their name 2. However, unlike many income stocks that ’deservedly’ declined because they were overvalued, the small- and mid-caps – particularly cyclical and value names – include among them many stocks that were attractive even a year ago. After underperforming substantially over the last year, many now look like steals.
Figure 1. In Asia ex-Japan stock markets, in 2017 it paid to be big
Source: Hermes, Northern Trust, Bloomberg as at 31 December 2017
As for the best-performing Asian equity fund managers over the last year, this list, perhaps more than in most years, had its share of the very best and the very mediocre. The best managers, like the Little Prince in French writer and aviator Antoine de Saint-Exupéry’s short story, finally saw with their hearts – perhaps after searching far and wide for the most attractive stocks – what was always in plain sight: the metaphorical rose meant just for them, the largest four stocks in our benchmark. The mediocre managers, of course, simply bought these same names because they were the most obvious (and had positive momentum), without agonising over their decisions. Both calibres of manager did fantastically over the last year because they held all or some combination of the same largest benchmark stocks: Tencent, Alibaba, Samsung Electronics and Taiwan Semiconductor Manufacturing Company.
Why the largest stocks did best last year
We believe that there are several reasons why the largest stocks in our benchmark performed exceptionally well last year, and why there was a correlation between size and performance.
1 - The largest stocks delivered
The businesses underpinning the largest stocks in the benchmark continued to perform well – both in terms of sustaining industry-leading positions and by growing earnings and cash flow. Indeed, because of this, we continue to hold our stakes in Alibaba, and other similarly valued new-technology companies, and Samsung Electronics, albeit at an underweight position 3. As shown in the following table, even after strong stock-price performances, the valuations of the largest three benchmark stocks are not excessive relative to expected earnings in the context of likely growth.
Figure 2. The valuations of the biggest – and among the best – performers over the last year were reasonable
2- Taking a lead from US new-technology and media stocks
Alibaba, Tencent and other large Chinese new-media stocks, such as Baidu and JD.com, which we also hold in the portfolio, have been rising in line with their US counterparts. Tencent has similarities with Facebook. Alibaba and JD.com are comparable with Amazon, and Baidu draws comparisons with Alphabet. When their US counterparts’ stock prices rise, these companies begin to look relatively attractive and therefore rise too. This is particularly so because the US stocks, even following their continuing stock-market strength, do not appear to be particularly expensive relative to their value, and we expect them to continue to rise.
Figure 3. Rise of the new media: US and Chinese tech giants’ stock performance
3- Passive managers usurp active rivals
As shown in figure 4, in the last decade flows to emerging-market active managers have been anaemic and, lately, negative. We believe that the stock prices of the largest companies in the benchmark have benefited (at the expense of the smaller companies) from passive managers supplanting active managers.
An active manager suffering redemptions needs to divest across the market-cap spectrum, whereas the passive manager only needs to buy the larger cap stocks dominating the benchmark to achieve an acceptable level of index replication. This is particularly so for passive managers running broader benchmark-tracking funds (such as emerging-market and global products), as opposed to single-country funds, because smaller companies are even less important for those broader funds.
In addition, within the increasingly competitive and concentrated active manager space, those large fund managers that have performed the best are attracting the most investment – aiding both momentum and size styles.
Figure 4. Tale of two flows: passive emerging-markets managers have thrived since the financial crisis
4 - Investors’ taste in fashion
Investors occasionally focus on one or two attractive, or unattractive, aspects of an investment and invest, or divest, accordingly. What has been in vogue for a few years, and still is, has been momentum, both earnings and price, and growth, just as ‘income’ was until 2016. In addition, the market is, more than in most periods, willing to pay up for what is regarded as scarce or rare. Growth companies that are dominant in their industry and are very large (which include the largest four stocks in our benchmark) are indeed scarce, and have become popular among investors.
Where the compelling value is now
Themes and investor fashions, such as momentum and size, are the mantra of certain investors who invest in stocks only because they screen well on certain factors. Of course, if enough investors follow suit, the forces they create can provide a powerful backdrop in the form of headwinds or tailwinds for pure stock pickers such as us. In the long term, only the price-to-value proposition counts – and that is where we continue to concentrate our research efforts. We believe that the most compelling value in the Asia ex Japan region now is to be found in the laggard mid cap cyclical and value space -particularly in Korea and China, and have been adding to our already significant holdings of these kinds of stocks.