Markets have got way ahead of themselves
May 2020 | BY Ellerston Capital
The colossal bounce in global equity markets in the face of incredibly weak data has some experienced managers bracing for another leg down.
Although equity markets have fared much better in Asia than in developed economies this year, Mary Manning, Portfolio Manager at Ellerston Asia is bracing for markets to correct again. As she tells us here:
“…markets globally have gotten way ahead of themselves since March 23rd and there is currently a huge disconnect between markets and underlying economies. I am expecting a correction in markets and therefore have a high cash balance in my portfolio”.
However, as Mary explains here, she believes that once economies and markets are synchronised again, Asian equities are where investors should be.
Read on to hear why, as well as her thoughts on another flare-up of US-China relations, ten stocks that are benefiting from the crisis, and her thoughts on Tencent’s $300 million investment into Afterpay.
How did Asian equities come through the March quarter so much better than Australian equities?
There were 3 main reasons why Asia outperformed Australia by such a wide margin in the first 3 months of 2020.
First of all, COVID-19 is, to an extent, largely following a FIFO (First In First Out) path. North Asia, in particular, was the first to enter the epidemic and countries like Taiwan and Korea did a very good job of controlling community-wide transmission. So while most developed markets like the US, Europe and Australia, were still in the exponential growth phase of COVID in March, a number of Asian countries had already plateaued.
The second reason for Asia’s outperformance is the differences in sector composition, specifically the low weighting of oil and the high weighting of tech in Asia. The March quarter was characterised by a shocking sell-off in the oil price. Asia as a region is a net oil importer and the energy sector is less than 4% of the MSCI Asia ex-Japan benchmark. As such, low oil is a macro tailwind for many Asia countries and the low weight of oil stocks in Asian benchmarks helped Asia’s relative performance.
The flip side of the sector coin is that Asia has disproportionately high exposure to the technology sector at almost 40% if you include internet and e-commerce stocks like Tencent, Alibaba, JD, Baidu, etc. There are many sub-sectors of tech (internet, e-commerce, on-line gaming, cloud, data centers, IT hardware, etc) that may actually benefit from COVID-19 related quarantines. While ‘old economy’ and oil sold off sharply in the March quarter, tech held up remarkably well. This helped Asia outperform.
The third reason Asia outperformed in the March quarter was mean reversion and valuations. When COVID-19 broke out, Asia had just emerged from a 2-year-long trade war between China and the US. The uncertainty regarding the outcome of the trade war had kept Asian markets under pressure despite the fact that many Asian companies where delivering on growth and profitability. The valuation differential between developed markets (DM) like the US and Australia and Emerging Markets (EM) including Asia was at multi-decade highs pre-COVID. So in short, DM had more to fall.
Your fund came through even better, 0.9% ahead of the Asia index. How did you achieve that?
We achieved this by sticking to our process and strategy. Ellerston Asia is a high growth, high quality, benchmark independent fund with strong ESG credentials.
On growth, when COVID first broke out in China at the end of January, we broke the portfolio into 3 buckets:
- Stocks whose growth outlook was directly negatively impacted by COVID;
- Stocks whose growth was not directly impacted but that had expensive valuations or high betas (and therefore could fall disproportionately in a bear market); and
- Stocks whose growth could potentially benefit from COVID and the related isolation orders.
In late January, we sold stocks in the first 2 buckets and increased position sizes for stocks in the last bucket, which were mostly tech companies
Ellerston Asia has very stringent ESG criteria so we generally are underweight the energy sector. When oil collapsed, we had no exposure to upstream energy stocks which generated positive alpha.
Ellerston Asia also has a large-cap bias. The MSCI Asia- ex Japan Index outperformed the Small Cap Index by over 8% in the March quarter as low liquidity stocks across the world got punished. The high-quality positioning was also helpful because our portfolio (ex-financials) has net cash balance sheets on average and positive free cash flow. As such, we have only had one company, Reliance Industries, raise capital year to date.
Being benchmark independent was also a factor leading to outperformance. If we don’t like the macro outlook for a given country we don’t have to be invested in that market, unlike some funds that have minimum exposure requirements. At certain points in the March quarter, we had no exposure to Malaysia, Thailand, Singapore or the Philippines.
At a stock level, we had over 25% of the portfolio in the largest Asian tech companies, which was a good call at both a sector and stock-specific level.
Finally, we take capital preservation very seriously and during the March quarter at certain points, we were at 20% cash.
What are some of your holdings that have benefited from the crisis?
There are two main groups of stocks that have benefited: Indian pharma and “stay at home” tech.
Cadila is an Indian company that we added to the portfolio in March. It has the third-largest market share of hydroxychloroquine in the US. For some time, there was a suggestion that this drug was helpful in treating COVID-19 but this has yet to be proven by clinical trials. Regardless, the stock has performed very well. SUN Pharma, the largest pharmaceutical company in India, has also benefited from COVID and is a core holding in our portfolio.
With respect to stay at home tech, companies like Tencent and Netease (online gaming) and JD and Alibaba (e-commerce) have also benefited from the quarantine conditions associated with COVID.
Meanwhile, tech hardware companies such as TSMC, Samsung Electronics and SK Hynix have also benefitted from the stay at home/work from home thematic due to greater computing-related demand.
To what extent did SARS give a playbook to navigate Asian markets during COVID-19? Was there another crash that gave a better blueprint?
SARS definitely helped Asian countries navigate COVID-19.
Behavioural changes like wearing masks, strict hygiene requirements and temperatures checks were already in place or at least ready to go in many Asian countries, and the public health systems had institutional memory about protocols and best practice during an epidemic.
Taiwan is a good case in point. The country was one of the most impacted by the SARS outbreak back in 2003, recording the third-highest death toll globally. The SARS experience most certainly helped Taiwan act more quickly to the threat of COVID-19. Taiwan was one of the first countries in the world to impose travel restrictions to and from China back in late January. The proactive response of the government, along with effective screening, quarantining and testing, are key reasons why Taiwan has only 440 confirmed cases so far.
In addition to SARS, some Asian countries like Korea had an outbreak of a coronavirus called MERS (Middle East Respiratory Syndrome) in 2015 and this was instrumental in informing their response to COVID-19. Given their experience with MERS, where the first Korean case was imported from Bahrain, very early on, Korea implemented a 24/7 emergency response system to screen all travellers entering the country from Wuhan. The first case was identified and confirmed on January 20 at Incheon Airport, the same day the first case was confirmed in the US. Korea now has less than 11,000 confirmed cases while the US has over 1.3 million.
The relative success that Taiwan and Korea have had in controlling the spread of COVID-19 along with supportive stimulus measures have seen the TAIEX and KOSPI emerge as two of the best-performing markets in the region calendar year to date.
Which Asian country will take the longest to recover, and why?
Until a few days ago I would have said India because the policy response to COVID-19 was very minimal versus other countries around the world. But on May 12, Prime Minister Modi announced a major fiscal stimulus package (better late than never!) so I think India will now recover in-line or possibly even faster than its Asian peers thanks to its young and primarily rural population.
I think Thailand may take the longest to recover for 3 main reasons: (1) The Thai economy wasn’t in good shape prior to the outbreak of COVID; (2) The Thai economy is dependent on tourism more so than its Asian peers; and (3) Thai policymakers have less optionality than peers given that interest rates are already very low compared to other many Asian countries (less than 1%) and the government has already announced 3 fiscal packages totalling about 10% of GDP, so they can’t really do much more if the economy remains weak. We remain underweight Thailand and only have one investment in the country.
How big a risk is a flare-up of the US-China trade war?
I expect a deterioration in US-China relations due to COVID. The situation is exacerbated because it is an election year in the US and Trump desperately needs someone to blame for the state America is in both economically and from a public health perspective.
We consider 3 avenues for a backlash against China:
- Economic (trade war resurgence, crackdown on Huawei/ZTE);
- Markets (increased scrutiny of Chinese ADRs, banning US government pension funds from investing in China) and
- Diplomatic (increased engagement with Taiwan, military presence in the South China seas, support of Hong Kong protesters).
For these reasons, our China portfolio is primarily domestic demand stocks.
Do you think the Chinese market bottomed in March? What are you looking at to make your call?
We are long term investors in China and have consistently had over 60% of our portfolio invested in the Greater China region. For Ellerston Asia, it is about managing sector allocations and long term holding position sizes, rather than picking the bottom for the Chinese market.
That said, my view is that markets globally have gotten way ahead of themselves since March 23rd and that there is currently a huge disconnect between markets and underlying economies. I am expecting a correction in markets and therefore have a high cash balance in my portfolio.
For months now, Ellerston Asia has had the view that different markets will trough and recover at different times.
Six factors that we look at to determine what countries we want to be overweight or underweight at a given time include:
- COVID: Have infections peaked? If so, at what level? Is there a risk of a second wave?
- Lockdown: Was the lockdown full or partial? What is the timeframe for re-opening?
- Policy Response: What has been the monetary and fiscal policy response? Is it adequate?
- Valuations: Do valuations adequately reflect the underlying economy? How far from March lows and GFC lows are P/B valuations? Are EPS revisions disconnected from stock price performance?
- Technicals: Are markets near technical support levels? Resistance levels?
- Oil: Is the country a beneficiary of a lower oil price?
Tencent is in the local news with its sizeable investment in Afterpay. As your biggest holding, why do you think Tencent has made this move? How did Tencent fare through the crisis?
Tencent’s investment in Afterpay is important for Afterpay and garnered a lot of attention in the domestic market.
But frankly, it is not significant for Tencent. Tencent has:
- Stakes in mega-cap companies like JD, Meituan, Pinduoduo, SEA Ltd and Tencent Music that total over $61 billion;
- AFS (Available for sale) stakes in companies like Tesla, Activision Blizzard and Snap which total over $14b and
- Unlisted investments in unicorns like Didi and Webank which are estimated at $22 billion.
Adding these all up, Tencent has stakes worth almost $100 billion. A $300 million investment in Afterpay is therefore insignificant in our SOTP valuation and it represents approximately 0.07% of Tencent’s market cap.
I think Tencent made this move because it likes to have its fingers in lots of different pies. After their stake purchase in Tesla, I asked management why they did this? The answer was that if autonomous driving takes off they want to be at the forefront of what people are doing in their cars (online gaming, WeChat, e-commerce) when they don’t have to pay attention to driving anymore. They take stakes primarily to learn, not as a pathway to M&A.
Is now a good time to invest in Asian equities?
The cash balance for Ellerston Asia is currently high at over 17%. As mentioned above, I think there is a major disconnect between economics and markets globally. I don’t think right this moment to initiate positions in equities, full stop.
However, once economies and markets have re-synchronized, either by markets going down (the most likely case) or economies recovering significantly (less likely), I feel very strongly that investors should invest in Asian equities.
First of all, Asia as a region was more successful in flattening the curve of COVID-19 and minimizing deaths compared to most large economies in DM (Europe, the UK and the US) and is faring much better than non-Asia EM (Russia, Brazil and Turkey). So from a country/region asset allocation perspective, Asia looks attractive.
Secondly, Asia is a structural growth story driven by demographics, infrastructure buildout, technological leapfrogging and a rising middle class. These driving forces are not going away and the COVID sell-off will create some excellent long term buying opportunities.
Thirdly, valuations are very attractive with MSCI Asia ex-Japan currently trading at 1.3x P/B versus the ASX 200 at 1.7x P/B and the S&P 500 at a whopping 3x P/B!
Finally, I think investors need to get real about the “policy put” and what it means to be invested in markets with zero/negative interest rates and ongoing QE.
Since Japan started QE in 2001, the Nikkei 225 (in JPY terms) has increased less than 2% on average per year. MSCI Europe (in EUR) has also fared relatively poorly since Draghi’s “whatever it takes” speech in July 2012.
Global investors need to recognize that the Japanification of developed markets has been accelerated by COVID and is possibly here to stay. In this context, investors definitely need exposure to the structural growth stories still available in Asia.
This thought piece was published at Livewire.