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Asia trusts are the secret to bargain growth

Asia Pacific ex-Japan investment trusts offer growth at a discount
Asia trusts are the secret to bargain growth

Asia Pacific ex-Japan equities look like one of the best bargains in the investment world. They have been making good returns and have further to grow, but remain cheaper than equities in many other regions.

“At a time when there is a debate about valuations of equity markets being historically high, Asia is the only market where current valuations, measured on a cyclically adjusted price/earnings (CAPE) basis, are below the long-term average,” says Jason Hollands, managing director at Tilney Group. "Asian equities are on a CAPE ratio of 16.3 times earnings compared with a long-term trend of 17.2 times earnings."

That is despite the stellar growth of the market over the past year. So far this year, the MSCI AC Asia ex-Japan index is up 30.8 per cent. Asia’s major tech stocks, which are among the world’s most highly valued companies and include Chinese internet company Tencent (HKG:700) and ecommerce giant Alibaba (US:BABA), are responsible for that growth, and are in some cases more profitable than US-equivalents such as Facebook (US:FB), Amazon (US:AMZN) and Alphabet (US:GOOGL).

“People worry about markets being a bit hot because MSCI Asia Pacific index is up about 30 per cent or more since mid-2016,” says Rob Morgan, pensions and investments analyst at Charles Stanley. “But valuations really aren’t stretched and if you are going for growth Asia is the natural place to look. In 2007, when global markets were overvalued across the world, and Asia was particularly overvalued, the price-to-book ratio was 3.0 times. Today it is 1.8 times. The premium that you paid for Asian equities over global equities was 20 per cent in 2007, but today Asia stands on a 28 per cent discount to global markets.”

And Asia’s growth is built on solid fundamentals. “The economic growth forecast for Asia is still robust,” explains Mr Morgan. “China is growing at 6 per cent and forecast to do so until 2020. India is growing at more than 7 per cent and there is a healthy amount of economic growth in that region, but you are paying less for that growth in Asia than you are in the US.”

Proceed with caution

The outperformance of certain companies, in particular Chinese tech stocks, has resulted in this country accounting for 34.1 per cent of the MSCI AC Asia ex-Japan index, and the information technology sector more than a third of it. The 10 largest stocks in the MSCI AC Asia Pacific ex-Japan index also account for over a quarter of it.

"The main caveat is that the strong performance of Asian markets is being driven by the performance of stocks such as Tencent and internet search engine Baidu (US:BDU)," says Mr Morgan. "The market has bifurcated and those stocks are skewing the average."

That is an issue if you fear a tech bubble and/or problems stemming from China’s debt levels, for example. However alongside these there are still deep pockets of value to be found.

 

A good way to enter

Because you need to invest in Asian equities for the long term, investment trusts, which don’t have to meet redemptions because of investors pulling money out of them, are a good way to buy Asian equities. It also means investment trust managers can invest in and take a long-term view on smaller and less liquid Asian stocks, which could be less well researched, and so give them an edge over open-ended funds.

“When you’re invested in regions and markets that can be quite volatile it can be advantageous to hold them through a closed-ended vehicle because in a scenario where you get a shake-out the manager does not have to liquidate the entire portfolio,” explains Mr Hollands.

The Association of Investment Companies (AIC) Asia Pacific ex Japan sector is also one of the largest investment trust sectors, with 15 trusts to pick from. And like the equities they invest in, these trusts are on relatively cheap valuations compared with other sectors, and offer strong growth potential.

“The Asian trust sector appears to be one of those anomalies,” says Anthony Stern, analyst at Stifel. “It remains somewhat out of favour despite offering value and good returns in recent years.”

The AIC Asia Pacific ex-Japan sector is on an average discount to net asset value (NAV) of 7.9 per cent. “It’s interesting because there is definitely an appetite for Asia, but many trusts are trading on double-digit discounts,” says Mr Morgan.

Investment trusts in the AIC Asia Pacific ex-Japan sector have also, on average, outperformed open-ended Asia Pacific funds. Over five years the AIC Asia Pacific ex-Japan sector average is 80.2 per cent compared to the Investment Association (IA) Asia Pacific ex-Japan sector average of 74.8 per cent, according to FE Trustnet.

Trusts can boost their performance by gearing – taking on debt – to increase their exposure to markets. This can enhance their returns in rising markets, but also increase their losses in falling markets.

However many of the trusts in this sector are relatively small. For example, Martin Currie Asia Unconstrained (MCP) has assets under management of just £171.8m, making it less liquid than a large trust or fund. But all the trusts in the AIC Asia Pacific ex-Japan sector are “viable” sizes, adds Mr Hollands. And smaller trusts can make an investment of a meaningful size in smaller as well as potentially less liquid companies.

A downside to Asia Pacific ex-Japan investment trusts is that their charges tend to be higher than the clean share classes of open-ended Asia Pacific ex-Japan funds. The average ongoing charge for Asia Pacific ex-Japan trusts is 1.13 per cent. By comparison, the 101 Asia Pacific ex Japan open-ended funds with unbundled fees offered on Hargreaves Lansdown’s platform have an average ongoing charge of 0.96 per cent.

Aberdeen Asian Smaller Companies Investment Trust (AAS) has the highest ongoing charge in its sector of 1.69 per cent.

Some Asian trusts have bought in to the tech-driven Asian growth story, while others take a more value-oriented, or defensive, view on markets. So far this year trusts with a high exposure to Chinese tech stocks have outperformed those that take a value-orientated approach. But over the longer term, smaller companies funds and value-focused funds have outperformed.

An alternative approach is to opt for a value-focused fund that could outperform if the large-cap tech stocks that have been outperforming suffered a correction

The tech bulls

The top-performing trusts over one year are Schroder Asian Total Return Investment Company (ATR), which has delivered a share price return of 40.5 per cent, Pacific Horizon (PHI) with 34 per cent and JPMorgan Asian Investment Trust (JAI) with 30.7 per cent. The MSCI Asia ex-Japan index returned 25.4 per cent over this period.

Of these, Pacific Horizon, which is managed by Baillie Gifford, is the most growth-focused, according to analysts at Numis Securities. Its manager, Ewan Markson-Brown, invests in innovative technology-driven companies that are likely to disrupt traditional industries, backing themes such as internet commerce, cloud computing and driverless cars. He believes many of the global companies of the future are those in emerging and Asian markets today.

“Pacific Horizon is really the fund that has shone in this tech rally,” says James Carthew, research director at QuotedData. "Half of it is invested in the tech sector and it has really reaped the rewards of that."

Three of the trust's holdings more than doubled their share price over its financial year between July 2016 and 2017 – Sunny Optical Technology Group (2382:HKG), Geely Automobile (HKG:175) and JD.com (US:JD). The trust’s largest holding is Alibaba, which accounts for 7.4 per cent of its assets, followed by Tencent, which accounts for 7.3 per cent.

Mr Markson-Brown, who has run Pacific Horizon since March 2014, is looking for stocks capable of growing at 15 per cent a year over five years, and the trust is geared to maximise exposure to markets within a range of -15 per cent to 10 per cent. The fund had net gearing of 7 per cent at the end of September 2017, which boosted performance. But gearing has only been used sparingly in the past 10 years, according to Mr Carthew.

The manager’s focus means that his portfolio is more expensive than the index. Pacific Horizon’s portfolio has a 12-month forward price/earnings ratio (PE) of 18 times, compared with 13 times for MSCI Asia Pacific ex-Japan index. And Sam Murphy, associate director of investment company research at Numis, says that “Pacific Horizon is quite racy and if markets do come off it will get hit”.

But Kieran Drake, research analyst at Winterflood, says: “The trust’s strategy of focusing on growth companies and the ‘new economy’ differentiates it within its peer group and we believe it offers potential for outperformance over the long term.”

The trust’s shares are trading on a 9.9 per cent discount to NAV and it has an ongoing charge of 1.07 per cent.

Schroder Asian Total Return is also a growth-focused fund, but differs from its peers because it uses hedges and gearing with the aim of delivering growth with lower volatility and less chance of sharp falls. It has been managed by Robin Parbrook and King Fuei Lee at Schroders since 2013, who also run the well-regarded Schroder ISF Asian Opportunities Fund (LU0106259988).

The trust holds around 60 stocks, including some smaller stocks than the larger open-ended fund can invest in. Over five years Schroder Asian Total Return has made 129 per cent, compared with the MSCI AC Asia ex Japan index’s 84.1 per cent.

“I like Schroder Asian Total Return because it makes strong use of the investment trust structure and takes a very pragmatic approach to investing,” says Mr Morgan. 

“The performance has also been fantastic. It’s more about deploying gearing and being willing to not invest, as well as using hedging to dampen volatility. When they are bullish, they capture as much of the market as possible, but they also add value on the downside by hedging the portfolio.”

Mr Drake likes Schroder Asian Total Return because of its “strong performance record” and the fact that it “has also demonstrated a degree of capital protection in difficult market conditions”.

The trust operates a discount control mechanism and its discount has narrowed in recent months due to its strong performance – at the time of writing it was trading at around par. It has also issued shares to meet investor demand in the past 12 months.

JPMorgan Asian Investment Trust has been run by Richard Titherington and Ayaz Ebrahim since May 2016, and has recently overhauled its discount management and dividend policy. It now pays quarterly dividends, funded partly from its capital. The nature of the companies the fund invests in has not changed, but because it pays income from capital in periods when the NAV is falling, the trust’s growth will be hindered.

However, high exposure to Indian banks, for example Indusind Bank (India:INDUSINDBN), Kotak Mahindra Bank (India:KOTAKBANKF) and Axis bank (India:AXISBANK), has recently boosted its performance.

But it is stock selection rather than deliberate exposure to sectors or countries that has driven this trust’s performance. Over 10 years it has lagged MSCI AC Asia ex Japan index, but Mr Drake says: “JPMorgan Asian has historically struggled to differentiate itself within its peer group, although its performance has improved considerably since the change of management arrangements in May last year.”

 

Value hunters and cautious investors

An alternative approach is to opt for a value-focused fund that could outperform if the large-cap technology stocks that have been outperforming suffer a correction. Value-focused managers tend to buy less expensive equities and focus more on fundamental indicators such as cash flow and price to book when selecting stocks.

“I would probably be tilting more towards value managers now because growth has had such a good run,” says Mr Morgan. “I like the managers at Invesco and Schroders who are holding the technology names and think those have further to run, but value has been the wrong trade for a long time, so I would be stocking up on that and taking profits from growth areas.”

Fidelity Asian Values (FAS) is the clearest example of a value-focused Asian fund. Nitin Bajaj, who has managed it since April 2015, and also runs open-ended Fidelity Asian Smaller Companies Fund (LU0702160192),

looks for undervalued small-cap stocks that can return 50 per cent over a three- to five-year period. He places strong emphasis on companies’ financial strength, earnings potential and competitiveadvantage, as well as price, and is much more bearish on the outlook for Asia than his peers. The trust has about 10 per cent of its assets in cash.

Mr Morgan says: “Fidelity Asian Values is a fund I like to own all the time because I think the manager is a good stockpicker. He has a pragmatic process that combines value traits with a willingness to own completely off-benchmark positions. He is just interested in owning companies that will compound over time, and for that kind of investment process an investment trust is perfect because he is under no pressure to sell.”

Mr Murphy says: “Smaller companies certainly suit the closed-end structure given the liquidity requirements. This trust will go all the way down to a $25m dollar market cap.” This could be harder to do with an open-ended fund. 

In 2016 Fidelity Asian Values was the top-performing trust by some distance, but Mr Bajaj’s bearish view on markets and small-cap approach means he has underperformed the sector and benchmark over the shorter term. The trust is trading on a discount of 8.5 per cent – its widest point since March 2017. But analysts say that could turn around if markets suffered a correction and growth stocks started to underperform.

Aberdeen, which runs Aberdeen Asian Income, Aberdeen Asian Smaller Companies, Edinburgh Dragon (EFM) and Aberdeen New Dawn (ABD), is typically viewed as a house with a more defensive and cautious stance on markets.

“Aberdeen’s house style is about high quality, strong businesses and sustainable business models,” says Mr Murphy.

 “Aberdeen is very focused on corporate governance and quality, and the sustainability of returns,” adds Mr Morgan.

That means that trusts such as Edinburgh Dragon have lagged, as the bullish sentiment sweeping markets has left them behind. The trust is heavily underweight China, in which it has 15 per cent of its assets compared to 34.4 per cent for MSCI AC Asia ex Japan index. The trust also does not invest in the mainland internet stocks found in growth portfolios. However, it does hold technology names such as Samsung Electronics (SMSD) and Taiwan Semiconductor (2330:TAI).

Recent poor performance led the trust’s board to commission a report into its investment process. But the report found that performance was in line with expectations over a full market cycle, so Aberdeen has been retained as manager.

Mr Morgan says: “If I was to go value hunting, Edinburgh Dragon would be the fund I would look at. It has had a tough time as its managers’ style has been out of fashion. They’ve had adifficult time, but it is well priced – at a discount of 12 per cent you are getting it well below the NAV.”

Alan Brierley, director of investment company research at CanaccordGenuity, has the trust on a buyrecommendation and says: “The fundamentally based, bottom-up stockpicking investment style is currently out of favour. However at some point the headwinds of recent years should turn into tailwinds.”

Edinburgh Dragon’s management fee has recently been reduced, taking its ongoing charge down to 1.03 per cent from 1.14 per cent.

 

Suggested investment trusts' performance (%)

TrustDiscount/premium to NAV*Ongoing charge + performance fee (%)*1yr share price return (%)3yr cumulative share price return (%)5yr cumulative share price return (%)10yr cumulative share price return (%)
Edinburgh Dragon Trust-12.61.1220.441.054.2165.8
Pacific Horizon -9.91.0734.071.2105.871.7
Fidelity Asian Values -8.51.2810.268.4114.8149.6
JP Morgan Asian-100.8330.775.8103.486.5
Schroder Asian Total Return Investment Company +0.11.0740.5100.1129.0143.5
AIC Asia Pacific excluding Japan sector average -8.2na22.251.181.7164.2
MSCI AC Asia ex Japan index nana25.459.384.1111.1

Source: FE Analytics, as at 3.11.17 *The AIC

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