Exciting opportunities emerging

Global growth is slowing, as evidenced by leading economic indicators across most major countries trending downwards. Following a decade of unprecedentedly low interest rates and abundant liquidity, central banks started to unwind quantitative easing in late 2017 and 2018, and a cyclical slowdown was widely anticipated. However, geopolitical events, the ongoing US-China trade dispute in particular, have exacerbated the slowdown, and are taking a significant toll on world trade. The global manufacturing purchasing managers’ index, seasonally adjusted, is now at its lowest levels since 2012. Germany, the world’s third largest economy, is on the brink of recession as data suggest its economy may contract in Q319 for a second consecutive quarter. Governments are responding to the deteriorating economic data and some central banks, including the US Federal Reserve, have reversed their tightening stances and cut interest rates. However, the impact of policy measures may be limited given interest rates remain close to historic lows, and the Chinese government is concerned about the country’s debt level. Geopolitical developments are likely to continue to influence the direction of markets for the time being. However, earnings revisions have adjusted sharply, and may now be at levels that give scope for some positive surprises. As shown in Exhibit 2 (RHS) Asian equities appear relatively attractive compared to global equities. The region is trading at a 13% forward P/E discount to the world market, and as discussed on the front page, its economies are growing significantly faster.

IAT was launched in 1995 and aims to provide long-term capital growth through investing in a diversified portfolio of companies listed in Asia. The trust changed its benchmark from the MSCI Asia Pacific ex-Japan Index to the MSCI AC Asia ex-Japan Index in May 2015 to better reflect its primary focus on Asia and persistently low exposure to Australasia. IAT’s investment mandate is flexible and Hargreaves is not constrained by index considerations. He follows a clear investment process combining a rigorous bottom-up approach to stock selection with top down input to determine asset allocation. Emphasis is placed on finding investments that are intrinsically undervalued on a long-term horizon of three to five years or more. IAT has a proactive board, which is committed to promoting the trust and narrowing the discount.

Hargreaves thinks the environment for investing in Asian equities is more attractive now than at the start of 2018 when economic data was strong and investor sentiment was bullish. The current outlook for global growth is weak and many leading indicators around the world are close to cyclical lows, and Hargreaves thinks we are near a cycle trough. Asian equity valuations have also moderated, and while they are not at recessionary levels, the manager believes they are at the bottom-end of their range and present some interesting opportunities for long-term investors. Hargreaves notes that it will be harder for economies such as China and India to continue to sustain high GDP growth, and he is cautious on China’s economic outlook. The manager believes its policymakers are doing enough to stabilise the economy; however, they have shown reticence to undertake stimulus beyond that goal. Hargreaves thinks China’s GDP growth will continue to decelerate as its government balances financial risks (high indebtedness) against short-term economic targets, and this challenge prevents him from being more optimistic on the outlook for Asian equities.

Hargreaves follows a fundamental investment approach and is unconstrained by benchmark considerations. The Invesco Asian equities team consists of six highly experienced investment professionals, and employs a detailed and rigorous stock selection process. The team conduct around 700 company visits each year to find firms with attractive market positions, robust financials, strong managements and a good track record on environmental, social and governance (ESG) issues. Particular attention is paid to valuations and Hargreaves looks to buy companies that trade at a significant discount to his estimate of their long-term fair value. The long-term focus is an important element of the process because the manager believes that over time, share prices reflect fundamentals; therefore, he is patient in waiting for an attractive entry point, and comfortable with being contrarian, investing in stocks that are out of favour. The team also uses top-down macroeconomic analysis to help guide country and sector allocations. Risks are managed through ensuring a diversified portfolio of 50–70 stocks, and the manager’s in-depth knowledge of the individual companies, which involves ongoing monitoring and dialogue with managements.

Exhibits 3 and 4 show IAT’s exposures by sector and geography, respectively, at end-July 2019. The largest sector exposure is financials at 33.9% of the portfolio, which also represents the most significant overweight relative to the index at 10.0pp. Hargreaves notes, however, that the financials weighting does not represent a view on interest rates; instead it reflects multiple secular themes. These include Hargreaves’ positive long-term view on India (the largest overweight by geography) and its banking sector. He considers India has the most positive economic reform agenda in the region, and Prime Minister Narendra Modi’s recent election success may strengthen his ability to continue these. The manager observes Indian banks’ balance sheets have improved over recent years, and believes they are in the early stages of a positive credit cycle. IAT’s holdings are in private sector banks, including HDFC Bank and ICICI, which are gaining market share from the state banks. Hargreaves also recently added to specialist lender Shriram Transport Finance. The company finances the purchase of second-hand commercial vehicles such as small trucks, construction vehicles and tractors, and is the leading player in the formal sector of the industry, with over 2m customers. Shriram estimates that around 55–60% of second-hand commercial vehicle financing is provided by informal, private money lenders, who charge very high rates of interest. Formal lenders have the potential to gain market share, while strong demand growth should also be underpinned by increased penetration into rural areas, and the need to replace old vehicles due to legislative pressure to improve emissions standards. Hargreaves has been following this stock for many years, and a sharp fall in the company’s share price in response to the country’s economic slowdown halved its price-to-book value multiple, presenting a buying opportunity for IAT. Other significant themes within the financial sector include positive prospects for the life insurance industry in China (Hong Kong-listed AIA), and a turnaround in profitability for general insurers (Australia-listed QBE and Korean Re).

Hargreaves also recently purchased a position in Indian commercial vehicle manufacturer Mahindra and Mahindra (M&M). The company makes a broad range of products, including trucks, tractors, two-wheelers and construction equipment. M&M is well-managed, with a leading position in most of its business segments. A poor start to the monsoon season had a negative impact on farmers, exacerbating the effects of a wider economic slowdown. Like Shriram, M&M’s share price has fallen significantly, giving the manager an opportunity to purchase the stock at a reasonable valuation.

The auto sector has also been extremely weak in China, hit by stricter emissions standards, an economic slowdown and trade tensions with the US. Hargreaves viewed China’s auto stocks as oversold, trading at unprecedentedly low valuations and he added to Dongfeng Motor. The company owns 50% joint ventures with each of Nissan, Honda and Peugeot in China, and together, accounted for over 10% market share of China’s passenger vehicle sales in 2017. The manager’s analysis indicated the market capitalisation of the company was below the value of the combined net cash held in the holding company and joint ventures, suggesting investors were ascribing a negative value to the operating business.

As shown in Exhibits 6 and 7, IAT has delivered good medium- and long-term performance. Over five and 10 years, the trust’s NAV total return has outperformed its blended benchmark, while the outperformance against the FTSE All-Share Index has been very significant over these periods. Over shorter periods, the trust has performed broadly in line with the benchmark; however, the manager focuses on long-term capital gains and is not influenced by shorter-term performance horizons.

IAT is currently trading at an 13.4% discount to its cum-income NAV, which is wider than its three-year average of 11.7%. The board considers a discount of less than 10%, in normal market conditions, is desirable and a number of changes were introduced last year to help broaden the appeal of the trust, with the aim of reducing the discount. These include: the intention to increase the dividend per share each year, utilising the company’s capital reserves if necessary; to use gearing more actively when appropriate, to take advantage of the closed-end structure of the fund; and; the introduction of a lower marginal management fee of 0.65% on assets above £250m. The board continues to have the ability (renewed annually) to repurchase up to 14.99% of share capital to help manage the discount. However, this facility will only be used when the board thinks repurchases will be effective, taking market conditions and comparable funds into account, and when it can enhance net asset value.

IAT is a conventional investment trust with one class of share: there are currently 69.5m shares in issue and a further 5.5m held in treasury. During FY19, the company repurchased into treasury 0.5m shares (representing 0.6% of the share base) at an average price of 265.3p per share. In FY18, the board conducted a tender offer for 15% of ordinary shares, which resulted in the repurchase and cancellation of 12.5m shares at a total cost of £39.5m. The trust is subject to a continuation vote; the next is due at the September 2022 AGM.

Gearing is permitted up to 25% of net assets and IAT has a £20m multi-currency revolving credit facility with Bank of New York Mellon. At end-July 2019, the facility was undrawn and the trust held net cash of 0.9%. The board has recently agreed a new a tiered fee structure with Invesco Fund Managers. The existing annual management fee of 0.75% of NAV continues to apply on assets up to £250m. A reduced fee of 0.65% will be payable on assets above £250m. The fee is split between the revenue and capital accounts in the proportion of 25:75. At end-July 2019 the ongoing charge ratio was 0.94%.

The trust’s investment objective is to provide long-term capital growth. Nevertheless, IAT’s dividend per share has more than doubled over the past 10 years to end-FY19 and the board intends for the annual distribution to increase every year. An interim dividend was introduced in FY18, which should represent around half of the full-year dividend. The board is able to use capital reserves when necessary to smooth dividend payments in years when they are not fully covered by revenue income. The total dividend of 5.7p per share for FY19 represents a 3.6% increase over the previous year, and a yield of 2.0%.

Exhibit 10 shows the nine members of the newly created AIC Asia Pacific sector. IAT is one of the smaller funds in the group, ranking eighth by size. Its NAV total return compares favourably over 10 years where it ranks third. Over one, three and five years, the trust ranks sixth, seventh and fifth, respectively. The trust’s ongoing charge ranks sixth but there is no performance fee. IAT has one of the higher dividend yields among peers, however, the discount to cum-fair NAV is currently one of the widest.

The IAT board consists of four independent non-executive directors, chaired by Neil Rogan (appointed in September 2017 and assumed his current role in July 2018). Owen Jonathan is the senior independent director (appointed March 2013 and assumed his current role in December 2018). The other directors and their dates of appointment are Tom Maier (March 2009) and Fleur Meijs (December 2016). A search for a new director is underway to replace Tom Maier who has served on the board for more than nine years. He has agreed to extend his tenure to maintain a four-strong board and allow for a smooth succession.