Invesco Asia Trust — Update 25 November 2015

Fears over growth in China and arguably ill-judged government intervention in the country’s stock market caused a global sell-off in the late summer. As can be seen in the chart in Exhibit 2 below, Asian markets fell more sharply than the UK and world indices, although the pace of recovery in recent weeks has been similar. While still ahead of developed markets over 10 years, Asian markets now lag substantially in total return terms over five years, having failed to make up ground lost in the ‘taper tantrum’ of mid-2013. Given that US and UK interest rates have still not begun to normalise, the uncertainty that led to this underperformance may take some time to abate.

While Asian company earnings have also failed to deliver on expectations (see The manager’s view below), economic growth in the region still outstrips forecasts for the rest of the world. The IMF’s expected GDP growth of 6.3% for China in 2016 may or may not prove over-bullish, but a forecast of 6.4% for emerging and developing Asia as a whole, with 7.5% growth expected for India, looks favourable against a 2.2% forecast for advanced economies next year.

Meanwhile, valuation metrics in major Asian markets (see table above) are in most cases below world averages (India is the notable exception here) and dividend yields for most markets are above the world average, suggesting that even if earnings from Asian companies fall short of expectations again next year, income could provide an attractive element of return in a world where interest rates in developed markets remain at multi-year lows.

Invesco Asia Trust (IAT) was launched in 1995 to seek long-term capital growth by investing in companies in the Asia Pacific region. Until 30 April 2015 its benchmark was the MSCI AC Asia Pacific ex-Japan index, which includes a c 20% exposure to Australia. The new benchmark, MSCI AC Asia ex-Japan, excludes Australasia, although IAT may still invest there (Australian exposure is currently c 4%). The trust is managed by Ian Hargreaves at Invesco Perpetual; Hargreaves has been sole manager since 1 January 2015 and was previously co-manager with Stuart Parks. IAT has a relatively concentrated portfolio of c 60 stocks and is unconstrained by its benchmark, although it does have some broad investment limits: no company may make up more than 10% of total assets, or 15% for companies in the same group; collective investments, warrants/options and unquoted companies are also all limited to 10%. Gearing may be employed in a working range of up to 15% (there is a formal cap at 25%). Continuation votes are held on a three-yearly basis unless shareholders vote to skip them; the last vote, due to be held in 2014, was waived and the next vote is scheduled for the 2017 AGM.

Hargreaves sees a period of below-forecast earnings growth as the principal reason for Asian market underperformance over recent years. This is partly due to a perception gap: Asian company earnings have been better or similar to those in the West, but have fallen short of over-bullish projections, leading to year-on-year downgrades. Historically, Asia has shown markedly superior growth, and earnings growth that is only in line with developed markets means Western investors may demand a higher risk premium or valuation discount to tempt them away from their home shores.

A number of factors underlie the lower recent growth. A sluggish global economy has depressed trade, exports and commodity demand. Rising levels of consumer and corporate debt also act as a brake on growth, although Hargreaves says a repeat of the 1997 Asian debt crisis is unlikely given the lower level of US dollar borrowings; local currency debt gives Asian economies more levers in the event of problems arising. The manager sees scope to make money through careful stock selection in the current market environment, with cyclical opportunities likely as growth ebbs and flows in an environment of generally subdued global economic growth.

Much investor attention is currently focused on China’s slowing economy, though Hargreaves’ view is less negative than those of many. China has a current account surplus, is a net creditor to the rest of the world and has a fairly closed capital account, which means there is limited scope for a crisis caused by capital outflows. Loan-to-deposit ratios for Chinese banks are at less than 100%. While consumption has been hit by the industrial slowdown, consumers are not over-indebted, wage growth is solid and unemployment is broadly stable. Residential property has staged a recovery over the past six months and there is also scope for a stabilisation in construction as the country works through excess inventory.

Hargreaves views 5.5-6% GDP growth for China as realistic; while this is below the current IMF forecast, it is higher than many estimates. “The idea of a Chinese ‘hard landing’ misses the point,” he says, pointing out that while some parts of the Chinese economy are suffering, others are not. Because of the negativity towards the market, there are opportunities to buy growth stocks at cheap valuations. The manager says that areas such as Chinese internet stocks have performed well and should continue to do so. “It’s a big economy and there are areas that are doing well,” he adds.

IAT’s manager blends bottom-up stock picking with an appreciation of the macro factors driving Asian and global markets to construct a relatively concentrated portfolio of c 60 stocks. Hargreaves is based at Invesco Perpetual’s Henley-on-Thames HQ but travels regularly to Asia to meet with holdings and assess potential new stocks. Hargreaves makes use of internal and external research resources to analyse balance sheets and identify business drivers and sources of risk and return for individual companies, as well as taking a view on the attractiveness of valuations relative to peers and to history. Top-down analysis is also undertaken to understand political and economic factors at play in the region, as these can have a significant influence on the competitive landscape.

Positions are taken and sized according to conviction and without reference to benchmark weights: by way of illustration, the second-largest holding, NetEase, makes up c 5% of the portfolio but is absent from the benchmark. The manager may trim or exit holdings where he feels valuations are becoming stretched, or may top up where he feels negative moves have been overdone. Dividends are not a primary focus, but the portfolio’s yield is among the highest in its peer group and largely in line with that of the index.

At 31 October there were 57 stocks in IAT’s portfolio, fewer than at our last note in February, and below the 66-stock average for the Asia ex-Japan peer group. The largest geographical exposures were to China, Hong Kong and South Korea, which between them made up 62.6% of the portfolio at 31 October. Hong Kong was also the biggest overweight relative to the benchmark.

Hargreaves says aggregate Hong Kong/China exposure has risen over the past six months, partly through an increase in the weighting to China Mobile (now in the top 10), which has good free cash flow growth and is benefiting from the 4G cycle in China, where most people use mobile devices as their primary means of internet access. Other stock picks include Minth and EVA Precision Industrial Holdings; the former is a small-cap auto parts maker with operations in Germany and the latter makes moulds and parts for photocopiers, but is also branching out into car body parts.

India is another small overweight and while the manager has taken some profits from UPL (a former top 10 holding) on valuation grounds, he has bought Bangalore-based Sobha, a small-cap property developer that is well placed for expected falls in interest rates and inflation in India, and Tata Motors, which should benefit from new Land Rover and Jaguar product cycles. Hargreaves says Tata is currently on a 7x P/E with potential to move to a premium to the global auto sector.

IAT has changed its benchmark from MSCI AC Asia Pacific ex-Japan (21% in Australia at 30 October) to MSCI AC Asia ex-Japan, which excludes Australia. The trust retains a small (3.6%) weighting to the country, with some resource stocks and government outsourcer Transfield; Hargreaves has sold his Australian financial holdings and reduced the weight from c 10% at the end of 2014.

Turnover remains low at c 30% for FY15, with more stocks sold than bought. There is currently no gearing, although the manager has run down the 4% net cash he held at the 30 April year end.

At 23 November, IAT’s shares traded at a 10.7% discount to ex-income net asset value. Over the medium term the discount has been largely in a range of 8-10% and the current level is broadly in line with the one-, three- and five-year averages of 9.5%, 9.8% and 9.4% respectively. This is also in line with the average discount for the AIC Asia Pacific ex-Japan sector (excluding specialist income funds), which stood at 10.7% at 16 November.

The board’s objective is to keep the discount below 10%, and a tender offer may be triggered if the average discount over a financial year exceeds this level. The last tender offer was in 2013; in FY15 the average discount was 9.5%. Share buybacks may also be used on an ad hoc basis to manage the discount; so far in calendar 2015 1.6m shares have been bought back at a cost of £3.03m.

A conventional investment trust with one class of share, IAT had 87.01m ordinary shares in issue at 23 November 2015. The trust has a revolving multi-currency credit facility of £20m, with an interest rate of LIBOR plus 0.85%. The board has set a working limit of 15% on gearing, but IAT has been largely ungeared recently; net cash stood at 4% in April, but had fallen to 0.1% at 31 October.

Invesco Fund Managers provides investment management and administration services to IAT and receives an annual management fee of 0.75% of the value of total assets (excluding any funds managed by Invesco) less current liabilities, calculated and paid quarterly. Fees are charged 25% to income and 75% to capital. There is no performance fee. At 31 October 2015 ongoing charges were 1.03%.

IAT’s objective is to achieve long-term capital growth, with no specific income requirement. As a result, income received is a product of stock selection. However, IAT has raised or maintained its own dividend every year since 2001, with a compound annual growth rate of 5.0% over the past five years, well ahead of the rate of UK inflation. Dividends are paid annually in June or early July. The FY15 dividend of 3.65p per share was fully covered by income and represented a 5.8% increase on the previous year’s dividend. At the FY15 year end, the trust had a revenue reserve of £5.89m, a 4.8% increase on the previous year and more than sufficient to cover the whole annual dividend if required. Based on IAT’s FY15 dividend and the 23 November share price of 178.0p, the trust currently yields 2.1%.

Exhibit 9 below shows IAT’s AIC Asia Pacific ex-Japan peer group, excluding three income-focused funds and one fund focusing on unquoted investments. Within this group, IAT’s NAV total return performance is above average over one, three and five years, ranking fifth, third and fourth respectively out of 12. Risk-adjusted performance as measured by the Sharpe ratio is also above the weighted average over three years. The dividend yield is the third-highest of the group. Ongoing charges are broadly average, as is the discount, and the trust’s small net cash position is below the sector average gearing level. Currently, half the funds in the group are slightly net cash and half have some level of gearing.

IAT has four non-executive directors. Carol Ferguson joined the board in March 2009 and became chairman in August 2013. James Robinson, the longest-serving current director, was appointed in January 2007, while Tom Maier became a director in March 2009 and Owen Jonathan joined the board in March 2013. The directors have backgrounds in investment management and law.