Schroder AsiaPacific Fund — Update 17 March 2016

Over the last 12 months, the benchmark has been weak in both absolute and relative terms, reflecting increasing concerns about developments in the Chinese economy in particular. However, despite global and Asian growth expectations generally being revised down, forecast GDP growth in Asia ex-Japan is still significantly higher than for advanced economies. On a longer-term view, drivers include growth in consumption as a result of higher disposable income, still relatively low household debt and low unemployment, growth in trade and financial services and infrastructure spending. Looking at valuation, the Datastream Asia ex-Japan index forward P/E multiple now stands at a c 20% discount to the world index, close to the low end of the five-year range.

For investors wanting to take advantage of the depressed valuations in the region, but nervous of exposure to value traps, a fund such as SDP with an active stance based on stock selection could be appealing.

SDP was launched in 1995 to seek capital growth from investing in companies in Asia excluding Japan. Since inception it has been managed by Matthew Dobbs, now head of global small-cap equities at Schroders. Having joined the company in 1981, he has been running Asian specialist funds since 1985. Dobbs works closely with Richard Sennitt in Schroder’s London office; he also manages the Schroder Oriental Income Fund. The SDP portfolio targets 70-90 holdings. There is a focus on companies with visible earnings growth, sustainable returns and valuation support, which can lead to significant underweight positions in certain sectors and countries. Risk controls dictate that no more than 15% can be invested in a single company and no more than 10% can be invested in other UK-listed investment companies. Up to 5% may be invested in unlisted securities, but in practice no such investments are held. While portfolio composition largely reflects individual stock selection and a consideration of fundamental risks, a proprietary risk management system provides an independent assessment, giving a quantitative view of the portfolio characteristics.

The manager can see value in parts of the Chinese stock market, having been cautious about the rally seen up to mid-2015. Dobbs acknowledges that there are risks that the economic situation in China deteriorates significantly, with the scale of credit growth a particular concern and underlying ‘real’ growth probably running in the region of 3-4%. Against this he believes the authorities will be able to navigate out of a worst-case scenario that might involve a collapse in the currency, deflation or a significant rise in bad debts. Positively, recent consumer statistics are not bad, with migrant worker wages up 7% year-on-year, for example. China is not losing share in the export market and the trade surplus is rising. China is the key domestic risk to Asian equities but, with the regional market now on a 1.2x price to book value, markets are at a level where, historically, buying has been rewarded.

Portfolio turnover can vary and has been 31.3% over the last 12 months. There are a number of new positions in the portfolio, but over the last 12 months, the basic core shape of the portfolio has not changed very much. The key investible themes remain the same, eg strong free cash flow generation, low-cost production and sustainable yield.

The portfolio is underweight the top decile companies in terms of market capitalisation. Dobbs comments that this does not reflect a top-down decision, but arises from stock selection and the rich opportunity set among mid- and smaller-cap companies in Asia, particularly in the consumer-related sectors. By contrast, some of the mega-caps face structural headwinds.

Matthew Dobbs and his colleague Richard Sennitt are based in London. They both have many years’ experience of investing in Asia (Dobbs has 34 and Sennitt has 22) and have daily contact with Schroders’ analysts based in Asia. The team of 43 operates from seven regional offices, including India. During 2015, Raymond Maguire was appointed as the new head of Asia research; he has introduced a new research template, which facilitates the screening of a broader universe of stocks.

The investment process is based around stock selection, with ideas generated by the manager and the in-house analysts. Resources include company meetings and quantitative screens focusing on macro- and company-specific factors including cash flow, earnings revisions and valuation. Country allocation is conducted each month using the output of a proprietary quantitative model and the manager’s qualitative views. Potential portfolio holdings are researched internally and models constructed with a standard format to eliminate where possible the differences in accounting regimes and to allow comparisons between companies in the same industry or region. Stocks are given a ranking based on their perceived quality, their valuation and the analyst’s level of conviction. The manager focuses on companies with visible earnings growth, sustainable returns and valuation support. They are ranked based on his view of upside/downside potential and his level of conviction. Weightings within the portfolio reflect these considerations and the primary objective is to create a portfolio with an appropriate level of stock-specific risk. There is also a proprietary risk management system, which provides a quantitative view of the characteristics of the portfolio. Investment restrictions are in place to ensure adequate diversification and spread of investment risk (see Fund profile section).

At the end of February 2016, SDP’s portfolio comprised 80 stocks compared with a range of 70 to 90 and a peer group average of c 70. The top 10 holdings accounted for 39.6% versus 33.7% at the end of February 2015. Eight of the top 10 positions were held at the end of both years. The portfolio has a high active share of 72.6%, with 22.7% of the portfolio in non-index stocks (as at the end of February 2016).

The top 10 overweight and underweight positions are shown in Exhibit 3. Looking at the top overweight positions, there is diversification by industry and geography. The manager has been cautious on both Chinese banks and insurance companies, as shown by the largest underweight positions, where four of the top 10 are in these industries. However, as evidence of the stock-specific, active nature of the SDP portfolio, the fourth overweight position is a Chinese insurance company with positive fundamentals in a sector with reasonable secular growth.

Geographically, the fund is heavily weighted to Hong Kong/China (50.4% at the end of February) with a 9.7% overweight. This is comprised of an overweight position in Hong Kong and an underweight position in China. The underweight position in China has been reduced with market weakness but, as the top underweights list shows, there are still significant stocks that Dobbs wishes to avoid. He sees many companies in Hong Kong as attractively valued; balance sheets have strengthened, dividend yields are attractive and managements are acting in the interests of shareholders. The overweight position in India (12.2% of the portfolio, overweight by 2.9%) has been reduced as a result of profit taking. Korea is the largest underweight position (-7.6%).

On a sector allocation basis, in line with our report dated 29 April 2015, the portfolio remains overweight consumer discretionary focusing on good-quality growth companies. The largest underweight sector is consumer staples, reflecting high valuations in this area and structural headwinds.

SDP has generated strong relative performance in share price and NAV terms over both short- and long-term periods, as shown in Exhibit 6. There have been periods of underperformance, most recently in April 2015, when China A shares and second-line stocks rallied sharply. SDP stuck to its strategy, the rally was short lived and the trust has continued to outperform (Exhibit 7).

The manager indicates that 60–70% of the net outperformance of 3.8% of the SDP NAV versus the MSCI AC Asia ex-Japan Index in 2015 was as a result of stock selection, especially in China. The focus has been on quality companies exhibiting real growth. There was also positive performance from stock selection in Taiwan, India and Korea.

On a geographic allocation basis, overweight positions in Hong Kong and India added to performance, as did zero exposure to Malaysia and an underweight position in Singapore.

Performance was negatively affected by exposure to Thailand, both in terms of an overweight position and from stock selection. An underweight position in Korea was a modest detraction from performance, but was more than made up for by positive stock selection.

The trust has the authority to buy back up to 14.99% of its shares to manage the discount to NAV. The board is proactive with regard to discount management, having an informal discount control policy to maintain the long-term cum-income discount below 10%, but does not wish to interfere with the natural liquidity in the shares. The last buyback was on 11 December 2015 (152,000 shares at 262.32p).

At 17 March 2016, SDP’s cum-income discount to NAV stood at 11.0%. This is wider than the average over one, three, five and 10 years (range of 7.5% to 10.5%) and modestly wider than the peer group average (see Exhibit 9).

SDP is a conventional investment trust with one class of share. There are currently 169.1m shares in issue and no shares are held in treasury. The trust has an indefinite life subject to a five-year continuation vote, with the next due at the 2021 AGM. During FY15, borrowings were restructured to lower costs. The US$75m revolving credit facility was replaced with a £30m revolving credit facility, of which £29.7m has been drawn down, and a £30 million overdraft. The current level of net gearing of 5.8% is well below the maximum allowed limit of 20%.

Schroders Investment Management receives a tiered management fee starting at 0.95% pa on the first £100m of assets, 0.90% pa on the next £200m, 0.85% pa on the next £100m and 0.80% on assets in excess of £400m. Ongoing charges were 1.03% in FY15, down from 1.08% in FY14. There is no performance fee.

SDP is focused on capital growth rather than yield; it does not have a yield target or a progressive dividend policy. A dividend has been paid in 18 out of 20 possible years; the exceptions were 2000 and 2001. The dividend was maintained or increased between FY07 and FY13. It declined by 18% in FY14 due to a lower revenue return, which was partly as a result of increased exposure to India, where yields tend to be lower. The FY15 dividend of 4.20p (99% payout) was 53% higher than in FY14, on a 51% higher revenue return, although part of the increase was due to factors that may not be repeated, including currency movements and a modest rise in the gearing. This equates to a current dividend yield of 1.6%.

There are 15 trusts in the AIC Asia Pacific ex-Japan sector. The five peers most directly comparable to SDP are highlighted in Exhibit 9. SDP is the second largest trust in the group. It has outperformed the weighted peer group average over one, three and five years. Risk-adjusted returns, as measured by the Sharpe ratio, have smaller negative values than the average over both one and three years. The discount is currently wider than the peer average and the net gearing is modestly lower.

There are currently five members of the board, all non-executive and independent of the manager. Having been chairman since the fund launch in 1995, the Honourable Rupert Carington (chairman) retired at the January 2016 AGM. He is succeeded by Nicholas Smith, who was appointed to the board in 2010. The other members are Anthony Fenn (appointed in 2005), Rosemary Morgan (appointed in 2012), James Williams (appointed in 2014) and Keith Craig (appointed in 2015). All of the board members have lived and worked in Asia.