Scottish Oriental Smaller Companies — Small-cap specialist, repositioned for growth

As shown in Exhibit 2, the MSCI Asia ex-Japan index performed strongly from early 2016 to early 2018, driven by synchronous global growth and strong upward momentum in corporate earnings revisions. For much of this period, the performance was polarised towards large market cap names, particularly in the technology sector (where China internet and manufacturers in South Korea and Taiwan are dominant). This was amplified by the significant inflows of exchange traded funds (ETFs) that focus on the largest and most liquid stocks to replicate index performance. Smaller companies appear to have been overlooked for some time, and the MSCI AC Asia ex-Japan Small Cap index has lagged the MSCI AC Asia ex-Japan index considerably, suggesting they are not widely owned. Asian valuations in P/E and price to book ratio terms do not seem overly stretched, following strong 2017 earnings growth of nearly 30%, though they are above their 10-year averages. Compared to global equities, Asia remains relatively attractively valued.

SST was launched in 1995, with the aim of generating long-term capital growth, primarily from investing in smaller Asian equities (excluding Japan) with market capitalisations below US$1.5bn at the time of investment. The trust is also permitted to invest up to 20% of the portfolio in companies with market capitalisations of between US$1.5bn to US$3.0bn. The investment approach is bottom-up and stock focused, without constraints on country and sector weights, therefore the portfolio’s exposures can diverge meaningfully from that of Asian indices (see Exhibits 3 and 4). While cultural, political and economic factors are considered, SST’s holdings primarily reflect the manager’s high-conviction investments in attractively priced, good-quality companies with a long-term investment horizon of at least three to five years. The small-cap mandate means investments can be less liquid, requiring patience with stock purchases and sales. The closed-ended structure of the trust is well suited to SST’s investment approach. Lead manager, Vinay Agarwal, formally assumed this role in July 2017 following a year as acting lead manager during Wee-Li Hee’s maternity leave. Hee has since returned as a co-portfolio manager, thereby ensuring continuity in the team.

Gearing of up to 50% of net assets is permitted. However, reflecting the manager’s view that Asian equities were unattractively valued at the time, and would require a significant correction for this view to change, a £20m loan facility was repaid early in June 2017. As at end-May 2018, the trust had net cash of 5.1%

Asian equities have performed strongly over the past two years. However, Agarwal believes this has been fuelled by unprecedentedly low interest rates, accompanied by rising debt at country and corporate levels. Although global interest rates have started to rise, the magnitude of change has been modest so far, while inflation has been benign, thus extending the period of loose monetary conditions. The manager is cautious and believes that this scenario cannot endure and when interest rates normalise, highly indebted countries and companies could suffer. Agarwal favours investing in countries with relatively low levels of debt-to-GDP, where recent growth has been driven by structural domestic factors (such as India, Indonesia and the Philippines), rather than those where growth has been supported by increased borrowing (such as China and South Korea).

The manager continues to find Asian equities in general to be expensive, although he is finding exciting long-term investment ideas in less-developed economies, where market penetration levels for consumer goods and services are low, providing good prospects for multi-year structural growth. Many of these markets (including Sri Lanka, Bangladesh and Pakistan) have lagged the larger, more liquid markets.

SST follows a conviction-based, bottom-up approach to find quality companies in which it can invest with a long-term horizon of at least three to five years. The manager’s approach has an absolute return mind-set and focuses on downside protection, as well as capital growth. The most significant source of investment ideas is direct company meetings. First State Stewart Asia’s team has 19 investment professionals and conducts over 1,200 meetings a year, seeking to find attractively priced, good-quality companies that can sustain long-term growth. It looks for companies with strong franchises and high barriers to entry, avoiding those that are dependent on government and regulation (such as state-owned companies). The quality of a company’s management is key and the team assess for integrity, risk awareness and the ability to allocate capital well. Country and sector weights are a residual of stock selection.

As shown in Exhibits 3 and 4, focus on stock selection without country and sector constraints means the SST portfolio differs significantly from the MSCI AC Asia ex-Japan index. Reflecting the manager’s preference for investing in markets with lower levels of national and corporate debt, SST is significantly overweight the index in India (18.6pp), the Philippines (7.8pp) and Indonesia (5.4pp), with notable increases in exposures to India (+4.9pp) and the Philippines (+1.8pp) over the year to end-May 2018. Much of this is accounted for by increasing the size of existing positions where opportunities arise, due to market weakness and/or higher conviction following ongoing engagement with management. These include: Concepcion Industrial in the Philippines, the market leader in air conditioners (38% market share) and refrigerators (27%); and Century Pacific Foods, a canned food manufacturer, also in the Philippines, which is transitioning to becoming a branded consumer business, with potential to significantly lift margins and profitability.

SST’s exposure to smaller markets is notable with an aggregate 9.8% invested in Sri Lanka, Vietnam, Pakistan and Bangladesh. These countries are among the least-developed countries in Asia and are classified by Morgan Stanley Capital International (MSCI) as ‘frontier’ markets (with the exception of Pakistan, which was upgraded from ‘frontier’ to ‘emerging’ status in 2017). These markets are less well researched and relatively illiquid, which in the manager’s view brings interesting, attractively valued opportunities for a disciplined and patient investor. Recent purchases in these countries include Pak Suzuki in Pakistan, the trust’s second autos holding in that market in addition to Indus Motors, which was purchased last year. Pak Suzuki has a 31% share of the autos market, which is controlled by three players (Indus Motors and Honda Atlas have 44% and 25% market share respectively) and penetration rates are among the lowest in the world at just 15 passenger vehicles per 1,000 people.

The portfolio is most underweight Asia’s largest markets, China and South Korea, where the manager believes rising interest rates could pose a greater challenge than for other countries in the region. These markets are also dominated by very large information technology (IT) companies, which the manager does not favour. IT has performed particularly strongly over the past few years, commanding valuations which he deems excessive (for example, China internet names including Tencent and Alibaba). The sector also contains contract manufacturers, which the manager finds structurally unattractive. These companies typically have limited pricing power, are at the mercy of commodity price fluctuations, and are highly cyclical in nature. Recent sales include Hana Microelectronics in Thailand, and Posiflex and Lumax in Taiwan.

Cash remains relatively high at 5.1% as at end-May 2018, but the manager has a good line-up of companies under consideration for investment. In addition, the portfolio has a number of relatively small positions he is looking to increase. For newer investments, the manager may add to a holding incrementally as he gains conviction through ongoing engagement with company managements and often, smaller companies are illiquid, requiring a patient approach to accumulating stock.

Over the past two years, the portfolio has undergone a shift in favour of higher-growth companies, with the manager gradually disposing of low-growth companies, many of which he views as ‘value traps’. The estimated three-year compound annual growth rate of earnings for new companies purchased between June 2016 and December 2017 was 17% versus 11% for those holdings sold. Over the same period, the number of holdings has been reduced from 77 to 63. This repositioning process is nearly complete, and the manager believes the portfolio is well placed to benefit from structural long-term growth in Asia.

As shown in Exhibits 5 and 6, SST has strong 10-year NAV total return performance, significantly outperforming the MSCI AC Asia ex-Japan, MSCI AC Asia ex-Japan Small Cap and FTSE All-Share indices. Relative performance against the benchmark over one, three and five years, however, has lagged. Asian equities’ performance since early 2016 has been fuelled by inflows from exchange-traded funds, which tend to buy the larger, more liquid stocks without regard for fundamentals, while smaller, high quality companies that meet SST’s investment criteria have been relatively overlooked in this environment. Furthermore, reflecting the manager’s view of extended stock price valuations, SST had higher than normal cash levels, which has been a drag on performance over this period when Asian equity markets were strong.

SST currently trades at a 14.8% discount to its cum-income NAV, which is wider than its three-year average of 12.5%, and towards the lower end of the 1.7% to 16.7% range over this period. Although there is no formal discount management policy, the board regularly monitors the trust’s discount to NAV, actively promotes the trust and has the ability, renewable annually, to purchase up to 14.99% of shares (see page 7).

SST is a conventional investment trust with one class of share: there are currently 30.4m ordinary shares in issue and, as at 21 June, 1.0m shares were held in treasury. During the six months to end-February 2018, the company repurchased 12,000 ordinary shares at a total cost of £123,000.

First State Investment Management (UK) is paid an annual management fee of 0.75% of net assets. An additional performance fee is payable if SST’s share price total return exceeds that of the MSCI AC Asia ex-Japan index by 10% over a rolling three-year period, capped at 1.5% of net assets. No performance fee was payable in FY17 and, as at end FY17, the ongoing charges were 0.99%.

SST’s primary focus is on capital growth rather than income. It pays dividends annually and for FY17, paid 11.5p (same as FY16), representing a yield of 1.2%. The board aims to at least maintain annual dividends, drawing on income reserves accumulated in previous years, if necessary.

Exhibit 8 shows the AIC Asia Pacific ex-Japan peer group of investment trusts, with market capitalisations over £100m. This group consists of 15 members with diverse mandates, including income-focused funds and Pacific funds (which also invest in Australasia), meaning direct comparisons can be less meaningful. SST’s long-term performance is strong, ranking first for NAV total return over 10 years, representing an annualised return of 14.6% pa. Performance has lagged in more recent years and the trust ranks 14th over one year, 15th over three years, and ninth over five years. SST’s discount to ex-par NAV is one of the widest among peers. In addition to weaker relative near-term performance, this may also reflect small-cap Asian equities being out of favour in an environment where large-cap stocks have led stock market performance over the past few years and investors have sought income from dividends. The trust’s most comparable peer is Aberdeen Asian Smaller Companies Trust, which trades at a similar ex-par discount to NAV of 13.4%.

The board consists of five independent non-executive directors. Chairman James Ferguson and Alexandra Mackesy were appointed in 2004 and Anne West in 2010. Two new appointments were made in 2017: Jeremy Witley and Andrew Baird. Dr Janet Morgan resigned from the board at the December 2017 AGM.