Fidelity Asian Values — The winners of tomorrow’ – starting to pay off?

The Asian economies outpaced advanced economies during 2020’s coronavirus crisis (see front page chart). Fast and stringent lockdowns in China and Hong Kong brought the virus under control much more swiftly than in western economies and while the US, the UK and Europe are struggling to contain second and third waves over the winter months, in China, Hong Kong, South Korea and Taiwan, economic activity has returned to almost normal levels in most sectors, except travel and hospitality. India and the South-East Asian economies have not fared as well.

Nonetheless, the International Monetary Fund (IMF) forecasts continued outperformance by the Asian economies in 2021, with projected growth of 8.3% this year and 5.9% in 2022, compared to a 1.1% contraction in 2020. This is almost twice the IMF’s projected growth rates of 4.3% in 2021 and 3.1% in 2022, in the advanced economies (following a contraction of 4.9% in 2020). Asian growth prospects are also very positive over the medium and longer term, driven by the growth of the middle class, especially in China.

Asian equity markets have rebounded strongly from their precipitous falls in Q120, with some now trading at or close to all-time highs. This has been driven in part by the better-than-expected regional recovery and by the arrival of proven vaccines, which removed much of the downside risk to the economic outlook.

Political developments have also been supportive for Asian equity markets. The election of Joe Biden as US president eased political uncertainties in the Asian region. While the underlying sources of tension between the US and China will persist, relations with the Biden administration are expected to be less tense and more predictable. Investors also welcomed the passage of further aggressive US stimulus and sentiment was boosted further in the closing days of 2020 by the conclusion of a major free trade agreement between China, Japan, South Korea, the ASEAN countries, Australia and New Zealand, after eight years of negotiations. Between them, these nations represent one-third of global GDP. The deal is expected to provide a sustained boost to trade and economic growth across the region, by lowering tariffs and other trade barriers. India is presently not a signatory to the deal, but the door is open for it to join at a later date.

While Asian equity markets have performed strongly recently, their relative performance has been more mixed. Asian stocks have outperformed the UK market (Exhibit 2, LHS), but they have lagged the world market historically and this underperformance has worsened in the past couple of years (Exhibit 2, RHS). The price/earnings discount between Asian markets and the world index has widened steadily over the past couple of years, despite Asia’s more promising growth prospects.

Another major theme for equity investors is the widening disparity between the performance of growth and value stocks. Global growth stocks, led by the US tech mega-caps, were outpacing value stocks before the onset of the pandemic, and since the Q120 market decline, growth stocks have recovered all the ground lost in the sell-off and have subsequently made unprecedented gains – of 40% or more in some cases – while value stocks have continued to languish below their pre-pandemic levels. On a forward P/E basis, global growth stocks are presently trading at 33x, while global value stocks are trading at 15x. This anomaly is as much a feature of Asian markets as it is in the US, the UK and Europe and the discrepancy is almost as stark – Asian small-cap growth stocks are trading at a forward P/E of 20x earnings, while Asian small-cap value stocks are at 10x.

Value stocks in general have only been this inexpensive relative to growth stocks two or three times in the past century – the last time being the tech bubble of the late 1990s – and most market participants view the eventual correction of this disparity as inevitable. In fact, during Q420, there was a bounce back in Asian smaller-cap value stocks as investors welcomed the arrival of vaccines and the associated improvement in the global economic outlook. Smaller companies in India and the ASEAN countries, which had been laggards, were among the biggest winners from this rotation. While some see this as the beginning of a trend improvement in value stocks, the recovery in value stocks has so far been tentative and it remains to be seen whether it will be sustained. In the meantime, many investors, including FAS’s portfolio manager, Nitin Bajaj, believe the valuation gap between value and growth stocks still provides a great and rare opportunity to buy good companies at very attractive prices.

This factor, combined with Asia’s favourable short- and longer-term growth outlook and the relatively attractive valuations of Asian stocks compared to the world market, suggests that investors with a longer-term perspective should benefit from an allocation to Asian stocks in general, and Asian value stocks in particular.

Fidelity Asian Values was launched in June 1996 and is listed on the Main Market of the London Stock Exchange. Since 1 April 2015, the lead manager has been Nitin Bajaj. He has over 18 years’ investment experience and also manages Fidelity’s Asian Smaller Companies Fund. Ajinkya Dhavale, an analyst specialising in Korea and Taiwan, has recently been appointed assistant portfolio manager. He has nine years’ experience with Fidelity and, like Bajaj, is based in Singapore. The managers aim to achieve long-term capital growth from a diversified portfolio of Asia ex-Japan equities. They are supported by the broad resources of Fidelity’s Asia Pacific ex-Japan investment team, which includes five dedicated small-cap analysts.

Bajaj invests across the market cap spectrum, although he generally favours smaller companies. There are no set limits on geographic and sector exposure, although single country and sector weightings are restricted to 25% and 15% of the fund respectively. FAS’s investment guidelines state that, at the time of investment, up to 10% of gross assets may be invested in a single company, a maximum of 5% may be in companies listed or domiciled outside the Asian region (if they have a high economic exposure to the area) and up to 5% may be unlisted securities (if they are expected to list in the foreseeable future). Derivatives are permitted as a cheaper alternative form of gearing to bank loans (contracts for difference) and to hedge equity market risks. The manager seeks to improve returns by taking short positions. Total derivative exposure is limited to 40% of NAV based on gross assets and 30% of NAV based on net market exposure. In the medium to long term, the board expects net market exposure to be 90–115%. At end-December 2020, net market gearing was 0.0%. FAS’s currency exposure is generally unhedged.

The trust’s index changed to the MSCI All Countries Asia ex-Japan Small Cap from the MSCI All Countries Asia ex-Japan index on 1 February 2020. This change reflects the fact that the manager finds more investment opportunities at the smaller end of the market cap spectrum.

FAS’s portfolio manager, Nitin Bajaj sees two key factors at play in equity markets. Firstly, market sentiment towards the value stocks that comprise 90% of the portfolio has been very unfavourable for many years. At the same time, the stocks of small and medium-sized companies, which comprise the bulk of FAS’s holdings, have also underperformed in a market dominated by mega-cap names. While there has been a recent improvement in the performance of value stocks, including in the Asian region, and smaller-cap stocks have participated in this bounce back, as discussed above, they remain broadly unloved.

However, these adverse influences have not reduced Bajaj’s confidence in the fundamental logic of his value-driven investment approach. ‘Over time, Asian value companies normally grow earnings faster than growth companies’, he says. Bajaj believes that history and probabilities both suggest that value investing will eventually return to favour, rewarding patient investors with a long-term perspective. In the meantime, the current extreme disparity in the valuations of value and growth stocks has created an unprecedented opportunity to invest in good companies at competitive prices. ‘We have taken advantage of market apathy towards value stocks to acquire a lot of interesting businesses’, he says.

Contemplating the year ahead, Bajaj reiterates his conviction that diversification into Asian countries other than China, and into a variety of good businesses across the region, continues to make good investment sense. ‘And on average, the trust owns better businesses than the market, bought at better prices, so the portfolio is superior to the market in quality, at a cheaper price’, he argues. ‘FAS is in a good place. The trust’s shareholders are set to reap the rewards as and when its smaller-cap, value stocks come back into vogue’, Bajaj concludes.

FAS’s manager seeks to invest in good businesses with robust balance sheets, run by competent managers. Bajaj’s criteria for judging good managers include a capacity to allocate capital wisely, and a willingness to treat their employees, customers and shareholders honestly and fairly, and he will only invest in businesses whose managers he feels he can trust.

Bajaj favours undervalued smaller-cap companies that have the capacity to grow into ‘the winners of tomorrow’ but have not been recognised by the wider market. Purchasing companies at a discount to their intrinsic value provides the manager with a margin of safety that assists him in his aim to avoid large losses. There are c 18,000 listed companies in Asia, providing a deep pool of investment opportunities.

The manager highlights three elements of the investment process:

The principles of responsible, sustainable (ie ESG) investing are embedded into Fidelity’s research and investment process. Fidelity believes that companies which flout laws or do not respect their employees, customers or communities will not be able to sustain high returns over time. Fidelity is encouraged that the investment community and consumers in general are paying more attention to ESG-related issues and believes that adherence by companies to the principles of sustainability will have an increasing impact on demand for their goods and services, so behaving responsibly makes good sense for companies and thus their investors.

Fidelity’s analysts and managers monitor the actions of corporates and, where necessary, engage with them with the aim of improving their behaviour. This process does not rely on external ratings. Fidelity is building up its internal sustainable ratings capability. FAS’s manager notes that this capability is especially valuable in assessing small and medium-sized companies, as external ratings agencies do not cover around 50% of the stocks held by the trust. If Bajaj is unhappy with a company’s response to his engagement efforts, he will sell his holding.

At the onset of the coronavirus crisis, as the economic implications of the crisis became clear, FAS’s manager sold or materially reduced exposure to a number of businesses which were well-financed for a normal recession, but not prepared for the unusually extreme challenges posed by severe and protracted lockdowns. More recently, Bajaj has made some further sales, mainly due to profit taking on holdings that have performed well despite the pandemic. One such example is Tianneng Power, which controls 85% of the market in batteries for e-bikes. The manager bought this stock at 4x earnings, well below its intrinsic value, and has since seen significant growth in earnings and margins. Demand for e-bikes has soared as people seek alternative modes of transport to avoid crowded buses and trains. Bajaj took profits in the summer when Tianneng Power’s price rose to 12x earnings, but when its price subsequently slumped, he reopened the position at 6x earnings.

The manager has also taken advantage of the market’s sharp sell-off to acquire other severely sold-down businesses, which he expects will not only survive the pandemic, but emerge from it in a stronger competitive position. One such company is an Indian company, Shriram Transport Finance, which finances second-hand truck purchases by disadvantaged individuals without bank accounts or credit records. Bajaj believes this is a ‘great’ business, with no competition, which has provided a 15% return on equity each year over the past 10 years. Yet this company was trading very cheaply, at only 7x earnings – so he has added to FAS’s existing position. Shriram Transport Finance is now one of the trust’s top 10 holdings. The manager has also acquired a position in a sportswear manufacturer that produces clothing for several big companies, including Uniqlo and Target. This company should benefit from its decision to move its production base from China to Vietnam to reduce costs, and it is increasing its market share.

FAS’s bias towards small- and medium-cap companies is illustrated in Exhibit 3. At end-December 2020, over half of the portfolio was invested in stocks with a market cap under £1.0bn and a further 20.5%of the portfolio was held in companies with market caps between £1.0 and 5.0bn. The remainder of the portfolio was invested mostly in large-cap companies, which tend to be in the top three in their sector. There has been some upward drift in the average cap size of the portfolio over the year to end December 2020. This is not a top-down or asset allocation decision on the part of the manager but rather the result of his bottom-up stock selection, including acquisitions of or increased exposures to some larger companies such as HDFC Bank and Axis Bank, SK Hynix and Taiwan Semiconductor Manufacturing, which the manager believes were particularly attractively priced. Market movements have also had an impact on average cap size – recent gains by several FAS holdings, discussed below, have pushed these holdings from lower market cap buckets into higher buckets.

FAS’s manager does not focus on the geographical or sectoral spread of the portfolio. Rather, as with market cap weightings, allocations across countries and sectors are the result of individual stock selection. However, as can be seen from Exhibits 4 and 5, the portfolio is well-diversified across countries and sectors. At the end of December 2020, its largest geographical allocation was in India, which comprised 22.2% of the portfolio (an overweight of 4.6pp). In addition to Shriram Transport Finance, mentioned above, four other Indian companies occupy places in FAS’s top 10 holdings, including the top three rankings. In addition to Indian banks Axis Bank and HDFC Bank, Granules India is the country’s largest producer of a limited range of high-volume, low-value generic drugs, a business model which results in a low cost of production. Power Grid Corporation, the sixth largest holding, is a high-quality regulated electricity transmission monopoly with impressive growth. China is FAS’s second largest geographical allocation (20.7%) and its largest overweight (7.6pp). Positions in Chinese companies include top 10 holdings in China Yongda Auto Services, a leading premium auto dealer benefiting from strong demand from China’s burgeoning middle class, and Fufeng Group, a food additives producer with a leading market share in the supply of food additive monosodium glutamate (MSG). The trust also held a notable out-of-index position in Australia (+7.2pp) due to the acquisition of several gold and nickel miners whose valuations reached very attractive levels, and an overweight to Indonesia (+6.4pp). FAS’s heaviest underweights are to Taiwan (-15.6pp) and South Korea (-9.6pp), where high-quality, attractively priced businesses are more difficult to identify. Nonetheless, Taiwan Semiconductor Manufacturing Company, the world’s largest semiconductor foundry and South Korean company SK Hynix, the world’s second largest maker of DRAM memory, are both in FAS’s top 10 holdings.

On a sectoral basis, at the end of December 2020, the trust’s most significant positions were overweight allocations to consumer discretionary (with an overweight of 11.0pp compared to the index) and financials (7.3pp overweight), and underweights in real estate (7.4pp) and IT (5.4pp).

FAS’s portfolio is not highly concentrated. It currently holds around 130 stocks, with 20.7% in the top 10 holdings as at end-December 2020, and a long tail of small holdings. It is the manager’s intention to reduce the number of holdings to 115–120 over time. Under normal market circumstances, he usually makes acquisitions with a three- to four-year time horizon, suggesting annual turnover of 25–35%. However, turnover was greater in 2020, as the manager made precautionary disposals and also sought to take advantage of opportunities presented by the market sell-off. Turnover reached 50% earlier in the year, but has since settled at around 30–40%. The portfolio’s recent higher turnover is reflected in the fact that seven of the portfolio’s top 10 holdings at end December 2020 were not among its top 10 list in December 2019.

The portfolio is presently ungeared on a net market basis. While the manager sees many more investment opportunities that he could exploit with the use of gearing, for the moment he prefers to adopt a more cautious than usual stance, given the unusual and potentially highly volatile nature of the current market environment. However, he has indicated that he may increase gearing slightly when circumstances allow. The portfolio currently has short positions comprising 1.0–1.5% of the portfolio.

The trust has delivered positive absolute returns over both the short and longer terms (Exhibits 7 and 8). Performance has been particularly strong over the six months to end-January 2021, when the trust returned 27.7% on a share price basis and 22.6% in NAV terms. This compares to a rise of 20.2% in the trust’s blended benchmark. However, performance has lagged the blended benchmark over longer periods. This longer-term underperformance is due in part to the fact that until recently, the trust has faced the dual headwinds created by its value style and smaller-cap bias at a time when investors have been focused on large-cap technology and other growth stocks, which have been the major driver of Asian equity markets, but which the trust does not hold. Noteworthy for UK investors is the fact that FAS’s performance has outpaced the UK market over all periods except three months, on a NAV basis – a reminder of the diversification benefits of investment beyond the home market.

The recent improvement in the trust’s performance suggests that some of the headwinds it has faced may be beginning to ease, thanks to the Q420 recovery in investor sentiment towards value stocks in general and the smaller-cap companies that FAS favours in particular. Some of FAS’s Indian and ASEAN smaller-cap holdings, which have been lagging the market, benefited from this. In the six months to end-December 2020, Indian pharmaceutical company Granules was the top contributor to performance, followed by Indonesian ceramics manufacturer Arwana Citramulia. Demand for its products was boosted by the trend for home renovations as people are forced to spend more time at home. Taiwan Semiconductor Manufacturing also added to returns, as did the Indian private sector lenders, Axis Bank and HDFC Bank, second-hand commercial vehicles financier Shriram Transport Finance and Korean lead acid battery maker Sebang Global, all of which recovered and outperformed the index in Q420. Chip maker SK Hynix benefited from a rebound in memory chip prices as well as an improvement in the outlook for 2021.

The main detractor from performance over the six months to end-December 2020 was China Overseas Land and Investment, which fell out of favour after its parent company, China State Construction Group, was adversely affected by a change in US regulation. Utility companies Chaowei Power Holdings and Power Grid Corporation of India also hurt performance.

On a geographical basis, FAS’s significant overweight to India was by far the most significant positive contributor to performance in H220. Its underweights to Taiwan and Singapore made lesser contributions, as did its overweight to Hong Kong, while its underweight to South Korea’s tech and biotech-dominated market was the main detractor. On a sectoral basis, FAS’s overweight exposure to financials contributed most to performance over the six months to end-December 2020, followed by its underweight positions in real estate and information technology. The trust’s underweights to materials and healthcare had the largest adverse impact on performance on a sectoral basis.

FAS’s share price was trading close to NAV at the onset of the coronavirus crisis. After widening to a discount of 15.7% in late March 2020, the share price traded at a discount of around 10% for several months over the summer and autumn, before narrowing to its current level of 3.0% as FAS’s performance benefited from an improvement in investment sentiment towards smaller-cap value stocks. This compares with average discounts of 6.9%, 1.9%, 4.3% and 7.4% over the last one, three, five and 10 years respectively. The discount has scope to narrow further if this improvement in investment sentiment towards Asian value stocks is sustained.

The board has authority, renewed annually, to allot up to 10% in issue and to repurchase up to 14.99% of shares in issue. The board uses this authority to actively manage the discount. In the first half of the last fiscal year ending 31 July 2020, the trust’s shares mostly traded at a premium and the board issued 266,000 shares. Between late March 2020 and the end of the last financial year, it repurchased a total of 1.6m shares. During the current fiscal year, the board has repurchased 0.7m shares.

FAS has 73.2m ordinary shares in issue. It has a variable management fee (effective since 1 August 2018) based on the trust’s performance versus the benchmark. The base fee is 0.7% of net assets per year, with a maximum of 0.9% and a minimum of 0.5%. This arrangement helps to compensate investors during periods of underperformance. In FY20, the variable management fee was 0.59%, 19bp lower than 0.78% in FY19. The FY20 ongoing charge was 0.98%, unchanged from FY19 and lower than the FY18 figure of 1.17%.

FAS is subject to a five-yearly continuation vote, with the next vote due at the 2021 AGM.

FAS pays an annual dividend in December, from revenue reserves. In FY20, the trust paid a dividend of 8.5p per share, a 3.4% decline from the 8.8p per share paid in FY19, but significantly higher than the 5.5p per share paid in FY18. Over the long term, it is the board’s intention to pay out what the trust receives in income. However, at end-FY20, revenue reserves stood at £9.8m (amounting to 13.2p per share), up slightly from £9.7m at end-FY19 (13.5p per share). The board views this retention of a small portion of FY20 income as a precautionary measure, given the unusual nature of the current market environment. Based on the current share price and the FY20 dividend, FAS offers a dividend yield of 2.0%.

FAS is a member of the AIC Asia Pacific Smaller Companies sector, due to its focus on smaller-cap stocks. As can be seen in Exhibit 10, the trust’s NAV total returns ranked first among peers over one and five years and second over three and 10 years. Its discount is the narrowest in its peer group and its ongoing charge is competitive. No performance fee is payable and its gearing is average for the sector. The trust pays the highest dividend in the sector, 0.8pp above the average.

FAS has five independent non-executive directors. Chairman Kate Bolsover joined the board in January 2010 and assumed her current role in December 2014. Grahame Stott was appointed as a director in September 2013, Michael Warren in September 2014 and Timothy Scholefield in September 2015. Clare Brady joined the board in August 2019. Between them, the board members have experience and skills in investment management, banking, financial services and consulting.

In the 2020 Annual Report, the board detailed its succession plan for the next four years. Graeme Stott will complete his nine-year tenure on the board in 2022 and will step down at the 2022 AGM. He will be replaced as Audit Committee chair by Clare Brady. Kate Bolsover will step down at the AGM in 2023, completing a nine-year tenure as chair.