By Dhananjay Phadnis, Portfolio Manager, Asian Equities
12/11/2021
Global investors are turning to Asia as a source of diversification and yield. But as uncertainty surges in China and the region continues to see an uneven economic recovery, market participants are trying to deepen their understanding of the region.
Environmental, social and governance (ESG) investing is also swiftly gaining prominence in more developed markets – but it is still only at a nascent stage in Asia. With ESG mandates at the forefront, investors may be wondering how they should think of Asian markets and properly allocate capital to Asian assets. Here, we look at several potential sectoral opportunities that are playing out and discuss why a sustainable investing approach can be an excellent way to identify value-generating opportunities in the region.
Adjusting to the realities of Asian markets
For investors used to investing in developed markets, like the US, assessing Asia is an acquired skill. Asia is not a homogenous entity. Instead, it is a collection of different markets, each with its own economic construct and system of governance. These idiosyncrasies cannot be ignored when analysing stocks.
Understanding what has happened in past market cycles is also particularly important. We’ve gone through many different cycles in emerging markets, and the lessons of history can teach us a lot. For instance, the history of the Asian crisis reminded us how an upcycle – with all its excesses – appears. More importantly, it also helped us understand what happens when the macro environment swings the other way to extreme bearishness, and showed us how vital it is to scrutinise a company’s balance sheet, studying debt levels and foreign currency mismatches to gauge whether the business can survive such crises.
On a broader note, we would also caution against taking liquidity for granted. In a bull market, Asia can seem flushed with liquidity. However, when we enter bear territory, the speed at which such liquidity dries up can take investors by surprise.
Of course, all these peculiarities do entail more due diligence. That is also why we believe an active strategy can be particularly fruitful in the region. A train of thought that extends to ESG investing.
ESG investing is still at an early stage – which creates opportunities
The pandemic was a positive driver of ESG investing in the region, with investors increasing their sustainable holdings and incorporating ethical factors into their analysis and decision making1. This is a promising sign, but the reality is that ESG investing is still at an early stage here in Asia.
To us, this is an opportunity. For instance, ESG disclosures provided by the companies remain quite scarce, leading to reliance on third-party ratings providers. However, just because a company has a poor third-party sustainability rating doesn’t necessarily mean it’s a bad ethical play. In fact, this could be an opportunity to engage with the company and help directly drive that ESG improvement – and capture the resulting additional value.
As interest in sustainable investing grows, it is critical never to lose sight of valuations. Whenever there’s a significant surge in interest in a particular theme, there is always the potential for bubbles. Compromising returns for the sake of ESG is antithetical – and unnecessary. We believe it is possible to get the best of both worlds by investing in businesses that can mitigate sustainability risks and be long-term compounders.
That focus on taking the long-term view is also helpful when examining some of the changes in Asia right now.
The long-term perspective in China
The recent market volatility in China is one good example. It might seem that such an uncertain situation is a good reason to stay away from China – and other Asian markets, for that matter. But that would be short-sighted.
We see events in China as a culmination of several longer-term factors. The first is regulatory catch-up, where the Chinese authorities are beginning to impose privacy and anti-monopoly regulations in a space where companies previously had little oversight. A lot of this is merely bringing these companies closer in line to what we see in more developed markets.
The second factor is controlling financial excesses in the system. This has been going on for quite some time, so it is nothing new. Finally, some of the regulations being imposed are related to specific challenges – such as addressing demographic decline and educational affordability. In other words, a lot of this short-term turmoil stems from things that make logical sense when we zoom out and take the longer-term view.
Overly focusing on the short-term could also lead us to miss the forest for the trees. We believe there is far too much emphasis on theeffectof regulations. For example, if we look at earnings and many of these companies – primarily gaming and advertising-driven businesses – have historically grown at a fast pace. So, a slowdown in earnings is something that could naturally arise from regular long-term competitive dynamics. Yet, there is still a tendency to attributeeverythingto regulations.
Semiconductors and gaming – longer-term structural benefits despite short-term downside
Semiconductors and gaming are two more examples that show the dichotomy between the longer-term and shorter-term value propositions. Because of the disruptions we’ve seen in the supply chain, many semiconductor companies have been building up record inventory levels2. As supply chains normalise and this inventory unwinds, we might thus see a lower growth patch.
Again, this short-term view ignores the longer-term structural benefits that have accrued to the semiconductor space because of such disruption. The industry has been consolidating for the past decade3, with the pandemic only briefly interrupting this trend4. This has led to a much less volatile and more rational market structure – with a substantial competitive moat on top resulting from the high costs of entry.
Similarly, in gaming, there has been a short-term selloff due to uncertainty surrounding concession renewals. This stemmed from official Chinese comments on greater regulatory scrutiny over the sector5. Now, while regulations are challenging to anticipate, these companies have historically generated substantial cash flows. Once the pandemic subsides, and we are on the other side of this regulatory reset, these companies could return to the growth track.
In short, despite the short-term headwinds, the long-term industry dynamics could create some compelling opportunities within these sectors.
Financials and healthcare display positive structural dynamics
Continuing the sectoral theme, we believe financials and healthcare are two sectors with positive structural dynamics. Financials in the region have taken quite a beating because of the pandemic, and there are more than a few restructured assets sitting on balance sheets.
For high-quality private sector financial institutions in less developed markets, we believe they can come back strongly as the cycle improves. We specify less developed markets because financial institutions in developed market-equivalent countries are highly rate sensitive – and rate cycles are difficult to predict. We are also not bullish on state-owned banks as they are not in control of their own destinies. Finally, insurance is another sector opportunity as it has historically been underpenetrated in the region.
As for healthcare, we think a few of the top names in the sector can break out from the Asian markets and onto the global stage. Right now, we see a new wave of biologics, large molecule and innovative drug companies. Those with excellent execution and the ability to create optionality around their core businesses will be the standouts. Value creation opportunities will come as these optionalities are fulfilled – investors must understand all the different optionalities and assess them probabilistically.
The key to value generation in the Asian markets
The market is understandably biased toward the short term. By taking a longer-term perspective – and drilling down on high-quality companies – we can pinpoint value-generating opportunities. This longer-term view should also encompass ESG and sustainability because, as the trend shows, these will only continue to grow in importance.
1https://www.cnbc.com/2021/03/04/sustainable-esg-investments-surged-in-asia-pacific-in-2020-msci.html
3https://www.accenture.com/us-en/blogs/high-tech/semiconductor-consolidation-expansion
4https://www.design-reuse.com/news/50674/2021-semiconductor-acquisition-agreements.html
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