Invesco: Why invest in Asia now?

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Invesco Asia Trust plc
Invesco Asian Fund (UK) 
Invesco China Equity Fund (UK)

Asia’s growth potential is well known. It’s supported by strong structural trends such as urbanisation, rising incomes and the growth of the middle class. China’s economic rise over the years has prompted many investors to seek broad exposure to its market through ETFs.

But Asian equity markets are a diverse set – they’re interconnected but unique, and often driven by entirely different factors. This results in a wide dispersion in performance and valuation, and creates opportunities for stock pickers, such as our Henley-based Asian and Emerging Markets equities team.

The team adopt a contrarian approach to investing, which leads them to lean into risk when it’s most likely to be rewarded. This enables them to identify undervalued opportunities before others do, capitalising on the market’s excessive negativity. This approach can be especially rewarding at inflection points.

Asian valuations: is a change of direction on the cards?

Looking at Asian markets in aggregate, the valuation of the MSCI Asia ex Japan index as represented by its price-to-book ratio recently reached such an inflection point.1 This has only occurred a handful of times over the last two decades.

Figure 1. Asia ex Japan equity markets have reached an inflection point

Source: Refinitiv as at 31 March 2023.

Although markets have rebounded off those deeply discounted levels, they remain attractively valued relative to historic levels. They also continue to trade at a discount to developed markets – particularly the US. The team believe there’s scope for this to narrow, with US dollar strength challenged by a slowdown in the US as the Fed seeks to root out inflation.

For our Henley-based Asian and emerging markets equities team, valuation doesn’t always act as a catalyst. But it provides them with grounds for cautious optimism in Asia’s prospects. Beyond that, they believe the outlook for growth in Asia remains positive cyclically as well as structurally.

“In our view, post-pandemic economic activity is gradually returning to normal, albeit without a full recovery in some industries that have suffered from chip shortages and supply chain disruption, such as autos.” says William Lam, Co-Head of the Asian and Emerging Markets Equity team. “And despite enjoying a favourable growth differential over other regions, inflation is less of a concern in Asia. This suggests they have greater policy flexibility should developed market demand for Asian exports roll over.”

We have provided a few case studies below, where you can find out more about the specific investments the team has made in Asia. Whether it’s China or Indonesia – the region offers a rich seam of opportunities to mine.

Case study: investing in China

Our Henley-based Asian and emerging markets equities team have long been cautious on China, given macro, geopolitical, regulatory and governance risks. But they’re not averse to leaning into risk when periods of excessive negativity provide them with opportunities to buy quality stocks at what they believe to be bargain prices.

Figure 2. China’s underperformance in 2021/22

Source: Bloomberg as at 24 April 2023.

Events in 2021/22 saw China underperforming the broader market significantly. The team felt that investment risk was being mispriced for several reasons. Firstly, the biggest source of macro uncertainty was the country’s adherence to a ‘zero Covid’ policy. While there was no visibility on how and when restrictions would be lifted in the near term, it was easier to assume China would learn to live with the virus on a medium-term view.

Secondly, a peak in regulatory tightening appeared to have been passed, for both ‘new economy’ sectors and property developers, with authorities unwilling to risk further weakening a slowing economy. While regulators remain active, and risks remain, recent measures have been to support the property market and promote the role of innovative ‘new economy’ companies in bolstering the broader economy.

Geopolitical risk is harder to analyse, and US-China tensions remain in focus, particularly over Taiwan. The Russia-Ukraine war has raised the stakes, demonstrating how coordinated sanctions could be brought against China, should it be seen to offer Russia lethal weapons. However, there has been no change in the team’s view that China has every incentive to avoid such sanctions. They believe that China remains committed to globalisation – even in the face of measures intended to restrict its access to technology essential for producing advanced chips.

“As China underperformed, we felt that investment risk in China was being better rewarded than before,” William Lam says. “So, we selectively added exposure to China, reducing our underexposure to the region relative to the MSCI Asia ex Japan index. Our portfolios hold a mix of large internet companies, life insurers, autos and auto parts manufacturers, a wind turbine manufacturer as well as selected property and consumer-related stocks.”

Case study: investing in South Korea

South Korea has long been one of the cheapest markets in Asia, and deservedly so, according to detractors who point at the geopolitical risk, the cyclical nature of its economy, and governance matters. Given raised concerns about a global cyclical slowdown, a weakening tech cycle, and the impact of elevated oil prices on its external trade balance, it’s not surprising that South Korea was one of Asia’s worst performing markets in 2022 – whether that be for equities, bonds, and currencies.

But our Henley-based Asian and emerging markets equities team have been happy adding exposure to Korea, and are prepared to see through the near-term uncertainty, comfortable with the stocks they hold on a three to five-year view. They also note evidence of gradual improvement in governance, with better access to senior management and attractive dividend yields already on offer. Combined with what the team believe to be a sustainable positive long-term trend towards paying out more in dividends to shareholders, this could have positive implications for valuations.

Figure 3. Dividend growth in Korea

Source: Refinitiv as at 24 April 2023.

The team has invested in LG Chem, South Korea’s largest chemical company with a focus on petrochemicals, advanced materials, and life sciences. A few years ago, the company carved out its highly successful battery business into a separate entity to improve its competitiveness and allow it to attract investments and partnerships of its own.

LG Energy Solution (LGES), as the new entity became known, is the second largest electric vehicle (EV) battery maker today. Its debut on the stock exchange in 2022 marked South Korea’s biggest initial public offering and instantly turned LGES into the country’s second most valuable company after Samsung. It has benefitted from geopolitical tensions, as US car companies have looked for sources of EV batteries outside China.

Despite the carve-out, LG Chem retains a more than 80% stake in LGES – a stake that’s valued at twice the current market cap of LG Chem. It has therefore benefitted from the success of its subsidiary, while also being able to refocus on its core businesses, such as its advanced materials division that supplies the materials needed for battery making.

Case study: investing in Asia’s tech industry

Asian technology companies have been significant contributors to the long-term performance record of our Henley-based Asian and emerging markets equities team. However, they have actively reduced or sold positions in late 2020 and early 2021 after a period outperformance fuelled by the market recognising the sector’s improved earnings prospects during the pandemic.

"We continue to favour selected companies within the sector, particularly those with strong competitive positions,"

William Lam, Co-Head of the Asian and Emerging Markets Equity team

“The likes of Taiwan Semiconductor Manufacturing and MediaTek have been beneficiaries of strong structural trends, such as 5G proliferation, the Internet of Things, and developments in areas such as AI and the Metaverse” says William Lam.

The memory semiconductor market is going through a sharp downturn at present, as is normal for the industry, with valuations now at more reasonable levels. The team have been monitoring the sector closely – these downcycles tend to be relatively short in duration, with an upcycle inevitable at some stage in their investment horizon. Capital expenditure (capex)2 cuts from weaker players in the market tend to be the first signs of an end to the downcycle and the very recent news is encouraging on this front.

The team have also found opportunities to add to selected tech hardware manufacturers, which have fallen out of favour, and yet, have scope for improvement supported by net cash balance sheets and compelling dividend yields. Largan Precision is one of the leading designers and manufacturers of smartphone camera lenses. The team considers it to be a high-quality, innovative company that can maintain its market leading position as flagship phones continue to adopt higher spec cameras.

Its shares fell out of favour when US sanctions against Huawei meant the loss of its largest customer, with the resulting gap in orders proving difficult to fill. For the team, this underperformance represented an opportunity to invest. But chip shortages meant that camera spec upgrades were postponed, while other component prices have been going up.

“Sometimes, being contrarian can mean being early to invest,” says William Lam.

He notes that the team’s focus is on building conviction in their estimate of fair value rather than identifying potential positive catalysts for the share price. Largan’s ultra-conservative management, who communicate very little to the market, haven’t helped either.

“So, we decided to judge them by their actions rather than their words,” he adds, “and that gave our team grounds for optimism.”

2021 saw a first ever share buyback, as well as an increased dividend pay-out ratio. More recently, capacity has been added, with hopes that the second half of 2023 will see a periscope upgrade in smartphone camera lenses.

Case study: investing in Asia’s financial sector

Asian financials are well-represented across the portfolios managed by the Henley-based Asian and emerging market equities team. They’re often good consumer proxies and beneficiaries of interest rate normalisation. The team favour banks and insurers with strong capital positions that they consider to be high quality and undervalued. Various secular themes are represented.

Exposure to banks is predominantly expressed through overweight positions in India, and for some portfolios, Indonesia. These have been deliberately selected as banking markets have already undergone significant credit downcycles in the last five years or more.

“We believe this reduces credit risk,” says Ian Hargreaves, Co-Head of the Asian and Emerging Markets Equity team, “and importantly, the potential for good credit growth ahead.”

He adds how this was demonstrated through the pandemic, where bad debts were low despite economic dislocations. The banks held by the team also feature high capital ratios, low loan-to-deposit ratios and strong retail (low-cost) deposit bases.

Other significant themes within financials include long-term positive prospects for the life insurance industry in China (AIA and Ping An Insurance), and a turnaround in profitability for general insurers such as QBE Insurance and Samsung Fire & Marine.

Case study: investing in ASEAN

Optimism surrounding South-East Asia’s growth prospects has returned post-pandemic, with the region well placed to benefit from supply chain diversification. Indonesia had a tough Covid-19 experience, but the economy appears to have scope for better growth after a weak period. According to our Henley-based Asian and emerging markets equities team, this is supported by the commodity cycle and current account surplus. Moreover, they believe that near-term uncertainty is starting to lift, while valuations still appear attractive.

“Our recent investment in selected cement companies reflects how the capital cycle presents opportunities,” Ian Hargreaves says. “We believe that the cement market in Indonesia is approaching the bottom of the cycle with capacity utilisations falling below 60% following three to five years of increased supply.”

He notes that the Indonesian government have introduced a moratorium on new cement capacity, which should help alleviate overcapacity as demand grows thanks to continued infrastructure and property investment. There’s also the prospect of consolidation within the industry, given that many smaller players are loss-making in the current environment.

Indonesia’s largest cement companies are currently trading below replacement cost, with significant market share, strong free cash flow and relatively healthy balance sheets. The team believe the capital discipline being forced onto the industry, as well as long term demand growth, ought to lead to higher returns on capital in future, which should lead to higher valuations for the shares.

Figure 4. Enterprise value vs replacement cost

Indocement

SIG (Semen Indonesia Group)

Source: as at 31 August 2022.

Opportunities in Asia

Asian equity markets represent a diverse set of opportunities for investors. But while the pandemic weighed on the market over the past few years, there are signs that things are changing.

Post-pandemic economic activity is gradually returning to normal in Asia, and inflation is less of a concern than in developed markets. Moreover, the recent inflection point in the valuation of Asia ex Japan equity markets appears to indicate that investors now have the rare opportunity to capitalise on the market’s excessive negativity.

By conducting thorough research and focusing on high-quality companies, investors can potentially reap the rewards of investing in Asia.

Footnotes

¹The inflection points are the areas beneath the lower dashed line, where the graph changes direction.

²Capex is money a company uses to purchase, maintain, or expand fixed assets.

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Investors in less developed countries should be prepared to accept significantly large fluctuations in value.

Investment in certain securities listed in China can involve significant regulatory constraints that may affect liquidity and/or investment performance.

Important information

All information as at 30 April 2023 unless otherwise stated.

Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice. This communication is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.