What are the factors that deliver long-term returns when investing in Asian markets?
Economic dynamics in Asia provide enormous opportunities to create alpha from stock picking. But it is rarely a function of the level, or even change, of nominal GDP. This article from GSFM’s investment partner Man GLG, examines the opportunities available to investors in Asian markets.
The economy is not the market
China is a big part of Asia…but it is not everything. In markets, and in US markets above all, the most crucial lesson from 2020 was a reminder: the stock market is not the economy. Yes, earnings cycles in aggregate move with economic cycles. But index concentration in secular growers and gargantuan price-to-earnings (PE) multiple expansion hammered home the point that the stock market and the economy can have divergent paths, even during a multi-generational recession.
Asian investors have never had the luxury to forget that markets and economies diverge, due to different, more painful dynamics. Asia has boasted extraordinary nominal growth rates over the past 20 years: 13 percent nominal compound annual growth rate (CAGR) from 1999 to 2019, based on the IMF’s series for emerging Asia, versus 5.5 percent for the world.
China’s growth miracle was, of course, an outsized contributor, growing from USD1 trillion to more than USD14 trillion over this period, a compound growth rate of nearly 15 percent. Still, even the rest of Asia was none too shabby, growing from approximately USD950 billion to USD6.5 trillion, compound growth of almost two times the world average at nearly 11 percent.
This is without doubt an economic miracle, but less so for the stock market.
Over the 20 years to end 2020, Asia outperformed world equities handsomely, by almost 100 percent, or 3.4 percent annualised. But the total return over the period does not tell the whole story: from December 2000 to December 2010, Asia ex-Japan outperformed global equities by 150 percent, and in the subsequent 10 years, it underperformed by 25 percent.
During this second decade, Asian nominal GDP grew almost 4.5 times quicker than global nominal GDP. Asian economies arrived, but equities absolutely didn’t. What has been going on?
The USD6 trillion Chinese elephant in the room
Everyone with a passing interest in China has a favourite fixed capital formation statistic.
One of the most eye-catching is that between 2011 and 2013, China consumed more cement than the US did in the entire twentieth century, 6.4 gigatons versus 4.4 gigatons. Part of China’s response to the Global Financial Crisis (GFC) was to materially expand credit provision to state-owned enterprises, with regional administrations incentivised to deliver high nominal GDP and employment growth. The explosion of cement consumption was one outcome of this policy, where real estate development, in particular, grew at astronomical rates. Between 2009 and 2014, floorspace under construction grew by almost 130 percent, to more than 7 billion square metres, equivalent to five greater Londons.
Alongside this, manufacturing capacity in everything grew enormously: for example, steel grew from c800 million tons per annum to almost 1.2 billion tons per annum, and auto manufacturing capacity grew from approximately 15 million light vehicles to almost 37 million.
This boom in fixed capital formation added handsomely to GDP and created a lot of jobs. But it also resulted in slack in the economy. While capacity utilisation data are scarce, some estimates for the automotive industry suggest that by 2019, capacity utilisation was scarcely over 50 percent. And what we can see in industrial state-owned enterprises is the impact in aggregate on profit margins, which approximately halved between 2008 and the 2016 deflationary scare trough (Figure 2).
For the China investment tourist, the economic growth rates were tantalising. But the reality is that earnings revisions and investment returns were on a completely different track from the economy, and were, in fact, a victim of runaway capacity growth.
Fast forward to late 2020, and the picture changed materially. Supply discipline in previously oversupplied industries rationalised and earnings power returned in some cases, against a backdrop of slowing headline GDP.
Figure 3 shows the annual earnings per share progression and stock price for a leading player in solar glass and associated systems. This company grew its net plant, property and equipment assets five-fold between 2010 and 2015 during a capacity expansion boom. Pre-tax returns on these assets declined from 32.5 percent to 18 percent. It was not until industry asset growth slowed and the winners reclaimed pricing power that earnings revisions turned positive, to the enormous benefit of the stock price.
South and southeast Asia’s US dollar problem
China is a big part of everything in Asia. But it is not everything. Two of Asia’s other material nominal GDP growth drivers – India and Indonesia – experienced a very different headwind in this post-2010 period, despite spectacular levels of nominal GDP growth.
If China’s experience was an exorbitant privilege of excess national savings and external surpluses creating seemingly endless free capital to fund infrastructure, India and Indonesia’s deficits made (and continue to make) them particularly vulnerable to periods of US dollar strength tightening domestic financial conditions.
Earnings per share for MSCI Indian and Indonesian indices in USD between 2010 and 2019 fell by seven percent and 17 percent, respectively. In part, this is just straight translation of earnings from local currency. But the strength of the dollar also tightened financial conditions, reduced nominal growth and deflated commodity prices. In India, this contributed to the emergence of a prolonged bad debt cycle for the banks; and in Indonesia, commodity exports stagnated.
In both cases, even underlying local currency earnings were subdued versus the previous decade: growth CAGRs of 4.5 percent and 2.9 percent for India and Indonesia respectively for 2010-19, versus 18.4 percent and 32 percent for 2001-2010.
Similar dynamics were also at play in the Philippines, Malaysia, Singapore and Thailand. Together, these countries were 28 percent of MSCI Asia ex-Japan at end-2010, and 22 percent by the end of 2019.
The alpha opportunity
What matters most when looking at investments is the alpha opportunity – and that alpha opportunities are greatest where there is breadth in independent bets. This is a central tenet in Richard Grinold and Ronald Kahn’s Fundamental Law of Active Management.
For liquid public market strategies, we are acutely aware that bets need not just be independent, but sufficiently liquid too. Figure 7 filters the emerging markets index for companies trading more than USD15 million per day and calculates the average pairwise correlation for these stocks.
On average, EM ex-Asia has a pairwise correlation weighted by number of stocks at 0.45, versus 0.3 for Asia. Also, the number of liquid stocks outside Asia is very low: just 139, versus 913 in Asia. Only Brazil has anything approaching a broad investable universe at 50 liquid stocks, but this comes with a lower degree of stock independence than anywhere in Asia.
So what should investors do?
According to Man GLG, the first thing is to sack any manager who talks up the prospects of an Asian country’s GDP growth. The second is to focus relentlessly on finding the companies with the best and most persistent positive earnings revisions. The third, to look for breadth in independent bets.
Principally this is a bottom-up exercise, but it is clear from the explanations above that macro dynamics can have material impacts on earnings developments. Consequently, understanding where earnings revisions are trending by country, sector and factor is crucial. Man GLG’s quant research team has developed some tools to help its discretionary portfolio managers do exactly this, and they add conviction to the investment team’s fundamental views on the best places to direct research attention.
Notably for Asia, the best quintile of earnings revisions in Indian companies is closing materially versus China. This is consistent with Man GLG’s view that, structurally, India is exiting a long decade of deleveraging and low growth, that a weaker US dollar is loosening financial conditions, that the Covid-19 recovery continues to lag China, and that from the Chinese side, the defensive attributes of mega-cap tech platforms become less desirable when the world is reopening and nominal growth is accelerating.
To be clear, earnings revisions are still superior in Chinese companies, but the second derivative is closing in India’s favour. And in markets, second derivatives are important.
Similarly, from a factor perspective, the prospect of reopening is seeing the best quintile of revisions shift materially in favour of Value, such that the best quintile of earnings revisions is now loaded more in favour of Value for the first time since 2016. This is a highly significant development which lends fundamental support and momentum to a segment of the market that has been deeply out of favour for several years.
In conclusion, economic dynamics in Asia provide enormous opportunities to create alpha from stock picking. But it is rarely a function of the level, or even change, of nominal GDP. Macro policies and endogenous conditions have a tangible impact on corporate earnings, and it is understanding where earnings revisions are changing and persisting that is the source to unlocking greater returns over the long run.
Man GLG also believes the best utilisation of resources is to focus on uncovering differentiated, independent investment opportunities. A small slice of deliberate macro input can materially improve returns at various points in the cycle. But ultimately, the secret to enduring outperformance is a diversified portfolio.
By Andrew Swan, Head of Asia (ex-Japan) Equities
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