Optimism high despite bad spell

Asian equities were hit by global investor concerns in October as all but one stock market in the region suffered negative returns. Several markets fell by between 4 and 10 per cent and India came back from the all-time high reached on 5 October.

As concerns about inflationary pressures, slower economic growth in the US and high oil prices have eased slightly, so Asian stock markets continued their general upward momentum, which started in early 2003, in November. In the three years to 17 October 2005, the S&P/Citi BMI Asia Pacific index returned 83.34 per cent.

From the start of 2005 to 6 November 2005, the FT/S&P World Pacific Basin ex Japan index returned 11.7 per cent. This far out-performed the S&P 500 index, which returned 0.7 per cent over the same period. But the Asian index has under-performed the FTSE All Share (12.9 per cent) so far in 2005 as well as the Dow Jones Euro Stoxx (15.3 percent) and the Topix (30 per cent) indices.

Asian fund managers are optimistic about the outlook for equities in the region and the economic numbers give some credence to this confidence. In 2004 and 2005, Asia has been the fastest growing region in the world and this is expected to continue in 2006. GDP growth in Asian excluding Japan reached 7.5 per cent in 2004, is predicted to be 7.0 per cent in 2005 and is forecast to be 6.7 per cent in 2006. In contrast, global GDP growth was 5.1 per cent last year and is expected to be 4.3 per cent both this year and next year.

Interestingly, however, earnings per share (EPS) growth in Asia have fallen significantly in absolute and relative terms. Last year, EPS growth in Asia was 60 per cent but in 2005 it is expected to decline to 5 per cent and reach 10 per cent next year. While the major markets have seen falls in EPS growth as well, they are all expected to be above Asia in 2005, including the US (12 per cent) and the eurozone (14 per cent). Nevertheless, next year, Japan and Asia are expected to have the joint highest EPS growth at 10 per cent.

Not all the economic data provides good news for Asia, however. A slowdown in exports and a bigger bill for oil imports is expected to slow economic growth to 5 per cent this year. Economists argue that with the exception of the Philippines, Asian countries are still reliant on exports for economic growth. There are concerns as well that consumption has slowed because of high fuel prices, which are also feeding inflation. Furthermore, there is anxiety over the economic impact of a potential mass outbreak of Avian flu.

Stuart Parks, manager of the Invesco Asian Equity Core fund, argues that valuations of equities in the region are not stretched despite the strong returns over the past three and a half years. “The average price to earnings ratio across Asia is 11 times, which we do not consider to be expensive. There is also an average dividend yield of around 3 per cent across the region.” He adds that the return on equity in Asia has been rising since 1998 to reach 15 per cent this year. This is below the 18 to 19 per cent in the US but represents increasing profitability in Asia.

‘The economic growth and rate of inflation mix in China is almost ideal while Asia will benefit from an economic recovery in Japan as it has been absent for 15 years’ Stuart Parks, Invesco Asian Equity Core fund

The performance of Asian equities, according to Mr Parks, has been strong over the past three years partly because of the improved balance sheets of companies, the increase in corporate dividends, the reduction in external debt and the balance of payment surpluses across Asia.

Further factors that enhance the outlook for Asia, says Mr Parks, are growing exports, continued economic growth in China of more than 8 per cent (with inflation of around 1 per cent) and an economic recovery in Japan. “The economic growth and rate of inflation mix in China is almost ideal while Asia will benefit from an economic recovery in Japan as it has been absent for 15 years.”

Other factors that have led to the rise in Asian stock markets, says Allan Liu, manager of the Fidelity Funds South East Asia fund, have been rising domestic consumption, healthy exports, strong economic growth in India and China, rising liquidity and favourable government legislation.

Of the negative equity returns in October, Mr Liu says: “While there were specific factors which drove the under-performance of individual countries within the Asia Pacific ex Japan region, overall investor sentiment was dampened by uncertainty surrounding the deteriorating outlook for global economic growth as well as the expected rise in interest rates despite various natural crises which appeared detrimental to the US economy.

“Heightened levels of concern regarding the outbreak of avian bird flu as well as a strengthening of the US dollar also further negatively impacted sentiment. Foreign investors indiscriminately sold a record level of Asian equities during October.”

Oil weighs heavy

The markets that suffered the most in October were China and India. Indeed, India fell by 10 per cent in dollar terms during the month after reaching an all-time high on 5 October.

Mr Liu says: “The China equity market under-performed as the decline in oil price weighed heavily on its index heavyweights in the energy sector, which comprise nearly 30 per cent of the MSCI China index. Quarterly results were also unimpressive with evidence of further margin erosion due to rising input costs. Market sentiment weakened as cases of the Avian bird flu were announced, raising fears of an outbreak.”

He adds that the recent short-term volatility has presented the fund with an opportunity to selectively invest in or increase exposure to those stocks and sectors which were previously not attractively valued. The longer term drivers of the market, including earnings growth, remain intact, argues Mr Liu.

‘These positive fundamentals are attractive valuations, continued economic and earnings growth and expanding domestic demand’ Mark Mobius, Templeton

He also claims that the fund is overweight on Indonesia, Korea, Singapore and China but is underweight on Taiwan and Hong Kong. “We have found an increasingly number of buy ideas in China, which has raised the fund’s exposure to China to an overweight position.” The sectors invested by Mr Liu include media, integrated energy, property and gas utilities. “The fund remains overweight the consumer discretionary, industrials and energy sectors and continues to be underweight the financials and telecommunication services.”

Mark Mobius, manager of the Templeton Asian Growth fund, says there has been no change in the fundamentals among Asian equities despite the correction in regional stock markets in October. “These positive fundamentals are at both the national and company level. These are attractive valuations, continued economic and earnings growth and expanding domestic demand.”

This means Asia is less dependent on trade outside the region although Mr Mobius admits a sharp slow down in the US economy would badly affect Asian stock markets. “We think the US economy will slow as interest rates rise but this will be offset by growing domestic demand in Asia.” While Asia has traditionally had a high savings rate, this is beginning to fall slowly as consumers increase their spending, which, it is argued, bodes well for domestic demand across the region. Mr Mobius says the region will also benefit from the economic growth in Japan. “This will boost exports from the rest of Asia.”

He adds that valuations still offer investment opportunities. “They are not as cheap as before but valuations are still generally attractive.” Indeed, Mr Mobius sees only two potential threats to the region – a pandemic of Avian flu as well as a substantial slow down in the US economy.

According to Mr Mobius, the Templeton Asian Growth fund may under-perform in the short term as he takes a longer term view of stock valuations. “It can take three to five years for the value we find in stocks to be realised. This is why performance over three and five years is relatively better than one year.” The fund has returned 33.15 per cent over one year (compared to 38.44 per cent by the S&P/Citi BMI Asia Pac ex Jap index), 90.40 per cent (83.34 per cent) over three years and 60.74 per cent (43.53 per cent) over five.

The Schroder ISF Asia Eq Yield fund takes a different approach to investing in the region. King Fuei Lee, manager of the Schroder ISF Asia Eq Yield fund, says it has a high dividend strategy. He says: “We target three types of companies for the fund. These are companies paying most or all their earnings in dividends, those companies growing their dividends and those producing surprisingly high dividends.”

Liu: foreign investors sold record levels

Mr Lee admits that the fund has been helped by the increasing prevalence of companies to pay dividends across Asia. There is now an average dividend yield of more than 3 per cent in the region. Mr Lee says this is partly because of improved balance sheets and cash flow over the past seven years. “There has been improved corporate governance and management across the region since the Asian crisis.

“Profit margins have improved and company management is more aware of returning money to shareholders. Even technology companies have been paying dividends.” Mr Lee highlights technology companies in Taiwan as one sector he holds within the fund.

Angelo Corbetta, head of portfolio management in Asia at Pioneer Investments, says it is difficult to generalise about the investment opportunities in the region. “Taiwan has become a two-tier market where branding and good governance are rewarded while strategies based on lower margins are severely penalised. It is still too early to turn positive on Taiwan although value has started to emerge among financials, in particular.

“We are still prudent on Indonesia and Thailand while we are turning increasingly positive on China as the worst phase of margins compression is probably behind us.

“In India, it is time to be selective. Between the start of July and the end of September 2005, 92 per cent of the stock in India had a positive absolute performance. Going forward, it will be different. We are increasingly cautious on the banks in particular since current stock prices are discounting a golden scenario for the next 15 years.”

Robert Burdett, co-manager of Credit Suisse Multi-Manager, says his portfolios are still overweight Asia but he has altered the focus among the underlying funds. “We believe that to gain higher returns, investors should have a greater weighting to Australasia. This is because of the strength of the commodity markets and the large exposure of Australasia to commodities.

“Some Asian equity funds are able to take greater exposure to Australasia and we have increased weightings in such funds. An example is the First State Asia Equity Plus fund.”