- The length of economic disruption cause by Covid-19 will cause severe problems for businesses with weak market positions, low quality management and fragile balance sheets - both in Asia and elsewhere.
- Our focus on good businesses, run by solid management and buying them at the right price has not changed, but the portfolio has been proactively adjusted over recent months based on stress tests for Covid-19 impact.
- My value approach remains out of favour - with the market being led by growth and momentum - but we remain convinced that over time the market will reward business fundamentals.
The humanitarian and economic cost of Covid-19 has been clearly significant and for the next few months both individuals and business are likely to have to continue to operate under conditions they would have never planned for. From an investment perspective, this will cause severe issues for businesses with weak market positions, low quality management teams and fragile balance sheets.
My investment process is based on owning businesses with high returns on capital, run by competent and honest management teams and buying them at prices that leave enough margin of safety for mistakes. This has not changed, but I have had to make a few changes to the portfolio in view of the impact of Covid-19.
Most of the businesses held going into this crisis had no problems in getting through a recession but my stress tests for the impact of the virus suggested that a few will see their revenues decline by 30-50%. Fortunately, this was a small percentage (less than 2%) of total holdings and I have responded by selling or materially reducing positions in businesses which were well financed for a normal recession but will struggle in these stressed conditions. These include the likes of aircraft leasing company BOC Aviation in Hong Kong and outdoor apparel and equipment manufacturer Kathmandu Holdings in New Zealand.
At the country level, India and Indonesia have been two of the hardest hit markets in the region but I have not materially changed positioning here. The portfolio’s holdings are focused on best-in-class businesses with very well-financed balance sheets, which will come out in a stronger competitive position post Covid-19. For instance, India’s national grid, Power Grid Corporation, has a defensive business with high visibility of earnings from regulated assets. Elsewhere, India’s largest private sector bank, HDFC Bank, should benefit from its strong asset quality and low cost of funds to grow its market share in the industry.
The broad market sell-off back in Q1 also created some interesting opportunities to buy companies that I have followed and admired for a long time. Some of these like Bapcor, a leading auto parts retailer in Australia and New Zealand, and Vinda International, a leading manufacturer of branded paper products (kitchen, toilet, face tissues), have been part of the portfolio in the past but had been sold due to expensive valuations. I have used this market downturn to once again build positions in these excellent businesses.
Recent market leadership hasn’t changed
Although there has been lots of volatility in markets so far this year, what hasn’t changed is the leadership of large-cap growth orientated names. This trend has really been evident since 2019 and has accelerated in recent times to the extent that the valuation differential between value and growth is at an extreme level, last seen during the 1999 tech bubble.
This has been a challenge due to the portfolio’s focus on higher quality small-cap value stocks. In my opinion, this is the most time-tested way to invest and has served me well for the last 15 years. However, it has not worked during the most recent pullback.
Notably, even within small-cap indices there has also been significant divergence in performance from individual markets with Hong Kong, China, Korea and Taiwan performing substantially better than the likes of India and Indonesia. The portfolio’s overweight to these underperforming markets - due to better long-term growth, higher ROE and cheaper valuations - has also impacted relative performance. As an example, airport stocks in China fell less than utilities stocks in Indonesia. This does not sound logical.
Lessons from the last 25 years
In conclusion, here are some observations from my 25 years of experience in the equity market:
Small-cap value stocks grew earnings faster than small cap growth stocks.
However, the last 10 years has seen a market where despite better earnings growth, value has continued to de-rate.
Unless the world is very different for the next five years (ie. value stocks underperform on earnings), I think the odds are in favour of value stocks given the current relative valuation.
The caveat to this is that I could have said the same thing at the start of the year, but YTD 2020 has seen the most significant value underperformance for 20 years.
This phenomenon can also generally be applied to the portfolio - most of the businesses we own have continued to deliver as expected and have generated superior returns on capital and earnings relative to the stock market. However, the stock prices have underperformed. Sometimes the stock market in the short-term tells you a different story than the underlying fundamentals of a business.
|May 2015 - May 2016||May 2016- May 2017||May 2017 - May 2018||May 2018 - May 2019||May 2019 - May 2020|
|MSCI AC Asia ex Japan Small Cap (N) Index||-14.6%||44.4%||13.8%||-6.1%||-0.2%|
Past performance is not a reliable indicator of future returns.
Source: Fidelity International as at 31 May 2020. Basis: bid-bid, income reinvested in GBP.
©2020 Morningstar Inc. All rights reserved. The MSCI AC Asia ex Japan Small Cap (N) Index is a comparative index of the investment trust.
Comparing intrinsic value versus price is the basis of all investing. The long-term value of any business is driven by its ability to generate free cash flow. At times the market will have new concepts on valuation and hence blue-sky scenarios are priced not as probabilities but as certainties. I continue to believe that over time the market will come back to focus on business fundamentals, and I continue to invest on that basis.
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The value of investments can go down as well as up and you may not get back the amount you invested. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments are subject to currency fluctuations. The shares in the investment trust are listed on the London Stock Exchange and their price is affected by supply and demand. The investment trust can gain additional exposure to the market, known as gearing, potentially increasing volatility. This trust invests more heavily than others in smaller companies, which can carry a higher risk because their share prices may be more volatile than those of larger companies and the securities are often less liquid. This fund uses financial derivative instruments for investment purposes, which may expose the fund to a higher degree of risk and can cause investments to experience larger than average price fluctuations. This Investment Trust invests in emerging markets which can be more volatile than other more developed markets. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.