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The Tide Has Turned

Tuesday, May 08, 2018

A Q&A with portfolio manager Jian Shi Cortesi on China and Asia ex Japan equities…

Have there been any changes to capital flows across the region?

For me, the really interesting point is that capital flows into dedicated China equity funds have become positive over the last 12 months and momentum is accelerating. This contrasts strongly with the last five years as a whole – a period in which outflows have totalled USD 9.9 billion1. Unlike China, aggregate flows into the broader Asia ex Japan region over the last five years has been positive, by virtue of a strong inflow in 2017, but, like China, the momentum of these inflows has accelerated appreciably in recent months, especially in the first quarter of this year.

Can you explain this shift in sentiment?

Investors are being attracted back to China by a combination of a stable economic environment, robust earnings growth and modest valuations. It is a similar case for the rest of the Asia ex Japan region where momentum is being driven by a compelling mix of attractively valued stocks, undemanding FX and a robust recovery in earnings.

Are you concerned by the prospects of a trade war?

I manage two strategies – one that is aligned with the economic evolution of China from export to consumer driven and another with a broader Asia ex Japan remit. The positioning of the China strategy is fully aligned to the country’s economic transition. Consequently, almost 80% of assets are invested in (consumer-related) information technology, financials, healthcare and the consumer staples & discretionary sectors. Our financials exposure tends to be concentrated on insurance companies and this provides a less obvious way of harnessing the domestic consumption theme. Similarly, the composition of the broader Asia ex Japan portfolio is also concentrated in those five areas (same manager, same mindset), with the only noticeable difference being a higher weighting in technology. Consequently, we would estimate the revenue impact of a trade war on the companies we hold to be in the low single digits, perhaps not more than 1%.

What are the key differentiators for your strategies?

While we have covered the focus on domestic consumption, it is certainly worth noting that this provides an orientation towards businesses with higher growth expectations and lower debt (in comparison to the broader market). In addition, most investors will be aware that economic momentum in China is decelerating. However, this is an aggregated slowdown rather than a pervasive one. We are still seeing growth rates well in excess of 10% in certain consumer sectors. This reflects the rapidly expanding and increasingly sophisticated middle-class component of the population. So, a consumer focus allied with an informed investment process that can identify the right growth stories at an appropriate price makes a lot of sense.

An important point about the Asia ex Japan strategy is that it is carefully designed to add value from multiple angles. We begin with top-down analysis to determine the desired country weight. We then define sector allocation within those countries in accordance with big trends (consumption growth, aging population, technological advancement and environmental protection). Finally, a layer of fundamentally driven security selection is applied to fill the individual silos. The result is a concentrated portfolio of 50-70 holdings with an active share of 70-90%. In recent years, stock picking has proved the major source of relative outperformance, with asset allocation at the country level also adding value.

You mentioned active share; why is benchmark differentiation so important?

The Asia ex Japan region has a huge investment universe. In terms of Chinese companies alone, there are well over 4,000 stocks to choose from, listed on four different stock exchanges (including Hong Kong and the US). The local A-share equity market (Shanghai and Shenzhen) is the world’s second largest equity market. The sheer size of the opportunity set means that there are many under-researched investment opportunities for skilled managers with local knowledge to exploit. Conversely, because passive strategies are capitalisation weighted, they are concentrated in the best-known businesses which typically have much less scope for growth.

Clearly, a strategy that replicates the benchmark and levies fees is, by definition, going to underperform that index over any given period, but the extent of the underperformance tends to be significantly greater than the total expense ratio due to tracking errors. Conversely, our Asia ex Japan strategy has materially outperformed since its launch at the beginning of 2013. Furthermore, the extent of the outperformance has increased markedly since the most recent market trough in early 2016, demonstrating the high-growth nature of the businesses in which we invest.

1 Source: Morningstar Direct, the Asset Flow Module. Statistics refer to net sales flows only, including UCITS but excluding fund-of-funds. Data as at 28 February 2018


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