Investors can capture rewards by investing in Asia’s smaller companies. But focusing on company growth is not enough for equity investors in this space to make the best returns.
With a backdrop of tepid global growth, volatility and uncertainty, Asia remains one of the few reliable sources of growth today. Forecast to continue to grow faster than the rest of the world, we still see a huge number of opportunities for companies to take advantage of Asia’s structural economic growth story. We believe investors can capture this exciting return opportunity by investing in Asia’s smaller companies. But simply focusing on company growth is not enough for equity investors in this space to make the best returns.
Asian smaller companies’ shares have historically delivered significant returns over time and have outperformed their larger siblings; however they have done this with similar overall volatility or risk. The misconception that small equals risk, can be quashed when we compare the volatility of the respective MSCI benchmarks, which track very closely. This also speaks to the idiosyncratic nature of the smaller companies market and hence the low correlation and higher diversification from even the more focused portfolios.
The highly diverse market means there are as many risks as there are opportunities. As such, a stock specific, research-intensive approach is essential to ensure that bad apples are avoided and only the best are picked. There is no easy way to approach this puzzle, and it does entail a large dose of blood, sweat and tears.
Despite many intuitively believing a focus on growth is the best approach to investing in Asian smaller companies, history shows that taking a Value approach to investing in this market significantly outperforms over time. Investors focusing on growth and quality tend to over-pay for these stocks and hence give up future equity returns. The most important driver of equity returns over time is the price you pay and to avoid overpaying.
A true Value approach can be a very lonely business, as it drives a contrarian bias and takes you away from popular household names and towards those stocks that are unloved, ignored and under-appreciated by the market. This is essential to take advantage of mis-pricing as we look to exploit behavioural biases of other investors who tend to overpay for growth and underappreciate Value stocks.
To follow this approach requires discipline – within the Eastspring value equities team we use a range of objective quantitative valuation screens to anchor our thinking and unearth interesting investment candidates. We then spend a huge amount of time understanding the companies, the drivers of their earnings, the risks and the rewards and we look for a large margin of safety before looking to invest. We like companies that have moats and franchise value that are under appreciated or those with differentiated propositions of a next generation business.
Our valuation approach is anchored to discounted cash flow analysis. We look for companies whose cash flows are more stable and predictable giving us higher margins of safety and some downside protection. We also like to look to invest in ‘boring’ utilities which have strong cash flows and who tend to get neglected as the market gravitates to the flavour-of-the-month stories such as biotech, internet, e-commerce and so on.
Portfolio construction is a distinct activity which is built around capturing our best ideas while also looking to diversify risk. We build a high conviction portfolio of our best ideas – benefitting from natural diversification of the portfolio due to high idiosyncratic risk while we look for maximum upside potential. Within the Eastspring Asia Small Caps fund, we invest from the bottom up and our portfolio is well diversified, most of the investment opportunity set we find across Asia currently lies in countries such as China, Hong Kong, Korea, Taiwan and India.
Krishna Kumar is portfolio manager at Eastspring Investments.