“Failure is so important. We speak about success all the time. It is the ability to resist failure or use failure that often leads to greater success.” J.K. Rowling

There have been times, over the last couple of years, when we have felt like a complete muggle1. Darker forces (QE2 and the rise of the machines), have clearly been in the ascendancy. But, we believe in the old ways; and, as if by magic, the last six months have been considerably better. Of course, it is far too soon to declare victory.

Discipline and stubbornness are sometimes hard to tell apart. Some might say, the more so in this supposed age of disruption. We wonder when it wasn’t so, but such is the hubris of modernity. The pressure to capitulate, agree that it really is different this time, follow the crowd and buy into popularity are the most intense at turning points.

It is only in the final reckoning, with the benefit of hindsight, that observers are able to adjudicate discipline from stubbornness and success from failure. We are fortunate that we have a philosophy, a proven process and a long-term track-record. Even so, despite these touchstones and finger posts along the way, there is still much room for doubt.

Our last letter concluded in a similar fashion. Human nature and the emotions that drive the investment cycle remain unchanged though the ages. This cycle has been extended, but it is nothing novel. Maybe the rise of hyper-active passives is something new, but they probably do little more than exaggerate our existing human frailties.

“Success is not final, failure is not fatal; it is the courage to continue that counts."

Winston Churchill

And so all change; and yet no change. In the real world, despite all the excitable commentary, it is worth remembering that nothing bad or too unexpected has happened. Earnings per share (EPS) growth has, if anything, been better than expected. And yet, returns-dispersion has widened sharply.

For now, it seems, the market-gods are merely shuffling their feet. It does not take that much when, in all of history, interest rates have never been lower and debts are ever higher. Just imagine if events start to take on something of their own volition. Imagine that passives can compound negatively, just as they have positively leveraged recent trends.

All seems relatively calm for now, but there is a sense that the macro-plates are shifting. Our absolute returns remain respectable, while the relative gains are ticking along incrementally month-by-month. It is a slow way to get rich, perhaps unconsciously echoing Hemingway’s quip about how you go bankrupt: “Two ways; gradually and then suddenly.”

In America, in seeking to explain what is going on, there has been much vapid commentary about the renewed outperformance of value versus growth. In Benjamin Graham’s Bible (of investing, that is) the epigraph in Security Analysis reads: “Many shall be restored that now are fallen, and many shall fall that now are in honor.” Horace, Ars Poetica.

In our view, this is a distinction without a difference. One is very simply the product of the other. With no growth, there is no value, especially in Asia. Why bother, otherwise? And, let’s not get ahead of ourselves. In the US, growth stocks – however defined – have outperformed value stocks in nine out of the last eleven years.

That is essentially a decade and the whole of the post ‘08 GFC3 period.  By contrast, our own performance suggests that something different has been going on only in the last two-to-three years. To the bulls, the world has irrevocably changed; we are all technology investors now. To others it is the same age-old investment cycle. Asset allocators will allocate accordingly.

From J.K. Rowling’s Harry Potter series, a muggle is an ordinary human being who lacks any magical ability
Quantitative easing
Global Financial Crisis

Portfolio activity

Since our last letter, there has been more activity in our Asia portfolios than usual, particularly in respect of new names and with our all-cap strategies. This is not surprising at the smaller capitalization end of the spectrum, with portfolio turnover still generally in the 25-30% range per our typical holding period of three-to-five years.

For the larger-cap strategies, it is more unusual, but the changes reflect efforts to focus even more on absolute quality above all else. In the mix of odds and consequences that drive any portfolio decision, our focus on capital preservation has trumped valuation.

We have, in the past six months or so, bought Shanghai International Airport (SIA), Public Bank, Cognizant Technology, DBS Group, Techtronic Industries. All purchases remain relatively small positions.

We disposed completely of Singapore Telecom, Giant Manufacturing, Global Brands, Lupin, Cathay Pacific, Asustek and Ryohin Keikaku. Some of these positions were sold at a loss; however, we believed prospects had deteriorated and the quality of our portfolios have improved by selling them.4

What we bought

We bought Shanghai International Airport earlier in the year. It is a mainland-listed China A-share, with many of our strategies now having the flexibility to buy through the Stock Connect facility. We have benefited from the research and meetings that the team has had with A-share companies over the last ten years.

Our A-share companies have prospered since we bought them, though we suspect not least because of the inclusion of China A-shares into various MSCI indices (in June and soon in September ‘18 in a two-stage process). It is a truism that you sell, rather than buy, on such big announcements; and indeed that has seemingly again proven to be the case.

We have never paid attention to these indices; but, in the shorter-term, the decision to include A-shares has meant that general valuations have escalated. Nevertheless, we believe that the longer-term prospects remain positive. Shanghai International Airport is an SOE5, which should always give pause, but the company is run commercially.

SIA owns the bulk of Pudong International Airport in Shanghai. The story is straightforward, with duty-free shopping getting in the way of travellers, to the benefit of shareholders’ returns. Traffic growth is strong, landing fees have risen and non-aeronautical revenue (two-thirds of which is shopping) is now half the business.

The main duty-free concessions have just been renewed with a higher profit-share for the company, the group generates decent free cash-flow and it has no debt. However, a huge terminal expansion plan is underway, with the capital-spend of RMB20bn exceeding the company’s existing fixed asset base.

The expansion is expected to be completed post-2020. The likelihood of a sharp rise in depreciation and amortization charges, versus higher revenues, has been the subject of robust debate on the team. In the meantime, with defensive qualities, the price-to-earnings ratio (PER) has moved from teens to mid-20’s. We have trimmed our holdings as a consequence, perhaps more quickly than we would have liked, but the shares have escalated sharply.

In Malaysia, we added Public Bank, a bank that we have known for many years and own for clients in some of our dedicated country funds. Malaysia has long been a pariah for Asian investors, but a tumultuous election result has perhaps brought the country another chance. We are watching with keen interest.

Public Bank is managed very conservatively. It banks one segment of the population, has a fabulous deposit franchise and is still controlled by the founder-shareholder, Teh Hong Piow. The bank continues to grow steadily, with an ROE of 14-15% and a price-to-book ratio (PBR) of around 2x.

Indian IT services

We bought Cognizant Technology, which, though listed in the US, is similarly an Asian company. The group competes with Tata Consultancy Services (TCS) and Infosys6, providing IT services to the world. Like the others, Cognizant’s growth has been held back by lack of spending in the banking industry. Financial services accounts for 40% of sales.

In particular, their shorter-term growth has been hindered by a couple of European bank customers moving some business back in-house. Such things are broadly deflationary, but we believe this is shorter-term noise, with the longer-term drivers of digitalization (of everything) providing a strong structural tailwind for the sector and the company.

Banks and insurance companies apparently spend 5-6% of sales on IT and technology, while the corporate average is just 1-2%. We believe the longer-term opportunity is therefore quite substantial. Cognizant have a large presence in healthcare too (30% of sales) and the group has a public commitment to lifting margins.

This digital transition is something that we have already experienced with our other IT services companies. Our largest holding in this sector is perhaps the furthest ahead in embracing the new opportunities, per the US$1bn deals they have announced with the likes of Marks & Spencer and Transamerica. Our position in Cognizant remains small for the time being, with one constraint being our already large holdings in other IT services companies.

4 The foregoing is a complete list of all new holdings and complete disposals within the Asia Pacific Equities strategy for the 6 month period ending June 2018. It is being provided for illustrative purposes only and does not constitute any offer or inducement to enter into any investment activity nor is it a recommendation to purchase or sell any security.

5 State-owned enterprise

6 For illustrative purposes only. Reference to the names of each company mentioned in this communication is merely for explaining the investment strategy, and should not be construed as investment advice or investment recommendation of those companies. Companies mentioned herein may or may not form part of the holdings of First State Investments.

A Hong Kong industrial and Singapore banks

Another company that we have known for a long time is Techtronic Industries. It is HK-listed, owned by Germans, but operates mainly in America. Their primary customer is Home Depot, at 50% of sales. The growth driver has been Milwaukee power tools, where they compete directly with Stanley Black & Decker and Makita of Japan.

The business has continued to grow strongly, with product innovation and expansion into new product areas supporting sales. The Pudwill family own 30% of the company, with a professional CEO already in place for some time. It is one of the few smaller companies in Hong Kong that has continued to scale and grow over the last twenty years.

The valuation is now quite full (high teens PER) and the business is quite dependent on the US housing market. We have little idea how that will unfold in the shorter-term, but the company generates decent cash-flow and now has a net-cash balance sheet. This provides great comfort.

In Singapore, we have bought back into DBS Group after a number of years, in hindsight mistakenly selling the company on sharply-higher credit costs in their oil and gas book.

DBS has made a significant commitment to technology, embedding the approach throughout the organization.  On a medium-term view, DBS are optimistic that IT will reduce costs and they envisage ROE lifting from 12% to 14%.

The bank remains attractively-valued, at around 1.3x book for ROE of circa 11-12%. DBS has some funding advantages with a higher CASA ratio given their ownership of POSB Bank, and should benefit from higher interest rates. It is, we believe, conservatively-managed and very tightly regulated by the Monetary Authority of Singapore (MAS).

Sector allocation

First State Asian Equity Plus Fund


First State Asian Growth Fund


Source: First State Investments as at 30 June 2018. Allocation percentage is rounded to the nearest one decimal place and the total allocation percentage may not add up to 100%.
+Index: MSCI AC Asia Pacific ex Japan Index
*Index: MSCI AC Asia ex Japan Index
The Asian Equity Plus and Asian Growth funds are not available for investment by US persons. Fund information is being provided as an example of First States Investments’ expertise in the strategy.

What we sold

Singapore Telecom (SingTel) used to be a larger position for us, but we have been reducing exposure gradually over the last couple of years. We sold the last of the position in January, following a meeting with their largest 35%-owned associate investment and profit contributor, Telkomsel Indonesia.

SingTel, like telecom companies everywhere, has been struggling for growth for some time as voice and SMS carriage is substituted for digital services. With the recent release of poor 1H18 results from Telkomsel Indonesia, SingTel’s growth and cash-flow seems likely to slow even further. In addition, new entrants mean more competition at home.

In Australia, wholly-owned Optus’s position is not likely to get any easier, after the recent value-destruction at Telstra. It would not be surprising to see profits fall; and the 5%-plus yield does not in our view offer sufficient recompense. SingTel may prove relatively defensive from here, but we should be able to do better than that.

We have talked at length about Giant Manufacturing, with shared bikes being the most obvious manifestation of the difficulties facing the sector. Though such bikes do not compete directly with Giant, the free capital thrown at this new industry has distorted returns for all. Earnings remain under pressure even now and we exited entirely.

We have previously discussed Global Brands in some detail too. After halving the position, we finally sold the remainder, incurring a loss. It has been a costly mistake, as well as a reminder of why we tend not to invest in the retail sector. Fashion is perhaps one of the most difficult areas to make money. No cost-discipline was the final tell, given the lack of growth.

Lupin was always a much smaller position than other positions within the sector. We bought Lupin after the industry had already begun discounting the impact of US FDA7 inspections, as well as the tightening terms from US distributors. The CFO has always been very enthusiastic as well as highly plausible about pipeline prospects and the likelihood of a rebound.

Despite all that pharma-expertize, earnings for these companies have fallen as quickly as the share prices, which means that there is not even the comfort of the sector being attractively-rated. We believe that the US distributor changes are structural and US drug prices are very politically-exposed. We sold Lupin on a modest sector bounce.

After much drama, as well as far too much excitement, we sold Cathay Pacific. Their cost-reduction programs and roll-off of fuel-hedging combined to propel the share price, but it is a brutal way to make money. Wonderful company, terrible business sums up the situation. We retain exposure through another position, with Cathay being about 15% of the NAV8.

Portfolio positioning

Our overall portfolio positioning has not changed very much. India remains the largest exposure and still seems the easiest place to find high quality companies with decent growth. In particular, our returns over the last twelve months have been helped by the rebound in the IT services companies, as their growth has reaccelerated.

These IT companies have benefited from the more difficult environment in domestic stock-market India, with a big sell-off in mid-cap companies. The rotation is a reflection on overall valuations and marks a return to the more dependable, as opposed to the exotic. The reversal in the rupee, given India’s ongoing twin-deficits, has probably helped.

As discussed, we have trimmed our direct China exposure, but on account of bottom-up valuations rather than because of any premonitions. Our concerns about China remain broadly the same. Too much debt and a highly opaque financial system. These are things we thought should be associated with a weaker, rather than strong currency.

7 US Food and Drug Administration
8 NAV/RNAV = Net asset value/revalued net asset value

Country allocation

First State Asian Equity Plus Fund

First State Asian Growth Fund

Source: First State Investments as at 30 June 2018. Allocation percentage is rounded to the nearest one decimal place and the total allocation percentage may not add up to 100%.
+Index: MSCI AC Asia Pacific ex Japan Index
*Index: MSCI AC Asia ex Japan Index The Asian Equity Plus and Asian Growth funds are not available for investment by US persons. Fund information is being provided as an example of First States Investments’ expertise in the strategy.

Ten Largest Company Holdings

First State Asian Equity Plus Fund 

First State Asian Growth Fund

Source: First State Investments as at 30 June 2018.
The Asian Equity Plus and Asian Growth funds are not available for investment by US persons. Fund information is being provided as an example of First States Investments’ expertise in the strategy.

Outlook and conclusion

As noted earlier, if we were to be forced into a box, we would consider ourselves a growth investor despite our emphasis on capital preservation. In that respect, the last few years have been challenging, but in an age of zero interest rates and free capital perhaps that is not entirely surprising.

"Failures.. are finger posts on the road to achievement."

C.S. Lewis

That reminds me, that our former managing partner told me shortly after the team split in 2015 that he “rather feared our style was going to be out of favor for quite some time.” And here we are, three years later. He managed to magically retire at the top, after Stewart Ivory was famously acquired in 2000 – post the tech-wreck and at the bottom of the cycle.

You could not make it up, but on we go; and neither our philosophy nor the process have changed. It may be fanciful, but the current and rather long post-’08 bull market does seem increasingly exhausted. Profits growth is strong for now, but the supporting arguments for enthusiasm appear to be folding one-by-one.

Still in bed with an elephant

Investing in this part of the world has long been all about China. We have remarked before that we are all in bed with an increasingly irritable elephant. It didn’t used to be like this. India, being mainly    a domestic and consumer-driven economy, offers a ready alternative. But, the valuations there are already rather high.

China’s financial system often reminds us of that famous Churchill aphorism about Russia: “It is a riddle, wrapped in a mystery, inside an enigma.” There are few signposts as to where we are going. Like America, China is big enough, such that you can always find an anecdote or indeed even real evidence to support whatever opinion you care to advance.

These China scares come along fairly regularly, but one day we may indeed have a more significant and long-lasting reversal. Maybe even now? Nobody knows, but it would hardly be surprising, either hereabouts or indeed globally. There is very little margin of safety in the system, whether you consider the world on a top-down or on a bottom-up basis.

The past few years have been rather benign, markets-wise, which is all the more surprising because the real world has become ever more fraught. We have become immune to unaccustomed and unusual things, as well as perhaps anesthetized to the risks, so often have we charged onward through myriad false alarms.

Only time will tell, but today we are comfortable with our portfolio positioning. If normal service resumes, we will continue to produce respectable absolute returns, while a more dramatic reversal would probably flatter our relative performance numbers.

With history supposedly on our side, we hope to use ongoing market weakness to buy into higher growth companies. That remains the key challenge. In the meantime, we remind ourselves that those muggles declaring victory, after but a wrinkle in the tide of returns, are just as likely to be consumed by Death Eaters 9 as saved by compounding-magic.

9 From J.K. Rowling’s Harry Potter series, Death Eaters are a group of wizards and witches who practise dark magic and seek to eliminate muggles and muggle-borns (magical folk with human parents) from the community


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