Dear Valued Investors,
Valuations remain at the forefront of my thoughts when I look at Asia’s stock markets. We are swimming against the tide a bit now, as the markets have risen at a faster pace than the underlying growth of Asia’s companies. A price-to-earnings ratio* of 15.6X for Asia ex Japan is significantly above long-run averages. Now, I know that there is some justification for higher valuations in a world in which bond yields are extremely low. And there is some good news for investors in Asia’s equity markets—they remain at a similar valuation to troubled Europe and at a discount of about 15% to the U.S.i There are clearly some signs of excess as I’ll get into in discussing China and India. And there is always the danger of dismissing everything as a bubble when there is still value to be had in the markets. Nevertheless, I do think it is wise to tread a little more cautiously in light of the re-rating of Asian equities in recent months.
Let us start with China. There has been plenty of talk about bubbles recently. Isn’t it peculiar how China has just switched from one form of pessimism (a fear of imminent economic collapse) to another (a fear of an overheated stock market) without the usual step of optimism in between? Such is the lot of the world’s second-largest economy and pretender to the U.S.’s crown. Undoubtedly, there are some strange goings-on in China’s market. High retail participation increases the casino-like actions in the markets. Taking a passive approach to the markets right now risks buying into some companies that have very limited history and business models that are built on hopes rather than reality—and yet they can be multibillion dollar companies thanks to the valuations put on them by local speculators. And certainly, China stocks as a whole have seen the biggest short-term rise in their average valuations in the region. Yet, it remains true that the market of Hong Kong, through which most China investing is done, remains much more reasonably priced, at 14.4X forward earnings. Indeed, one can find businesses that have stood the test of time still trading at reasonable, sometimes cheap valuations. But it is definitely an environment in which one needs to tread carefully, and not get carried away.
In India, the problem remains partly cyclical and partly structural. Macroeconomic policy has been fairly tight over the past couple of years. This has impacted earnings growth, which has been disappointing. And although the new Modi government appears to be making changes to some of India’s structural bottlenecks—and particularly improving the efficiency of government—it has to contend with pushback from India’s formidable bureaucracy and the need to maintain foreign investor confidence. Reforms will likely have to be funded by fickle foreign portfolio flows, unless India can do better at attracting foreign direct investment. All of this should be seen as more of an opportunity than a threat—if it were not for the valuations of the markets, which at 16.4X forward earnings, is still among the more expensive in the region. We have been fairly cautious on India for a while. The good news is that the market has faltered this year and so the sentiment is no longer perhaps as ebullient as it has been. But the market hasn’t really become any cheaper either. Stock prices have just reacted to weak underlying corporate results.
In Japan, we have noted some success from attempts to reflate the economy, much to the surprise of those who suggested it would merely debase the currency and precipitate a debt crisis. The stock market has performed strongly. And this performance has only been enhanced with recent moves to improve corporate governance, particularly when highly rated companies embrace the government’s push for greater transparency. It gives other companies nowhere to hide. No longer can they say: “Well, the most respected companies don’t do it, why should we?” But at the same time, we have yet to see a lot of evidence for change in the operating metrics of corporate Japan. That may come. Until now, there remains more hope than reality, too. We have certainly seen, however, some signs of better use of cash. In a deflationary world, it was easy to let cash build up on the balance sheet, because it was earning a return. Now, with positive inflation rates, we have seen companies more inclined to raise dividend payments. Japan is by no means, however, a cheap market. And to justify the current valuations, companies have to follow through with better operating results.
In contrast to the big three economies, it is the Association of Southeast Asian Nations (ASEAN) that has struggled a bit recently, and now appears the more reasonably priced part of the region. It also remains among the more vulnerable to tighter money and a series of U.S. Federal Reserve rate hikes. My view remains that we ought not to see a series of Fed rate hikes in the current environment. Inflation is still in abeyance. The most likely scenario that would justify a sustained series of rate hikes would be a return of faster nominal growth in the world—real growth plus inflation. In such an environment, even higher interest rates are unlikely to be too much of a headwind, as Asia, and particularly ASEAN economies should benefit from easier business conditions.
I have been fairly upbeat in the recent past about the economic conditions in Asia. And I remain upbeat. Governments in the region seem to be determined to tackle long-term structural issues. The reason for my more cautious message is simply valuation. I admit that there is a risk in being too sensitive to valuations, but there does seem to be a relationship between current valuation levels and future returns on average. It often pays, unsurprisingly, to be buying when markets are cheap; it is just hard to do. As always, it pays to be patient—to buy quality, sustainable growth, but to do so at reasonable prices.
Robert Horrocks, PhD
Chief Investment Officer
iIn terms of Factset aggregates:
*Price-to-Earnings Ratio (P/E Ratio) is a valuation ratio of a company’s current share price compared to its per-share earnings and is calculated as the market value per share divided by
the Earnings per Share (EPS).