This article first appeared in Personal Wealth, The Edge Malaysia Weekly on June 19, 2017 - June 25, 2017
Value stocks outperformed growth stocks in Asia last year, according to Morningstar’s latest publication, Asian Equities Asset Class Spotlight. The outperformance was driven by a broad recovery in commodity prices, expectation of an improving US economy and its flow-on effects for Asia.
There was greater allocation to value cyclical stocks and away from quality growth stocks, driven by an improving macroeconomic backdrop and attractive relative valuations, says the report. Some of the areas of focus were real estate, financial and energy.
“Value stocks further extended their outperformance following the November 2016 US presidential election. The market took this result as a signal that out-of-favour cyclical sectors, such as energy and basic materials, were best positioned to benefit from potentially reflationary policies signalled by the incoming Trump administration,” says the report.
A number of factors drove value cyclicals and caused managers to avoid “quality growth names”, it adds. Concerns about a deteriorating nonperforming loan cycle and off-balance-sheet liabilities among state-owned Chinese banks have traditionally deterred managers from investing in the space, notes Morningstar, but more fund managers are warming up to such stocks as the valuations are sufficiently attractive to compensate for the apparent risks, which have stabilised over the past year.
Singapore has become a viable alternative for managers cautious about the risks among Chinese banks. “They were seen to offer higher quality loan portfolios, had attractive and, more importantly, sustainable dividend yields and were considered to be well positioned to potentially benefit from higher US interest rates,” says the report.
The underpenetration in China, in terms of life insurance policies, was seen as a structurally attractive theme among managers, says Morningstar. “However, they also acknowledged the risks associated with certain products, which can carry a high rate of guaranteed returns of 5% or more.”
As far as real estate is concerned, there was broad positive sentiment towards Hong Kong property developers focused on office space, as constrained supply has kept rents at elevated levels. Morningstar found that Chinese properties were also featured prominently in a number of portfolios.
“[This] is unsurprising given that real estate investment is often considered a key contributor to Chinese GDP growth. However, the preference was for developers with exposure to Tier 1 and Tier 2 cities such as Shanghai and Shenzhen,” it says.
“The consensus among managers was that the supply-demand picture in these cities was more balanced than in many of the
Tier 3 and Tier 4 ones, which suffered from oversupply. Managers also highlighted the difficulties faced by the Chinese government in implementing contrasting policy measures to restrain prices in primary-tier cities, but bolster demand in the peripheral cities.”
Other value cyclical sectors that saw the interest of managers were energy and materials. The report says that is because oil prices showed signs of bottoming out and investors’ expectations remained weak.
“While some managers liked beaten-down pure-play oil and gas producers, others preferred more diversified players. We saw several managers increase their allocations to state-owned Chinese energy producers, which, they argued, have implemented effective cost-cutting measures to protect profitability.
“A common, albeit relatively niche, investment play in the materials space was Indian cement producers which, according to the managers we interviewed, will be the primary beneficiaries of accelerated infrastructure spending in India.”
South Korean equities, which historically have traded at a discount to other Asian equities, in part because of concerns about corporate governance, are seeing a comeback. “Many of them are associated with majority family-owned businesses (known as chaebol) that often do not fairly treat minority shareholders. However, the introduction of government reforms aimed at improving corporate governance among chaebols has led to greater optimism among managers,” says the report.
“Samsung Electronics — one of the biggest constituents in many regional Asia equity indices — saw greater interest among the managers that we covered. While the managers acknowledge some of the headline risks associated with the company, they liked the prospects of its dynamic random access memory (DRAM) business and lauded the company’s efforts to progressively improve corporate governance. That said, they also recognised that the path to better corporate governance will not be smooth and the company may experience a few hurdles along the way.”
The Morningstar Manager Research (Asia) is a review of almost 50 strategies across four categories: Asia ex-Japan equity, Asia-Pacific ex-Japan equity, Asia-Pacific including Japan equity and Asia ex-Japan small/mid-cap equity.
Case for growth
As for growth stocks, more portfolio managers looked at companies with conservative balance sheets and strong earnings commonly associated with consumer staples stocks. Investors were willing to pay for the said qualities despite the higher volatility in equity markets. That is also why valuations in the sector are becoming stretched or overextended, says the report.
Some of the growth stocks in focus are India-based food businesses that distribute foreign-branded products. According to Morningstar, the portfolio managers saw multi-decade growth stories for these companies, even though the stocks were relatively expensive, as they would benefit from the rapid growth of the middle-class population in the country.
India’s financial sector is another area that presents growth opportunities. According to the report, most managers preferred private-sector banks as their stronger balance sheets and better management would allow them to continue taking market share from their public counterparts, which suffer from deteriorating asset quality and lack of capital adequacy.
“In the technology sector, outsourcing companies were well liked by the managers under our coverage as they stand to benefit from the accelerated capital expenditure of multinational corporations,” says the report.
Technology, which has been synonymous with high-growth stocks, is another area that has piqued interest. “Managers noted a particular strength of the sector: the firms’ ability to disrupt traditional bricks and mortar retailers and to monetise areas such as advertising and online gaming,” says the report.
While Chinese e-commerce plays featured prominently in some managers’ portfolios, others preferred companies that manufacture electrical components for automobiles, says the report. They reasoned that the growing complexity of car systems will lead to higher electrical content per car.
“We also saw renewed interest in some of the old-school PC-related names, with managers preferring companies that have reinvented themselves and diversified their revenue streams,” it adds.
Income stocks, which have been traditionally viewed as a proxy to growth stocks, evolved last year. The report attributes the change to the growing need for income-based investment objectives in the face of shifting demographics, as the baby boomer generation takes its first steps into retirement.
“These pressures have been exacerbated by more cyclical-oriented factors such as the global financial crisis and subsequent zero-interest policies adopted by a number of central banks across the globe. These tailwinds have helped prompt the rise in income-based equity strategies. The benefits are multiple: Investors can reasonably expect to receive a yield significantly higher than instruments such as government bonds, which are at historical lows,” says the report.
“Furthermore, these types of equity strategies that place greater emphasis on yield are typically seen as less volatile and potentially better equipped to successfully traverse markets that have seen significant spikes in turbulence over the past few years.”
Growing dividend culture
Morningstar’s research finds that Asian equities performed relatively well compared with other regions when it came to dividend yield. “On a dividend-yield basis, Asia-Pacific stacks up well on a relative basis, with only emerging markets and Europe enjoying a higher yield. Taking a closer look, the region benefits from having high-yielding markets such as Taiwan, Singapore and Australia, all of which enjoy a market yield greater than 4%.”
Morningstar notes the change in behaviour, for example, the shift among Japanese firms that are known for holding a lot of cash on their balance sheets. But these firms are starting to show more shareholder alignment.
“The lower yield offered in the US is not surprising. It could be argued that corporates have a great growth philosophy — retaining earnings to fuel expansion and looking to reward investors primarily through share price appreciation,” it says.
“In Europe, historically, there has been a greater propensity for corporates to pay out a large proportion of their earnings to shareholders in the form of dividends. In France, for example, some companies even pay a loyalty dividend to reward long-term shareholders over and above its normal dividends. European firms have also tended to have higher payout ratios than their US- and Asian-domiciled counterparts.”
Asian firms, meanwhile, are embracing a dividend culture. The report points out that almost 90% of firms on the MSCI Asia ex-Japan index now pay a dividend. This represents a huge increase over the past two decades, when the figure was closer to 60%.
“More importantly, payout ratios remain reasonable, highlighting the scope for dividends to increase over time. The importance of dividends becomes apparent when they make up an increasing proportion of total market returns. This is particularly so in the context of an overall slowing growth market,” says the report.
A key reason behind the emergence of a dividend culture in Asia lies in government support for more shareholder-friendly policies, such as initiating or increasing dividends, and other capital initiatives for investors, says Morningstar. “In addition, the governments in the region are hoping for an increase in stable global ownership of listed firms, which reduces their domestic reliance.”
For example, in South Korea, the government levies penalties on firms that are seen to be hoarding cash rather than distributing it to shareholders. Meanwhile, the introduction of the Nikkei 400 Index in Japan emphasises corporate-governance factors, quality and return on equity, which are likely to lead to a higher dividend yield.
“Other markets such as Taiwan and Australia have long-standing tax policies that encourage firms to pay dividends to shareholders. Even in China, the government has encouraged its powerful state-owned enterprises to place a greater emphasis on shareholder returns, and this has flowed through to dividends and other capital initiatives. Similarly, the expansion and opening up of the onshore A-share market has seen selected firms use dividend policies as a way to encourage global ownership,” says the report.
Corporate governance is seen as a way to increase dividends. According to Morningstar, companies in the region that have been looking to introduce or increase dividends have been improving corporate governance and strengthening shareholder alignment.
The report says one of the arguments used when it comes to income investing is that being dividend-focused will come at the expense of growth and is likely to result in lower returns. Morningstar, however, points out that the MSCI AC Asia Pacific ex-Japan High Dividend index has fared considerably better than the MSCI Asia Pacific ex-Japan index. Moreover, it has managed to do so with lower volatility (see chart).
“Both income- and growth-focused investing have a role to play when it comes to Asian equities. The favourable thematics, such as the growing middle-class consumer and positive demographics, lend themselves to both styles of investing,” says the report.
It adds that the factors that have made dividends more attractive in Asia are not likely to recede anytime soon. “The Asian equities landscape has matured over time. When it was first considered as a standalone region, investors saw Asia as a growth proxy. The region has matured into a diversified market that offers investors a range of strategies, from broad regional offerings to small/mid-cap strategies, absolute return and income-oriented options.
“Accordingly, Morningstar’s coverage of the region has grown, having introduced a dedicated Asia ex-Japan small/mid-cap strategy and further expanding this year to offer an Asia-Pacific ex-Japan equity income category in May. The continual growth and development of Asian equity markets, including the opening up of the Chinese domestic market to foreign investors, ultimately will result in a greater diversity of strategies that meet the needs of fund investors.”
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