The right way to invest in a thematic is not an index
Andrew Swan is Head of Asia (ex-Japan) for Man GLG, the discretionary investment business of Man Group, a global manager of $200 billion in assets with headquarters in London. Andrew is based in Australia and joined Man in 2020 after starting his analyst career in 1994.
GH: You manage portfolios of Asian equities excluding Japan. How much of the performance and potential is a China story?
AS: Asia is an ever-changing part of the world. A few years ago, China was the dominant source of returns in the region, but China is going through a challenging transition that is a tough environment for equities. At the same time, we are seeing improving opportunities in the rest of the region, especially in Southeast Asia and India. Asia is really diverse and some smaller economies are improving a lot.
GH: What are say, three other countries with good medium-term potential?
AS: Indonesia, Thailand, Philippines have good opportunities, and a fourth, India, should be in the mix. Young populations in a fast-growing part of the world. Of course, that doesn’t always translate into good returns but the potential is strong at the moment.
GH: What about the global macro threats of inflation, interest rate rises and shortages in both labour and materials?
AS: Well, they are big challenges facing the rest of the world right now but one of the key reasons inflation is a problem in the West is the scarcity of labour. But these four countries offer young populations and an abundance of labour and they’re not seeing wage inflation or interest rate pressure. These economies are more resilient to a global slowdown than in the past because they’re more about domestic demand, and there’s not the same level of speculation in the system as in the West. As a result, they’re recovering strongly.
GH: Although Asian GDP grows faster than the rest of the world, you’ve written that Asian countries have arrived but Asian equities haven’t. So now you’re seeing a brighter outlook?
AS: The greatest mistake people make when investing in Asia is to think that because it’s a high growth market, it should generate higher returns for its companies. But that has not proven to be the case over the last decade. There have been some fantastic opportunities inside the market but the overall market has underperformed developed markets which have been growing at a slower pace. Overall, in Asia, there has been too much capacity and companies lose pricing power and profitability suffers.
But at a time when developed markets are slowing due to inflation and rising rates, we expect the narrative of the underperformance of Asian equities to come to an end. And with enormous dispersion inside the market, the opportunity set as a stock picker, as an active investor, is much better in Asia than in developed markets where stocks are more highly correlated. It’s really tough to get returns above the market in developed markets.
GH: Most people in Australia are underinvested in Asia, and probably think they can gain Asian exposure through global large caps. I’m not only thinking of the big tech companies, but Procter & Gamble, Coca-Cola, Lever & Kitchen, Starbucks, they all have large Asian businesses. What does an Asian portfolio give to an Australian investor?
AS: Asian companies are exposed to different factors than in an Australian portfolio, and while large global companies give some Asian exposure, and they tend to be well managed, Asia is usually a small part of what they do. The last 10 years have been a developed market story but the West is now paying the price for an incredibly accommodative monetary environment but Asia does not have the same excesses in the system.
GH: Are geopolitical tensions in places such as Taiwan and Pacific islands making conversations with Australian investors more difficult?
AS: I have been doing this in Asia for 20 years, and it’s always a question from investors. Not to be dismissive of it in any way, but in the last four months, it’s become more of a barrier. My response is in two parts. First, if a major military conflict happens, it will affect everything in your portfolio, Russia and Ukraine multiplied many times over with a big shock to the global supply chains. Mainland China and Taiwan are critical in global trade in all products from high tech like semiconductors through to low tech like base materials. So this shock to the supply chain would hit all markets.
But the second thing is, following events of the last year or two, companies are rethinking how they do business in the region. After a couple of decades of globalisation and integration, we’re seeing an unwind. Rather than a first focus on the economics of a transaction, now geopolitics is probably equally first. Companies are adjusting their long-term thinking but they still want to be in places like China. It’s a big, growing market. So they are reducing the number of logistical steps in their production and targeting more at the local Chinese market with local product. Multinationals in China are sourcing more locally than internationally due to the risk of further conflict.
And Chinese corporations are also trying to reduce their reliance on the West, and that’s throwing up good opportunities. The investment challenge is to find the companies benefitting from more self-reliance and deglobalisation. We think a lot of companies will benefit from this process. Those local suppliers that are replacing imports and foreign competitors can do extremely well, and we’ve identified a few so far.
GH: On your portfolio, what are some of your largest investments by country and sector? And is it the big macro thematics you like or is it more company-specific?
AS: Well, it’s the same mistake people make thinking Asia is a high-growth market and therefore the market overall should be high growth. It doesn’t play out that way and the same goes for thematics. They can dominate returns in a short period of time but there must be a follow through into profitability rather than only top line or revenue growth or volume growth. With many companies, the first phase looks good but in the second phase, most of those things fail. The trick is to identify what is sustainable. We remain fundamentally focussed so profitability is key. We know the region and we follow profitability and avoid the companies that lose a lot of money if it doesn’t translate into profits. We do have companies that benefit from thematics but we follow them through profitability.
Health care looks attractive, especially as populations are ageing and they demand better health systems. One of our core holdings is a medical equipment company in China. The quality of hospitals and health services in China is insufficient, but this company has gone from reengineering Western solutions and doing it cheaper and faster, to becoming much more innovative. It spends enormous amounts on research and development. While it started as a basic assembly company, buying components and putting them together with cheap labour, they now rely less on international components and they innovative with their own end products.
Innovation is critical to China’s future, and the Chinese Government is the main customer and it wants more self-reliance and innovation, and the company is now selling internationally. For example, they now sell the number one patient-monitoring device in the UK. It’s a company that can grow 20% to 30% per annum in a world where growth will become scarce. The key is not simply buying China health care due to the obvious need, because the Chinese Government squeezes suppliers of products such as common drugs or medical devices. The investing challenge is not the thematic but care in execution, as more companies fail than succeed.
GH: That’s a good example of not just buying an index or a theme but finding the best companies. Have you got another example?
AS: Well, most people do not know what a harmonic reducer is. It’s a lightweight mechanical gear that goes into a robotic arm. So here are two thematics, if you like. One is China running out of workers as the overall population is declining, the working population is shrinking, yet it’s still a manufacturing hub. The only way to deal with that problem is to automate the manufacturing processes. So we’ve seen an enormous growth in robots in China, and that will likely continue.
There are two sources of robots. There are international sources, which is what China started with, and then there are domestic-manufactured robots. And due to global tensions and deglobalisation, Chinese companies are sourcing more robot arms from Chinese companies. Back to harmonic reducers. A Japanese company previously held a 70% market share, then a company we own developed the same component at a 30% cheaper price. So Chinese robot makers have been shifting across, especially after the rise in tensions in the South China Sea. The last thing a car manufacturer who relies on a robotic arm wants is for one tiny component to suddenly stop arriving from Japan. Sitting in Australia, investors see China as a risk, but digging below the surface, you see what’s really going on.
GH: Can we turn to the other side of your portfolio for an example of something that didn’t work well and taught you something about your investment process.
AS: Yes, although I’ve been doing this for 20 years and delivering consistent returns from the same process, we learn from our mistakes and there have been several stages of evolution of my process. One of our strategies is to look for positive surprises in a company’s fundamentals or profitability versus what the market expects, but it requires a forward-looking view on what is going to happen, so we don’t get everything right. Six out of 10 is a good hit rate to deliver strong results for our clients.
We owned a company which was doing a lot of market research and testing of biologic drugs, their profits were being upgraded and they benefitted from COVID and the manufacturing of vaccines. Yet if you look at their share price, it peaked in the middle of last year. The share price disconnected from the earnings upgrades. When we see a breakdown in that relationship, we start to get worried. Sometimes it’s just short term and you can buy that weakness. But sometimes, if it’s persistent, you need to listen. And this was one of those times we thought was a short-term problem, but it persisted and we decided we didn’t know what was going on. Rather than saying the share price is wrong, we exited the position. We needed to know what was driving the price.
The market can be incredibly clever. My suspicion is that the market started to worry about the longer-term earnings outlook for this company, whether the lack of COVID in the world or more importantly, the whole US/China picture and scrutiny from US regulators. That’s my theory. The clouds are over the long term but we have not seen the earnings downgrades yet.
GH: So what’s your elevator pitch for an Australian to invest in Asia?
AS: The key is to understand why you’re buying Asia, for its growth and dynamism, and find a manager who knows what drives returns in Asia. I’ve only been back in Australia for about 18 months and some of the commentary about Asia is, shall we say … strange. You need to accept the volatility because it is an emerging part of the world and it’s constantly changing, but with that comes opportunity. Taking an objective and forward-looking view is how you generate consistent returns over the long term.