The Asian growth story: how investors can participate

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1 The Asian growth story: how investors can participate King Fuei Lee, Head of Asia Equities, Singapore January 2013 Even as the US struggles with its debt burdens and Europe battles its sovereign debt crisis, the structural Asian economic growth story plays out unabated buoyed by the long-term trends of urbanisation, industrialisation and positive demographics. Asia is now moving into an era of unprecedented urbanisation. The Asian Development Bank 1 is forecasting more than 55% of the population to be urban by Asian cities will be expecting an influx of another 1.1 billion people over the next 20 years, creating increased prosperity for the region. Meanwhile, with generally well-structured societies and more stable governments in place, the industrial revolution that started decades ago in Asia should continue to unfold at a pace that far exceeds developed countries. Positive demographics are giving impetus to these economic trends. However, while the long-term economic themes in Asia are well recognised and understood by the investment community, the ways for investors to participate in this structural growth story remain shrouded in mystery and misconceptions. Traditionally, investors hoping to participate in a country s economic growth try to do so by investing in the country s stockmarket, often through index funds and actively managed relative return funds. After all, conventional wisdom is that the faster an economy grows, the more corporate profits in the country will grow, and hence the higher the stockmarket returns the investors will achieve. This could not be further away from the truth. Don t just rely on economic growth An academic study by Elroy Dimson, Paul Marsh and Mike Staunton, professors from the London Business School (LBS) 2, has found no evidence of a positive relation between a country s gross domestic product (GDP) growth and its investment returns. On the contrary, their analysis of the financial data of 83 countries going back to 1990 showed that slower-growing countries actually delivered better investment returns than their faster-growing counterparts. This is a conclusion that an investor in the Chinese stockmarket will likely concur with as he finds his or her $1,000 investment in the MSCI China index in 1993 dwindle to $660 in 2011, while the Chinese economy registered an average nominal GDP growth rate of 15.5% per annum over the same period (see Chart 1 on the next page). 1 things know 2012 urbanization asia 2 Dimson, E., Paul Marsh and Mike Staunton. (2002). Triumph of the Optimists: 101 Years of Global Investment Returns. Princeton, NJ: Princeton University Press.

2 Chart 1: MSCI China index versus China nominal GDP Source: Factset, December 2011 So why does high economic growth not always translate into superior stockmarket returns, and how can investors wishing to participate in this Asian growth story do so? Focus on dividends One of the reasons for the poor relation between economic growth and investment returns stems from the fact that the total return from the stockmarket is really made up of two components, namely capital appreciation and dividend return. Capital appreciation is notoriously susceptible to non-fundamental influences like momentum and sentiment. Fortunately all is not lost. The same LBS study has also found that real dividend per share (DPS) growth is particularly strongly correlated to real GDP per capita growth (see Chart 2). Because dividends can only be paid out of corporate earnings which are in turn directly driven by the state of the economy, dividend returns tend to be highly linked to economic growth. Investors seeking exposure to the multi-decade Asian growth story should pay close heed to the dividends that they are capturing from their equity investments (see Chart 3 on the next page). Chart 2: There is a strong positive relationship between GDP growth and real DPS growth ( ) Source: Dimson, Elroy, Marsh, Paul, Staunton, Mike, Global Investment Returns Yearbook ABN Amro, Amsterdam. 2

3 Chart 3: Dividend return is highly correlated to economic growth in Asia Source: Factset, IMF, Schroders, December 2010 Ignore the stockmarket index and look further down the market cap spectrum Another explanation for the poor relation is because the stockmarket index does not precisely represent the country s economy. This can be very problematic for investors targeting the Asian market index as more than half of the index is in fact made up of global cyclicals or companies which are more exposed to the vagaries of the global economy than to domestic Asian influences (Chart 4). Investors looking to play the Asian growth story should therefore ignore the benchmark when investing in the region and focus on companies that genuinely benefit from favourable domestic dynamics. This is particularly important for investors willing to look further down the market capitalization spectrum as small- and mid-cap companies in Asia typically earn a greater proportion of their revenues domestically (see Chart 5). With these smaller stocks generally also suffering from poorer analyst coverage, the greater inefficiency in their share prices should represent opportunities for making multi-bagger returns. Chart 4: Asia ex Japan stockmarket capitalisation weightings Source: DSGAsia, October

4 Chart 5: Asian small- and mid-caps typically have higher exposures to their domestic economies Proportion of domestic revenues (average) 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% China & HK Indonesia India South Korea Malaysia Philippines Singapore Thailand Taiwan Large Small Source: UBS Quantitative Research Buy good stocks, not markets An often cited reason for the inability for high economic growth to manifest in strong returns is that the growth is being siphoned off by insiders executives and managers at the expense of shareholders. Despite the hype about the tremendous economic growth in Asia over the next few decades, it is crucial for investors to realize that ultimately it is stocks that make up their portfolios, not markets or countries. The key for investors to participate is simply to ensure that they only invest in good companies. These are essentially companies which are able to channel the growth back to shareholders in the form of high-quality earnings, and delivered within a system of strong corporate governance and sound business practices. Performing in-depth bottom-up research on companies and understanding their business models and earnings drivers will go a long way in helping investors crystallise the Asian growth story in profitable equity investments. Valuation is important In a recent Financial Times article 3, it was revealed that when asked why high-growth economies tend to produce disappointing returns, Professor Marsh had explained, We suspect the story about economic growth is already in stock prices. You would have to have been a hermit for the past 20 years not to know the China growth story and you would expect that to be factored into stock prices. [ ] The problem with growth is it can get overhyped very easily. Just as with investing in growth stocks, the returns from investing in growth markets can be pretty meagre if the future growth is already reflected in the prices. With the region currently trading at 1.7x price-to-book (see Chart 6) and 13.9x price-to-earnings (see Chart 7), valuations are thankfully reasonable compared to longer-term averages. For long-term investors looking to participate in the Asian growth story, now is as good a time to start accumulating af 11e2 8aaa 00144feabdc0.html 4

5 Chart 6: Price-to-book of MSCI AC Asia Pacific ex Japan Index Source: Factset, MSCI Chart 7: Price-to-earnings of MSCI AC Asia Pacific ex Japan Index Source: Factset, MSCI Important Information: The views and opinions contained herein are those of the King Fuei Lee, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.. This document is not suitable for retail clients. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA, which is authorised and regulated by the Financial Services Authority. For your security, communications may be taped or monitored. 5