Was the First Half of 2105 really so bad?

Apologies for a rather lengthy absence but first an enjoyable holiday made it tempting not to do anything for a few days.  Then markets have been frenetic over what is usually a relatively quiet period in the summer and demanded more than my usual amount of attention. 

I have a couple of interesting postings in the works having been to Manila and Hong Kong recently as well as some insight from what is going on in Italy; but for now, thought I would share an edited version of a letter I wrote for the month of August to shareholders in one of the funds we advise; CIM Dividend Income, a high yield equity fund that largely focuses on Asia.  Please note that nothing in this letter should be taken as giving advice to invest either in the fund or in any of the companies named; and also please note that I have edited out one or two elements which are pertinent to shareholders only.  Hopefully what is left will provide interesting insights into the crazy world of financial markets, especially in Asia.

You will be aware that the markets in Asia have been dire during the last few weeks.  China-related shares in Hong Kong have been hard hit with the main index off approximately 12½%.  Elsewhere local declines were aggravated by weak currencies relative to the US dollar. 

The only consolation, and it is not much of one in the short term, is that there is a significant disconnect between what is happening at companies compared against the behaviour of the financial markets.  Performance in Hong Kong in particular has been adversely affected by measures taken by the Chinese government to try and protect savers who invested in domestic Chinese shares, whereas there has been no effort at all to encourage support for Hong Kong.  Indeed selling pressure has increased in Hong Kong as a result of these measures.  That said the companies are on average reporting reasonable results and providing cautiously comforting guidance when taken as a whole.  I just returned from meeting many of these companies.  Overall the team met over 40 companies during the last two weeks and reviewed nearly 70 results.  I think it is useful to summarise our findings in the table below, albeit our categorisation is a somewhat crude assessment of whether the businesses we own are getting more or less valuable.  Flat means plus or minus 5.0%.

Performance: HK/China Interims - 1H 2015

	Sales	Earnings Per Share	Net Asset Value	Leverage
Up	33	32	36	25	Better
Flat	15	15	24	19	Same
Down	19	20	7	20	Worse

 

You can draw a couple of conclusions from this data.  The first is that significantly more companies delivered reasonable topline growth than were down.  Most also delivered Earnings Per Share growth albeit the ratio is a little lower on this measure.  There has been a trend to margin compression due to overcapacity in some sectors but the area that has suffered most has been property.  The reason why that is happening now is that most reported bookings relate to contracted sales for late 2013 and early 2014 when restrictions on the property market were biting hardest and pricing pressure was at its peak.  Generally the companies in that sector are expecting material margin recovery in 2016 and most believe that their mix will begin to improve in the second half of this year.  I think we are seeing the trough, but do not expect margins to return to where they were in 2013.  Still every single property company we met claims that the gross margin they expect out of the 2015 contracted sales book is considerably above the level reported in the income statement of 1H 2015.  Of course we will not see any of that until 2H 2016.

Growth in underlying Net Asset Value has also on balance been heavily positive.  The one area we have to watch is leverage.  There the data is more ambiguous. 

If you are wondering why there is no mention of the dividend, we have not included that metric in the table since only a minority of companies pay interims; and thus the sample is skewed and also too small for us to draw any conclusion.  What I can say is that there were no negative surprises and a couple of positive surprises in our universe.  

Turning to a much larger sample, all China listed companies covered by Australian broker Macquarie, the analysts at that firm saw real improvement in several areas when aggregating 2015 1H financials.  In contrast to all the media negativity they detected reasonable average earnings growth, somewhat better balance sheets, and arguably most important and interesting of all higher Return on Assets, a trend they have noticed and monitored since the end of 2013.     

There are times when I feel I am living in a parallel universe.  This is one of them.  Overall earnings are up, as are NAVs though margin movements are varied.  Still there is nothing on the ground to justify the treatment Hong Kong shares have received over the last two months at the hands of the market.  The economy is in transition.  Some sectors may be in decline while others are enjoying good growth, but across the board the larger listed companies are gaining market share.  At the risk of repeating myself, Hong Kong never enjoyed the run up that took place on Chinese domestic exchanges; yet it has participated to a large extent in the decline.  The CSI is off 40% from its June peak, while the Hang Seng has retreated by 24% since its April high.  The same index was down at the end of August YTD by 8% and YoY by a similar amount, while the Hang Seng China Index is down 19% this year.

Over in the real world management run businesses in which you can invest; and investors can monitor the collective effort of a workforce, working on our behalf combined with assets, real and financial, to deliver services or produce products consumers are prepared to pay for.  Over time good businesses build value and the value of our investment goes up as well regardless of the mood of Mr Market.  Occasionally Mr Market goes off the rails.  When that happens those with their feet on the ground get gifted with a great opportunity: as they did in 1981 and in 1987, and then again in 2001/2, and one more time in 2008.  Possibly we are nearly there again in 2015, at least as far as Hong Kong goes as on most valuation metrics the market trades between one and two standard deviations below its average.  Some shares are back where they were in 1H 2009 post the GFC sell off.

Since future returns are generally recognised to be a function of entry price it is worth remembering what came after 1981, 1987, 2001/2 and 2008 when entry prices were attractive due to severe market setbacks; and also it is worth remembering what happened to shareholders who reduced their equity holdings at those moments (a large number unfortunately).  Most never got back in and missed the rallies that always follow when markets are oversold and valuations fall over 1 standard deviation below average : which is where we have got to now in our main market.  Sentiment surrounding Hong Kong is dire and valuations reflect such sentiment.  That is a time to buy not sell.  Of course prices can still go lower and seasonal patterns suggest they will at least in September and October; but if they do we should enjoy an even stronger rally when the market turns.

The most surprising feature of last month was the drop in share prices of Singapore REITs.  This occurred regardless of whether the relevant underlying currency was neutral (Singapore assets), negative (the Rupiah) or positive (the Yen).  So one thing is clear: investors are not bothering to look at either the underlying assets or the income streams in this environment.  Many REITs dropped 10% during August.  Yields blew out from 7% to 8%.  Some now yield 10%.  Yields such as these were last seen in the second quarter of 2009.  Subsequently in 2010 and 2011 most of these shares rose 25-50%; a few even more.  While concern relates to an expected interest rise in the US, and some modest increases in local rates, the gap between REIT yield and SIBOR has widened over the last few weeks. 

My assessment is that we are seeing margin calls.  Singapore is regarded as conservative; but certain aspects of its financial services are not.  The high net worth/wealth management industry offers leverage, often at 3 to 1, for what are viewed as conservative assets.  Many REITs fall into this category.  Thus a 10% decline in price translate to a 40% decline in equity requiring a margin call; and so it goes.  Banks and brokers are notoriously unhelpful and can be vicious when margin calls are not met.  If you happened to be on the beach with your mobile off, you can come back from lunch to find your shares were sold.  Anecdotal evidence suggests some of this was going on last month.  The result is that we are now getting to see attractive buying options.  10% in Singapore dollars underpinned by a reasonable property portfolio is not to be sniffed at.  I tried to convince some clients in the first half of 2009 to help me create a Singapore REIT fund and think the time may be coming once again when investors with cash should consider doing just that. 

In Indonesia the share price selloff starting in July has been the steepest recorded over the past 10 years.  While nothing guarantees it cannot continue, history shows that this sort of decline does not last for long; so we should be more or less done here as Indonesia has gone from relatively expensive to relatively cheap in a matter of a few weeks, even assuming lower growth.      Indonesia remains an area of concern.  The government has been a disappointment with reforms stalled, planned infrastructure acceleration intermittent, and inconsistent policy making.  A recent cabinet reshuffle followed by renewed commitment to the all-important drive to upgrade infrastructure and reignite FDI hints that things may improve, but the market will want clear evidence this time round.  A new round of measures to stimulate the economy shows the right spirit, but implementation has been the weak part of Jokowi’s reform packages.   

Another upset in August came from Taiwan.  There is no particular reason why this should have happened except that everywhere else was going down.  Taiwanese shares have come down considerably.  Even before the latest selloff they were close to one standard deviation below the 10-year averages for that market, on both a Price-to-Earnings and Price-to-Book basis.  Now on the negative side one should note that there are no major new electronic product categories in the pipeline over the next year that could stimulate another round of growth at the core component sector that makes up so much of the listed market and also has been a driver of the overall Taiwanese economy.  Still when the price is right you are not paying for any topline growth; and Taiwanese management is notoriously good at extracting cost.  It is perfectly feasible to expect improvement in margin sufficient to deliver a degree of profit growth in 2016 even if sales are static; and that dynamic can continue for an extended period along with the opportunity to change product mix.  Therefore this latest, incremental collapse in share prices seems unwarranted.    

   

One encouraging sign is that we have begun to see a repeat of a pattern that emerged in the last quarter of 2008, when management and controlling shareholders of companies started to buy shares and increase their ownership, and a number of companies also began to buy back shares.  In contrast to US practice, Asian companies seem to buy when their shares are cheap and issue them when they are expensive.  It is too soon to say that this is a firm trend but the number of instances noted suggests this activity could become significant; and it underlines the gap between what insiders see and what the financial markets think. 

Insiders got it right in 2008.  When insiders use cash to buy shares it is usually a positive signal for investors if not necessarily for short term traders.