While valuations are improving in certain areas, challenges persist across the region
By Brent Bates, Senior Portfolio Manager. Posted on Expert Investment Views: Invesco US Blog.
Virtually all Asia Pacific countries and sectors are experiencing negative earnings revisions, with return on capital falling to decade lows, a weak export environment and lackluster domestic economies. In this environment, investors have sought the highest-growth and highest-quality companies irrespective of valuation. Because the Invesco International and Global Growth team is not willing to buy at any price, we have been priced out of many of businesses we believe are attractive. But we see signs that this is starting to turn in certain areas.
At less than 13x price-to-earnings (P/E), Asia valuations appear reasonable, but this doesn't tell the whole story. Asia has been a bifurcated market, with lower-quality/lower-growth stocks getting cheaper, and higher-quality/higher-growth stocks getting more expensive. More recently, however, this trend has started to turn, and a greater number of high-quality businesses are approaching levels that warrant our interest. We're eyeing more companies today than we have in quite a while.
Growth continues to slow in China, as valuations start to improve
From a fundamental and economic perspective, not much has changed in China over the past three months as the economy continues to slow. In fact, in 2015 China had its slowest pace of growth in many years.1 What's more, economists expect growth to continue decelerating, and we see very little in the leading indicators to argue against this.
The biggest change over the past three months in China has been negative investor sentiment and the associated capital outflows, which are being driven by the acknowledgement of policy missteps and potential for further renminbi devaluation. In addition, the markets are behaving as if the Chinese economy is in free fall, with Chinese nationals siphoning money out of the country as quickly as possible and policymakers are powerless to stop the capital flight while having effectively lost control of the currency.
Where we see opportunity: Despite this bearish picture, all hope is not lost. That's because we believe that the best opportunities often emerge when fear levels are running high, and we are starting to see some very good businesses approach reasonable valuations. Chinese staples, including market share leaders, in many cases have net cash and consistently generate good spreads on capital. Historically, these companies had price/earnings valuations in the mid-20s, but now they are being priced in the mid-teens.2 The risk inherent in the valuation is much less than we have seen in quite a while.
Emerging markets still challenging
There are mounting concerns in the emerging markets (EM) surrounding companies with dollar-denominated debt. While it is true for the asset class, it has little impact on our holdings due to the quality of the balance sheets we own. Excluding our two bank holdings (Kasikornbank (OTCPK:KPCPY) in Thailand and ICBC in China, which represent 1.13% and 0.77% of Invesco International Growth Fund, 2.69% and 3.48% of Invesco Asia Pacific Growth Fund and 3.33% and 4.37% of Invesco Developing Markets Fund, respectively as of Dec. 31, 2015), our remaining holdings have either net cash or a net debt position that is less than 2% of market cap3 - this keeps with our quality growth investment philosophy, which emphasizes earnings, quality and valuation (EQV).
Overall, valuations in emerging markets look reasonable, with the cyclically adjusted P/E approaching 2008 levels and trading one standard deviation below the 30-year average.4 The discount relative to the US is approaching the 1997-98 lows, which occurred during the Asian financial crisis and Russian ruble crisis.5
Where we see opportunity: Prior to the most recent drop in the market, attractive valuations had been found in the low-quality, highly cyclical businesses. However, we avoid these companies. Instead, we are beginning to see value emerge in higher-quality businesses, and we believe valuations are becoming more attractive in emerging market staples. With that said, it is important to understand that although EM equities have experienced significant outflows, the liquidation of the EM credit markets has yet to commence. If credit spreads widen, this will place additional stress on the region.
Earnings outlook is dimming in Japan
One notable place where we have seen an inflection in the earnings outlook is Japan. In recent years, Japan had been the real bright spot as one of the few markets to experience positive earnings revisions as a result of the currency tailwind from the weaker yen. However, in the fourth quarter, this market experienced its first downward revisions in the past couple of years. The currency has been strengthening since the beginning of December and the risk to market expectations continues to rise as consensus has yet to feed this into their models.
Where we see opportunity: We believe valuations are becoming more attractive in Japanese Internet companies. We also see Japanese industrials - including global leaders in fields with long-term structural growth - that have net cash, generate high thru-cycle return on invested capital and are down 35% from their peaks. On full-cycle earnings and valuation metrics, these businesses are beginning to look attractive.
- Bloomberg, as of Jan. 22, 2016
- FactSet, IBES
- FactSet, Bloomberg
- BCA Research
- FactSet, Invesco Dec. 31, 2015
Price-to-earnings (P/E) ratio, also called multiple, measures a stock's valuation by dividing its share price by its earnings per share.
Spread represents the difference between two values.
Standard deviation measures a portfolio's range of total returns and identifies the spread of a portfolio's short-term fluctuations.
An inflection point is an event that results in a significant positive or negative change in the progress of a company, industry, sector, economy or geopolitical situation.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Investments concentrated in a comparatively narrow segment of the economy may be more volatile than non-concentrated investments.
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Investment opportunities are slowly emerging in Asia Pacific markets By Invesco US Blog