When will prices in China and Japan become attractive?
Slowing global trade has weighed down export-oriented markets in Asia, and the regional earnings outlook has been deteriorating rapidly. Over the past six months, earnings expectations have been revised down 4% for the MSCI All Country Asia Pacific Ex-Japan Index.1 For December, the earnings revision ratio (which compares positive versus negative revisions) fell to 0.39, the worst reading ever recorded outside of a recession.2 The downgrades were broad-based and included all Asian economies, with 13 of 16 sectors (as defined by Merrill Lynch) experiencing at least twice as many downgrades as upgrades.1 Despite this gloom and doom, some Asian companies are beginning to look attractive using our team's Earnings, Quality and Valuation (EQV) criteria.
Chinese economic growth has slowed
Real gross domestic product (GDP) growth has been decelerating in China, with pressure from both the consumer and industrial base.3 Consumption began to slow in the second quarter of last year and has steadily deteriorated since. For example:
- 2018 auto sales declined for the first time in 20 years, and the latest reported monthly figure showed a double-digit decline.4
- Industrial profit growth has declined for seven consecutive months and turned negative on a year-to-year basis in November (the lowest reading since January 2016).5
- The latest Purchasing Managers' Index reading of 49.4 moved into contractionary territory for the first time since 2016.
- Total exports declined 4% year-over-year in December 2018.
Government steps up stimulus measures
The US-China trade war is beginning to have an impact far beyond a weakening economy - the list of manufacturers (both foreign and domestic) that have been talking about exiting China is growing. In response to these developments, the government has begun to step up stimulus levels. The People's Bank of China recently announced a 100 basis point cut to the bank reserve requirement ratio to help improve liquidity. This is the fourth cut since the beginning of 2018, but with a twist - this latest action was the first unconditional reserve requirement cut in three years.
The Chinese government is also beginning to target specific industries for assistance. For example, China is now encouraging incentive programs for autos and home appliances. At this point, the level of stimulus still remains low, giving policymakers significant capacity for increased measures.
Our take on China
Despite the uncertainties, the sell-off provided opportunities for us to deploy capital into China as valuations have begun to factor in a healthy degree of pessimism. As a whole, Chinese companies are now valued at 10x forward earnings.6
Japan faces earnings pressure and an upcoming tax hike
Similar to other export-oriented markets, slowing global trade is also weighing on Japan. Earnings expectations have been revised down, and if the recent strength in the yen were to continue, it would likely place additional pressure on earnings growth in the next fiscal year (which runs April 1, 2019, to March 31, 2020).
One of the big questions the market is beginning to wrestle with is whether the Japanese economy is strong enough to weather the upcoming consumption tax hike scheduled to take place in October. The slowing global growth environment certainly does not help offset this headwind.
Hopeful signs in corporate governance
However, it is not all bad news in Japan. In January, there were two notable examples of improvement in corporate governance.
- First, the largest brokerage firm in Japan (Nomura Securities - not a fund holding as of Dec. 31, 2018) announced a major change to its compensation structure - it would be linked to performance instead of tenure. Compensation has long been a significant obstacle in Japan, as it is widely believed that linking pay to tenure does not incentivize employees or management to do a good job.
- Second, Olympus (not a fund holding as of Dec. 31, 2018) announced it had agreed to adopt a number of proposals from foreign investment activist ValueAct Capital. This is potentially the watershed moment for shareholder activism in Japan. Olympus is replacing the CEO and three members of its board of directors. One of the activist's partners will be joining the board and will be responsible for appointing two other non-Japanese directors. In addition, the company is transferring management of its core medical business to the US and announced a plan to cut non-production expenses.
This level of response to shareholder activism is unprecedented in Japan. Considering this happened very recently, it is too early to say whether shareholder activism will now take hold and drive a wave of change. However, we will be keeping an eye on this issue.
Our take on Japan
The Japanese market has been trading at 11x forward earnings7 - the most attractive valuation in many years - and has given us an opportunity to add to existing positions. While we have not initiated any new positions in the past few months, many higher-quality businesses are approaching levels that warrant our attention.
The Chinese stock market was down 30% from its peak and was the first to enter a bear market.8 This has provided a number of opportunities to find attractive valuations. In 2018, we initiated positions in five new businesses (including two in the fourth quarter). Here is some insight into the two most recent initiations.
Alibaba (NYSE:BABA): This is a company we have talked about many times and wanted to own but could never make sense of the valuation. With Alibaba falling from its June 2018 peak above $210 into the $150s and below in October, valuation became reasonable and provided the opportunity to take an ownership position. After stripping out the cash, the company was trading at less than 20x earnings when we initiated our position in the fourth quarter.9 (1.09% of Invesco International Growth Fund as of Dec. 31, 2018).
Alibaba has briefly traded at comparable valuations in the past, so what makes this time different? Previously, the valuation was heavily skewed toward e-commerce, as the company's nascent businesses (such as Ant Financial and Cloud) were small and contributed significantly less to the valuation. Today, many of these businesses are well-established and their path to profitability is more visible, making it easier to assign a valuation. Also, Alibaba has accumulated significant stakes in listed entities that did not exist several years ago, giving us more confidence on the valuation than in the past.
New Oriental Education (NYSE:EDU). This was our other initiation in the fourth quarter (0.82% of Invesco Asia Pacific Growth Fund, 0.86% of Invesco Developing Markets Fund, and 0.25% of Invesco International Growth Fund as of Dec. 31, 2018). New Oriental Education's stock price was above $100 in June 2018, and the company was trading at 30x earnings after stripping out the net cash. The stock subsequently fell into the $50s with valuation improving to a more reasonable 15x ex-cash.9 This is the largest private education provider in China, with services including English language courses, college admission test preparation, K-12 after-school tutoring and more. New Oriental Education is a highly profitable business that generated a 20% return on invested capital in the last fiscal year.10 We believe concerns around increased government regulation of the education sector likely fueled the sell-off in the stock. The government is trying to increase the formalization of the education industry (a majority of teachers did not have certifications and a large portion of providers had no business license in sampled cities). This near-term uncertainty gave us the opportunity to buy the company at a reasonable valuation. The government has begun to force unlicensed providers to shut down, and the large reputable/compliant players (like New Oriental) should benefit.
Japan and China were the two biggest homes for capital deployment during the quarter. There is a common theme among the stocks I mentioned - both were market darlings and very good businesses that had fallen from unusually high valuation levels. Sometimes the market gets enamored with a good story. But growth can't continue straight up forever, and market psychology changes along with expectations. This is why our bottom-up EQV process places a great deal of emphasis on valuation.
1 Sources: Invesco, MSCI and FactSet, data as of Jan. 16, 2019
2 Source: Bank of America Merrill Lynch, recessions included were those in 1991, 1998, 2001, and 2008
3 Sources: Bloomberg L.P., Macquarie, data representing the calendar quarters ending on Dec. 31, 2018
4 Sources: Bloomberg L.P., Bank of America Merrill Lynch and Macquarie, data as of Jan 16, 2019
5 Source: Bloomberg L.P., as of Jan. 16, 2019
6 Source: Citigroup, as of Jan. 16, 2019
7 Sources: FactSet, Citigroup and MSCI, data as of Jan. 16, 2019
8 Sources: Bloomberg L.P., CSI 300 Index, data as of Jan. 16, 2019
9 Sources: Bloomberg L.P., FactSet, data as of Jan. 16, 2019
10 Source: Bloomberg L.P. and company financials, data as of Jan. 16, 2019
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Holdings are subject to change and should not be considered buy/sell recommendations.
The MSCI All Country Asia Pacific ex-Japan Index is an unmanaged index considered representative of Pacific region stocks, excluding Japan.
Gross domestic product is a broad indicator of a region's economic activity, measuring the monetary value of all the finished goods and services produced in that region over a specified period of time.
The Purchasing Managers' Index (PMI) is considered an indicator of economic health for the manufacturing sector.
A basis point is one hundredth of a percentage point.
Forward earnings are company's projected earnings over the next 12 months.
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The deteriorating state of earnings in Asia by Invesco US
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