Asian Exposure

Tiburon eyes up the opportunities awaiting its portfolios

MARK MARTYROSSIAN, RICHARD PELL-ILDERTON AND MARK FLEMING, TIBURON PARTNERS

“In the next big leg down in Asia, I’ll be there” is a common refrain from investors these days. Structural bulls of Asia to a man, most have watched the rally since March with scepticism (“it’s a bear market rally and will end in tears”) that has, over the last three months, turned into increasing concern (“I’m not in it”) as Asian markets have gathered a head of steam.

Those that bought into the “decoupling” trade in 2007 only to see Asian markets underperform markedly in the first half of 2008 and then correlate hideously post the collapse of Lehman Bros were perhaps understandably sceptical earlier in the year. Theirr lack of confidence was reinforced by the widespread view that Asia, as workshop of the world, is so heavily export dependant. The argument is simple: with the western consumer flat on his back then Asia will struggle. Right?

Well, wrong actually – clearly there are several export dependent sectors represented in Asian markets but Asian economies will not fall in a heap while the western consumer repairs his balance sheet. China’s net exports for example represent some 12% of the economy. Asian domestic economies are alive and well.

Don’t hold your breath
So to all those who remain cashed up waiting for the next “big leg down” in Asia, we say “don’t hold your breath”. The panic about whether your money was even safe in the bank is a thing of the past. The nationalisation of large swathes of the western banking system removed the risk of systemic failure and capital markets have begun to function again. Trade finance has once more started to flow. Confidence has returned. And of course the global economy will, after the usual lag, start to benefit from the torrent of supportive fiscal and monetary measures unleashed by governments and central banks. Interest rates are at record lows around the world. Quantitative easing has taken place in a number countries and fiscal policy has been loosened worldwide.

The reason why so many investors remain marooned in cash lies in the nature of this recession. Unlike “normal” recessions, the one we are experiencing was caused by a financial crisis rather than problems in the real economy or increasing interest rates. A direct consequence has been the most violent inventory cycle that we have ever seen. With the disappearance of financing for several months, businesses liquidated everything that was not nailed down. Against a backdrop of industrial production and GDP figures tumbling, extrapolation became the name of the game: two poor data points became the harbinger of a descent into the abyss. In the panic, what many in the market failed to notice was that demand, whilst anaemic, was by no means as bad as the destocking figures suggested: Taiwanese electronic revenues for example were down by 70% to 80% in the fourth quarter of 2008 as the production channels ran dry whilst the data we were seeing suggested that end demand was down but by nowhere near as much (15% to 20% perhaps). Is it any wonder therefore that TSMC’s utilisation rate has since spiked from 40% to 85% over the last several months?

And then of course there is the volte face in policy from Beijing. Having had its foot firmly on the brake for the better part of 18 months in an attempt to head off fixed-asset investment and deflate an insipient property bubble, China changed tack in November. Much of the slow down in Chinese growth was therefore “self inflicted”. But in the febrile atmosphere of last year this downturn in growth caused even more alarm: even China, the engine of growth, was stalling. . Once again, in the panic investors were slow to appreciate the significance of Beijung’s move from brake to accelerator.

Unlike their sickly counterparts in the West who ignored governmental exhortations to lend to beleaguered consumers and simply hoarded cash, the Chinese banks flooded the system with loans. Undoubtedly some of this cash will have already found its way onto the gaming tables of Macao, the A-share market and other similarly “productive” forms of investment. And the bears will suck their teeth and warn of non-performing loans down the track. Although the pace of lending will certainly slow, the Chinese engine is purring again and, after a weak first quarter, growth will be back up in the high single digits for the year.
All good stuff but extrapolation is a dangerous game and it would be just as wrong to extrapolate the recovery continuing to move in an uninterrupted fashion upwards as it was to assume the death spiral that was consensus a few months ago. Commodity prices have probably bottomed, but in some cases the rebound is a result of price sensitive Chinese strategic buying – particularly copper. One cannot assume the same level of interest at $2.50/lb as there was at $1.50. There was even conjecture in the market a couple of weeks back that the Chinese would turn sellers at the margin – how about that as a catalyst for a retracement?

As markets have rallied and shorts have been covered it has dawned on participants that not every company with debt will go bust. This change in perception is where the quick, easy money has been made. Many of these opportunities have played out. In many cases, particularly for some of the highly geared cyclicals which have been forced to raise a lot of money at recent prices, the capital raising is highly dilutive and per share asset values have fallen as a result. Together with stock prices rising by between 50% and multiples from recent lows, a lot of value has been priced out of these sectors.

So are we bearish?
So are we bearish? Not by a long chalk!! Whilst we are cautious on Asian indices, we are very bullish on Asian prospects and the mispricings that remain in our universe. At the same time as risk appetite has returned, many ‘defensive’ stocks have collapsed. ‘Expensive’ defensives are now ‘dirt cheap’ defensives. A lot of stocks in sectors such as healthcare, utilities, infrastructure, consumer staples and even a few unloved later cyclicals such as media are now offering the sort of value proposition that a lot of the now sexy, then toxic stuff did in February.

Record low absolute valuation multiples – often 30% less than those on offer three months ago – and relative valuations that have fallen by around 50% over the same time period make a seductive risk/return proposition. These companies will not need to raise capital, earnings estimates have been pretty stable and if the rally continues – which we think is likely given the huge amount of cash still sitting on the sidelines – investors will feel comfortable allocating fresh money to these types of businesses. If the market corrects, these will not be the first things the fast money sells as it no longer owns them.

We have not abandoned cyclicals altogether, as there are still a few names which have done relatively little, but the portfolio is now concentrated in these laggard sectors. While it would be reckless to assume the sort of returns over the remainder of the year that we have enjoyed so far – circa 45% – we can see a realistic prospect of solid, double digit returns, though with a likely near-term pullback in a few of the more overbought indices. The good news from a market perspective is that recent action has opened up a polarisation in valuation between cyclicals and defensive names, which provides the next great opportunity for the active manager. It is at times like these that active management comes into its own, (see Figs 1 and 2).

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With the turmoil in the markets the analytical fraternity have also contributed to the pool of mispricings and opportunities at the stock level. With stock prices rocketing many have been busily tweaking their weighted average cost of capital, perpetual growth rates and ‘fair’ discounts to NAVs to keep up, when in fact fundamental influences have changed little over the last few months. This trend is particularly obvious in the property sectors in Hong Kong and Singapore. There the embarrassment factor of pitching your target price at maximum discount to a forecast falling NAV becomes acute when perception shifts to a steady NAV – as has been apparent from the data over the last few months – and the discount narrows to average or even bull market levels. The key word here is perception. The looming oversupply in Singapore office space and the pressure on rents in Hong Kong have not gone away. Indeed, the sharp move up in sovereign yields must pressure capitalisation rates and hence market prices when the estate agents wake up. The market has just chosen to view the glass as half full rather than half empty. We view it as time to leave the bar for some fresh air after a fantastic near term profit.

Politics play their part
Politics have also played their part in creating opportunities in the region. The Korean market has been upset by the escalation of provocation by the North by ‘testing’ missiles, detonating a 20 kiloton device and talking about moving to a ‘war footing’. The knee jerk reaction of selling the market and currency down provided an opportunity to buy some of the ‘safe and boring’ companies alluded to earlier, particularly in tobacco and food where there are some real bargains compared to the elevated multiples that some of these types of businesses sell at elsewhere in the region.

In India, politics have provided opportunities on the other side of the ledger: This recent election result caused a 20% move up in the market as Congress was returned with an enhanced majority and will be less beholden to minority coalition partners. Good news if you are a Congress MP looking for a plum job, but rather less obviously great news for investors. Indeed for the IT, pharmaceutical and other export orientated industries the result is an unambiguous negative as the 5% appreciation of the rupee will decimate their earnings if this level of the currency is sustained.

The bulls will tell you that reforms will now come thick and fast and that infrastructure spending will accelerate. With a federal budget deficit of 10% already (and a lot more if you include state deficits) we doubt much more is feasible. Yet the big contractors have risen 40% in a few days, and now trade on 25 times earnings. Banks and other high beta domestic plays have moved in similar fashion. Again we struggle to rationalise this.

In Australia, the politicians have played a part. Having rebuffed the bid for Ozminerals’ Prominent Hill, they will also be held culpable in Chinese eyes for Rio’s snubbing of Chinalco, which was then made much worse by the announcement of the Rio/BHP iron ore joint venture, neatly creating a duopoly from the prior three player market. Yet the Chinese need minerals, and can’t afford to throw all the toys out of the pram and walk away.

We expect the response to be a ratcheting up of interest in Africa and South America together with a focus on smaller Australian deals which fly under the political radar screen. We also expect a wave of deals in junior iron ore miners as Chinese steel mills look to create some tension in price negotiations, and the fund has added to its exposure here as well.

Hatchers and parapeters
No matter how unpleasant the pain trade has been as equity markets have rallied, resistance to re-entering the higher beta Asian markets remains considerable. Reluctant investors fall into two broad camps: the “hatchers” (as in those who have battened down there portfolios) and the “parapeters” (as in those who are peering over the top).

The hatchers remain implacable: we are not out of the woods yet they warn. They point darkly to the recent dire warnings from both the European Central Bank and the International Monetary Fund about the Euro zone and British banks. Listen to Mervyn King, say the hatchers, quoting his recent speech to the Mansion House: “Stress tests designed to assess the viability of banks are very different from tests of the capacity of the banking system to finance a recovery”.

Most hatchers are deaf to all arguments that suggest Asia is not totally prey to the woes that have so severely afflicted western economies. And even those who are not point dismissively at valuations. Even at the lows of November last year Asia was on 1.2x book – that’s nowhere near the lows it struck during the Asian crisis of 0.8x book.

But in 1997 things were very different: large tracts of the region were bust. Companies galore went to the wall. Some countries even. Banks were being hammered as non-performing loans ballooned and some borrowers just evaporated with currencies in freefall. Asia is very different today. Gearing is now relatively modest and many companies are sitting on net cash. Structurally, profitability is better and equity bases are much more solid.

The parapeters, whilst more biddable cannot bring themselves to jump aboard after the run we have had. It is the parapeters who hold the key in our view – they see that the future is Asian and are looking to finesse an entry point. For all their talk of a “big leg down” we suspect the weight of their cash and the opportunity cost of holding it will prove decisive in making any leg down we see a modest one.

The move away from cyclicals and into cheap defensive and/or growth names we made in early May has continued apace, and has been a phenomenon observed in most markets. It seems increasingly consensual that a major restocking cycle is underway, and while this may have another quarter or so in it, the markets have clearly priced some of this extra improvement already. How they will react to the inevitable slowdown in activity once the supply chain has been re-filled is unknown. We have a sneaking feeling that straight line extrapolation of data points has become an essential analytical tool, fuelled by a long period of economic expansion. It is unlikely to be as useful over the next few years as economies work their way out of the debt mountain and perceptions of the inflation dynamic fluctuate.

Companies themselves are wasting no time replenishing their funding, and equity issuance is running at unprecedented levels, recently augmented by a few IPOs and an increasing number of opportunistic placings from insiders. This again points us towards the unloved defensives with no need for new capital and share prices too low to prompt insider selling.

The attraction of defensives is not peculiar to Asia. We have seen it playing out recently in a number of different markets. In our view, Asia still has the advantage of superior fundamental influences and whilst no means unaffected by the woes of the West has underappreciated domestic dynamics playing out in a number of markets. Where perhaps we differ from a number of our peers who are playing the same game is that further out, though demand may remain modest in Asia, it will be better than elsewhere and that the inflation trade will pay dividends.

The Western World’s pensioning provision has recently been highlighted by several high profile closures of final salary pension schemes. The (politically unpalatable) realisation is dawning that public sector retirees are entitled to fantastic and completely unaffordable deals which will be in large part funded by current generation private sector workers – who will become a rapidly shrinking part of the overall population as fertility falls and longevity rises. It will finally dawn on the populous that they need to save more – a lot more.

Most Western Governments will need to slash spending and raise taxes. This is clearly a toxic combination as far as growth is concerned, and will speed the accession of savings-rich eastern economies up into the Premier League of developed countries, while requiring their own consumers to spend more.

For anyone in the West who doesn’t want to retire in penury, long-term investing in Asia looks more and more essential.

ABOUT THE AUTHORS

Mark Martyrossian has been engaged in Asian investment banking since 1986. From 1991 to 1997 he worked for Crosby Securities, later SocGen-Crosby. In 1997 he became an executive director at Warburg Dillon Read before leaving Hong Kong to establish Tiburon Partners with Richard Pell-Ilderton in 2002.

Richard Pell-Ilderton qualified as a solicitor in 1985 and practised in the area of securities law and regulation for 10 years with the City law firm of Wilde Sapte, now Denton Wilde Sapte. In 1996 he joined SocGen-Crosby in Singapore. He left the Far East to set up Tiburon Partners with Mark Martyrossian.

Mark Fleming commenced his Asian fund management career in the early 1980s. In 1986 he joined British Airways Investment Management Limited. In 1995 he was appointed head of international equities. He also managed the Asian portfolio for the performance fund. Mark joined Tiburon Partners in 2003.