Hermes Emerging Markets Asia manager Jonathan Pines says the recent shift out of defensives into cyclical stocks has been indiscriminate and that the next phase will be a refocus on quality.
Pines is looking to find cyclicals with strong balance sheets which he believes are less likely to suffer long duration down cycles and expects to profit from the market’s return to focusing on strong company fundamentals after the recent 'dash for trash'.
Strong balance sheets
He told Citywire Global: ‘The shift to cyclical stocks has been indiscriminate as low quality stocks have been attracting as much attention as quality cyclicals but we think that in phase two the market will start to be more discriminating among cyclicals and there will be greater demand for the better quality cyclical companies, with stronger balance sheets, higher quality assets and shorter duration down cycles.’
Pines cites his largest holding, Chinese port company Cosco Pacific, as a case in point, which although it is cyclical in nature, has still managed to produce steady earnings through its down cycle.
‘Cosco Pacific is trading on a price to book of 1.2x. It has high quality assets which will probably be around in 100 years’ time. Its earnings are cyclical but it has been consistently profitable for each of the last at least 17 years and so has produced consistent NAV growth even in cyclical down periods.'
He compares that to some firms in the steel and shipping sectors, which had strong performance last year in the ‘dash for trash’ but which he thinks could experience major drawdowns when the market cycle turns back against them.
Central to Pines’ investment process is to pick stocks he believes have limited downside risk, rather than those that potentially can make the biggest gains.
‘When we get a stock wrong we don’t lose a lot of money because we buy stocks with a high margin of safety, which comes from a process of looking to buy stocks cheaply relative to their quality, which tend to have less debt too.’
Two key examples are top 10 holdings in Korean department store Gwangju Shinsegae and Chinese sportswear brand China Dongxiang.
Pines likes the former because it has around two thirds of its market value in cash and short term investments, while he expects China Dongxiang to perform better from here.
‘We started buying China Dongxiang at around 70 cents per share. It has around 1.20 per share in cash and short term investments, so as investors we are not paying anything for the company’s operations.
‘Before buying we [wanted to make sure] the company was no longer making losses or depleting its cash and it appears to have a responsible management team in terms of cash preservation. While it is unlikely to get back to the highs of 2007, it has good upside from here.’
Another key holding is Apple’s largest components supplier Taiwanese Hon Hai Precision which Pines believes has a good chance of dramatically increasing its margins thanks to the sheer scale of its business.
Apple is Hon Hai’s biggest customer and has thus been able to squeeze Hon Hai’s margins. But the balance of power might be shifting as there are not many companies like Hon Hai that can offer such a huge workforce of nearly 1 million.
Because Hon Hai’s margins are so thin [1.5%], a very small single digit increase in the price of Apple’s end product could theoretically allow Hon Hai’s profitability to double.
While there are concerns over the weakening Japanese currency’s impact on Korea’s exporters, Pines is still finding attractive value opportunities in the country as he can access companies such as car maker Hyundai and tech giant Samsung Electronics through the preference share market at much cheaper valuations than the ordinary shares.
‘In Korea, preferred stocks trade at a discount of up to 70% to ordinary shares. In the case of Hyundai, the ordinary shares are on a price to earnings ratio of 6x while the preference shares are trading at 1.5x which is quite tempting.'
The fund continues to avoid quality defensive stocks such as Unilever Indonesia, as Pines thinks the sector has got to incredibly high historic valuations.
‘The flight to quality was especially pronounced in Asia and because there are very few value opportunities in Asia, when you find them the differentiation between quality and cyclicals is huge.’
Pines is avoiding Chinese banks as he believes that while loan growth fundamentals look promising, there is still a lack of transparency over their business models.
He has no exposure to the Philippines and has a big underweight to Indonesia as he thinks both countries now look very expensive after strong market runs.
‘The Philippines has always traded at a discount to China, but it is now trading at double China’s valuation.'
Since launch in January 2010, the fund has returned 53% compared to the MSCI ac Asia ex Japan return of 18%.