China businesses are unattractive to investors

Emma Wall  |  20/04/2016Text size  Decrease  Increase  |  

Emma Wall: Hello and welcome to the Morningstar series, "Why Should I Invest With You?" I'm Emma Wall and I'm joined today by Mark Asquith, Manager of the Somerset Capital Emerging Markets Small Cap Fund.

Hi, Mark.

Mark Asquith: Hello.

Wall: So, I thought we'd start with China. It's the biggest part of emerging market investing and it's somewhere that you're not feeling too positive about at the moment, is it?

Asquith: Yes, easy to say after it collapsed in the second half of last year and the beginning of this year. I think it's like the baddie at the end of the Western who gets shot and then you think he is dead and he comes back with a hidden weapon.

China is not particularly attractive from a bottom-up perspective. Valuations are better, but fundamentally the businesses remain unattractive. They are in a system which is largely rigged by state-owned players which makes it very hard to compete against them, especially in the small cap space and regulated pricing, along with vested interest. So, it doesn't make for a particularly healthy industry landscape.

Then from the top-down view, they have been running like a rat on the wheel since 2008 when there was a huge fixed asset investment and the concomitant debt overhang, given that there weren't prices available to generate returns on that investment. So, they tried to equitise the heavily indebted companies at the beginning of last year, hence you saw the huge rally which then collapsed as people decided these weren't good credits.

They then doubled credit growth at the end of last year. So, we're in quite a scary situation, but they may have one last weapon and that could be they double credit growth again or they may devalue the currency. But both have profound influences for the world. You may get a strong deflationary pressure; you may get strong inflationary pressure.

Wall: And of course, as a stock picker, all of that is just background noise, validating your decisions not to go for these companies because their investment case is not compelling?

Asquith: It's nice when they both align. So, if both top-down and bottom-up are negative, then it's an easy avoid. I say easy, but at the beginning of last year we had almost nothing there and it was going through the roof, that's less easy.

Wall: I know that you put some cash to work at the end of 2015 into areas that you saw opportunities in, one of them being South African stocks, which I think a lot of investors know very little about with the exception perhaps of Tiger Brands (UG5A). What investment opportunities are there out there?

Asquith: So, it's the best performing stock market since 1900 which a few people know and you see very high returns on capitals and the companies there. So, those are two symptoms. What are the causes of those symptoms? It has actually an incredibly wide range of industries and wide range of listed industries, everything from quite strong construction / road building firms, right the way through to branded goods and they have been forced to develop those because of apartheid.

So, you've got that wonderful range of sectors to invest in, very good management teams and a lot of strong compounding growth stories, so something likes Clicks (CLS), which we bought recently, is basically the Boots pharmacy of South Africa with tremendous growth.

It wasn't one of the cheap stocks we bought last year, 19 times earnings, but I think its growth is being drastically underrated. Something like Raubex (B7P), which is a road builder, was trading at five times price to earnings, 0.5 price to book, with a good balance sheet, competitive advantage in a cyclical industry where we're seeing supply exiting. So, a couple of opportunities there.

Wall: And looking then across the other side of the globe, I know South America is also an area where you have been deploying cash. I think a lot of concern about that region has been oil price and commodity-related. However, it seems like you are finding opportunities there?

Asquith: Yes. I mean, as ever, the starting point is, these are stock markets, not GDP markets or commodity markets and it's the quality of the companies and the prices you get them at which dictates the opportunity set. You can buy the entirety of South America for less than the Taiwanese weighting in the MSCI Index, less than the Korean weighting. I mean, Mexico, Chile and Brazil together has some 12%, 13%, they are miniscule compared to what they are. No one wants to be there. They have had a little pop recently. There may be a drawback. But there are plenty of good Brazilian small cap companies…

Wall: And not all related to energy, or are you seeing opportunities there?

Asquith: Again, few related to energy. I wouldn't touch Petrobras (PETR4), but you can buy in Brazil M. Dias Branco (MDIA3), which is the number one pasta and cookies manufacturer. We're buying at 11 times price to earnings. Staple stocks have been at 30 times for years. You can buy Porto Seguro (PSSA3), a fantastic auto-insurer. Everything they do only increases their barrier to entry, their stickiness with the customer. Again, you can buy that almost single-digit P/E multiples.

In Mexico, I've just been talking to ARA (ARA), one of the homebuilders there, and the industry has seen huge bankruptcies over the past five or six years, declining returns for a decade and growth is coming back and they are available at very cheap valuations.

So, South America, much hated, doesn't make up much of the index, worth looking at. China, Korea and Taiwan together make up about half the index; I think there's still trouble there, although they may be jumping up and making a little more appreciation this year. But long-term, there are other areas to look at in GEM.

Wall: Mark, thank you very much.

Asquith: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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