In the second quarter, the Wasatch Emerging Markets Small Cap Fund gained 2.61%, but underperformed its benchmark, the MSCI Emerging Markets Small Cap Index, which gained 4.50%. Emerging-market equity returns were mixed but saw continued strength in North Asia. China and Hong Kong, while volatile, ended the period with outsized gains and the Fund’s underweight position in China and the underperformance of our holdings there detracted from performance relative to the Index. The Philippines and Indonesia were both weaker markets.
While China continued to dominate the conversation in emerging markets, there have been interesting developments in other markets as well, and we have found many attractive opportunities. Historically, Korea has been a value-oriented market dominated by the chaebols.†† However, there is a next generational entrepreneurial shift going on. This shift is toward more knowledge-based areas like health care, e-commerce, online and technology. When a cultural shift like this occurs in the equity markets, it is seen first in the small cap universe. Wasatch has been building our Korea portfolio over the past three years. While we’re still structurally underweight versus the benchmark in Korea, our companies outperformed this quarter. Hanssem Co. Ltd., a manufacturer of kitchen and bathroom furniture, Medy-Tox, Inc., a developer of biopharmaceuticals for cosmetic applications and the treatment of muscular disorders, BGF Retail Co. Ltd., a convenience store chain, and InBody Co. Ltd., which produces an interesting technology for measuring fitness and body composition, were all top 10 contributors this quarter.
Taiwan is another interesting market. Taiwan, along with India, has the highest number of quality small cap companies. It also has a supportive macro environment with a strong current account surplus, stable growth and strong currency stability compared to the U.S. dollar. Taiwan’s equity market is broadening beyond technology, and the country’s economic integration with China is continuing with many companies seeing growth from their Chinese investments. The Fund and the benchmark are approximately equal-weighted in Taiwan at over 17%. In the second quarter, our portfolio companies significantly outperformed those in the Index adding nicely to relative performance. Ennoconn Corp., which develops industrial motherboards, and PChome Online, Inc., an online shopping service, were both top contributors this quarter.
Our overweight position in the Philippines detracted from relative performance, as this was a weak market. We have been overweight in the Philippines for a number of years, as we like the country’s strong macro backdrop. Structurally, we think the Philippines is in very good shape with a current account surplus and a strong banking system. In addition, economic growth is increasingly supported by home-country consumer demand that stands to benefit from lower oil prices. While growth slowed slightly in the first quarter of the year, it is still solid. Melco Crown Philippines Resorts Corp., Security Bank Corp. and Bloomberry Resorts Corp. were among the detractors from the Fund’s performance for the quarter.
China’s capital markets have seen a lot of changes in the last few months. In addition to the changes in China’s financial markets, there are ongoing economic changes and reforms happening in China, which have direct impact on China’s financial markets, most notably the reform of state-owned enterprises (SOEs). The following is our take on what the state of play is at the present time, how we see things developing, and how we have positioned our emerging market portfolios for these changes.
Where Are We Now?—A Quick Summary
The Shanghai-Hong Kong stock connect††† program was launched November 17, 2014. The Shenzhen-Hong Kong stock connect program is expected to be implemented later this year. This will mean a large number of domestic Chinese stocks can be bought through the Hong Kong Stock Exchange.‡ Chinese investors can also buy Hong Kong stocks through their exchanges—the Shanghai Stock Exchange‡ and the Shenzhen Stock Exchange.‡
MSCI, a U.S.-based provider of global indices, will add Chinese stocks listed in the U.S. (Alibaba and Baidu,‡‡ for example) to its Emerging Markets/China indices later this year. Recently, MSCI made its long awaited statement on whether it would include A-shares, which are denominated in China’s currency the yuan and traded on the Shanghai and Shenzhen stock exchanges, in the MSCI Emerging Markets Index (we have details below).
Just recently the China Securities Regulatory Commission (CSRC) and the Securities and Futures Commission (SFC) of Hong Kong jointly announced the Mainland-Hong Kong Mutual Recognition of Funds (MRF) initiative, which means that Hong Kong domiciled funds can be eligible (subject to certain criteria and quotas) to be offered in China. “The Memorandum provides a framework for mutual recognition of publicly offered funds between the CSRC and the SFC so that these recognised funds could be offered to the public in both markets. This initiative represents a significant milestone towards strengthening regulatory ties and cooperation between the CSRC and the SFC.” (“Circular on Mutual Recognition of Funds (MRF) between the Mainland and Hong Kong,” Securities and Futures Commission of Hong Kong, May 22, 2015). This initiative will increase the choices for Chinese domestic investors, which is part of the long-term agenda. The present structural challenge for domestic investors in China is the lack of maturity and depth of their markets.
What Is the Impact of the MSCI Announcements?
MSCI announced on June 9th that China’s A-share markets (Shanghai and Shenzhen) would be included in its global indices but not in 2015 as had been expected. Now, 2017 is likely to be the earliest time as MSCI continues to work with Chinese regulators to iron out some remaining issues. Concerns for institutional investors that argued against immediate inclusion of A-shares were lack of clarity on quotas (for qualified foreign investors) as well as within the stock connect programs. Some investors do not have access to A-shares. If these shares were included before these concerns were addressed, the benchmark would not represent a level playing field.
With the 2017 timeframe, it is possible that China weightings would increase from the weights today as more stocks are listed, although this also depends on the valuations‡‡‡ of component stocks. China will become the elephant in the MSCI Emerging Markets Index, challenging the diversity and breadth of the Index. “According to MSCI, if all A-shares were to be included at their full weighting, China would take up 43.6% of the emerging markets index.” (“As non-events go, this was a big one,” John Authers, FT.com, June 9, 2015). With China’s likely weight being significant, the emerging market indices may end up getting diced and sliced differently (e.g., an Emerging Markets ex-China Index).
Are There Useful Precedents in Market History?
It is hard to find helpful precedents for what is going on now in China and its financial markets because of the scale and potential impact in terms of the integration of China’s capital markets, its financial opening up and drive toward the internationalization of the renminbi (another name for China’s currency). Asset managers, index managers and those who define the indices (like MSCI and FTSE) have had a hard time keeping up with the pace of change. When China was not open, it operated on the periphery of the global capital markets. Today, as China has opened up its financial markets, it is a recognized central player on the global stage reflecting its economic heft.
Will China Become a More Significant Capital Exporter?
Just as China will import capital in the next few years via foreign direct investment and its equity and bond markets, it will also become an even larger capital exporter, reflecting the scale of its economy and the desire of Chinese individuals and corporations to own more assets overseas. According to a Bain & Company report, “Based on International Monetary Fund data, we project that China will add $87 trillion (calculated at fixed 2010 exchange rates) to the growth of total global financial assets by 2020…That is more than four times the amount of capital that will be generated by the Japanese economy and will surpass both the US and EU by some $25 trillion.” (“A World Awash in Money: Capital Trends through 2020,” Bain & Company, 2012, p. 9 - 10). Financial assets are added as a multiple of gross domestic product (GDP)§ and not all of China’s changes will result in capital exports. However, it is likely the amount of financial assets exported from China into other countries’ financial sectors will increase as China develops a more global financial portfolio, and as Chinese corporations increase mergers and acquisitions.
The same Bain & Company report noted that one of the main risks of this superabundance of capital is the creation of asset bubbles. In the past, China’s bubbles have usually been domestic, however, the sheer amount of capital that China will add to the global financial markets suggests that cross-border bubbles can be created.
We should be concerned about valuations in Hong Kong and China. Many signs point to speculative excesses in Chinese stocks and these excesses can get exported to the Hong Kong market (arguably, we have seen this in the property market). Money seeking to diversify is not always valuation sensitive. There should be concerns that by making foreign investors “forced investors” (through MSCI indexing) in a domestically-driven bubble, we endanger other investors. The deflating of Japan’s bubble was primarily domestic. As John Plender pointed out in a recent article, “Bubbles come in different shapes and forms, but it is striking how often they are the byproduct of attempts to make difficult economic transitions.” (“Why China is blowing an equity bubble,” FT.com, June 9, 2015).
There are essentially four separate exchanges—Hong Kong, U.S., Shanghai and Shenzhen— which hold significant weights of Chinese equities. The onshore markets of Shanghai and Shenzhen have largely been inaccessible to foreign investors. These stock markets are becoming more accessible this year but after they have had large run-ups. The Hong Kong and U.S. markets for Chinese stocks have largely been driven by institutional investors and valuations have generally reflected that (and more global valuations). A very different crowd has driven the run-ups in the Shenzhen and Shanghai stock markets, reflecting a less institutionalized investment environment.
The Shenzhen Stock Exchange could be considered the Nasdaq of China. It lists the stocks of younger companies, manufacturers and electronics start-ups. It has fewer of the SOEs that are an important part of the Shanghai Stock Exchange Composite Index.§§ Shenzhen has had more time than the Shanghai Stock Exchange did to digest the fact that it will be connected to Hong Kong so Hong Kong investors can buy Shenzhen listings and those in Shenzhen can buy Hong Kong Stock Exchange listings. The phrase “irrational exuberance” can most definitely be applied to the Shenzhen Stock Exchange. The two largest members of the Shenzhen Composite Index§§ are Shenwan Hongyuan Securities Co. Ltd. and Guosen Securities Co. Ltd.,‡‡ both securities companies. Shenwan has a market capitalization of US$47 billion and a price-to-earnings (P/E) ratio§§§ of 38. Guosen has a market capitalization of US$45 billion and was up 149% year-to-date through June 30, 2015. Guosen has a price-to-book value# of 8.6. Contrast this with Goldman Sachs‡‡ and its market cap of US$96 billion and its price-to-book value of 1.2. Overall, it is interesting to note how many China-listed securities firms have market caps above US$15 billion (I calculate 11 in total). The total market capitalization of securities companies listed in China is US$400 billion, and that does not include banks, which have mammoth market caps.
Another set of data points provides insight into valuations. Shenzhen has some 1,730 members in its composite index. Of these, 177 have market caps above US$5 billion. Roughly half of these names have price-to-book ratios of over 10 times. This is astonishing. In this select group many companies have P/E ratios above 50 and some are over 100.
The Shanghai Stock Exchange is more dominated by SOEs like banks. We expect China’s policymakers to continue pushing for SOE reforms as they realize the negative drag on investment and GDP development these entities have had. They will likely force SOEs to become more focused on returns on equity and capital. Shanghai investors have been less crazed about the market since it does not exude the technology spirit that Shenzhen does, although its chart does resemble gazing at the Tetons (a sharp ascent). As of June 30, 2015, the Shanghai Stock Exchange was up over 113% since a year ago! Using our quantitative screens we can see that some 600 names out of the 990 Shanghai-listed names with market caps above US$500 million have price-to-book ratios above 5, which we consider to be high.
With both the Shanghai and Shenzhen stock exchanges, there are some interesting parallels to the U.S. markets in the late 1990s. If we look at SOE banks, they are inexpensive to reasonably valued (under 1.5 times book value) depending on one’s view of the transparency and solidity of their balance sheets. Some areas of these markets are low priced (which makes the averages look more reasonable) especially in the financials sector, just as there were undervalued sectors in the U.S. market in the late 1990s (non-Internet names with real assets). There seems to be a “new generation” of investors who are bidding up technology and Internet names in China. The generational divide was very evident in the U.S. Internet bubble, which burst in March of 2000.
How Does This Affect Our Positioning?
We are not inclined to own China’s A-shares at the present time, as the small pockets of stocks with reasonable valuations are unlikely to be protected. Much of the movement in the A-share markets can be seen as policy driven initially (with exuberance driving these markets on from there). Shenzhen had run up nearly 75% year-to-date through June 30, 2015 and Shanghai had climbed over 33%, with all the signs of overvaluation (which does not mean these markets cannot keep going up). Higher interest rates are unlikely and controls on margin debt may not be enough.
At present, China’s weight, which consists of stocks listed in the U.S. and Hong Kong and on other international exchanges, in the MSCI Emerging Markets Index is 25%. For now, we are comfortable being underweight (in the 14% to 16% range) relative to the Index where we tend to own lower beta## names. Recent names we have added include Towngas China Co. Ltd., a growing utility in natural gas, and Yuexiu Transport Infrastructure Ltd., a toll road operator with a strong track record. (Current and future holdings are subject to risk.)
What we do see at the present time is strength in North Asia, particularly in China, Taiwan and Korea, and we see opportunities overall in these markets. The Taiwan market especially continues to grow its breadth of interesting small companies.
We very much thank our investors for the faith they have shown in us.
Roger Edgley, Andrey Kutuzov and Scott Thomas
Source: MSCI. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties or originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (www.msci.com)
††The word “chaebol” means “business family” or “monopoly” in Korean. The chaebol structure can encompass a single large company or several groups of companies. Each chaebol is owned, controlled or managed by the same family dynasty, generally that of the group’s founder.
†††The Shanghai-Hong Kong Stock Connect is a mutual market access program, through which investors in Hong Kong and mainland China can trade and settle shares listed on the other market, respectively, via the exchange and clearing house in their local market.
‡The Hong Kong Stock Exchange, one of the world’s largest securities markets by market capitalization, traces its origins to the founding of China’s first formal securities market, the Association of Stockbrokers in Hong Kong, in 1891. A second market opened in 1921, and in 1947 the two merged to form the Hong Kong Stock Exchange. The Shanghai Stock Exchange is the largest stock exchange in mainland China. It is a non-profit organization run by the China Securities Regulatory Commission (CSRC). The Shenzhen Stock Exchange, based in Shenzhen, Guangdong, is one of China’s three stock exchanges. The other two are the Shanghai Stock Exchange and the Hong Kong Stock Exchange.
‡‡As of June 30, 2015, the Wasatch Emerging Markets Small Cap Fund was not invested in Alibaba Group Holding Ltd., Baidu, Inc., Shenwan Hongyuan Securities Co. Ltd., Guosen Securities Co. Ltd. or Goldman Sachs Group, Inc.
‡‡‡Valuation is the process of determining the current worth of an asset or company.
Return on equity (ROE) measures a company’s efficiency at generating profits from shareholders’ equity.
§Gross domestic product (GDP) is a basic measure of a country’s economic performance and is the market value of all final goods and services made within the borders of a country in a year.
§§The SSE Composite Index is a stock market index of all stocks (A shares and B shares) that trade on the Shanghai Stock Exchange. The Shenzhen Composite Index is an actual market-cap weighted index (no free float factor) that tracked the stock performance of all the A-share and B-share lists on the Shenzhen Stock Exchange.
§§§The price-to-earnings (P/E) multiple, also known as the P/E ratio, is the price of a stock divided by its earnings per share.
#The price-to-book ratio is used to compare a company’s book value to its current market price.
##Beta is a quantitative measure of the volatility of a given stock relative to the overall market. A beta above one is more volatile than the overall market, while a beta below one is less volatile.