By MICHAEL FLITTON & FAY REN
On Wednesday 10th March 2021, Michael Flitton and Fay Ren hosted an Investment Update Webinar for the TM Cerno Pacific strategy.
Titled ‘Looking Local and Growing Global’, the session looked at the rise of experiential consumerism, further growth in mobility and evolving consumer tastes across Asia, showcasing companies in the portfolio as examples that are well positioned to exploit such trends.
The managers have compiled answers to the questions from the audience during the webcast.
There has been rotation in global markets, is that the case in Asia also?
The potential reopening of the global economy has created two headwinds. Firstly, the mechanistic pull downwards exerted by higher discount rates on long duration assets. Growth businesses by their nature have more of their value residing in the future, which means a greater impact from higher discount rates on stock prices. Secondly, and more practically speaking, the availability of growth has broadened. Technology, and other Covid beneficiary sectors, are no longer the only game in town. Investment appetite, previously herded into a narrow funnel of stocks, has begun to fan out.
So, a rotation is underway, in Asia as elsewhere. Health care, technology and consumer discretionary sectors have given way as unloved names in financials, materials and energy have surged. This is an inevitable consequence of the brightening outlook for economic growth and creates opportunities for us in businesses we like. So, while short term performance will experience some headwinds, we are focused on the long-term opportunity, which remains significant.
The themes and stocks are not exactly secrets. How do you think about the valuation levels at which you enter and exit your positions?
The strategy can be characterised as GARP or growth at a reasonable price. Valuation plays a key role in how we comprehend the opportunity for investment, but it must be seen in the context of the attributes of the company. For the aggregate portfolio we can see that invested businesses exhibit superior characteristics to the broader market across cash returns, margin structure, balance sheet and growth. For this superiority, we pay a premium. How much premium is a qualitative judgement.
At the initiation of a position, we undertake scenario analyses. In these we build conviction as to how a stock has the potential to double over the next five years. If the price is already high this work helps quantify the level at which it would become a contender for investment.
For invested positions, we monitor how that balance between business characteristics and price evolves. Where stock performance deviates significantly from the rest of the portfolio we will look to trim or add as appropriate. We do not tend to sell a position solely on the basis of valuation if the company continues to execute and its long-term growth remains attractive. We believe in the power of compounding. Straight sales are triggered when something fundamentally changes in the criteria with which we assess a company, for example governance.
We are constantly comparing the prospects of stocks on the bench to those in the portfolio. If a portfolio stock enjoys a strong run, which we feel leads to a dislocation with its long-term potential competition from the bench may lead to its substitution.
Do you believe that the sorts of companies represented in your portfolios are not widely held across the generality of Western portfolios?
It is our observation that the Asia’s rising role in global innovation remains underappreciated. Most Asian focused portfolios remain tied to the concept of the consumer and a rising middle class as the best route into Asia. The consumption story remains a powerful one, but risks missing the much larger opportunity set presented by Asian innovators. Far from being a passive consumer of Western innovation, Asia is increasingly the global hub of its generation. So, while we cannot comment on whether certain stocks are widely held, we can say that the idea underpinning the strategy is not, in our view.
What is Cerno’s view on the ethics of investing in ecommerce enablers like Tencent/WeChat that drive environmentally damaging consumption at huge volumes?
It is certainly true that certain aspects of social commerce facilitate compulsive purchasing. The very nature of the livestreaming experience is designed to convince. Whereas 1990s teleshopping was linear and limited, livestreaming is personal, experiential, and varied. Conversion rates for categories susceptible to impulse shopping, like beauty or clothing, are significantly higher on livestreaming compared with conventional e-commerce. Social commerce effectively brings the sales function online, where standard e-commerce is focused only on passively dispensing a requested product.
However, conversion rates are also symptomatic of the better medium and overall consumer experience. Social commerce reduces purchase friction. Viewers can ask questions in real time of the hosts. For subjects like cosmetics or clothes, host tips on suitability or pairing create a personalised experience. This saves consumers time and may ultimately reduce waste in the form of ‘trial and error’ purchases. Not all livestreaming channels are sponsored, with many dedicated to reviews which enhance consumer knowledge and displace spending from low quality goods.
We would argue that the picture is complex. While social commerce does facilitate compulsive purchases, it also provides a valuable customer service which may allow consumer resources to be directed more efficiently.
Is it a worry that PE ratios are double the Asia index when growth has headwinds like those we see currently?
Valuation in and of itself provides only a partial picture of the prospects for an investment. We need to see adequate compensation in the quality and growth characteristics of the business for a given price. Qualitative and quantitative factors all feed into our understanding, from the competitive position and resilience of relationships to the cash flow generative nature of the assets. While the portfolio is on a premium to the market, there is a clear superiority in business characteristics, including growth. Where we feel a stock exhibits inherently higher risk than others, for example an earlier stage company, we limit its weight in the portfolio.
Could you ask the team to comment on the current reflation trade/tech rout? Demand is clearly there for these businesses and the top lines will move, but the multiple the market is willing to pay may change if real rates keep rising and investors favour cyclical low-quality stocks.
The rotation out of Technology shares and into companies exposed to ‘opening up’ has been on the cards for some time. The sector has benefitted not only from the low interest rate environment (valuation bump), but also its status as ‘the only game in town’. We have said before that as the availability of growth broadens, we would expect valuations to face headwinds as investors can now allocate to a wider range of companies. The violence of the move has been something of a surprise, however. China is prone to wild retail swings and this has likely exacerbated the move in markets there. The retail boom in the US is well documented.
The growth prospects for the businesses which have flourished over the past year remain in place. As you correctly point out it is a question of price. The snap back we have seen in yields has taken us back to pre-pandemic levels. It is difficult to assess the impact of fiscal largesse meeting disrupted supply chains. This could certainly stoke inflationary pressures. However, a more likely outcome, in our view, is that we eventually revert to the pre-pandemic world of disinflationary pressures hampering the ability of rates to rise. This would suggest a volatile period ahead but one in which higher rated names can still perform.
More powerful than this reality over the near term is the market narrative. We are gripped by the rotation narrative so the caveat, as always, is that these things can go on longer than one might expect.
Is this more of a North Asia Fund than a Pacific Fund. Semantics but perhaps more accurate?
We are currently exhibiting a heavy bias towards North Asia. It offers the deepest pool of high-quality innovating businesses, with accumulated institutional knowledge from established global businesses in Japan/Korea/Taiwan and China’s more recent efforts to move up the value chain.
This thinking echoes that of the Global Leaders strategy where James has articulated that that fund – whereas submitting to no geographic constraints other than a global sales base – will naturally invest in countries with a high degree of intellectual property generation.
However, we do not have country allocation targets in this fund and the geographic orientation is a result of bottom-up stock picking. Outside North Asia we currently have allocations to Australia and ASEAN. We have owned India in the past, and rotated out into China, which has proven to be the correct thing to do particularly in 2020 given China’s effective control of the Covid-19 spread within its borders and the strong economic recovery that ensued. India (and other South Asian nations) remains part of the overall opportunity set and will certainly be revisited in the future.
You mentioned that China was taking Japan’s position in certain industries…will Japanese companies struggle to keep up with the Chinese innovators?
The sectors where Chinese businesses have effectively competed with and/or overtaken Japan are mainly in the front-end consumer electronics (e.g. smartphones, household appliances) and internet space (Japan was late to that game). Many of these consumer-facing businesses are relatively easy to disrupt once the quality and brand value are in place, as tech barriers are not as high. Chinese brands are gaining presence, although it does not necessarily mean Japanese brand value has been impaired. The absolute size of China’s market is growing and able to accommodate growth of both foreign and domestic brands. Japan (and other MNCs) will however face tougher competition going forward to retain/grow market share.
Industrials on the other hand, is one of those sectors that demands a much higher barrier to entry, protected by a long-term institutional accumulation of IP, know-how and regulations, and remains difficult to penetrate. Japan is one of the countries that has very successfully migrated up the value chain over the past few decades to dominate high-end manufacturing. As we highlighted in the slides, Japan remains the leader in high value-add precision manufacturing, particularly in semiconductor equipment, electrical machinery/robotics, and auto components (e.g. Nidec/Murata). China will catch up in selected areas, but it will take time and heavy investment to displace Japan entirely (not that it is the goal). We aim to identify industries where China can compete (e.g. Hengli in hydraulics), and maintain our holdings in Japan where competitive positioning continues to remain in favour.
How will you position the fund to protect against pressure on China to reduce the country’s carbon footprint?
China’s target to become carbon neutral by 2060 will require both top-down and bottom-up efforts, where environmental considerations are becoming increasingly important. The fund has exposures to several themes:
- Resource efficiency through semiconductors & digitisation
- Electronic vehicles via our B2B suppliers, where the adoption is set to accelerate driven by favourable policy support and subsidies
- Green machinery benefiting from an upgrade cycle, where again, policy dictates that heavy polluting mobile machineries need to be eliminated from the market within a short 3 year deadline
- Tighter regulations across many sectors: our exposure to CTI, China’s largest private Testing, Inspection and Certification provider has a large business in environmental testing and certification. The company is actively working alongside regulators to ensure corporations adheres to higher industry standards in general
Companies’ own initiatives are equally important: Internet names with large energy consumption such as Alibaba have pledged to target 100% renewable energy in their data-centres, as well as reduce and replace packaging with biodegradable materials, whilst planting 55 million trees in China’s Northwest as part of the Ant Forest program.
We do not own businesses in the fossil fuels or mining sectors which will expect to see regulatory headwinds going forward.
What are the regulatory risks for big tech in China? Are there any areas you would avoid?
In a similar vein to US & Europe, Big Tech regulations is increasing. Consensus clearly agrees that they hold too much power over personal data and display anti-competitive monopolistic behaviours to varying degrees. Regulatory overhangs are likely to remain throughout 2021, and we will continue to see negative headlines and price volatility across a wider array of internet names. Already, we have seen fines issued and possible proposals of non-core asset divestures.
We would expect internet giants to become less acquisitive, where M&A will be subject tighter reviews for stifling innovation in the long-run. Also, there will be much harder scrutiny on the use of individuals’ data, which may slowdown profitability from targeted advertising/marketing and developments of AI data training. Fintech will be the most impacted from two aspects: loans & payments. Policymakers are pre-empting a credit crisis and de-risking the system, introducing caps on banks’ exposures to fintech platforms, and take on too much credit risk that they do not understand, especially the more vulnerable smaller regional banks. Ant & other fintech businesses will not be able to grow their books as fast and will be expected to become more asset heavy and account for more risk. On the payments side, Central Bank issued digital currency creates an additional uncertainty to the future of payments in China, which is currently dominated by Alipay and Tencent Pay.
Regulatory flashpoints are not an unusual occurrence in China, we have seen similar abrupt interventions with Tencent in gaming (no new distribution or monetisation licenses granted over 8 months), online education, and P2P, to state three cases from the recent past. The policymakers may be heavy-handed but, if executed in a non-disruptive manner, these measures should result in more orderly competition, prudent M&As and stronger financial conditions for the internet and fintech sectors in the long-run.
Are you concerned about political risk impacting returns in terms of China/human rights and possible sanctions?
We are conscious of the possible risks of further sanctions and restrictions to technology access to Chinese institutions/businesses. However, the China holdings in the portfolio are mostly exposed to a domestic revenue base and growth profile. We do not have exposure to any SOEs or companies that have known or suspected human rights violations, which are the most at risk. The exporters we own that occupy high sensitivity areas in the tech supply chain (e.g. semiconductors) tend to be Japan/Taiwan/Korean businesses.
Where we do own Chinese businesses with intl. revenues (e.g. Mindray/Hengli, both with ~25% foreign revenues, not all from DM), the exposures are to less sensitive areas such as medical devices and industrial machinery where there does not appear to be obvious flashpoints. The companies’ internally developed core IP should at least provide some buffer to any extreme scenarios.
The ambitions of expansion into Western markets via M&As would however be substantially curtailed, as Chinese investments are expected to undergo harder scrutiny by antitrust/CIFUS (e.g. Alibaba/MoneyGram in 2018). That being said, our investment case for these businesses does not depend on significant penetration into Western markets for growth, the domestic market remains by far the main driver with a long runway, and other emerging markets also presents a rich opportunity set.
India: which sectors are likely to catch-up/overtake China, if any? Why? And is “social commerce / livestreaming and e-commerce” emerging as significant in India?
India is not short of entrepreneurs and there is a vibrant start-up scene. Technology adoption would facilitate quality businesses to scale much quicker than in the past, although it requires the supporting infrastructure and policy structures (IP protection/legal etc.) be in place. India has the groundworks in the digitisation of the economy supporting new technology adoption, both in the consumer (e.g. e-commerce) and corporate (e.g. software/IT – already the largest in IT outsourcing) sector. It has the 2nd largest internet users and consumer base globally, with a large pool of STEM graduates.
On social commerce, currently this trend (at least livestreaming) has not yet become mainstream outside China. Amazon/Instagram are all trying to incorporate livestreaming/direct check-out features into their apps, and in India there are a number of emerging social commerce platforms like Bikayi, Meesho, CityMall etc. That have seen 20-30x growth since the pandemic, albeit from a small base. The necessary supporting factors in India exist to allow mass penetration:
- A large mobile-driven economy
- Young population highly receptive to social media and video-streaming
- Cheap & fast connectivity offered by large telcos like Reliance/Jio
- Aadhar program facilitating secure digital payments
This form of D2C commerce is particularly suited to SMEs seeking to market and scale operations to a national base, of which India has ~30m. The projection (by Bain) is to reach $16-20bn in GMV by 2025, and adoption should help to accelerate the growth of the overall e-commerce sector in India. This will help to cultivate local champions in the internet & consumer sectors.
The manufacturing sector is also benefiting from migration of businesses out of China, and FDI has been improving. India is the only economy that can compete with China on scale. But to compete effectively, providing better infrastructure and policy frameworks, which have been moving in the right direction, is critical. In the higher value-add segments, it will require reorientation away from pure cheap labour, higher R&D investment and knowledge accumulation, which will take time.
India also has a large pharma sector, and like China, historically dominated by generics manufacturing. China’s push for healthcare innovation in recent years is a coordinated effort from the top-down, as well as time-critical urgency driven by a rapidly aging demographic (whilst India has a much younger population). In this regard, China would see faster growth in the near/mid-term, but in the long-term I would not be surprised to see India catch up/overtake.
B. Telco: what are the relevant trends and considerations in the industry in Asia-Pacific, including regulatory issues?
Assuming this question relates Telecom and Internet, China should continue to lead trends in the development of this sector as it is the most advanced in the region (e.g. Singapore’s SEA Ltd. = Alibaba + Tencent). But we would expect to see greater variations as business models around Asia mature and evolve organically to move away from the imitation phase. In terms of regulations, we should see more backlash on big telcos on monopolistic behaviour, as is currently happening in China and developed markets. In this scenario, anti-trust would tighten around the acquisition of start-ups stifling innovation in the long-run, particularly by foreign businesses as countries may wish to cultivate domestic champions. We would also expect to see harder scrutiny on data protection of citizens, which demands data-centres to be located within borders, and greater restrictions on the use of analytics to profile individuals would slowdown targeted marketing and AI learning.