Asian markets: Is global growth the trump card?

In Asia ex-Japan, the building blocks are in place for shoring up top-line growth. And although quality remains the biggest stumbling block in Japan, valuations have been improving. Let’s take a closer look at Asian markets through the Earnings, Quality and Valuation (EQV) lens that we use to evaluate potential investment opportunities.

Asia ex-Japan: Global growth is key

For the past several years, slowing top-line growth in the Asian region – along with an inability to pass along cost pressures – led to operational deleveraging, which drove perennially negative earnings revisions. More recently, the earnings outlook has stabilized as headwinds associated with operational deleveraging have receded. This trend has been driven in large part by corporate capital discipline. Capital expenditures relative to sales across the region have reached all-time lows¹ as companies are doing a better job of reigning in spending, and labour cost pressures are easing. In addition, the foundation for top-line growth is becoming more supportive as export competitiveness has improved due to cheaper currencies. A more helpful commodity price backdrop is also helping some Asian countries.

All these factors could potentially drive an upward trajectory in return on invested capital, in stark contrast to the past several years. The building blocks are in place, but global growth could be the trump card in determining the final outcome. China is obviously going to play a significant role in determining the size of that global growth trump card. Here’s what we’re seeing:

• China’s gross domestic product numbers have been stable for the past three quarter.²
• Some broader economic indicators – specifically electricity generation, industrial profits, consumption and the Producer Price Index – appear to be improving²
• At present, this is being offset by the removal of capacity in some problematic industries, which we view as a necessary step to improve the long-term health of China’s economy

Discriminating market conducive to investing

With the return of operational leverage and growth prospects across Asia beginning to broaden out, the market is no longer chasing the highest-growth and highest-quality businesses at all cost. It’s begun to differentiate based on fundamentals and valuations, and we’ve seen a rotation toward cyclicals. A discriminating market is more conducive for us, and we’ve begun to see some encouraging investment opportunities emerge.  If the rotation continues, we expect more opportunities to present themselves.

Japanese valuations promising

In Japan, currency continues to rule the day. The Japanese market (Nikkei 225 Index) is down around 8% this year in local terms, but up almost 6% in U.S.-dollar terms.³ The market sold off in June as the currency strengthened, and then recovered the losses in mid-July as the yen weakened. Despite double-digit moves in both directions, the market has remained essentially flat since the end of March.

The yen’s strength is placing pressure on Japan’s export competitiveness, causing deterioration in economic data. In addition, business investment is falling, industrial production is anemic and domestic consumption isn’t able to offset the headwinds. These factors continue to ripple through Japanese companies as both revenue and earnings estimates were slightly revised down in the past three months.

Here’s an EQV snapshot of what we’re seeing in Japan:

• From an earnings and valuation perspective, the market is more attractive, with earnings growth prospects and price/earnings multiples similar to those in the rest of Asia
• Quality remains the biggest stumbling block. Despite some improvement, companies still aren’t allocating capital effectively. They continue to bloat their balance sheets with cash and businesses that perform poorly. As a result, quality metrics are inferior to those in the rest of Asia, in our view.
• Improving valuations have warranted attention, particularly in Japanese consumer staples, which have de-rated about 20% since July 2015.⁴ While we haven’t initiated new positions, this area holds promise.

As always, we believe our long-term, bottom-up, stock-picking approach can reward investors over the long term.