The case for a bullish outlook on Asian stocks

David Urquhart makes the case for a bullish outlook on Asian stocks.

Economic statistics about Asia’s industrial revolution are impressive. China’s economy, for instance, has expanded four-fold in the past 10 years. This means that it has added Australia’s economy 10 times over.

As a stock picker, I analyse Asia from a bottom-up perspective. But whichever way you view the region, there is strong evidence that Asian stocks will be worthwhile investments in coming years for four main reasons.

The first is that Asia’s macro-economic outlook is brightening. While China’s 10 per cent-plus annual economic growth dominates the headlines, the other large countries in the MSCI AC Asia ex-Japan Index are thriving again.

After shrinking in 2009, most of the region’s economies are poised to grow in 2010 and beyond thanks to government stimulus programs.

The outlook is upbeat for the region. As far as analysts are forecasting, Government finances are largely in order, current-account surpluses reign and investment is prolific.

Goldman Sachs predicts Korea will grow 4.3 per cent per annum, Singapore 4.3 per cent per annum and Hong Kong 4.6 per cent per annum over the coming nine years.

While gross domestic product (GDP) does not automatically equate to robust shareholder returns, it does provide an environment within which companies and, more importantly, earnings can thrive.

The second reason for my strong belief in Asia is that the region’s economies are maturing.

They are passing beyond the investment-driven developing phase to a more balanced mix between investment and consumption. Larger services sectors are typical traits of developed nations.

The services sectors in India and Korea now comprise about 60 per cent of GDP, not far from the mid-70 per cent score for key western economies.

Taiwan and Singapore are already at this level of sophistication, while the ratio for Hong Kong is 92 per cent.

As incomes have grown, people have emerged from poverty and become spenders. At the same time, goods have become more affordable, governments are encouraging more leisure time and recent stimulus packages have fanned consumption.

Many companies are benefiting from higher demand in Asia for cars, health services, media products, consumer goods and, to a lesser extent, even financial services (though many people in Asia will not borrow to buy a house — they prefer to pay cash).

China, for example, displaced the US as the world’s largest auto market last year, with 13.6 million cars sold in China — compared with 10.4 million in the US.

Brand power equals better returns

The third important development in Asia’s favour is the emergence of credible Asian brands.

Asian companies typically began as low-cost manufacturers that made goods such as shoes or PCs for global brands such as Nike or Hewlett Packard. Over time they invested to boost product quality to the standards required of multinationals.

One sign of the intensity of Asian research is that Asia was the source of 18 per cent of the world’s patent applications, up from 3 per cent in 1995.

Better and more sophisticated products have created Asian brands that are taking on established Western names in Asia — particularly in consumer electronics where names such as Samsung from Korea and Acer from Taiwan were largely unknown 10 years ago.

Once Asian companies see they can compete against international brands at home, they look to export.

Walk into JB Hi-Fi or Harvey Norman stores and you’ll notice that Asian brands are hogging the shelf space. Brand building is important for investors, because brand strength leads to pricing power, hence higher and more stable earnings through economic cycles.

The final reason for my optimism about Asia is that valuations are favourable. The better returns that come with brand development have boosted the return on equity for Asian stocks.

Since the mid-2000s, Asia has generally delivered better returns on equity than other regions (see graph on opposite page).

This trend will probably persist. So while on a price-to-book basis Asia only looks fair value, the region looks attractive when comparing returns on equity because of this likely improved profitability.

Some caution is required

There are risks with investing in Asia, of course. In my opinion, you need to monitor regulatory and corporate governance risk.

With regulatory risk, investors must understand that governments exert a strong influence over companies and there are certain industries where national interest will trump concerns about shareholder interests.

Concerns about corporate governance in Asia are usually tied to the fact that many of the companies are young and the person who founded the company is the major shareholder, CEO and, perhaps, the chairman as well.

These people see the company as theirs, and think of minority shareholders as silent partners.

There are also some cowboys, but you’ll find them anywhere (think Enron, Bond Corp, etc).

The key to managing this risk is to look for signs of conflicts of interests and to assess the independence of the chair, the directors and the accounting practices followed.

It should be noted that regulatory risks are not unique to Asia.

The good news is that the Asian crisis made Asian companies and governments realise the worth of corporate governance.

Accounting standards are lining up with international standards.

Consolidated financial statements are issued on a regular basis (at least annually, but in many countries quarterly).

Since the mid-1990s, there has been a dramatic improvement in disclosure and a much better understanding of shareholder rights.

Asia faces an exciting outlook in the coming years. Companies have the opportunity to build their businesses in healthy economies where the consumers enjoy growing incomes and a propensity to spend.

Just as Asian economies have tripled their output in the past decade (or in China’s case, more than quadrupled it), many Asian companies are set to make similar stunning gains in terms of revenue, profits and shareholder returns in coming years.

David Urquhart is portfolio manager of Fidelity Asia Fund.