Sep 30, 2016

Christine Tan's Top Picks: September 30, 2016

BNN Bloomberg

Christine Tan , BNN

Christine Tan, Chief Investment Officer and Senior Portfolio Manager, Excel Funds

Focus: Emerging market stocks
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Market Outlook
We are eight months into 2016 and the macroeconomic outlook for developed countries is weaker than initial expectations. Black swan political events such as the Brexit “yes” vote introduced further volatility to developed markets and currencies, especially the British Pound, Euro and Eurozone. U.S. economic data, while gradually improving, is still mixed. The IMF has reduced 2016 GDP growth expectations for the U.S. from 2.8 per cent to 2.2 per cent, which is slower than 2015’s pace of growth. On Wednesday, IMF Managing Director Christine Lagarde indicated that U.S. growth expectations will again be reduced in next week’s update. The mixed economic data combined with expanded monetary easing from the Bank of Japan (BOJ) and the European Central Bank (ECB), which essentially means U.S. monetary policy is tightening on a relative basis, has kept the Fed on hold. This is in contrast to expectations (recall the “dot plot”) of four rate hikes in the U.S. at the start of 2016. Our team’s view has been that there will continue to be global deflationary pressures emanating from weaker growth in developed countries and the ongoing moderation of growth in China to a more sustainable 6 to 6.5 per cent level. We continue to expect emerging market (EM) countries to outperform economically and contribute the majority of global growth.

Most investors recognize the economic growth potential of EM. However, they have historically focused on the perceived riskiness of EM. This is in large part due to a comfort with Canada and other developed countries. However, events in the past several months have shed light on an issue we have discussed with our investors since the Taper Tantrum of 2013, namely perceived risk versus actual risk. After Bernanke’s announcement of QE tapering in 2013 as a prelude to the eventual normalization of rates, global investors have repatriated capital from EM to return to U.S. dollar assets on the expectations of economic improvement as well as expectations of a strong U.S. dollar, since interest rate hikes would increase the interest rate differential between Treasuries and other sovereign bonds (especially Japanese government bonds, or JGBs, and Euro sovereign bonds). This has resulted in an expansion of valuation multiples on U.S. equities to historic highs, and certainly higher than warranted given the earnings growth outlook. As the BOJ and ECB experiment with unprecedented negative interest rates to stimulate economic activity, the impact on developed country sovereign bond yields has been profound, with approximately trillions of dollars invested in developed country sovereign bonds now offering negative yields. This contrasts with the EM bond market, which still offers a significantly higher yield.

So fear and perceived risk of EM (and more recently European) assets have resulted in U.S. equities at historic high multiples and trillions of dollars in negative-yielding government bonds. As a result, we believe there is significantly higher “real risk” investing in expensive perceived-haven assets than investing in EM today. There is also heightened political risk in developed countries as the anemic economic recovery post-2008 leaves many either unemployed or underemployed, while easy monetary policy rewards the asset owners, thus widening the economic disparity.

In contrast to Brexit and the uncertainty around the upcoming U.S. elections, there have been numerous meaningful and positive macro events in EM over the last few months. Just to highlight a few, on June 28 the Indonesian parliament approved an extensive Tax Amnesty Scheme (TAS) that would allow either repatriation of assets from overseas at a low tax rate of 2 to 5 per cent, or declaration of overseas assets without repatriation at a tax rate of 4 to 10 per cent — all prior tax liabilities forgiven. On August 3, the Indian Senate passed a Constitution Amendment Bill that would facilitate a roll-out of a single Goods and Services Tax (GST) that replaces a complex multi-layered state and central government tax system. This was one of Prime Minister Modi’s main election promises and a very impressive achievement given the requirement for approval by both houses of Parliament in the world’s largest democracy. On August 31, Brazil’s Senate completed the impeachment trial of President Dilma Rousseff with a clear majority vote removing her from office. Her successor, President Michel Temers, is already focused on key items of reform. And on August 29, after more than 50 years of conflict with the government in Colombia, the Revolutionary Armed Forces of Colombia (FARC) formally announced a ceasefire. Argentina and Peru are now helmed by new pro-business and pro-reform leaders. These achievements are especially remarkable considering the challenging global macro environment facing us today.

Despite the year-to-date outperformance of MSCI Emerging Markets Index versus MSCI World Index and the S&P500 (+12.2 per cent versus 1.4 per cent and +3.2 per cent in CAD terms as of September 28, 2016), EM equities trade at a compelling 13.2x forward 12 months earnings versus expected earnings growth of approximately 18.2 per cent. EM currencies, as measured by the MSCI Emerging Market Currency Index, have rallied year-to-date 1.9 per cent against the CAD and up 6.6 per cent against the USD. From March 31, 2009 to August 31, 2016, this currency index has appreciated 23 per cent against CAD and 18 per cent against USD. This floating flexibility in EM currencies has been an important factor in the current account and economic rebalancing over the last three years, and also a key differentiator from the “old EM” of the 1990s when fixed currency regimes provided governments and central banks with limited flexibility.

We believe that many EM countries have evolved from boom-and-bust cyclical economies reliant on exports to developed countries into self-sustaining economies with a strong domestic drive. This has given rise to secular growth themes such as the domestic consumer, increased spending on healthcare and education, infrastructure investment and technology as both an enabler of new business models and a source of innovation. We focus on investing in solid businesses that benefit from these secular growth themes.

Top Picks

AIA Group (AAGIY.PK)
Founded in 1919 in Shanghai, AIA Group has grown to become the largest Pan-Asian insurer with operations across 18 countries in the Asia Pacific. The company is called AIA because it became a subsidiary of U.S. insurer AIG in 1945, before being spun out in 2009 as a result of the Great Financial Crisis. The company went public in 2010 on the HK Stock Exchange. Very low insurance penetration in the Asia Pacific region, strong income growth combined with a young demographic, position the insurance sector well, for years if not decades, for strong underwriting growth. There are a few more regional insurance players that trade at a lower valuation, but AIA is our top pick in the sector for its rock-solid balance sheet, earnings growth visibility, regular dividend increases and market leadership in most of its markets. We also like management’s discipline in terms of market and product expansion. With its large scale, AIA is now converting more of its new insurance business into cashflow. Therefore, we believe there is room for higher dividend increases. HK and China currently represent approximately 60 per cent of AIA’s business, but we expect solid growth in other key markets such as Singapore, Thailand and Malaysia to further diversify AIA’s insurance book.

LG Household & Healthcare Ltd. (051900.KS)
Beauty and skincare spending in China has been growing very strongly over the last few years. According to the National Bureau of Statistics of China, the total market grew from RMB 89 billion (C$18 billion) in 2010 to RMB 205 billion (C$41 billion) in 2015. But if you consider the size of the population, that’s only C$30 per person on items ranging from face creams to sun lotion to cosmetics. We believe beauty spending by women is the highest margin segment with rapid growth. Chinese women currently use an average of two products a year versus nine in the U.S. and U.K. — and 14 in Japan! Among the various brands, Korean cosmetic brands are very popular with Chinese women. LG Household & Healthcare has three divisions: Beautiful, Healthy and Refreshing. The Healthy division offers a range of hair care, laundry care, infant products and oral products including the “Method” brand we see here in Canada. The Refreshing division distributes sparkling beverages, juices and bottled water. Both these businesses are relatively low growth and management is focused on expanding operating margins. The reason we own LG H&H is for its Beauty businesses, and more specifically for its strong expansion into China. LG H&H’s market share is currently 2 per cent but with its prestige brand-focused expansion, we believe the company could increase its sales by almost four-fold by 2020. Not only will this drive sales growth but because cosmetics result in a much higher margin, the company’s overall margin will also expand.

Naspers Ltd. (NPSNY.PK)
Naspers was founded in 1915 and has grown into a large group of internet, e-commerce and entertainment investments. Naspers’ investee companies benefit from three key secular themes: i) the internet creating new business models for traditional sectors, ii) the rise of the EM consumer and iii) the internet’s role in replacing the need for physical infrastructure to accelerate growth (eg. leapfrogging directly to wireless communication with limited wireline buildout). The majority of Naspers’ enterprise value is attributed to its 34 per cent stake in China’s largest technology company by market cap, Tencent. It also owns a 29 per cent stake in Russia’s Mail.ru, a provider of internet services, instant messaging, e-mail, online gaming and social networking. Once we account for the public market value of Naspers’ stake in Tencent and Mail.ru, the rest of its businesses are valued as negative value. We expect that as these different segments mature and begin to generate positive returns on invested capital, we will see a significant rerating of this “rump” from negative to positive enterprise value.