Do Eastern investments still hold promise?

Eastern promise is on hold.

The Indian rupee is at a record low against the US dollar, industrial production has fallen for the first time in two years, and India's government is mired in the maddening, corrupt muddle that old Asia hands reckon is one thing about India that will never change.

Over the border to the north, India's so-called rival for eventual global economic supremacy is also facing "interesting times". House prices in certain regions of China are in free fall; hot money is leaving the country; banks are still deluding themselves about the worth of their property loan book and the Communist Party has priorities beyond those of confirming a new leader, namely fretting over social unrest.

Beijing may now have a grip on inflation, but the new challenge - rebalancing the economy after a sustained period of excessive, occasionally reckless investment - could prove more testing. The Chinese are not a people known for buying things they do not really need.

Eastern promise has, for many investors, also proved costly. The Indian stockmarket lost some 20% of its value in 2011 - more than 30% when measured in dollars - while China, as measured by the Shanghai index, is now around 60% below the 2008 peak.

Yet, from downtown Singapore, the city state that stands apart, the message to investors in the region is this: keep on smiling. Fund managers, of course, are paid to be optimistic; but while Andrew Gillan, 32, an Asian specialist with Aberdeen Asset Management, must similarly whistle a happy tune, he says investors should look at the big picture.

Over the past three years, the Indian stockmarket, in rupee terms, has gained more than 80%, says Gillan, manager of Edinburgh Dragon Trust (EFM), a heavyweight in its sector. He has no truck with the stark views of Lord Meghnad Desai, emeritus professor at the London School of Economics, who in December declared: "The Indian 'miracle' is over. When and if India regains its growth is anyone's guess. In the meantime, welcome back to the Hindu rate of growth."

Gillan says: "We are not economists. With India, the macro and micro are very different. India was the worst-performing market in Asia in 2011, but we still view India as a key opportunity. That is why Edinburgh Dragon has 15% of its assets dedicated to the country, the second-largest country in Asia.

"The currency has been weak because of the fiscal situation and the country's reliance on energy imports. But the Indian consumer is not indebted. Hero Motor Corporation, which makes motorcycles, grew its earnings by some 20% last year and so did HDFC, a mortgage company. Our investments there have performed pretty well, in terms of both share price and earnings."

Economics might not be Aberdeen's forte, but the science behind stock selection is a different matter. The firm now follows a simple formula devised some years ago by Hugh Young, Aberdeen's main man in the region and doyen of Far East fund managers; it owes little to second-guessing currency movements, political factors and so on.

The focus is first on quality, cash-generating companies with a prominent position in their industry; then on governance and management, which, once an investment has been made, is visited twice a year. Third, and arguably most important, is the market price of its desired companies.

This template means portfolio turnover is low, and Edinburgh Dragon's number of holdings is generally between 45 and 50. Also, it tends to limit its sphere to large companies.

But, as Gillan points out, his trust readily "top slices" when prices get too robust - such as Edinburgh Dragon's recent lowering of its holding in Hindustan Unilever - and adds on weakness. Its approach to governance is unwavering, and, on occasions, this can prove costly.

Missed opportunity?

In 2011 for instance, Edinburgh Dragon's relative performance suffered from its unwillingness to invest in Korean motor groups, a decision taken because of corporate governance concerns at the likes of scandal-ridden Hyundai. This company, and fellow Korean carmaker Kia, cashed in on the problems suffered by Japanese rivals after the tsunami, but Gillan is unmoved.

Despite missing out on this bonanza, Edinburgh Dragon's net asset value fell by less than 4% in the company's financial year to the end of October. That was about half the decline in its benchmark, the MSCI All Country Asia ex Japan index.

As in the West, corporate profits in the Far East have been buoyant and well-managed. Companies have, in the main, achieved strong balance sheets and good cashflows. Markets are trading on 12 times this year's anticipated earnings, compared with 18 times when markets peaked in 2007. Fiscal policies have lowered inflation fears, Gillan adds, and lower inflation is positive for profit margins.

Notwithstanding the unknowns of the eurozone debt crisis, Gillan expects regional growth of around 6% this year. He is encouraged by Asian Development Bank research which shows that intra-regional trade, among major economies, grew last year by almost 50%. Essentially, he argues, equity prices in main markets are at bargain levels.

Like any sane investor, Gillan gives a wide berth to most Chinese companies, partly because of poor governance, partly because of the low regard for shareholders, and partly because of dodgy accounting. Indeed, direct investment in China accounts for about 7% of the investment trust's portfolio, a weighting that last year helped to drive the fund's outperformance of its benchmark.

Yet he likens the investment background in China to that prevailing in India: murky at the macro level, clearer at the micro. He owns a few 'Red Chips', such as China Mobile, PetroChina and the other oil major, CNOOC, but his mainland exposure is largely through companies listed and run from Hong Kong, that have survived business cycles, political upheavals and more.

The challenges facing Chinese banks are very real, with repercussions from non-performing loans and over-investment in fixed assets expected to come to the fore this year. But, as with India, consumer demand from a huge population presents a different story, he says. "We still think China is heading for a soft landing rather than hard."

Much of Gillan's exposure to the region is through companies listed and managed in Singapore, that other capitalist citadel of the overseas Chinese, in addition to Hong Kong entities. The current state of play in Indonesia - which, with a population of more than 200 million people and untapped commodity wealth, is the new big hope of the region - illustrates why.

"It has not been easy to directly invest into Indonesia. The market is expensive, especially the banks, which are selling at three times book value. And it is hard to find companies that meet our criteria for quality. But we own Singapore banks, and these have a stake in Indonesia's future growth."

Exposure to the Indonesian consumer is partly through Edinburgh Dragon's significant shareholding in Hong Kong-listed Jardine Strategic, whose roots in the region go back to the Opium Wars of the 1800s. "A conglomerate of good businesses," Gillan says. Last year, the company returned some of its surplus cash to investors. Gillan says cash returns and share buybacks by leading companies are becoming more prevalent in the region.

Overall, Singapore and Hong Kong-listed companies represent almost half Edinburgh Dragon's assets.

As with Korea, which Gillan accepts is a relatively cheap market, Edinburgh Dragon is underweight in Taiwan. He says the Taiwan market is too concentrated on electronic companies and these are dependent on cyclical and short-term trends. But Taiwan Semiconductor is a world-leader in its field; and the company expects to double output over the next five years, and is therefore in favour with Gillan.

Like a few other canny investors in the region, Gillan has strayed off benchmark to invest in Sri Lanka. It's "an important trading hub and our companies there offer good returns", he says.

Right now, as Sri Lanka recovers from the protracted war with Tamil separatists in the north, the country qualifies as a "frontier" market. Its progression to an emerging market, he says, will depend on foreign capital flows and improved liquidity.

Thailand, itself once a frontier market, is host to two Edinburgh Dragon investments, both illustrating the potential upside when things fall into place. Siam Cement last year broadened its presence in south-east Asia by taking stakes in two Indonesian cement companies, while PTT Exploration and Production moved farther afield by taking a 40% stake in Statoil's Canadian oil sands project.

Neither Thailand's political turmoil nor the recent floods that threatened Bangkok and damaged the economy served to unnerve Gillan. "Totally irrelevant. We are long-term investors. It is these short-term movements that give us the opportunities to buy when markets go lower."

Andrew Gillan

Age: 32

Position: Manager, Edinburgh Dragon Trust. Senior manager, Aberdeen Asset Management.

Education: Bishop's Stortford College, Hertfordshire. Studied French and European history at Edinburgh University.

The past: Murray Johnstone. Moved to Singapore when the company was bought by Aberdeen.

Home: Singapore. Competes in triathlons.

Finances: All in Asia, including Edinburgh Dragon and Aberdeen Asian Smaller Companies (AAS) trusts.

This article was taken from the February 2012 issue of Money Observer.