Fidelity Asian Values (FAS) has released its annual results for the year ended 31 July 2024, during which it provided NAV and share price total returns of 3.2% and 1.7% respectively, both well-behind that of its benchmark, the MSCI All Countries Asia ex Japan Small Cap Index, which returned 13.7% during the same period. Commenting on the results, FAS’s chairman, Clare Brady, said the “Portfolio Managers Nitin Bajaj and Ajinkya Dhavale have delivered periods of significant outperformance since Nitin’s appointment in April 2015. However, as we all know, the value of equity investments can go down as well as up, and there is no avoiding the fact that the year ended 31 July 2024 has been a relatively disappointing one for the Company and its shareholders”. The trust benefited from its holdings in India during the period but was hurt by an overweight exposure to China.

FAS’s managers believe that many Indian companies, particularly technology stocks related to AI, are overvalued, and have allocated more to China where they see attractive value opportunities, particularly in companies serving the domestic consumer. However, China has been very out of favour with investors and so the positions have yet to deliver but the managers believe they will achieve their potential in time.

Investment managers’ review

This is provided in the form of a Q&A, which we have reproduced for you below.

Question 1: How has the Company performed in the year to 31 July 2024?

Answer: During the year ended 31 July 2024, the Company’s net asset value (“NAV”) rose 3.2% as compared to the 13.7% total return from the Comparative Index (the MSCI All Countries Asia ex Japan Small Cap Index (net) total return (in sterling terms)). The total share price return was -1.7% due to the widening of the discount to NAV.

Overall, our stock selection contributed positively to the Company’s relative performance versus the Comparative Index. However, our market selection remained a drag against the backdrop of continued divergence in country performance.

Our investment process is driven by owning good businesses run by managements we trust and investing in them only when we have ample margin of safety – this often leads us to take contrarian positions as it is easier to find undervalued businesses in countries which are out of favour with investors. Following this philosophy, we have a significant percentage of our portfolio in China and Hong Kong and Indonesia compared to the index but in all these markets small caps saw a sharp fall in share prices and underperformed the regional small cap index. Conversely, India, where our portfolio has a large underweight due to valuation concerns, rose strongly and outperformed the index.

Question 2: What stocks have been the main contributors and detractors to performance during the period and why?

Answer: It was not surprising that our top three contributors relative to the Index during the 12-month period were from India while our largest relative detractors were all from China and Hong Kong as it was very much in line with country performance within Asian small caps.

In India, our holdings in the country’s largest power trading company PTC India was a key contributor. It reported strong volume growth particularly for higher margin long-term trades. Exposure to Granules India added value as the small cap pharmaceuticals company continued to increase its leadership in high volume products such as paracetamol and new launches in higher margin drugs. Similarly, India’s 4th largest mortgage financier LIC Housing Finance benefited from its access to low-cost funds helping it focus mainly on prime borrowers and maintain high returns on equity and strong asset quality. We continue to like all of them but trimmed exposure on strong performance and reduced the margin of safety.

Most of the detractors in China and Hong Kong operate in consumption and housing driven sectors where near-term weakness in demand led to earnings downgrade as well as multiple deratings. For instance, Hong Kong-listed Galaxy Entertainment Group which is the second largest casino operator in Macau hurt returns due to increased competition and Chinese consumption recovery being slower than we had anticipated. However, tourism spending remains one of the most interesting areas in China given rising incomes, changing demographics and attractive valuations for Macau based casinos. Similarly, our holding in drug retailer Yixintang Pharmaceutical, which has a leadership in Yunnan province, fell on the back of the introduction of a price comparison system. We continue to like its structural medium to long-term prospects as it consolidates in a fragmented sector. It provides low double-digit Return on Equity (“ROE”) which is a measure of the prospective return against the value of the shares, and trades about 8 times its 12 month forward earnings, which is a measure of the price of the shares against the likely future profits. Meanwhile, the biggest detractor China Overseas Grand Oceans is one of the country’s leading property developers focused on tier 3 cities that is gaining market share as weaker players are going out of business. It trades below 0.2x its book value, which is a measure of the price of the shares versus the value of the assets of the company. It provides about a 9% dividend yield.

While these companies have detracted from performance over the 12-month review period, their valuations reflect earnings expectations that are at trough levels providing us a significant margin of safety and upside potential.

Question 3: The Company’s portfolio is overweight in China. Why do you prefer investment in China compared to other countries in the Asian region?

Answer: We do not invest in countries, we invest in businesses. Our higher exposure to China is driven by the bottom up security selection in a range of well-financed and well-run businesses where their current valuations provide a sufficient margin of safety compared to most other markets in the Asian region.

We understand the concerns investors have about China’s geopolitical issues, its property downcycle and weak consumption trends. In our opinion, the housing cycle downturn has been absorbed in a large measure and its negative impact on the economy will be felt to a lower extent next year. This is part of an economic cycle correction, but sound businesses will still be around, likely to be in better shape and emerge stronger as the cycle recovers. Given current valuations, there is significant upside on owning these businesses over a 3-year horizon. The cycle in China is not too dissimilar to the US cycle post the housing crisis in 2007 or the economic downcycle in India between 2011 and 2013.

In our opinion, China has created one of the best infrastructures in the world – both human and physical. The foundations are strong and hence our belief that the weakness we see currently is cyclical rather than structural. We believe in good businesses, run by competent and honest people and buying them at cheap prices. We are finding quite a few of these in China today and hence the significant overweight position in China.

Question 4: Looking beyond China, where do you currently see the best opportunities?

Answer: Beyond China, Indonesia is one place that is providing opportunities to own a good mix of growth and quality businesses at attractive valuations as the market has lagged most of Asia over the last year. It is the third largest economy in the region after China and India with a strong demographic profile with tailwinds for consumption shifts as well as infrastructure development. The country has been more prudent with its public finances than other countries in the region. Our exposure to Indonesia is diversified across financials, building materials, industrials and consumer businesses that offer fairly high and sustainable returns at sufficient margin of safety. Indonesia has some of the strongest banking franchises with conservative underwriting culture. They have stable asset quality and benefit from structural growth as penetration levels are increasing from low levels. The consumer companies owned in Indonesia are also high-quality franchises with market leadership. This gives them strong pricing power and ability to generate margins that are higher than global peers over the long term.

We have also been adding exposure to businesses in Korea. The country’s ‘value up’ programme that pushes for governance reforms should yield positive outcomes from Korean corporates. We have selectively been adding positions in companies where there is considerable margin of safety built into current valuations to limit the downside, but potential for gains is immense if their management teams improve total shareholder returns through higher dividends and buybacks.

Question 5: Small cap value stocks continue to outperform small cap growth stocks over the longer term. What has driven this and do you expect the pattern to continue?

Answer: Small cap value stocks have performed better than small cap growth stocks over the last 25+ years. This is essentially because the small cap value stocks have grown earnings faster than small cap growth stocks.

Over 80% of our portfolio remains in these value stocks as we believe they will continue to do better based on their superior earnings growth and higher cash returns in terms of dividends.

Question 6: How do you view macro and geopolitical events and the effects they will have on your portfolio?

Answer: Macro and geopolitical events are not central to our decision-making but we realise we cannot ignore them entirely, as companies exist within business cycles and they are impacted by geopolitical events. So, we try to factor both into our decision-making predominantly at single stock level and at portfolio risk level. These give us guard rails rather than being the main driver of decision-making. Stock picking is the mainstay of the investment process. This has been its strength, and we feel we are better placed if we ‘stick to our knitting’.

For instance, we are aware of the tensions between the USA and China and feel that this is a long-term trend but it is beyond our expertise to predict specific events that can trigger near-term market responses. Therefore, we continue to follow our process and have chosen to focus more on opportunities in domestic-demand led Chinese businesses rather than the businesses that derive significant revenues from the US market.

At the same time, it is helpful to reiterate that macroeconomic factors are cyclical – they come and go – if we can construct a diversified portfolio of good businesses run by competent and honest management teams and invest at a price that leaves sufficient margin of safety, we should over time be able to generate returns for our investors over the medium to long term.

Question 7: How does the Company consider governance and stewardship?

Answer: The investment process centres around good businesses managed by good people available at a good price, which implies that we actively look for a business that solves a problem for its consumers. The ‘good people’ behind a business respect law and regulation and take care of their employees, customers, the environment, and shareholders, as well as managing their businesses responsibly. We strongly believe that only an honest and competent management team will drive the business towards creating value over the long term. It is unlikely that a management team that has not focused on shareholder returns over the last 15-20 years will suddenly start putting the shareholder at the heart of what they do.

Fidelity International is a signatory of the UK Stewardship Code that sets globally recognised standards of stewardship for investors saving money on behalf of UK savers and pensioners. We support the Code’s aim of encouraging big investors to focus on promoting good corporate governance at the companies they invest in.

Fidelity’s stewardship activities support the responsible allocation of the Company’s assets in two main ways: by informing the investment process at the research and investment decision-making stages, and through leveraging our ownership position in companies with the aim of effecting positive corporate change.

Question 8: What is your approach to gearing and short positions? And what impact have they had on returns during the year and over the longer term?

Answer: The level of gearing in the Company remains a function of the number of investment ideas we find. It increases when we see more ideas than money and it reduces (or we keep a higher cash balance) when we do not find as many ideas.

Gearing has recently increased as we have found investments in China, a market which has been out of favour with investors. However, valuations in many other parts are not as attractive. India remains expensive leading us to reduce exposure in this market.

Question 9: What are some of the points that are important to remind the holders of the Company?

Answer: We own businesses that are better quality than the market and are currently priced at cheaper valuations than the market. This has been the bed rock of our investment process for over a decade. The portfolio’s Return on Equity (“ROE”) remains at a premium to the market while the Price to Earnings ratios of our holdings are at a significant discount.

The ROE metric of the portfolio is higher than that of the market implying the Company is generating superior returns for each pound of shareholder’s equity than the market. Further the blended Price to Earnings ratio of our holdings is at a significant discount which implies that we are paying a lower price for each potential pound of future earnings by our portfolio companies compared to the market as a whole.

This is driven by our historically high exposure to China, Hong Kong and Indonesia where businesses are undervalued versus their long-term returns potential, as well as due to our low exposure to India, given valuations in the Indian small cap segment are extremely expensive.

We do not predict market movements and have come to understand that markets are seldom rational in their short-term responses. Thus, we consistently focus on investing in good businesses, run by good management teams that are available at a suitable margin of safety. This is the approach that has stood the test of time generating sustainable performance for the Company in the long run and should do the same in the next few years.