Perspective

Is there an "epic bubble" in Asia?


Some strong words from Jeremy Grantham of GMO about the US stock market may be ringing in many investors’ ears right now as markets climb ever higher:

“The long, long bull market since 2009 has finally matured into a fully fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterical investor behaviour, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea Bubble, 1929, and 2000”, Waiting for the Last Dance, January 2021.

As an Asian equity investor it is not my place to dwell on US stock markets. However, the more I look at valuations and current trading patterns there, the more I tend to agree with Mr Grantham’s conclusions. With gains accelerating and the extremely high level of participation of retail investors, we do not view current US stock market conditions as healthy. 

Are Asian equities in a bubble too? 

In his report, Mr Grantham suggests that “value” stocks and emerging markets (of which Asian stock markets now account for 81%) are the safest places to be, relatively speaking.

However, we believe “frothy” (if not outright bubbly) conditions are now broadly prevalent across global stock markets. If the US stock market corrects, Asian markets will not be immune. Particularly given the very high correlations in short-term performance.

But how worried should investors in Asia be?

Let’s start with the reassuring charts first. Chart 1 shows a variety of valuation measures, on which Asia doesn’t look crazily expensive, particularly on forecast 2021 price-to-earnings (P/E) ratios.

Meanwhile, most markets are offering dividend yields of between 2% and 4%, which perhaps are not to be sniffed at in a zero interest rate environment.  

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Also, as chart 2 shows, return on equity (RoE) has been under pressure. RoE  is a profitability ratio that measures the ability of a firm to generate profits from its shareholders' investments in the company. However, we should see a good cyclical improvement as the global economy normalises. This should support stock market performance.

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These charts are pretty reassuring. Elsewhere though, other signs are more worrying and lead us to think that 2021 will be a challenging year for Asian investors to make significant absolute returns. 

Chart 3, for example, shows that on a trailing basis (that is, using past profits as a guide) Asian valuations are now as high as they have ever been in the recent past. This means we really need good earnings growth in 2021 to justify current share prices.

Can Asian profits meet such elevated expectations? Based on history, almost certainly not; brokers’ forecasts nearly always disappoint. This is one of the main risks for 2021.

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Chart 4 has perhaps the more interesting sector breakdown. The black dots show the current forward price-to-earnings (P/E) ratio for all the key sectors in Asia. The forward P/E uses projected earnings, so it assumes all those nice earnings-per-share numbers come true. The bars have the historic range since 2004. 

Of note is that nearly all sectors outside those facing significant, obvious and in some cases terminal, challenges (property, banks, insurance, utilities) are near or at the top of their historic ranges. 

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Valuations may not be crazy, but they are most definitely expensive versus history. And if earnings don’t come through, we doubt markets in Asia will perform well in the near term.

More anecdotally, similar to in the US, we have seen a very large increase in retail investor participation in stock markets across Asia. Historically this has been a good indicator of market peaks. 

What are these retail investors buying? It appears retail money is heavily flowing into thematic Exchange Traded Funds (ETFs) in the region, some of which have seen their assets grow exponentially. 

The most popular themes are of course electric vehicles (EV – more on these later), the internet sector, technology, green energy, biotech and so on.

True to form, brokers are now feeding the bubble by coming up with ever more nonsensical price targets based on ever more nonsensical valuation methods to justify further moves in the hottest areas of the market. 

This is summed up nicely in the great chart below from David Scott of Chaam Advisors, which we think encapsulates the way the market often works for the “hot” sectors.

We are now indeed moving to the right hand side of the chart, with broker notes on EV stocks in particular now only talking about “potential customers”, normally in 2030. Meanwhile, the one we love regarding the “neatness of business model” is that apparently EVs are really software platforms that provide mobility as a service.

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Why the BEVI bubble is still a concern

As we’ve discussed regularly in recent months, the area that concerns us most regarding valuations is in the biotech, electric vehicle and internet (BEVI) sectors.

Our worries to date about the BEVI bubble have proved completely unfounded as most stocks have surged ever higher.

So have we got it wrong? 

We think not. In fact, we would rate the current trading in the EV stocks in Asia as one of the clearest bubbles or manias we have seen in our 30-year investment careers.

Our problem with EVs is not that we don’t believe they are better cars than traditional internal combustion engine ones (ICE). Nor do we doubt that we are on the cusp of an inexorable acceleration in EV car sales over the next five to ten years.

Our problem with EVs is that they are all technically very similar. An EV has a fraction of the number of moving parts that a traditional car has.

What does this mean? If an EV is mostly a battery, a motor, and a lot of electronics, then the barriers to entry are low as most of these can be bought off the shelf. An EV doesn’t need hundreds of brilliant German engineers to optimise its ICE engine, so your entry barriers to making a good EV are lower. 

With barriers to entry relatively low (vs a traditional ICE car), lots of hot money in the sector and a huge numbers of new start-ups, all the classic ingredients are in place for a major price war and shake out. This is very similar to what we have seen in the past in the smartphone and flat panel television market in Asia.

As Chart 6 shows, it is already hard to differentiate between EV cars.

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We expect that, like any predominantly electronic product, the consumer will buy the latest cars with the best looking design, the latest electronics, and the best price.

This could result in relatively short product life cycles. Indeed, it is interesting to note in chart 7 how quickly newer models with the latest electronics and batteries quickly take market share from older models.

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So what does all this mean for the automotive and related stocks in Asia? We think the EV stocks themselves will disappoint and many will fail as the industry will need to consolidate. 

Sales volumes will be strong as competition and rapid technology improvements lead to better, cheaper products. But the huge number of players making fairly generic products means profits will be thin or non-existent. 

Internet stocks are a much more interesting example and, in Asia’s case, more important given they take up around 20% of the main Asian equity index, the MSCI AC Asia ex Japan. 

These stocks are amongst the most innovative companies in Asia with genuinely disruptive business models that deliver new and better services to consumers, whether it is e-commerce, music and film streaming, social media, food delivery, ride hailing, travel aggregation and so on.

However, we are now increasingly worried that excessive euphoria is driving many stocks in the sector to bubble-like valuations which leave them vulnerable to very sharp falls if the now-lofty expectations for sales and profits fail to be met.

With brokers continually increasing their revenue and margin forecasts to justify share price moves (remember broker forecasts don’t lead but follow share prices upward) we think the scope for disappointment within the sector is significant. 

When we look at most internet-related sectors in China they seem to be getting more competitive, not less. Also, new formats like live streaming e-commerce look set to potentially disrupt more traditional e-commerce channels. 

With rapid disruption, lots of competition, vast arrays of new disruptive services and a now relatively well penetrated e-commerce sector (latest consensus estimates are that e-commerce is now over 35% of total retail sales in China) we don’t believe this is a case of everyone’s a winner.

So going back to the first question: are Asian markets a bubble? 

We would say in aggregate they are not – we can still find things we want to buy in some sectors, particularly in the semiconductor and tech hardware sectors.

But bubble-like conditions clearly are prevalent in a large and growing part of our Asian investment universe (and around 30% of Asian indices by market cap), so we need to tread carefully.