Smaller companies in Asia: where the long-term potential lies
Karex provides an apt illustration of the types of opportunities offered up by smaller companies in Asia.
CEO Goh Miah Kiat cites an anecdote which illustrates how the industrial processes of his company, a condom manufacturer, have been transformed. He recalls how once a key part of the manufacturing process was performed by chopsticks.
Needless to say, production methods have moved on and Karex, listed in Malaysia since 2013, is now the world’s largest manufacturer of condoms.
Operating mainly as an original equipment manufacturer (OEM), around half of its revenue is derived from stable sources of income from contracts with entities that include NGOs, WalMart and, most recently, the UK’s NHS.
The structural themes that make the region such an exciting prospect for investors will likely never fade. These include favourable demographics, the rise of a sizeable middle class with increased spending power and wide-scale urbanisation.
However, as investors we see a more exciting ongoing transition. Asia has traditionally been viewed as the “West’s factory” with its abundant cheap labour and developed supply chains.
This, though, is rapidly changing as these same labour costs rise. Now, Asian companies are creating a lot of the value for end products and services themselves.
Budgets for research and development (R&D) are rising for many Asian companies and the evidence of the positive effects of this are encouraging (see chart below).
In place of the usual copycats from countries such as Korea, China or Taiwan are some truly innovative and exciting firms. Long term, this is a trend that is unlikely to change.
Smaller companies vs. large caps in Asia
Why do we prefer small caps? It’s simple, really. What you tend to get when you invest in large caps in Asia is an excess of state-owned enterprises (SOEs).
A large proportion of the MSCI stock indices, for example, are dominated by these behemoths. On the whole, we avoid these given their generally poor corporate governance and often apathetic attitude towards the interest of minority shareholders.
It has become clear that for investors to really tap into the Asian growth story, and its accompanying liberalisation, exposure to smaller companies is important.
Besides this, smaller companies have also outperformed. Their track record over the past 15 years has been impressive1, although this of course offers no indication of future performance.
Besides one or two blips throughout that period, such as the years of the Asian Financial Crisis, Global Financial Crisis and (oddly) last year, small caps have outperformed their larger cap brethren2.
For investors, the exposure to the local markets means you are paying to tap into this exciting growth. It is far easier for smaller companies to grow at a faster clip and where we see accelerated growth at an early stage in Asian companies, we also see returns.
How are valuations looking?
Currently, on a price-to-book3 (PB) ratio, small caps in Asia are trading roughly in line with the historical average of 1.3-1.4x. This discount to large caps in Asia can vary widely from 10% up to 45% of PB but would normally average 20-30%.
This discount has narrowed considerably over the past few years but has started to creep back up (see chart below) as investors plough capital into large caps, which in our view is based largely on a reflation trade4 on China.
A large bounce in commodity-type names has been the result and was one of the main reasons for the outperformance of regional large caps last year.
How do we go about selecting the companies best placed to reward investors? On a company level, clearly the management and business model are key factors. How do the company’s distribution, brand and technology fare on a three-year horizon? And does it have a moat that protects it from competition?
On the management end, we aim to ensure that the owners or majority shareholders are on the same page as us minority investors, i.e. creating shareholder value.
Scrutinising a firm’s corporate governance can include carrying out forensic accounting and digging into the owners’ histories – whatever is possible in order to safeguard our potential investment.
Closely monitoring their track record and weeding out any questionable governance or capital allocation decisions are also paramount.
Our financials focus is very much on the company’s ability to efficiently manage its balance sheet and as investors we are return on invested capital5 (ROIC)-centric. We look at companies that possess higher ROIC but, crucially, also have reasonable debt levels.
Where are we seeing the best opportunities?
A number of interesting, and family-owned, businesses can be found in India and they continue to do, successfully, what they’ve been doing for decades.
Admittedly, the business environment in the country can be chaotic but where chaos exists opportunities can usually be found. Liquidity and valuations are two issues we have to grapple with in the market but the long-term opportunities present in India are still exciting to us.
Meanwhile, in Taiwan companies have managed to carve out particular niches in certain sectors which have embedded them as crucial players in global supply chains.
Elsewhere, in China, we are less enthused than many investors by the top-down picture and are more focused on corporate governance concerns.
Overall, though, the small cap space in Asia continues to present investors with an exciting opportunity to tap into the extraordinary pace of change that is ongoing in the region.
At this level, the most innovative and nimble companies flourish and will most likely be the biggest winners of the overarching structural themes.
1. Macquarie Research, 28 February 2017↩
2. Macquarie Research, 28 February 2017↩
3. Price-to-book is a financial ratio used to measure a stock’s market value to its book value.↩
4. A reflation trade is one which invests on the back of a pick-up in inflation and earnings growth↩
5. Return on invested capital is a financial ratio used to measure profitability and value-creating potential of companies after taking into account the amount of initial capital invested.↩
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