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Asia increasingly good for offshore allocations

More countries in Asia are presenting solid investment opportunities for SMSFs seeking greater international equity exposure. Paul Quah identifies where some of the best prospects lie.

The focus has recently increased on the importance of global investing for Australian investors. The need for international diversification stems from concerns about equity home-country bias, the potential for this bias to be compounded with continuing inflows of superannuation contributions and a softening economic outlook for Australia.

The equity home bias results in a typical balanced portfolio having about 32 per cent exposure to Australian equities, a significant overexposure when compared to Australia’s contribution to world gross domestic product (GDP) of only 2 per cent or a share market weight in the MSCI World Index of less than 3 per cent.

This growing focus on international diversification is real, with savvy Australian super funds now allocating a significant portion (around 30 per cent) of their investments to international equities. However, it seems trustees of SMSFs are yet to realise the need for increased international diversification, with only around 5 per cent of their investments allocated to international equities.

Why invest in Asia?

The investment case for Asia is strong. With 22 per cent of the world’s GDP coming from Asia, and as home to 3.2 billion people or 45 per cent of the world’s population, Asian economies are growing at a faster rate than the rest of the world.

Despite this, Asia (ex Japan) is often overlooked for separate asset allocation in global investing. We believe it won’t be long before institutional investors start increasing or making dedicated allocations to Asian equities; indeed, the recent introduction of the Shanghai-Hong Kong Stock Connect will invariably force global index providers to increase their exposure to Asia.

The big-brush thematics as to why Asia is attractive are plenty. The emergence of Asia’s middle class and spending power is certainly one such theme we see playing out on a daily basis, but we are also as excited by the ongoing trends in urbanisation, infrastructure build-out, the breaking down of trade barriers and improvements in competitiveness and labour productivity.

The attractiveness of investing in Asia is further amplified in the land of small caps in our view. Asian small caps have significantly outperformed Australian small caps by at least 6 per cent a year (with and without currency effect) over the past five to 10 years. They have also outperformed the Australian broader market by 1.8 per cent a year over the past 10 years.

The fundamental story is even more enticing. To start with, the opportunity set is large, spanning more than 5000 companies across the 10 key Asian markets. One simply has more choice. And unlike the larger companies in Asia, there are more company managers there who are nimble enough to position for new growth opportunities, be it locally or overseas, and not be constrained by ownership ties with government. What might also surprise is we generally find Asian small company balance sheets to be more than adequate, which we think may be a function of the hard lessons learnt during the 1997 Asian financial crisis and weathering the global financial crisis in 2008.
And the icing on the cake is that investment opportunities are generally not well known or priced in, as reflected in the almost non-existent level of professional analyst coverage or institutional shareholdings in these companies. It is indeed this inefficiency that, as an Asian small-cap manager, we are positioned to exploit.

Education in Singapore

One such opportunity we see in Singapore that should resonate well with many Australian parents is in children’s schooling. As in Australia, Singapore’s education system is highly regarded and of high quality – one just has to look at the International Baccalaureate Diploma results in recent years, where both countries occupy the top two positions in terms of academic achievement.

The snapshot is that schools do well, amazingly well, where demand for places in the top private schools outstrips supply. And as economic truisms follow, we see this reflected in continued tuition fee increases in both Singapore and Australia.

But that is where the similarities end. In Singapore, private school tuition fees have risen at twice the rate of Australia and for investors there is actually a listed private school, Overseas Education, in Singapore, where there is no such choice in Australia.

Private schools satisfy two incredibly important criteria that investors should always have at the top of their shopping list for any investment: pricing power and high barriers to entry. In well-functioning and safe economies, such as Australia and Singapore, these are businesses that have more customers (students and parents from overseas emerging middle classes) than they can accommodate (seats and classrooms). And the barriers are high, where the strength of the brand and alumni are forged over years, if not decades, self-reinforced by an ability to attract and pay for quality teachers and new facilities, let alone needing to occupy a reasonably large premises from the get go.

In our view, other education providers, such as vocation or language training businesses, do not stack up as well as a fully-fledged, schoolyard, bricks-and-mortar, old-fashioned, K-12 private school – especially when it comes to pricing power and entry barriers. There is also no reliance on government funding.

Digging deeper, the economics are also quite interesting. Overseas Education can record as profit around 20 cents in every dollar received after satisfying fairly predictable expenses, such as the cost of teachers, where increases are passed on in the form of higher tuition fees. We also like the fact profits are real cash and not just accounting profits as school fees are paid upfront yearly.

Finally, in comparison to many other businesses, we can project this cash flow with a high degree of predictability years out. The bonus for us in this current investment is Overseas Education is months, if not weeks, away from completing its new campus, which can accommodate up to 1000 more students for a total of 4800. Together with tuition fee increases, this underpins what we believe to be a compelling growth outlook.

Thailand’s online retailing

Over in Thailand we are currently invested in a unique traditional retailer that is organically morphing into what could well be a major online retailer in the region.

We think the potential for growth here is enormous. It was only two years ago that Thailand was one of three countries in the world without 3G connectivity (alongside North Korea and Cuba). Furthermore, credit card penetration was only 5 per cent, with the local market protected by import taxes.

Now Thailand has more than 24 million internet users (and, not coincidentally, Facebook users), credit card penetration of more than 15 per cent, an active social media penetration rate of 52 per cent (slightly behind Australia) and 31 per cent smartphone penetration (less than half the rate of Australia, but catching up fast).

And this is where the stars align for Officemate. Established more than 20 years ago as a traditional office supply wholesaler in Bangkok, its current MBA-trained chief executive (from the founding family) launched a business-to-business platform a few years back by having the vision and ability to nail down its back-end logistics and warehousing.

It wasn’t too long after that, in 2012, that Thailand’s largest retail group, Central Group, which was clearly in agreement with the potential of online retailing, fast forwarded what would otherwise have been a number of painful years and took a controlling interest in Officemate. The brief was simple: Officemate and its chief executive were to launch and operate Central Group’s online shopping strategy for their two major department stores, which account for more than half of every dollar spent in shopping malls in Thailand.

We are watching this with avid interest: just in March, Officemate launched the two department store online retail platforms. We are not expecting Amazonian or eBay-type growth, as several pieces of Thailand’s economy and infrastructure still need to fit together, but our early entry into the stock provides what we deem a comfortable margin of safety for this investment.

Automotive innovation in Taiwan

The coming few years will mark Australia’s well-publicised final exit from the automotive manufacturing world with the impending Ford, Holden and Toyota plant closures.

What’s interesting is that if the view of some commentators that the decay set in some 30 years ago is right, it would also be about that time Taiwan put into motion its Auto Industry Operation Guideline (1972). This was followed by numerous development initiatives aimed at learning how to develop leading-edge auto components and technology in what the Taiwan Transportation Vehicle Manufacturers Association deem as the ‘production technology absorption period’ spanning more than 20 years.

Our excitement here is that as investors in Asia, we can now benefit from the work done during the ‘active development period’ that describes most of the development since 1999. The opportunity presented is a combination of a mouth-watering global thematic in the emergence of electric vehicles to advanced safety systems, in keeping with the rise of the intelligent car, married with Taiwanese managers who are free to be entrepreneurial, running highly specialised plants within the comforts of a highly integrated and seamless supply chain on the outskirts of Taipei. The inter-industry and customer relationships, local and otherwise, have stood the test of time since the 1970s.

Hota Industrial, for instance, a Taiwanese company specialising in gear transmissions since 1966, is what the industry calls a tier 1 supplier, meaning it has a direct plug into the carmakers. But the more important meaning from our perspective is that it tells us Hota is good, very good in fact, with the big carmakers often preferring them over others based on quality, reliability and financial viability, among many other factors.

One of Hota’s customers is Tesla Motors, arguably the most progressive carmaker in the world, renowned for taking the lead in the development (and sales) of electric vehicles. Just in the last quarter, Tesla announced it sold more than 10,000 electric vehicles, which is 55 per cent more than a year ago. For this year, Hota expects its sales to Tesla will double.

As impressive and important, from a sustainability point of view, we think Hota has got the science down to as close to making cookies as one possibly could if the level of production automation is anything to go by, based on our observations on a recent tour of its plant in Taichung (an hour from Taipei on high speed rail).

Investing in Asia is not without risk and in small caps we believe there is no substitute for travel to get our noses on the ground, braving the infamous traffic in many parts of the region as we tyre-kick our way around a few times a year.

The good news is it’s getting safer. It should be as Asia and the rest of the world start to piggy-back on the legislative wave of increased auto safety (from tyre-pressure monitoring to reverse camera systems being made mandatory standard features) introduced or to be introduced in the United States and to some degree the European Union. On that note, we are riding comfortably with our investment in an Asian specialist auto safety component supplier to General Motors, Volkswagen, Nissan and some of the other biggest automotive companies in China.

Investing in Asia generally is getting safer as well. Despite possible concerns from many investors about the transparency and corporate governance of companies operating in the region, we have usually found the standard is in fact very high, and in most cases rising.

Many of the obstacles investors believe stop them from investing in Asia are easy to overcome, and in our view the opportunities that await them are definitely worth the effort.

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