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Asian equities: It's the price, not the
quality
By John Mulcahy
Oscar Wilde famously defined a cynic as a man
who knows the price of everything and the value of
nothing. So how would he have described investors who
were skeptical about an Asian market (China H shares)
valued at a price-to-earnings ratio of 6.4 times
earnings two years ago, but who don't seem to be able to
get enough of the same market at a value of 15.4 times?
It's not difficult to see why Asia is again the
flavor of the month, as the MSCI Asia Free ex-Japan
Index has risen 48.8 percent since October 2001, and by
38.2 percent over the past year alone. Institutional
investors are notorious for chasing market performance
rather than anticipating it. To be fair, this is not
entirely self-inflicted, as the great unwashed, or
ordinary fund buyers, tend to channel money into markets
that have already performed. Fund managers are forced to
invest this cash-flow, and the tendency as a consequence
is for funds to buy at the top of the market and to sell
at the bottom.
Still, the reality is that Asia
is where the growth is, and with Japan finally showing
some signs of life, combined with China's unrelenting
economic progress, the center of gravity for equity
investors has moved back to the Pacific region. On a
geo-political level, China and Japan seem to be more or
less on the same page, and there is considerable
delicacy in Washington's dealings with Beijing and
Tokyo.
On the one hand, the Asian central banks
are assailed by President George W Bush and his Treasury
Secretary John Snow for manipulating their currencies.
On the other, it is clear that China holds the key to
containment of North Korea. It does not require too much
imagination to conclude that the US rates an unstable
Pyongyang rather higher on the list of Asian demons than
an undervalued yuan.
While Latin America is
closer to the hearts of US institutional investors than
Asia, the reality is that there is little growth in that
region and international capital flows are
unsentimental. The prospect of falling costs of capital
around Asia will stimulate investment in capacity around
the region and support a renewed round of earnings
growth. Using the average earnings yield as a proxy for
the cost of capital, the average across ex-Japan Asia is
currently 6.4 percent compared with 7.75 percent two
years ago. Paradoxically, the decline in the cost of
equity capital comes at a time when Asia is reflating,
suggesting that companies can finance expansion at
increasingly attractive costs even as demand for their
goods is surging.
While central bankers shift
nervously in their seats at the prospect of renewed
inflation, the past decade in Japan, and elsewhere in
Asia, suggests that the managers of these economies are
better able to manage inflation than deflation. From an
equity investment standpoint, Asian markets have tended
to perform better as inflation has accelerated, even
though the seeds for eventual disaster are sown during
this phase. It was cheap capital, or rather the
irresponsible spending of that capital, that brought
about the collapse of the Asian economies in the late
1990s.
Anyone with an investment tracking the
MSCI Asia Free over the past year would have been quite
content to book that performance. That is particularly
true given the torrid time that managed funds have had
in Asia since 1997. Unfortunately, most funds will have
underperformed the benchmark index, and the wall of
money chasing Asian markets now is trying to catch up
with performance that has already happened. In other
words, history is in the process of repeating itself.
"The rogues are all coming back," says one
long-time observer of the Asian investment scene in Hong
Kong. "[In Asia] we don't know how to do it other than
by boom and bust. This time will be no different." That
does not mean everyone is convinced, as an arch-bull of
Japan during that market's collapse, James Montier of
Dresdner Kleinwort Wasserstein, notes in a recent
report. The title of the report, Won't Get Fooled Again,
reflects Montier's confession of his own misguided
optimism during an earlier cycle in Japan. He maintains
that Japan is a cyclical market with mediocre prospects
until a change in economic policy coincides with cheap
valuations.
As funds flow back into Asia in
volumes last seen in the heady days of the 1990s, the
bears have retreated deep into the woods. The tendency
to dismiss any market adjustment as a "correction" in a
structural bull market recalls earlier times. A cartoon
published at the time of the Crash of 1987 - Black
Monday - showed a brace of huge grizzly bears hiding
behind the door of a darkened room. Tentatively looking
into the room was a nervous investor, and the voice from
the room said: "Bears, what bears? No one in here but us
corrections."
Indeed, the mood of the markets is
closer to the running of the bulls in Pamplona than to
the Teddy Bears' Picnic. According to
EmergingPortfolio.com Fund Research, global funds in its
coverage have been net buyers of US$7.8 billion in East
Asian emerging equities this year and net sellers of
$1.5 billion in Latin American stocks. In India, foreign
institutional investors (FIIs) have placed a net $1
billion in India in October, a record for any single
month. Of the $1.037 billion in net FII investment into
India in October, more than $981 million was in stocks,
and the balance in debt.
Japan has seen more
than six months of net buying of its stock market by
foreign investors this year. Data on the Japanese
economy has generally been positive this year, and more
than a decade of recession and poor markets may be
coming to an end there. The forthcoming election is
likely to see Prime Minister Koizumi re-elected, and
some Japan veterans are convinced the turning point has
come.
Brian Nicol, a former fund manager who has
been covering Japan for more than 20 years, and produces
an independent daily newsletter on the Japanese market,
reflects the careful optimism of the bulls. "Corporate
profits are looking strong and the banking problem is
being addressed. It is my belief that recent airpockets
in economic data releases will prove temporary, and the
much-awaited upturn in the domestic economy will
materialize."
According to stockbrokers selling
Asian markets to global institutional investors, fund
managers are reluctant to listen to negative stories on
these markets. Deutsche Bank strategist David Scott,
voicing concern about the lack of bears in the Asian
markets, says there has been a classic "bear
capitulation", and he notes that no institutional
investors at a recent investment conference in Hong Kong
wanted to hear a bear story.
The revival of the
Asian bulls has been a long time coming, according to
the more sanguine observers, but talk of bubbles has
also resumed. The problem with that position is the fact
that Asian markets are notoriously driven by liquidity,
and the reality is that it is far more important in bull
markets to follow prices rather than value. "Never mind
the quality; follow the money," is the market maxim.
During the dull years of the bear market,
institutional fund managers pored over data, criticizing
research that dared to make a bullish case. Now, they
have no time to listen to their brokers as they battle
to invest the huge inflows of money. One Japanese fund
has seen its asset size grow by 20 percent over the past
month, from $100 million to $120 million, on inflows
alone. "What should I do? Refuse the money because I
think the market may be a little rich?" says the fund
manager, who did not wish to be identified.
While Asia ex-Japan has had its share of
volatility in recent years - including the "phony" bull
market in 1999-2000, when companies changed their names
to acquire an image of technology - there has not been a
sense until this year that a genuine recovery was under
way. That is at least in part due to the belief that
Japan itself is shedding the recessionary monkey from
its back.
It is also a function of another
phenomenon, the continued success of Communist China's
long march to the market. The difficulty for investors
in China's success is the lack of investable assets.
Bank Credit Analyst, in a recent study on China,
concluded that China had only $50 billion in investable
market capitalization available to foreigners. Too much
money chasing too few goods is a principle that comes to
mind in considering the dramatic revaluation of China's
equity markets over the past year. For example, Hong
Kong's H-share index was trading on a multiple of 8.7
times annual earnings in October last year. It is now
trading at a multiple of 15.4 times. Datastream's China
index has moved from a valuation of 8.6 times to 11.7
times over the past year.
It may well be that
the 77 percent inflation in the China H-share index over
the past year is a legitimate restatement of the
underlying value of the earnings prospects in China. But
it is also likely that investors frustrated at the lack
of investment opportunities in China have been seeking
proxies for the China story in other markets. "Japan's
stock market may be an indirect route into China by
participating through large-cap companies investing in
the region," says Bank Credit Analyst.
For the
year to date, the Morgan Stanley EAFE Index, which
covers Europe, Australia, Asia and the Far East,
essentially the world minus the US, is up more than 18
percent. This was driven in part by the performance of
East Asia's emerging markets, but also by Japan's
performance. Japan accounts for 23 percent of the EAFE
Index.
It is likely the markets will take a
breather, or "consolidate" at some point in the next few
months, but the signs are there to support the notion of
a long-term bull market in Asia. The challenge for
investors is in timing. Extremists are always right at
some point in the cycle, but the key is to extract
profits from the process. The markets appear ready for a
pullback, which will probably do nothing more than
attract another massive wall of money. The game is on
again.
John Mulcahy has been covering
Asia for 20 years, as a journalist with the South China
Morning Post and Far Eastern Economic Review and as
equity research head at Vickers da Costa, Peregrine and
UBS.
(Copyright 2003 Asia Times Online Co,
Ltd. All rights reserved. Please contact
content@atimes.com for information on our sales and
syndication policies.)
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