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Animal Spirits Pan Asia Strategy 23 November 2017 Animal Spirits Reconciling Nifty-style and Asian small cap equities Continuing the Nifty-style theme, we suggest having some exposure to Asian small caps to hedge concentration risk as growth returns Asian small caps are outgrowing the broader indices, and while size alone favours the mega caps, JASDAQ and KOSDAQ surprise Based on factor and thematic selection, we add Canvest Environment Paul M. Kitney, PhD Protection and Lee & Man Paper to our top picks (852) 2848 4947 [email protected] Asian small caps and diversifying market concentration risk. While large cap and especially mega cap equities have made an outsized contribution to equity returns, our analysis demonstrates evidence that growth stocks are now generating alpha. Small cap names, particularly those with sustainable growth, provide diversification from Nifty-style market concentration. Small cap growth is superior and the price for growth is reasonable. MSCI Asia ex-Japan small cap earnings growth is markedly outpacing the broader MSCI Asia ex-Japan index, and the PEG is meaningfully lower for 2018 and 2019. Animal Spirits top picks Company Ticker JASDAQ and KOSDAQ outperform with concrete earnings drivers. New China Life Insurance 1336 HK While the JASDAQ has outperformed the TOPIX since January 2017, the PICC 1339 HK KOSDAQ has only started to outperform the KOSPI since October 2017 Hana Financial 086790 KS Yes Bank YES IN but is making up for lost time. Earnings growth for both over-the-counter SK Hynix 000660 KS (OTC) markets is more rapid than the broader indices, but we find the NCsoft 036570 KS JASDAQ is more attractively priced, relatively. Tencent 700 HK Brilliance China Auto 1114 HK Beijing Enterprises Water 371 HK Small cap focus and top picks. We add Canvest Environment Protection PTT Pcl PTT TB Group (1381 HK, HKD4.61, Buy [1]) and Lee & Man Paper Manufacturing SK Holdings 034730 KS (2314 HK, HKD9.1, Outperform [2]) to our top picks list. We focus on LG Corp 003550 KS Canvest Environment Protection 1381 HK quality and growth in the KOSDAQ, discussing relevant themes. We screen Lee & Man Paper 2314 HK both the KOSDAQ and emerging Asia small caps, and discuss promising Source: Daiwa themes and stocks. See important disclosures, including any required research certifications, beginning on page 16 Animal Spirits: 23 November 2017 Growth’s return to prominence encourages some small cap exposure in Asia Can small caps help hedge market concentration risk? Having some small cap Recently, Animal Spirits broached the subject of market concentration risk, concluding that exposure can help there is a Nifty-style to market leadership at present, predominantly led by the technology hedge market sector. We also found, in the particular case of Korea, that earnings growth and concentration risk comparative valuation were compelling outside of the narrow corridor of Nifty names and without sacrificing indeed well beyond information technology (IT). We argued a barbell approach, weighting earnings growth the exposure to the index heavyweights, ideally with the use of volatility (via call options in a cash extraction strategy), and then expanding into materials, financials, energy sectors, as well as non-heavyweight names in IT. Now, the question posed here is whether Asian small cap equities can fit into this diversification strategy, in a market characterised by mega cap leadership, without sacrificing performance? We argue there is the case for some small cap exposure based on an earnings growth argument and recent trends indicating that shareholder returns are rewarding growth more than they have in some time. Yet first we need to address the immediate question of large cap dominance. Large caps have driven market returns When we observe the broad indices for Japan and Asia ex-Japan (see below), the “size” factor has been trending down, which means that small cap stock selection, ceteris paribus, has induced a negative excess return. In other words, large caps have outperformed — surprise, surprise! So why would we consider small caps in these circumstances? The answer relates to the Latin phrase above. All things are not equal. MSCI Asia ex-Japan: size factor excess returns MSCI Japan: size factor excess returns 120 115 115 110 110 105 105 100 100 95 95 90 Jul-16 Jul-17 Jul-16 Jul-17 Apr-16 Oct-16 Apr-17 Oct-17 Apr-16 Oct-16 Apr-17 Oct-17 Jan-16 Jun-16 Jan-17 Jun-17 Jan-16 Jun-16 Jan-17 Jun-17 Feb-16 Mar-16 Feb-17 Mar-17 Feb-16 Mar-16 Feb-17 Mar-17 Dec-15 Aug-16 Sep-16 Nov-16 Dec-16 Aug-17 Sep-17 Dec-15 Aug-16 Sep-16 Nov-16 Dec-16 Aug-17 Sep-17 May-17 May-16 May-17 May-16 Source: Factset, IBES, Reuters, MSCI and Daiwa Custom Product Group Source: Factset, IBES, Reuters, MSCI and Daiwa Custom Product Group Yet growth has returned to favour What changed in Asia ex-Japan during 2017 was growth returned to favour and has been outperforming since March, as shown in the chart below. In the previous Animal Spirits report (Nifty-style, Korea and the other seventy percent, 15 November 2017), in the context of Korea, we demonstrated the bifurcation of the outperformance and underperformance of growth and value stocks, respectively. This trend clearly extends beyond Korea. We argue that small caps are a way to gain diversified exposure to growth-style. The regional small cap team at Daiwa, led by John Choi, has a growth-oriented stock-picking methodology, expressed in their Discovery product (Asia small-cap weekly). Animal Spirits chose its top pick this week from Daiwa’s small cap Discovery research coverage. 2 Animal Spirits: 23 November 2017 MSCI Asia ex-Japan and Japan growth factor excess returns 130 120 110 100 90 80 Jul-16 Jul-17 Apr-16 Oct-16 Apr-17 Oct-17 Jan-16 Jun-16 Jan-17 Jun-17 Feb-16 Mar-16 Feb-17 Mar-17 Dec-15 Aug-16 Sep-16 Nov-16 Dec-16 Aug-17 Sep-17 May-16 May-17 MSCI Japan MSCI AxJ Source: Factset, IBES, Reuters, MSCI and Daiwa Custom Product Group Superior earnings growth and PEG appeal in small caps Asian small caps are So are Asian small caps more “growthy” than the broader indices? Absolutely. Consider the outgrowing the broader table below. For 3 consecutive years, including forecasts, earnings growth in the MSCI indices and growth is in Asia ex-Japan Small Cap index has outpaced the parent, larger cap index. Using 3-year vogue rolling compound average earnings growth rates (CAGR), PE to growth (PEG) ratios for the small cap index are meaningfully lower than those of the broader index, despite the slight small cap PE premium. In our opinion, this is mispriced growth. We think Asian small caps, particularly those with higher growth profiles, are worth some exposure, especially since growth-style is gaining traction in the current market environment. MSCI Asia ex-Japan: small cap versus benchmark earnings and valuation comparison MSCI AC Asia ex-Japan MSCI AC Asia ex-Japan Small Cap EPS Growth CAGR 3Y PE Calendar Year PEG EPS Growth CAGR 3Y PE Calendar Year PEG (%) (%) (x) (x) (%) (%) (x) (x) 2017E 25.1 0.5 14.8 28.62 53.5 7.0 16.6 2.37 2018E 18.3 11.2 12.5 1.11 23.3 28.4 13.5 0.47 2019E 9.9 17.6 11.3 0.64 16.7 30.2 11.5 0.38 Source: MSCI, Bloomberg, Daiwa Customs Product Group Note: Calendar year PER used in this table JASDAQ and KOSDAQ outperformance stand out While in broad Asia ex-Japan indices small caps have not kept up with their larger cap counterparts in recent history, the same cannot be said for the OTC markets in Japan and Korea. The JASDAQ has consistently outperformed the TOPIX over the past 2 years and more recently, there appears to be a sea-change in Korea, with the KOSDAQ undoing most of its 2017 underperformance over the past 2 months. JASDAQ relative to TOPX and KOSDAQ relative to KOSPI return history 140 130 120 110 100 90 80 70 60 1/1/2016 4/1/2016 7/1/2016 10/1/2016 1/1/2017 4/1/2017 7/1/2017 10/1/2017 KOSDAQ/KOSPI Rel Perf JASDAQ/TOPIX Rel Perf Source: Factset, Daiwa Custom Product Group The jury is out as to whether the strong outperformance of these small cap indices merely reflects isolated domestic or idiosyncratic drivers, or is this a harbinger of change more broadly for small cap returns in Asia? 3 Animal Spirits: 23 November 2017 In the case of Korea, thus far the move in KOSDAQ has been driven largely by domestic retail investors, but our sources on the ground inform Animal Spirits that institutional investors are getting involved and their interest extends beyond several healthcare and biotech names, that give yours truly vertigo. For example, CMG Pharmaceutical (058820 KQ), Sillajen (215600 KQ), and Celltrion Pharm (068760 KQ) equity prices have risen more than 100% over the past 2 months. Chinese competition for An emerging KOSDAQ-related theme, more grounded in fundamentals, is the increased Samsung suppliers’ competition for the services of the Samsung group component suppliers from Chinese components implies technology companies. Historically, these companies have had little pricing power and better margins for were at times squeezed by Samsung during cost-cutting phases. However, that is likely to several KOSDAQ listed change with the need for Samsung to secure its supply chain, driving a new relationship companies with its suppliers, resulting in better pricing terms for the latter and ultimately higher margins.
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