Positioning for resilience in volatile times
Endowus Insights

Leap into prosperity this CNY 💰     Get an $88 head start to growing your wealth.

Leap into prosperity this CNY 💰Get a $88 head start to growing your wealth.

Positioning for resilience in volatile times

Updated
24
Nov 2022
published
5
Aug 2022
investment strategy focusing on governance, earnings growth

Our thoughts:

Quality always pays off in the end. Short-term market volatility is not a reason to pull back risk appetites, but rather an opportunity to add high-quality companies, with good governance and solid prospects, at more attractive valuations.

FSSA Investment Managers (an autonomous investment team within the First Sentier Investors group) has been investing in Asia and global emerging markets for three decades. We are conservative investors, and resilience during market sell-offs has underpinned our long-term performance. We believe this is an outcome of our unrelenting focus on quality.

As bottom-up stock pickers, we focus on company fundamentals, such as the competitive moat and the management. Even good companies are tested in downturns, but the qualities they exhibit often lead to greater advantages when the external environment improves. Investing in quality companies gives us the conviction to add to a position when the price has fallen.

The following are some of the factors we seek when selecting companies to invest in.

Before the storm:

Long-term earnings growth, structural tailwinds

Clients often ask us about the macro environment and whether it will be a V-shape, L-shape or U-shape recovery, or if there will be a hard or soft landing. 

The honest answer is that we don’t know – none of us can predict the future. In our experience, company earnings drive share prices. 

So while property cycles and economic cycles are important, we believe a better question to ask is, “What will happen to company earnings in the next five to ten years?” As the share price is likely to follow. 

Part of this is finding long-term structural growth drivers to support our bottom-up company research. 

For example, China’s ageing population and shrinking workforce means that automation should be a growing trend. Last year was a record-low year for birth rates in China. Based on the demographic trend, in the next 10 or 20 years there should be increasing demand for robotic equipment as well as components that can improve the production process.

Meanwhile, healthcare spending in China is much lower than in developed countries. This, combined with China’s ageing population, means that demand for healthcare should remain steady, despite the short-term policy noise. Other trends driving growth in the healthcare sector include domestic companies moving up the innovation curve and consolidation among the industry leaders. 

The people factor: good governance

The FSSA team spends a significant amount of time assessing the people leading a company. 

We particularly like to see leaders that are risk aware and humble, like Sandeep Bakhshi, chief executive officer (CEO) of ICICI Bank, or those that look after a broader set of stakeholders, like Joey Wat, CEO of Yum China, which has one of the most generous employee benefit programmes in China. 

Or managers that constantly try to be forward-looking, like MercodoLibre’s chief financial officer (CFO) Pedro Arnt, who is known for his lack of complacency.

The next thing we look for is alignment of interests. We want to see simple corporate structures and long-term-minded owners who are on the same page as minority shareholders. 

We do not like to see complicated structures, cross holdings, dual share classes which benefit one set of owners versus the others, or companies that have state ownership, as their interests may be different from ours. We tend to shy away from initial public offerings (IPOs) due to the asymmetric risk between the sellers and the new shareholders.

We also focus on boards and their composition. They are the ones responsible for business strategy, capital allocation, and incentive structures. Therefore, it is important for a board to be composed mostly of independent directors who have the experience of serving in other organisations and are likely to stand up for minority shareholders when things go wrong.

A good example among our holdings is Syngene International, a biotech manufacturing company in India. The board is majority independent, with only the owner and the CEO on the board as insiders. The rest of the directors come from a tapestry of reputable organisations. 

This focus on governance has helped us avoid some pitfalls. 

For example, we had no investments in Russia prior to the invasion of Ukraine. We have always found it hard to invest in Russia given our focus on governance and quality. Whenever we carried out due diligence on a company, its ownership would include someone who would be close to Putin. This was a difficult roadblock for us to overcome. 

As a result, we have not had to make any changes to the portfolio amid the recent global tensions with Russia.

Dominant industry positions, strong competitive advantages

While governance is paramount, we also look for strong business models with solid long-term growth prospects. 

We tend to focus on companies that benefit from domestic demand and have circular long-term growth drivers such as demographics, urbanisation, productivity catch-ups, or import substitution. 

These companies may operate in smaller industries, but from experience and observing other economies, we know that these industries tend to become larger as incomes grow.

Additionally, each of our holdings should have a clearly defined competitive advantage. For example, airports are a legal monopoly — they are retail businesses with captive consumers that tend to come from the higher income segments of society. 

Another example of a competitive advantage is economies of scale, like with Chinese e-commerce giant JD.com. As they grow in scale, these companies can give back those advantages to consumers and set up a virtuous, enduring cycle of growth. 

A trusted brand name such as Colgate-Palmolive, or quick-service restaurants like Domino's, can also be considered a competitive advantage. They have significant moats in terms of what they represent to customers and the premium they can therefore charge. This helps to protect margins during challenging periods.

Another sign of a sustainable competitive advantage is high cash generation. We dislike companies that need large amounts of capital to grow cash flows. We focus on asset intensity, working capital, and free cash flow (FCF) generation as metrics.

Putting all this together, we look for businesses with good governance, strong competitive advantages, and solid prospects; in other words, companies that can sustainably compound cash flows at high rates.

During a crisis:

When the market falls, we typically do not turn over our portfolios or sell out of our existing holdings. 

There is a strong belief on our team that every crisis presents an opportunity. During weak markets, better-quality companies often have an opportunity to gain market share and become stronger – and we can buy them at more reasonable prices than before. 

That said, when a market shock such as a pandemic or geopolitical conflict occurs, we may conduct additional checks on our assumptions and revisit our target valuations and conviction levels.

Some of the additional factors we check include: 

Business performance during previous downturns

If a company has shown resilience in a previous downturn, that can bode well for the current situation. 

We own Recruit Holdings in Japan, which is a leader in the global human resources (HR) industry. Recruit’s main growth driver is its HR technology business, primarily through Indeed, the largest online career search engine in the world. 

The business demonstrated its resilience through the Covid-19 recessionary period, as revenue was virtually flat in fiscal year (FY) 2021, while margins declined only slightly. Driven by labour shortages and strong pent-up demand, revenue subsequently more than doubled in the first half of FY2022 and margins surged. 

As market sentiment turned this January, Recruit was sold off on concerns that its high growth would be unsustainable, though the number of job postings continues to trend strongly across the US, Europe and Australia. We are confident that the company will recover, given its sound fundamentals. 

How management teams responded to Covid-19

We were challenged in the early stages of the pandemic, given the unprecedented lockdowns and uncertainty. 

What ultimately gave us confidence were the meetings we held with management in that period. We realised that while the crisis was negative, many of our holdings would end up benefitting in the long run, relative to their competitors.

One example is HDFC Bank in India. At the height of the pandemic, as India came to a standstill for four months, HDFC Bank's customers had zero revenues, and there were serious questions about how they would pay their interest costs. 

However, HDFC Bank’s actual provision rates did not rise much during that period, while deposits accelerated significantly. In our view, that is another feature of well-managed and reputable banks. During periods of stress, there is a flight to safety, and depositors move their savings to banks that they believe are better placed. 

In fact, this is typical of all the banks we have invested in across other markets within our strategy: they generally have industry-leading deposit franchises, which gives them a cost of funds advantage during tough times. They have risk-aware and countercyclically-minded management teams, and they usually come out of crises with a higher market share, better returns, and an improved customer base.

We have been invested in HDFC Bank for nearly two decades, and we saw these advantages come to the fore during the global financial crisis (GFC) in 2008, the taper tantrum in 2013, and again during the Covid-19 lockdowns over the last couple of years in India. 

With our views on the quality of HDFC Bank — and having spoken with the CEO — we concluded that it should emerge from the pandemic stronger than ever.

What we focus less on

  • Commodity prices, interest rates, and other major macro factors

    As bottom-up investors, we cannot forecast macro movements or outsmart the market on a short-term basis, but we are resolute in our belief that quality always pays off in the end.

    If we invest on at least a three to five-year time horizon and seek out capable companies that are focused on long-term and sustainable growth, we believe we can continue to deliver reasonable absolute returns for our clients.

  • Unsustainable earnings growth

    In our view, not all earnings should be judged similarly — earnings that are mostly delivered in cash and from highly recurring revenue or new avenues of growth are more sustainable.

    Less sustainable are those earned in a cyclical recovery, or from reflationary trends, leverage, share buybacks, or requiring a greater amount of capital.
  • Market volatility and short-term relative weakness

    We are convinced that the way to achieve superior long-term returns is to focus on long-term absolute returns.

    By being benchmark agnostic, we can position our portfolios differently from the crowd, during times of widespread fear as well as euphoria.

    Amid the recent market weakness, we have taken advantage of the lower valuations to add to existing holdings and those ranked as high quality on our watch-list.

Building conviction in individual companies

We are experiencing volatile times, with interest rate hikes led by the US Federal Reserve, the Russia-Ukraine conflict, trade and technology tensions between China and the US, and China’s Covid-19 resurgence and regulatory crackdowns being just a few of the latest flashpoints.

By listing out the key components of quality, we hope to shed light on how we maintain our investment discipline and adhere to our long-standing investment philosophy and process, which we believe is the most important thing to do during uncertain times. 

To us, short-term market volatility is not a reason to pull back our risk appetite, but rather an opportunity to add high-quality companies at more attractive valuations.

We cannot predict the nature or severity of the next downturn. Nor can we expect positive performance in all market conditions. 

But we are assured that, after experiencing many cycles over the past three decades, our investment process has proven its resilience over the long term.

This article was originally published by First Sentier Investors on 4 May 2022.

First Sentier Investors (formerly First State Investments) manages US$180.3 billion in assets (as at 31 March 2021) on behalf of institutional investors, pension funds, wholesale distributors, investment platforms, financial advisers, and their clients worldwide. The firm is a standalone global investment management business with offices across Europe, the Americas, and Asia Pacific. First Sentier Investors’ expertise spans a range of asset classes and specialist investment sectors focused on delivering sustainable investment success based on responsible investment principles.

FSSA Investment Managers operates as an autonomous investment team within the First Sentier Investors group.

Endowus has three funds from First Sentier Investors (as of 5 August 2022): the FSSA Dividend Advantage Fund, the FSSA Regional China Fund, and the Bridge Fund.

Get started building your own portfolio with these funds on the Endowus Fund Smart platform.

<divider><divider>

First Sentier Investors disclaimer

‍Reference to specific securities (if any) is included for the purpose of illustration only and should not be construed as a recommendation to buy or sell the same. All securities mentioned herein may or may not form part of the holdings of First Sentier Investors’ portfolios at a certain point in time, and the holdings may change over time.

This material is for general information purposes only. It does not constitute investment or financial advice and does not take into account any specific investment objectives, financial situation or needs. This is not an offer to provide asset management services, is not a recommendation or an offer or solicitation to buy, hold or sell any security or to execute any agreement for portfolio management or investment advisory services and this material has not been prepared in connection with any such offer. Before making any investment decision you should consider, with the assistance of a financial advisor, your individual investment needs, objectives and financial situation.

We have taken reasonable care to ensure that this material is accurate, current, and complete and fit for its intended purpose and audience as at the date of publication. No assurance is given or liability accepted regarding the accuracy, validity or completeness of this material and we do not undertake to update it in future if circumstances change.

To the extent this material contains any expression of opinion or forward-looking statements, such opinions and statements are based on assumptions, matters and sources believed to be true and reliable at the time of publication only. This material reflects the views of the individual writers only. Those views may change, may not prove to be valid and may not reflect the views of everyone at First Sentier Investors.

About First Sentier Investors

‍References to ‘we’, ‘us’ or ‘our’ are references to First Sentier Investors, a global asset management business which is ultimately owned by Mitsubishi UFJ Financial Group. Certain of our investment teams operate under the trading names FSSA Investment Managers, Stewart Investors and Realindex Investments, all of which are part of the First Sentier Investors group.

We communicate and conduct business through different legal entities in different locations. This material is communicated in:  

  • Australia and New Zealand by First Sentier Investors (Australia) IM Limited, authorised and regulated in Australia by the Australian Securities and Investments Commission (AFSL 289017; ABN 89 114 194311)
  • European Economic Area by First Sentier Investors (Ireland) Limited, authorised and regulated in Ireland by the Central Bank of Ireland (CBI reg no. C182306; reg office 70 Sir John Rogerson’s Quay, Dublin 2, Ireland; reg company no. 629188)
  • Hong Kong by First Sentier Investors (Hong Kong) Limited and has not been reviewed by the Securities & Futures Commission in Hong Kong. First Sentier Investors and FSSA Investment Managers are business names of First Sentier Investors (Hong Kong) Limited.
  • Singapore by First Sentier Investors (Singapore) (reg company no. 196900420D) and this publication or advertisement has not been reviewed by the Monetary Authority of Singapore. First Sentier Investors (registration number 53236800B) and FSSA Investment Managers (registration number 53314080C) are business divisions of First Sentier Investors (Singapore).
  • Japan by First Sentier Investors (Japan) Limited, authorised and regulated by the Financial Service Agency (Director of Kanto Local Finance Bureau (Registered Financial Institutions) No.2611)
  • United Kingdom by First Sentier Investors (UK) Funds Limited, authorised and regulated by the Financial Conduct Authority (reg. no. 2294743;  reg office Finsbury Circus House, 15 Finsbury Circus, London EC2M 7EB)
  • United States by First Sentier Investors (US) LLC, authorised and regulated by the Securities Exchange Commission (RIA 801-93167)

To the extent permitted by law, MUFG and its subsidiaries are not liable for any loss or damage as a result of reliance on any statement or information contained in this document. Neither MUFG nor any of its subsidiaries guarantee the performance of any investment products referred to in this document or the repayment of capital. Any investments referred to are not deposits or other liabilities of MUFG or its subsidiaries, and are subject to investment risk, including loss of income and capital invested.

<divider><divider>

Endowus disclaimer

Investment involves risk. The value of investments and the income from them can go down as well as up, and you may not get the full amount you invested. Past performance is not an indicator nor a guarantee of future performance. Rates of exchange may cause the value of investments to go up or down. Individual stock performance does not represent the return of a fund. 

Any forward-looking statements, prediction, projection or forecast on the economy, stock market, bond market or economic trends of the markets contained in this material are subject to market influences and contingent upon matters outside the control of Endow.us Pte. Ltd (“Endowus”) and therefore may not be realised in the future. Further, any opinion or estimate is made on a general basis and subject to change without notice. In presenting the information above, none of Endowus Pte. Ltd., its affiliates, directors, employees, representatives or agents have given any consideration to, nor have made any investigation of the objective, financial situation or particular need of any user, reader, any specific person or group of persons. Therefore, no representation is made as to the completeness and adequacy of the information to make an informed decision. You should carefully consider (i) whether any investment views and products/ services are appropriate in view of your investment experience, objectives, financial resources and relevant circumstances. You may also wish to seek financial advice through a financial advisor or the Endowus platform and independent legal, accounting, regulatory or tax advice, as appropriate.

Disclaimers
+
–
More on this Tag
investment strategy focusing on governance, earnings growth

Table of Contents