Highlights:
- Asia ex-Japan equity market suffered in 2018, declining by 14.7% (in SGD terms)
- Looking forward to 2019 and 2020, it is crucial we look at the market’s expected earnings growth, because historically there is a close correlation between that and the market’s potential performance
- Earnings per share (EPS) for Asia ex-Japan market is expected to hit a record level by 2020. EPS estimates by analysts have been downgraded in recent times and EPS for 2019 is now expected to be negative year-on-year
- However, we believe analyst estimates may be too conservative and taking into account too many of the negative factors stemming from 2018
- On a total return basis, coupled with the other contributors to a market’s total returns (including dividend yield), Asia ex-Japan market looks very attractive and there is a strong possibility the market will rise to a record high level by end-2020
- We do not expect a major crisis in Asia ex-Japan in next two years, but volatility will persist especially with the Sino-US trade and geopolitical tension in the background
- Even after the rally at the start of 2019, the potential upside in Asia ex-Japan remains good, at about 25% by end-2020
- Favourite funds with exposure to Asia ex-Japan include Schroder Asian Growth and First State Dividend Advantage
In my recent article, “Welcoming the year of the Pig with KonMari-like portfolio spring-cleaning”, I wrote about how there is one constant when it comes to investing – volatility in the markets.
At the FSM INVEST Expo held on 19 January 2019, the matter of volatility was also something I mentioned when I presented on this topic, “With earnings estimates at record highs in 2019, when will Asian markets hit record highs?”
I received some questions on whether our research is really suggesting we will see a record high in the Asian markets soon. Some investors were rather incredulous, understandably perhaps, following the torrid year we had in 2018, when the Asia ex-Japan equity market declined by 14.70% (in SGD terms). Our home equity market, the FTSE STI, fared a bit better, going down by 9.82% in 2018. We can all agree the Dog Year was not very kind to our equity markets.
Common concerns raised included the current Sino-US trade and geopolitical strife and the possibility that China’s economy may tumble harder than expected. While these concerns will likely continue to dominate the news headlines and may continue to dictate the two nations’ longer-term relationship and impact the global balance of power, it is also important to remember that:
- News headlines are not a good forecast of how markets are going to perform; and
- There are fundamental drivers of how markets perform in the long term and essentially, earnings growth is one of the key ones to always keep an eye on.
Earnings growth as the key determinant of share price performance
When it comes to investing in the stock markets, one of the most important factors in making an investment decision is to look at the market’s expected earnings growth. At the individual company level, is a company expected to make more money in the next couple of years? Everything being equal, the more earnings a company can make, the more its share price will rise. Hence, earnings growth drives share prices, leading to capital appreciation. The correlation between earnings growth and stock market performance is very close as we can see in Chart 1 for the Asia ex-Japan market.
At the market level, e.g. the FTSE STI, the earnings per share (EPS) growth is a combination of all the 30 companies’ EPS. The various reasons why a company would make more money could be multi-fold, including the economic growth rates going forward; the expected trickle-down effect in making consumers spend more; a technological breakthrough in the company’s products pipeline which leads to increased consumer demand or improvement in operational efficiency.
Talking of economic growth, while there have been dark clouds hanging over the outlook for economies such as China, Asia ex-Japan as a group is expected to see decent growth; in 2019, economic growth for Asia ex-Japan economies is expected to come in at 5.7%, while that of the global economy is expected to come in at 3.6%.
Asia ex-Japan: how is its earnings growth potential?
If we look Chart 1 for the Asia ex-Japan market, we see that there is a close correlation between earnings growth and share price performance in the longer term. Yes, in the shorter term, e.g. a period of few weeks or months, the share price performance may swing in a big or exaggerated way, but over a longer period of one to two years, the correlation between earnings growth and share price performance is unmistakable.
Chart 1: Correlation between Earnings Growth & Market Performance for Asia ex-Japan
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From Chart 1, we can see that the index moves up and down. The big decline over 2007-2008 was due to the global financial crisis. The less steep fall over 2016 was due to fears of a hard landing in China that did not materialise. In 2018, investors were worried over the Sino-China trade war, as well as slowdown in the China economy.
Based on the EPS for the companies in Asia ex-Japan, their EPS is expected to hit a record high level by 2020. At FSM INVEST Expo on 19 January 2019, the growth in EPS estimates used in my presentation deck for the financial years 2019 and 2020 were 1.9% and 12.6% respectively. In the one month since then, analysts have been downgrading the EPS estimates for Asia ex-Japan for 2019. Based on the numbers as at 18 February 2019, the EPS year-on-year growth had been updated to -0.4% and 13.1% for 2019 and 2020 respectively.
We believe the reasons for the downgrade for 2019 are due to too much pessimism from analysts following a difficult year in 2018 when a lot of dark clouds hovered over the horizon for the Asia ex-Japan market. However, looking backwards to derive the future EPS is not the proper way as that means being reactive and short-sighted.
If we stretch the time horizon and look further – in this case, let’s look to end-2020 – it is possible that EPS estimates by analysts may go up once they see the actual EPS coming in better than expected in the coming quarters. Besides the EPS growth, the other factors to look into to assess a market’s attractiveness and potential are its valuation and its dividend yield.
Valuation is something we pay close attention to as well. For valuation, it is essentially an exercise in assessing whether a market is cheap or expensive, or close to its so-called fair value based on its price earnings (PE) ratio.
Based on our estimates, the fair PE ratio for the Asia ex-Japan market is 13.5X. This fair PE ratio gives us guidance on a few things. For instance, if the market’s outlook looks great but is trading at a very high PE ratio (way above the fair PE), it may mean that we may not be getting good value. It would likely mean that the market has run ahead of itself and investors have become exuberant. That is the time to trim our exposure and look for other opportunities.
So, where is Asia ex-Japan’s PE ratio for the year 2019 and 2020 at now? Based on the latest numbers as at 18 February 2019, the forward PE ratio (based on its 2019 and 2020 EPS) is 12.7x and 11.3x in 2019 and 2020 respectively. If the market reverts back to its mean (to its fair PE ratio of 13.5x) which we believe it would in the longer term, and with the contribution of dividends (which is expected to be in the region of 3% per year), the Asia ex-Japan market is expected to have a total return of about 25% by end-2020.
The brighter spots within Asia ex-Japan
Within Asia ex-Japan, the largest component based on the MSCI Asia ex-Japan’s geographical breakdown is China. China is one of the markets we rate as Very Attractive – 4.5 Stars based on our research team’s Star Ratings methodology. The likes of Tencent and Alibaba are now the top constituents within the index. Both are proxies to the huge potential of rising consumerism in China and the region, especially with Alibaba’s more global footprint. Tencent as my research colleague Zi Yang noted, has tremendous potential from its key products such as WeChat that can be further monetised.
The other companies within the top 10 of the index include the traditional technology-related plays Asia is famous for, including Samsung Electronics and Taiwan Semiconductor. My colleague De Jun had presented on the semiconductor cycle at FSM INVEST Expo, and he had shared that a lot of the semiconductor companies had been bashed down in 2018 to very attractive levels. You can view their presentation deck here.
Exposure to Asia ex-Japan
If you’re looking to tap on the potential of Asia ex-Japan, the Schroder Asian Growth Fund and First State Dividend Advantage have performed very well over periods of 3 years and more. You can also do a more detailed comparison of the two funds’ performance in our Fund Selector here.
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