Market Update - August 2014

Douglas Isles, Investment Specialist, explains Platinum’s current portfolio positioning and why we believe there are more attractive opportunities outside of Australia and the US, two of the world’s more expensive markets. Joseph Lai, portfolio manager of the Platinum Asia Fund, provides an update on the various currents of development in China.

We have found a big disconnect between the mood of many advisers we have spoken to over the last few months and the opportunities that we can see in the world today. Perhaps this is a function of asset allocation models.

We suspect locally managed equity portfolios have up to 80% combined exposure to two of the world’s more expensive markets, Australia and the US.  The Platinum International Fund allocates 12% to these markets, with 68% in the rest of the world, giving us a higher net exposure than normal.  Fund Manager Surveys tell us it is consensus to be carrying very high levels of cash, despite the world economy healing and there appears much concern about US interest rates normalising, despite bond markets pricing this in.

We appreciate that selecting fund managers is not easy and the parallel with our task of picking stocks is real.  Extrapolation is at the core of the problem.  When companies are doing particularly well or particularly badly, the stock market often fails to appropriately weight skill, luck, timing and persistence.  When choosing funds, many fail to determine the extent to which style can dominate over the short- to medium-term, and hence, chasing the latest hot fund tends to leave many disappointed.  Over time, our consistent approach may not always beat the index over short periods, but in the long run it delivers solid outcomes.

As we look around the world today, the US bull market is the most mature with its recovery widely known and small caps are now trading at historically high valuations.  Shorting these provides the bulk of our market protection at present.  We still like technology leaders, petrochemical related-capex and selected metals, a derivative of Asian change.  Europe is behind the US in its recovery, both as an economy and in terms of stock prices, and this gap provides relative value with consumer and pharma companies alongside Ericsson and Intesa Sanpaolo in the portfolio.  Japan throws-up several opportunities around corporate reform such as NTT and Panasonic, with a new index focusing on returns for shareholders acting as a Trojan Horse.  We are still hedged out of the Japanese yen and continue to avoid the Australian dollar.

Today, we have 27% of the Platinum International Fund invested in Asia; the highest level in our 20 year history.  We have increasingly moved capital there over the last year, funded by further reducing exposure to household names that served us well like Pepsi, J&J and Microsoft; Cisco, Shell and Adidas.  We are excited by the overarching theme of reform which is apparent throughout the region in differing forms.  In Korea, corporate governance improvements should benefit shareholders much like Japan.  India and Indonesia have both recently elected reformist leadership and we have exposure to an improving environment for infrastructure build in India.  The ban on exporting unrefined ores as Indonesia seeks to move up the value chain is helpful to our metals holdings, particularly nickel, and to some extent, aluminium.  In China, change may not benefit Australia, Brazil, South Africa and Russia, who have thrived on its investment boom but it is real.  However, the most negative stories about China such as empty apartments, likely coincided with the bottoming of its market, after valuations had already plunged to crisis levels.  Given the significance of the changes taking place, and more importantly, stock prices there, Platinum Asia Fund’s co-Portfolio Manager,  Joe Lai will now provide his thoughts on China.

What China has achieved in the last 20 years is truly remarkable.  What’s just as remarkable are the many critical changes happening presently.

We have talked a lot about the transition towards consumption-led growth currently underway.  What was most noticeable during our recent trip to China is that consumer-orientated companies are flourishing as incomes rise and job opportunities grow.

Ecommerce is growing at a staggering rate.  As physical infrastructure in China is underdeveloped, the new industry is leapfrogging traditional brick and mortar retailing.  Instead of seeing new factories being built to

manufacture export goods; warehouses and logistic centres now dominate the landscape.  Retailers like JD.com, the Amazon of China and specialty discount outlets like VIPshop invest in logistics required to deliver more and more goods to wealthier domestic consumers.

Yet, it’s safe to say many investors are bearish about China.  The big talking points are the shadow banking system and the property market.  We think they’re solvable problems.  It pays to remember that shadow banking is ultimately backed by Beijing.  Yes, there was explosive growth in this sector after the financial crisis.  And, as with any credit boom, there will be quality issues.  What’s important though is that Beijing has a number of levers it can pull to avert a crisis.  Also, shadow banking products are relatively simple; they are not the complex securitisations typically seen in the US and Europe.

It’s worth noting too that the Chinese economy is still growing and government debt to GDP is at a decent 50%.  Debt accumulated in China is mostly domestic and RMB devaluation can be a potent policy lever.  In the property sector, slowing sales will lead to a slowdown in construction.  However, with better prices and policy easing, we are seeing things stabilise.  Urbanisation is an ongoing trend.

It is impossible to overstate the importance of China deepening its reform efforts.  Instead of purely focusing on the rate of growth, focus of policymakers is now more on the quality of economic development - one that is sustainable, fair and efficient.

As part of the reform process, Beijing is taking steps to improve the running of State owned enterprises or SOEs.  After multiple attempts at change, SOEs make up only 20% of employment in urban China.  They are big players in major industries but can run inefficiently and invest inappropriately.  Lucrative perks and opportunities for self-enrichment were afforded to a privileged few.

SOEs have been told to operate more like private enterprises, to boost productivity and focus on their core area of expertise.  Private players are encouraged to invest into businesses that were previously off-limits and protected industries opened-up for competition.

In recent months, we have witnessed a string of high-profile corruption cases in China.  Some see the crackdown on corruption as politically motivated, a way for the leadership to get rid of its enemies.  Others believe it is doomed to fail because powerful people are immune from prosecution.

We don’t see things that way.  This anti-graft campaign is a powerful signal that the momentum for reform is building.  Wrongdoing is being exposed.  There is some evidence of change.  In the last few weeks, Beijing established a more open bidding process for government contracts.  Local government land sales were audited for the first time.  It’s early days yet but we view the corruption probes as key to removing anyone who might obstruct reform efforts and to mollify public opinion.

The anti-corruption drive is unprecedented - China’s biggest state-backed companies have been targeted.  Thousands of high-ranking officials, once thought to be untouchable, are being arrested.  The crackdown on bribery is systemic and more far-reaching than the international press would have you believe.  Inspectors are trawling the country looking for evidence of impropriety.  We can see the effect of this on local luxury goods sales.  Gifting is being rejected as a custom.

More importantly, State-backed companies are withdrawing from some parts of the economy and entrepreneurs are moving in.  This has given rise to a flurry of activity in the private sector and the excitement is palpable.  A number of new industries are developing in a unique way.

We visited Weichai Power.  That meant taking a high-speed rail from Beijing to Weifang; gliding along countryside at 300km/hr.  These trains are dramatically opening up the country which is a boon for local tourism.  Weichai has risen from ashes of near-bankruptcy to become the biggest manufacturer of heavy duty truck engines in China, a market that attracts formidable global players.  A series of reforms has enabled management to modernise the plant, invest in technologies and dominate distribution.  By acquiring a German company called Kion, it has become a global leader in complex hydraulics.

We visited battery-maker turned electric car maker, BYD.  China is trying to jump-start electric car technology to solve its energy and pollution difficulties.  We test-drove the latest model and marvelled at how far invigorating entrepreneurship has taken this company.

The shift to mobile platforms from personal computers has been rapid.  Baidu, Google of China, is seeing revenues growing at 60% a year.  Another company that makes use of mobility technology in a big way is Tencent - through its WeChat instant messaging app whose online social network is the Facebook of China.  It is busily building an ecosystem of brick and mortar businesses which its users can follow using their mobile phone, and providing loyalty schemes and payments systems on its mobile platform.

These are just a few examples of a truly exciting market.

If there is a message we want to leave you with it’s this:  China is attractively priced; SOE reform is real.  So too is the potential for very handsome long-term returns.

DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances. The above material may not be reproduced, in whole or in part, without the prior written consent of Platinum Investment Management Limited.