This article was written by Brent Bates, a portfolio manager with the Invesco International Growth team, focusing on large- and mid-cap Asia Pacific and Latin American equities.
Economic growth continues to decelerate across the Asia Pacific region. Domestic economies have not been robust enough to offset weakness in commodities and exports, and both revenue and earnings expectations were adjusted downward by 1% during the second quarter.1 Because growth is scarce, investors have been crowding into the highest-growth and highest-quality stocks; within Asia and Japan, this group of stocks is now trading at the highest premium to the rest of the market that we’ve seen in the past 20 years. 2
These are the types of businesses the Invesco International and Global Growth team prefers, but valuations have become “glamorous” and reached levels that do not make sense. As such, opportunities for us to invest in Asia have been scattered. We’re simply not seeing broad-based opportunities that align with our focus on earnings, quality and valuation (EQV). (This is similar to the situation we’re seeing in emerging markets.)
Trimming positions in Japan
Six months ago, Japan was the region where the team had deployed the most capital. Due to the market’s strong performance, we trimmed some positions in the second quarter where we believe valuations had become stretched. The Japanese market now trades at 16x earnings, as represented by the MSCI Japan Index, which is a 21% premium to the rest of Asia, as represented by the MSCI AC Asia Pacific ex Japan Index. 1
While earnings expectations in Japan were revised upward by 2% in the second quarter1— bucking the trend seen throughout the rest of Asia — it’s important to understand that the improvement is due to continued weakening of the Japanese yen. If you stripped out the effects of currency, earnings revisions would be negative.
There are reasons to be hopeful, however, as Japanese consumers have just started to experience positive real wage growth, and companies are beginning to make progress on reforms. There is a growing recognition of the importance of return on equity among Japanese management teams, and they’re beginning to take action to improve returns. Unfortunately, very few companies have communicated their strategy for driving returns higher. Until managements can articulate their goal and how they plan get there, we cannot properly access the value they can create.
One new opportunity in Australia
For the Invesco International and Global Growth team, the one new Asia Pacific holding we added during the second quarter was Aurizon Holdings (0.76% of Invesco International Growth Fund, and 0.99% of Invesco Asia Pacific Growth Fund as of June 30, 2015).
This Australian-based railroad operator has embarked on a significant cost reduction program in its transformation from a former government-owned and operated model to a privately run business. Nearly half of its operating profits are generated through a regulated return, and the other half are covered by long-term take-or-pay contracts. We believe this is a business that can generate earnings growth in the teens, and its price-earnings ratio was 15x as of May 4, 2015, which was a discount to local and global peers.3
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