Asia Small Companies: February 2020 Commentary

February was dominated by fears associated with the global spread of the coronavirus COVID-19. February started in relatively quiet fashion as we observed a generally positive Q3 results season in Japan, however, towards the end of the month corporate news was overwhelmed by a rising scale of panic in global markets associated with COVID-19. In US dollar terms our benchmark index of Asian small and mid-sized companies fell 8.35% during February, the worst month since October 2018 which was a period of fear associated with Trump's trade war with China. The Australian dollar continued to weaken during February bring the index return in AUD terms to -5.80% with the currency ending the month trading at just above US 65 cents.

At the time of writing, there are 86,032 confirmed cases of COVID-19 in 64 countries and territories, of which 92.1% of cases (and 96.4% of the 2,942 deaths) are in China. It may therefore come as a surprise to hear that the market in China rose by 1.96% in February, the only country in our region to register an increase. Hong Kong fell by just 0.80% which helped increase our combined exposure to China/Hong Kong from 14.0% in January to the current level of 16.5%. There were significant falls in Japan -11.45%, South Korea -8.84% and Singapore -6.87% while Taiwan recorded a much smaller decline of 2.51%. A key factor in the relative stability of the equity market in China appears to be the news that since 18th February the number of patients recovering from COVID-19 is exceeding the number of new cases. We are not downplaying the tragic events associated with COVID-19, however, in strictly market terms this is a familiar response to an unexpected event with an uncertain impact and time frame as the number of new cases COVID-19 rises in exponential fashion. That initial panic and negative response moves to a period of recovery when the degree of impact is better understood and the level of uncertainty declines. The pattern of market recovery in China is therefore "normal" in the context of the apparent reduction in the number of new cases and the volume of recovering patients. That pattern of recovery can be expected to follow in other countries around the world as the response to COVID-19 plays out in valuations of equity markets.

We are maintaining our view that China's better communicated and proactive response to COVID-19 in 2020 versus SARS in 2003 may have exaggerated the global stock market volatility, however, that isn't a reason to exit companies in the Asian region. Investor selling into this type of volatile environment typically "forget" to re-enter the markets as fear generates too many confusing signals. In terms of long-term investment outcomes, it is always better to be a net buyer in this type of situation. We expect to look back at the early months of 2020 as a period of market "noise" and not the key component of our investment returns achieved from the region.

For us, the month of February was business as usual as we undertook a number of transactions in the portfolio adding four new companies and selling out of two stocks. Three of the purchases were in Japan; Dowa Holdings, Square Enix Holdings and Calbee Inc. Dowa Holdings is an interesting company that has transformed from a zinc miner to be a leading recycling business in the Asian region. Square Enix Holdings is a digital entertainment business with a focus on computer games and is a natural replacement for our previous sale of Com2uS Corp in South Korea. Calbee Inc is a Japanese maker of snack foods and serves as a replacement for our sale of Hokkaido based supermarket chain ARCS which was sold due to very disappointing interim results and our loss of confidence in their business strategy. Our other sale in Japan was latex and resin manufacturer Zeon Corp, which was replaced by Dowa Holdings in the materials sector, the latter having a much stronger business outlook. Our final new addition to the portfolio was Powertech Technology Inc, a Taiwan based business providing semiconductor packaging and testing equipment trading on a p/e ratio of 10x and a yield of 6%.

We added to our holding of Xinyi Glass and China Water Affairs during February, the latter has now become a top ten stock position for us at 2.5% of the portfolio. In a month when the underlying index fell by 8.35% in USD terms, the majority of stocks in the portfolio fell during the month in a manner consistent with the broad based sell off, however, it was pleasing to see China Lesso Group and NetDragon Websoft increase by 16.1% and 13.6% respectively. China Lesso Group will see a small revenue impact from the extended closure of their Hubei plant while the remaining twenty two factories resumed production as planned on 10th February. The six analysts providing research for China Lesso are showing upside potential for the shares of up to 25% from current levels. China Lesso is now the largest holding in our portfolio at 3.8%. We were less impressed with NetDragon Websoft which took advantage of a 46% spike in their share price in the first half of the month to have a placing of new shares. While this activity is permitted under the stock exchange rules in Hong Kong, we prefer to see companies offer the opportunity for all shareholders to participate in a rights issue rather than private placements offered to a select few.

On the final trading day of February, when the markets across the world were falling in a COVID-19 induced panic, we were very pleased to see the shares in Japanese construction company Haseko Corp rise by 7.25% in response to the announcement of a significant share buyback programme. We remain very positive towards our holding of Haseko Corp, a company that trades on a p/e of 6x, has a return on equity of 16% and a yield of 3.6%. The buyback programme sends a clear signal to the market that the management believes their shares to be undervalued and we have upgraded our view of their governance in response to this event.

We will continue to invest in Asian small to mid-sized companies with strong value, momentum and quality attributes together with accounting, strategy and governance standards that meet our requirements. Long-term returns will be generated by the ability of our companies to deliver growing profits and dividends.