Asia Small Companies: March 2020 Quarterly Commentary

The quarter was dominated by fear associated with the Covid-19 pandemic which spread across the globe. Global markets typically fell by more than 20% during the quarter. Our benchmark of small to mid-sized Asian companies fell by 10.1% in Australian dollar terms, the impact of falling equity markets was partially cushioned by the weakness displayed by the Australian dollar. In US dollar terms the benchmark index fell by 21.8%. China and Japan recorded declines of 10.7% of 19.7% respectively while other markets across our investment universe fell by 20% or more. The Indian market fell by 34.5% and we continue to avoid investing in that market because the companies fail to meet our standards for governance and quality.

The “phase one” trade agreement between the United States and China was signed in mid-January, this removes one of the key risk factors that has hindered Asian markets in the past eighteen months. The agreement is more of a “truce” than a long-term solution for the United States trade deficits with China. In early March, President Trump signed the TAIPEI Act following an unopposed passage through the House. The support for Taiwan expressed in the TAIPEI Act will cause problems when trade talks resume next year.

With widespread social distancing and lockdowns imposed in response to the Covid-19 pandemic there will be considerable disruption to global economic activity and a short-term decline in corporate profits. Small to mid-sized companies in the region started the month of March on a p/e of 13.1x, that multiple will expand in short-term as profits are disrupted. This is a time for investors to be patient and to direct their thinking towards the long-term. Short-term disruption to corporate profits will not have a significant impact on the long-term equity market returns.

During March we received an important reminder that dividends are an important component of returns with 30 of our 34 companies in Japan trading ex-dividend towards the end of the month. Many of our companies in Japan maintain balance sheets with zero debt and strong balances of cash. The corporate sector in Japan has net cash balances in excess of USD 6 trillion and this is a moment in time when a conservative approach to business management is a positive. The UK listed banks have been directed by the regulator to cancel all dividends including those previously announced and due for payment in the next month. Dividend cancellation is very unlikely among the cash positive corporate sector in Japan. Investors are likely to have long memories when it comes to companies that did and didn’t maintain their dividends during this period.

Against such a negative backdrop for markets it was pleasing to see China Lesso Group and NetDragon Websoft each increase by 2% during the quarter. 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 3.7%. We were less impressed with NetDragon Websoft which took advantage of a 46% spike in their share price in the first half of February 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.

For us, the quarter was business as usual as we undertook a number of transactions in the portfolio adding four new companies. 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 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 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.

Performance record is in the table below:

Periods ended 31 March 2020	3 Months	6 Months	1 Year	Since Inception
Portfolio*	-9.7%	-2.7%	+1.1%	-4.6%
Benchmark^	-10.2%	-7.0%	-4.6%	-7.0%
Active	+0.6%	+4.7%	+6.0%	+2.6%