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Macro and geopolitical issues overshadow fundamentals

Tong Kooi Ong
Tong Kooi Ong9/10/2018 07:30 AM GMT+08  • 7 min read
Macro and geopolitical issues overshadow fundamentals
SINGAPORE (Sept  10): Globally, equity markets got off to a shaky start in September, which is historically not a good month for stocks if you are the superstitious kind. That said, there are reasons for caution.
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SINGAPORE (Sept 10): Globally, equity markets got off to a shaky start in September, which is historically not a good month for stocks if you are the superstitious kind. That said, there are reasons for caution.

Trade tensions remain high. The US and Mexico struck a bilateral trade deal at ­end-August, one that left out Canada — a party to the three-country North American Free Trade Agreement that US President Donald Trump wants to replace. Negotiations will continue and a final deal (to be made public and sent to lawmakers by end-September) could still include Canada.

The threat to leave Canada out in the cold is characteristic of Trump’s hardball tactics. It also raises the odds that he will up the ante in the ongoing trade conflict with China.

Another US$200 billion ($275 billion) worth of Chinese imports are poised to be slapped with 25% tariffs. China will then retaliate with its own tariffs on US$60 billion of US goods. This will represent a significant escalation from the just-effected reciprocal tariffs on US$50 billion worth of goods.

All prevailing indications suggest that Trump will do just that, perhaps as soon as this week or next. And why not?

So far, the strategy seems to be working in his favour. The US economy is humming and corporate earnings are robust, thanks to massive tax cuts and increased fiscal spending. On the other hand, statistics indicate that China’s economy is slowing.

These stats will have strengthened Trump’s belief that he holds all the cards, not just in facing off China but also the rest of the world. Mexico has fallen in line and the European Union appears keen to compromise.

As we mentioned a couple of weeks back, US stocks have benefited from rising global tensions, reaching record highs while markets elsewhere — especially emerging markets such as China — have suffered (see chart).

This begs the question, will the divergence of fortunes continue? Where do US stock valuations now stand from a historical perspective and relative to other markets? We will examine these issues further next week.

This stark performance divergence is part of the reason why our Global Portfolio has underperformed the MSCI World Net Return Index of late. The benchmark index is heavily tilted towards US stocks, which account for over 60% of its weighting.

By comparison, our portfolio is only 22% invested in US companies, including recently acquired shares in Apple and Facebook. On the other hand, we have substantial investments in China-based stocks, including Alibaba Group Holding, Shanghai Haohai Biological Technology Co, Nine Dragons Paper Holdings and Sunpower Group. Combined, they account for roughly 46% of total portfolio value.

This is not an excuse for our underperformance, merely an observation. Our investment strategy is value investing. We focus on finding attractively valued companies with strong outlook and fundamentals, not so much on top-down market allocation.

Shares in Chinese companies are seeing weakness, which may persist in the near to medium term, owing to trade issues as well as moderation in the world’s second-largest economy’s growth to more sustainable levels for the long run.

For instance, share prices for Sunpower have fallen off their recent high, even though the company reported robust 2Q2018 earnings and future expansion plans are on track. On the other hand, sales growth for Nine Dragons is expected to moderate if the trade war persists. But again, its longer-term outlook is still positive.

We retain conviction that our investment strategy will generate greater value in the longer term.

Shanghai Haohai recently released earnings for 1H2018. Revenue was up 25.8% y-o-y on the back of strong growth for ophthalmology (about 44% of total sales) as well as medical aesthetics and wound care products (23% of sales). Net profit grew more than 20% y-o-y. About 90% of sales are domestic (see table).

The company has established several market-leading products in the treatment for cataract — ophthalmic materials that are used for the production of intraocular lens (IOL) and corneal contact lens as well as ophthalmic viscosurgical devices (OVD) used in cataract implantation surgery.

The company’s growth prospect is huge. Surgical operation rate is very low in China currently and demand is growing rapidly with an ageing population. Shanghai Haohai estimates it has roughly 30% of the IOL market and 46% share of OVD products (making it the largest manufacturer) in the country.

Shanghai Haohai’s medical aesthetics products consist primarily of hyaluronic acid (HA) dermal filler — used to correct moderate to severe facial wrinkles and folds. The penetration rate for this market too is very low — compared with that in the US, Brazil and South Korea — but increasing in tandem with rising disposable incomes and the pursuit of aesthetic beauty.

The company is also a market leader in the manufacture and sales of products used for intra-articular viscosupplement, basically lubrication injections to treat osteoarthritis, or degenerative joint disease. This segment accounts for some 19% of total sales. The remaining sales come from anti-adhesion and haemostasis products, widely used in various types of surgeries.

As at June 30, Shanghai Haohai owned 60 product licences and 40 product pipelines in different stages of R&D (near production, clinical trials and pre-clinical study).

Its shares have done very well, up 47.6% since our acquisition in mid-December last year. We believe there is still plenty of room for growth. The company foresees future expansion will come both organically and from mergers and acquisitions.

On the other hand, our investment in G8 Education had fared poorly, losing 21% in value when we disposed of the shares. Its price has fallen by another 13% since then. On hindsight, the decision to cut loss was good even if the investment itself was flawed.

We underestimated the severity of the excess supply situation — supply is now peaking after accelerating in 2016/17. We believed the Australian government’s new Child Care Subsidy system (that came into effect in July) would raise subsidies for low- to middle-income families and boost demand for childcare services. But demand growth has been much slower than expected so far.

Occupancy fell in 1H2018 (to 70.1%) amid industry-wide excess capacity. That led to intense price competition. Crucially, costs also escalated, owing to regulatory changes for staff-to-children ratio. As a result, G8’s net profit dropped 24% y-o-y despite revenue rising 7.6%.

Recovery does not appear imminent at this point. It could take at least two to three years for the industry to rebalance the ­demand-supply dynamics.

Total portfolio value fell for the week, paring returns to 0.7% since inception. It continues to underperform the MSCI World Net Return index, which is up 3.8% over the same period.

Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.

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