The third bucket
Article | 10 July 2017
A new theme has emerged in the Invesco Perpetual Asian Fund.
I have written in the past about how the Invesco Perpetual Asian Fund can be broken down into various themes, or ‘buckets’ of exposure. The two long-standing buckets have been Chinese internet stocks (currently about 20% of the fund) and South Korea (currently about 23% of the fund).
In the first half of last year there was a discernible third bucket in the form of Australian commodity-related stocks, but over the last few months that bucket has gradually been emptied as the stocks have performed well (or been taken over) and we have reduced the exposure.
A new bucket that has grown over time, and is now as important as Chinese internet and South Korea, is the ‘strong balance sheet’ bucket.
Strong balance sheet = takeover target?
I have previously mentioned two Australian companies, UGL and Fairfax Media. At the time I said: “both have cash-generative business models with the ability to service a reasonable level of debt, but both companies are currently running with net cash1 on their balance sheets.” With hindsight it is interesting that I singled out these two, because coincidentally they have both seen takeover activity in the past few months. UGL was taken over by a rival called CIMIC at the end of 2016, and Fairfax Media is currently the subject of two competing bids from private equity groups. This is the sort of thing that can happen to companies with strong balance sheets!
On a similar theme, in February 2017 we introduced a holding in Changyou into the Invesco Perpetual Asian Fund, a Chinese internet game developer which had, at the time, over half of its assets held as cash (and like UGL and Fairfax, it has a very cash-generative business model). Last week the Chairman of Changyou offered to take the company private, agreeing to pay a 50% premium for the shares compared to the price they were trading at when we first started buying them.
It is not always good news when we hear that holdings in the fund have received takeover offers. Often it means that the eventual buyers take the upside that we had hoped to take for our clients. But it does at least indicate that our process of selecting undervalued companies is working, and that our own analysis is being validated by third parties over time.
Asian companies are conservatively managed
The broader point here is that Asian companies are not only reasonably valued in terms of price/earnings2, but their tendency to run conservative balance sheets is not captured by this valuation metric.
Research from investment firm CLSA3 has shown that Asian companies are on average less indebted relative to their market capitalisation, than companies in other parts of the world.
An additional part of CLSA’s analysis was that 23% of the companies in the S&P 500 index have net cash on their balance sheets, while 37% of companies in Asia excluding-Japan have net cash on their balance sheets (in both cases financial companies were excluded from the analysis).
Perhaps more pertinently, when you do the same analysis on the holdings of the Invesco Perpetual Asian Fund, then 53% of them have net cash on the balance sheet.
We may have to be patient with many of these holdings before the market appreciates their balance sheet strength; but in some cases like Changyou, UGL and Fairfax, we may see others take action to help crystallise the value we have identified.
Finally, it is also worth pointing out that theoretically, the cash on these companies’ balance sheets means that their share prices should show less volatility in the event of a market sell-off.
1 Net cash is a company's total cash minus total liabilities.
2 Price/earnings is the market price per share divided by annual earnings per share. The ratio is used in valuing companies.
3 Source: Factset, CLSA as at 31 May 2017.
All information in this article is as at 1 June 2017 unless otherwise specified.
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