“We do think there are some structural challenges in the equity markets in Asia and the way we invest is obviously that we are trying to avoid the pitfalls of that,” Singapore-based Danes told Fund Selector Asia.
Danes, who also co-manages an Asia long-term unconstrained fund and an Asia Pacific equity fund for Martin Currie, said one of the biggest challenges is that the growth of the markets in Asia has actually been through the issuance of shares — either by initial public offerings or by listed companies issuing more shares because they need more capital.
“A lot of people may have been telling you how exciting Asia is because there are many opportunities for companies to raise equity at a relatively cheap cost. [But the consequence is that] there has been a lot of dilution in the market. So, one of the biggest problems in Asia is the significant dilution to shareholder returns.”
A second issue, which “has been particularly troubling”, is the trend of lower profitability and declining returns among Asia-listed companies, he said.
“If you look at an average operating profit margin in an Asian company, until about a year ago, you would see 10 years of straight decline in profitability. Why is that? Partly because Asia is fiercely competitive, and so obviously profit margins get driven down.”
Another reason is the trend among multinationals to pour resources into Asia and expand, which impacts on the profit margins of existing domestic players.
“If I speak to global corporates who offer internationally and ask them where they invest in terms of having factories or building out brands, they will inevitably say Asia is top of the list, as the population is growing. So they will be putting a lot of new capital into Asia and it means the [domestic] companies in whatever industry it is will take a hit to profitability.”
Danes said dilution is a very serious risk over the coming 12-to-18 months that could get worse.
“The reason for that is there is quite an interesting thing going on in the credit market. It may well become more difficult for Asian companies to refinance their debt. Certainly it is a very real risk that some of those companies end up going into the equity market instead and then you will find that their costs increase.”
Danes said his recent asset allocation involves reducing exposure to consumption staples due to their relatively rich valuations.
On the other hand, he has been investing in slightly more economically-sensitive names. “They are not extreme, for example, some industrial companies and some consumer discretionary companies where we think the valuation is extremely attractive.”
Given thinning profits, Danes said the primary focus is on the company balance sheet strength and the ability to generate cash flow.
The Legg Mason Martin Currie Asia Pacific Fund uses as a benchmark the MSCI Asia ex-Japan Index while the Asia Long Term Unconstrained Fund has no benchmark index. Both are co-managed by Danes.