The best bargain stocks in Asia

Cris Sholto Heaton looks at where you should put your money to make the most of the Asian consumer boom.

Most articles about investing in Asia spend ages setting out the huge opportunity the region presents. This one won't. By now, there can be few investors who haven't been told many times that economic power will steadily shift from the developed world towards emerging Asia over the next few decades. Hundreds of millions of people will grow richer and buy more in the biggest, longest consumer boom the world has yet seen. And by now, you either believe this or you don't.

So rather than trawling through all the statistics about how many cars, fridges and tellies will be sold in the coming decades, let's look at where you should be investing to get the best from this boom. Chasing growth will not be enough. You need to think about which sectors are likely to create the most value for shareholders in the long run. And you should be aware that most Asia funds are heavily invested in all the wrong places. But the most important thing to remember is that just because Asia's prospects are so appealing, you shouldn't throw away normal investing discipline.

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Where to invest basic pointers

Firstly, don't ignore value. Overpaying for growth is one of the biggest sins of investment. If a stock is on a p/e of 50, it's probably very overpriced and you can find a better deal elsewhere. Closely related to this, you want to include plenty of stocks in your portfolio that are paying a decent dividend or should soon start doing so. This may sound contradictory if we're investing in Asia's growth, but the majority of long-term equity returns always come from receiving dividends and reinvesting them.

Second, corporate governance is vital. You need to invest in firms that will try to create value for all shareholders, not just for management or a single large shareholder. This is a problem in any market, but it's an even bigger one with emerging markets, where controlling shareholders frequently trample over the interests of minorities.

Finally, you want to invest in industries with some element of monopoly or barriers to entry. Why is this? Basic economics says that if a firm is generating excess profits, other firms will move into the industry. This increases supply and drives down prices and profits. In practice, of course, entering most industries takes more than simply raising some capital. But we can certainly see this process at work in cyclical industries, such as steel and chemicals, which are plagued by overinvestment during booms and gluts during recessions. Given how much investment will be taking place in Asia over the next few decades, these competitive forces are likely to be very strong. So we want to invest in sectors where firms have some ability to resist new entrants, and some pricing power.

Stock up on soap and shampoo

All this suggests that first and foremost we should be looking at the consumer staples sectors goods such as toothpaste, soap and shampoo. The long-term growth potential in Asia is enormous, even in these very basic goods. Only half of Indian citizens brush their teeth with toothpaste and a toothbrush, according to a Colgate survey. And in general, toothpaste consumption in emerging markets is on average 40% less than in the developed world. The poor will gradually begin to buy these basic staples, while higher earners will move up to high-margin goods (see chart below).

Top producers of fast-moving consumer goods (FMCGs) such as these which also include foods, tobacco and beverages earn higher profits by virtue of their brands. Although goods such as washing powder are often very similar, many consumers display loyalty to certain brands and will often pay a little extra for them. Just look at the branded goods sitting on the shelf of your local supermarket, compared to the store's own-brand products. In many cases, these will have come off the same production lines, but they sell for half the price. This is good for investors because it provides a firm with some protection from competition. What's more, because brand reputation is at the heart of a firm's success, FMCG producers tend to be very conscious of their image. This is more likely to create a culture of good corporate governance and treating shareholders fairly.

Lastly, demand for these products tends to be stable, even during recessions. People will put off buying consumer durables, such as a new washing machine, but they'll still buy powder to use in their old one. They'll still eat chocolate and buy beer. That means that these firms are less likely to get into trouble during an economic crisis, which make no mistake will happen again in Asia at some point. Even when times are bad, firms should be able to keep paying out steady dividends that can be reinvested at depressed valuations.

Healthcare offers similar potential. Again, it presents some barriers to entry. These include licensing and regulation, scarce resources (in the form of trained medical professionals) and the value and earning power of a brand that patients know. Trustworthiness is vital to healthcare companies, and a loss of it can be very damaging, which again argues for good corporate governance. And demand should be very strong as emerging Asia becomes richer. Healthcare spending now is typically around 4%-5% of GDP, while in the developed world 8%-10% is standard.

So there are good theoretical reasons for these two sectors to do well. But what does history say? Rigorous analysis is tough, because providers only started breaking down their indices into sectors in the last couple of decades. However, consumer staples was the best-performing sector in the S&P 500 from 1980-2009. And healthcare was the second best. Both delivered a positive return in all three decades. Both were also very strong performers (second and third, after oil and gas) in the MSCI Asia ex-Japan in the 15 years for which we have sector breakdowns for this, even though the Asian consumer boom is still in its infancy. Generally, the limited data available points to these being long-term outperformers in all markets.

Investing in infrastructure

So if I were only to invest in two sectors, they would be consumer staples and healthcare. But thinking about what will be needed to support these industries points to another promising area for investment. You can't ship ice-cream to a retail chain, or drugs to a hospital, without reliable infrastructure. You need to be confident that they will arrive on time, that they'll be kept in cold storage, and that power to that warehouse won't suddenly fail. And most of emerging Asia needs a great deal of work in this respect.

Still, there are a couple of vital things to remember with regard to infrastructure. First, bear in mind that many industries, such as power and water, will be subject to regulation and tariff limits. Less politically sensitive investments, such as logistics, are likely to deliver higher profits. Second, as an investor, your return on capital will be greater where capital is scarcer. You want to invest in infrastructure where the existing stock is limited and unlikely to grow too much too soon. So in general, look towards infrastructure in countries such as India and Indonesia where development lags, rather than China, where state-directed investment is proceeding much faster.

You also need to be cautious with the financial sector. Clearly there is huge room for growth in this business. In China, India and Indonesia, just 25%-50% of adults have a bank account, consumer debt is 5%-15% of GDP and under 5% of working adults have a credit card. And barriers to entry are often reasonably high: banks are licensed, regulated and need capital to lend. But at the same time, this is a fairly cyclical industry. Banks increase lending during booms and see bad debts pile up during busts. Emerging market banks are often state-directed, or controlled by individuals who make dubious lending decisions involving their other businesses or friends. However, selective investment in well-run, prudent and conservative financial institutions is likely to pay off. This won't just be banks and insurers; asset management firms should benefit from more people saving into investment funds, for example.

What about telecoms? That's a tricky question. There's no doubting the growth potential for the Asian mobile-phone market, but this is a capital-intensive industry prone to price wars. You should focus on markets where such wars are over and the number of players is set to consolidate, such as Indonesia.

For now, ignore the likes of India, where competition is still tough, or where a shakedown is yet to come. Similarly, be very selective in sectors such as IT. Competition will always be tough, and constant innovation means this year's star will be struggling in a few years' time. But the next IBM or Microsoft may well come out of Asia.

What not to buy

And which industries are unlikely to reward shareholders in the long run? History suggests that highly cyclical industries, such as steel and cement, won't.

Also, I'd avoid carmakers, even though many investors are excited about the huge number of potential car buyers in emerging markets. This industry has a bad record of excess capacity, political meddling (every country wants a national car champion) and troublesome unions. Even though the number of people travelling will explode, airlines have shown themselves to be value-destroyers beyond compare for similar reasons.

I'm also very cautious on real estate. This is an appallingly cyclical industry. In each boom, developers always demonstrate shocking capital management and a lack of awareness of what went wrong last time. Most eventually overbuild and borrow too much.

Instead, I'd focus on firms that own and manage high-quality real estate in areas where supply is constrained. Forget apartments in Shanghai I'd rather own well-located logistics facilities in Singapore and prime office space in Hong Kong.

Making the right choice

This leads us on to the big problem with most emerging market funds they don't own what you want to hold. Most funds stick fairly closely to the benchmark indices they are measured against. For index-tracking exchange-traded funds (ETFs), this is the point of them. For actively managed funds, this shouldn't happen, but it does, because it's riskier for the manager's career survival to take big out-of-consensus bets.

The trouble with most emerging markets is that the indices are dominated by the wrong kinds of stocks. They will be heavy on cyclical industrials, resources, materials, financials and real-estate stocks. They will be light on consumer goods and healthcare. And many of the firms will be of poor quality. Many will be government-controlled and subject to pressure to put state interests first. Others will be controlled by a local tycoon, who will rip off minority investors and squander cash on useless diversification.

Just take a look at the FTSE/Xinhua China 25 index (above). This is the basis for most Chinese ETFs, covering billions of dollars in assets under management at the moment. Yet 23 of the 25 stocks are government-controlled, while virtually none of the companies operate in FMCG and health. Note too that Chinese banks, which dominate the index, are of very poor quality. But this is just one of the worst examples. The truth is that most emerging Asia indices are unbalanced and full of poor-quality stocks. You should be highly selective with funds. Better still, consider building your own portfolio focusing on the most promising sectors. I look at some potential picks here: Four Asia funds worth focusing on.

Cris Sholto Heaton writes the free weekly MoneyWeek Asia email. He'll be launching his Asia Investor newsletter shortly, which will focus on overlooked small- and mid-cap Asian companies.

This article was originally published in MoneyWeek magazine issue number 481 on 09 April 2010, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.