OpenAI, the company behind ChatGPT, has joined the race between the three tech giants set to list in 2026, each tipped for a landmark initial public offering (IPO).

One week after Anthropic filed its own paperwork to the US regulator, the Securities and Exchange Commission (SEC), and in the same week as SpaceX is expected to float, OpenAI kicked off its own IPO process.

In a brief post on its website on Monday 8 June, OpenAI said: “We recently submitted a confidential S-1. We expect it to leak so we’re just announcing it. We have not decided on timing yet; it may be a while because there are things we want to do that are likely easier as a private company. But it’s a complicated set of tradeoffs and this gives us the option to go public sooner if that ends up being best.”

Filing a ‘confidential’ S-1 form means the SEC can review a company’s financials before having to make them publicly available, which can mitigate the level of market speculation ahead of an IPO.

How much is OpenAI worth?

At the end of March, OpenAI closed its latest funding round, with $122 billion of committed capital co-led by SoftBank, which – post-money – values the AI company at around $852 billion. Dwarfed by the $1.75 trillion SpaceX is said to be valued at, OpenAI ranks behind Anthropic’s latest valuation of $965 billion.

It said it was generating $2 billion in monthly revenue, a growth rate it claims is four times faster than “the companies who defined the internet and mobile eras, including Alphabet and Meta”.

At the time, the company also extended its availability to bank channels in a bid to attract investment from individual investors, which include via several exchange-traded funds (ETFs) from ARK Invest, which own the stock.

OpenAI’s democratic third phase

Alongside confirmation of its S-1 filing, OpenAI said it was entering its third phase.

Having spearheaded the consumer-facing AI boom when it launched ChatGPT in 2022, as of February it had around 900 million weekly active users and more than 50 million paying subscribers.

OpenAI has set out its three main goals: to build an automated AI researcher; accelerate the economy; and give everyone on earth an artificial general intelligence (AGI).

A blog by CEO Sam Altman and chief scientist Jakub Pachocki dated 8 June said its first phase had been about doing research toward AGI, its second began "when our research became relevant to the real world and we became a product company."

"Now we are entering the third phase. The economy is beginning to reshape around AI. The central question now is how to make advanced AI abundant, affordable, safe, useful and easy enough for every person and organisation to benefit from it."

In the article, they said rather than concentrating AI’s power in too few hands, which history shows creates fragility, the future needs a broad distribution of that power, which makes societies more "resilient, adaptable and free".

"That is why access matters. It is also why safety, privacy, affordability, open ecosystems, and public oversight matter," they said.

Andrew Van Sickle: Healthcare is a broad term. Could you start by outlining what exactly is in the MSCI World Healthcare index, the benchmark for your fund?

Sven Borho is the co-founder and managing partner of OrbiMed, and portfolio manager of the Worldwide Healthcare Trust.

Sven Borho: It captures every single part of the industry. You have the big pharmaceutical groups; more innovative smaller-cap pharma and biotechnology firms; generic drugmakers; medical-device makers; and service providers. These are the big health-management organisations (HMOs) in the US (the health insurers) and private hospitals. The index is diversified across the US, Europe and Japan, although it doesn't capture healthcare in emerging markets.

Andrew Van Sickle: It's often said that “health is wealth”, and investors have traditionally been able to count on both structural growth and income in this sector. But the index has had a difficult decade. What has gone wrong?

Sven Borho: One problem is that the price of pharmaceuticals became a political football, creating years of uncertainty. Drug prices were a key theme in the presidential election between Hillary Clinton and Donald Trump. We got a form of drug-price controls under Joe Biden, and the regime was tightened when Donald Trump returned to power.

The other key headwind was the rise in interest rates over the past few years. That hampers growth stocks, such as smaller biotechs, as dearer money reduces the present value of future profits. The S&P Biotechnology Select Industry index went nowhere between mid-2015 and mid-2025. The S&P Health Care Select Sector index gained 60% over that period, compared with 300% for the S&P 500 or 400% for the Nasdaq.

Andrew Van Sickle: Is the drug-price threat receding now?

Sven Borho: Yes, the sector knows where it stands now, so the uncertainty discount has started to recede. Trump was irritated that US drug prices were higher than elsewhere. He has now cut a deal with the sector, whereby the government will pay lower prices for future drugs and for current ones being delivered to Medicaid and Medicare programmes. The deal is being done with most-favoured nation (MFN) pricing, whereby prices will match those offered to a basket of other developed countries.

Meanwhile, mergers and acquisitions (M&A) are on the rise as big companies try to compensate for major drugs going off patent. When a drug reaches that stage, prices collapse by 98% as generic competition takes its toll. Merck's Keytruda, for instance, a cancer drug with annual sales of $30 billion, goes off patent in 2028. Each of the Big Pharma companies will see a large product go off patent between 2025 and 2028. This coincides with the Trump government's pricing deal, so the sector is facing a double whammy.

History shows it is impossible to rectify a pipeline gap like this through internal research and development (R&D) alone. So the big names will go shopping, acquiring the right to develop a drug from smaller firms with promising products, or buying them outright.

Big Pharma wants products with annual sales potential of $3 billion and above. If you're a speciality pharma firm or a biotech with a drug boasting that kind of potential, you're on someone's shopping list. That is why 30% of our portfolio is in biotech companies, with a heavy focus on those most likely to be bought out. Overall, 12% of the portfolio comprises a “basket” of the stocks most likely to be bought out.

Andrew Van Sickle: Returning briefly to drug development, what proportion of drugs successfully move from discovery to approval?

Sven Borho: The percentage hasn't changed much over the years: one in ten make it from pre-clinical trials through to regulatory approval. This is the biggest bottleneck in the sector. One can't speed up the process, which takes ten, even 15 years. Patients need to be on a drug for a certain amount of time, for instance.

And costs have risen sharply. Traditionally, it would cost around $1 billion to bring a drug to market. These days, it's north of $2 billion. Getting one person enrolled in a clinical trial can cost $300,000. Compliance and regulatory requirements, along with the general inflation trend, have driven up expenses.

Andrew Van Sickle: What effect could AI have on the sector?

Sven Borho: It is likely to help us come up with more compounds to test, but that will just add more potential treatments to the bottleneck building up before the clinical testing process. It is in the areas of diagnosis and treatment of disease that AI will be transformative. Given how it can amalgamate data – including your blood tests and MRI scans, say – and compare new information to it, it should become far better than a GP at diagnosing and treating disease. It may not be too long before people don't see a GP at all.

This should massively reduce costs – as should robots performing surgery. I think manual surgery will be a thing of the past in the not-too-distant future. Already today, you could have a physician operating in London on a patient in New York with a medical robot. One of our favourite companies, therefore, is Intuitive Surgical, which manufactures robotic surgeons.

AI should allow us to get a grip on healthcare expenditure; 12% of total healthcare spending (which in the US comprises a fifth of GDP) is on drugs, a proportion that hasn't changed over the years. Hospitals, surgeries, GPs and so on account for the rest. There should now be deflation in that 88%, counteracting the expense of the ageing of the population.

Andrew Van Sickle: What impact will weight-loss drugs have?

Sven Borho: People tend to think of the cosmetic element, and of course that spurred early adoption, but the big story is the impact on chronic diseases linked to excess weight, notably the big ones: cardiovascular disease, cancer and diabetes. Data suggests these treatments cut your chance of contracting Type-2 diabetes by 80%.

There are spillover effects in other areas – sleep apnea, for instance, or hip and knee surgeries, the odds of which dwindle if you are walking around with 20% less body weight. The next stage of the boom will be increasingly common oral treatments rather than injectables, with Eli Lilly the leader in the subsector. Weight-loss is a thriving division for other big names, but for me the most interesting way to play weight-loss drugs is Structure Therapeutics.

It focuses on oral treatments for obesity and related diseases. It has an oral obesity treatment about to enter phase III (the final stage of clinical trials) and it is second only to Eli Lilly's. It should hit the market a year after the pharma giant's treatment (which is supposed to arrive this month). The group will probably be acquired. Weight-loss treatments will be the largest drug category for years to come.

Andrew Van Sickle: Tell us about your fund and its top-three holdings?

Sven Borho: We launched it in 1995; I have been in the sector for 35 years. The trusts's net asset value (NAV) enjoyed a compound annual return of 13.5% from the fund's inception until the late spring of 2025, eclipsing the benchmark index's 11.3%. The secret to our success is an enduring focus on innovation – the highest-growth companies. We've always been agnostic about where those companies are, so we are widely geographically diversified. Our overweight position in biotechnology compared with the benchmark again highlights the concentration on innovation.

Eli Lilly, AstraZeneca and Boston Scientific are the top-three beyond our M&A basket. The last is one of the fastest-growing and best-managed medical-devices firms, a long-term compounder with 15% yearly growth in earnings per share. Eli Lilly is a bet on the weight-loss theme. AstraZeneca is the second-fastest growing pharma group in the world, mostly driven by oncology. We like to identify the fast growers, even in the large-cap segment. Intuitive Surgical and Boston Scientific are the fastest-growing medical-technology firms.

It's worth highlighting our holding in China's Jiangsu Hengrui Pharmaceuticals too. It's worth 5% of the portfolio and provides access to the extraordinary innovation in the Chinese pharma sector. Jiangsu has an R&D pipeline of approximately 150 projects, the second-largest in the world after Pfizer's 156. They have a competitive compound in practically every area.

What's more, going from the pre-clinical stage of the pipeline to phase one or two data (the stage at which you receive the first efficacy data in human clinical trials) takes them a third as long as Western companies and costs them 90% less. The scientists doing the work are just as qualified as in the West; many will have done their PhD or worked in a biotech here. Costs of R&D are much lower in China, as is the regulatory burden, especially when it comes to early stage trials.

Once they get to phase three of clinical trials, however, it gets trickier. A Chinese firm can't do those trials in Western markets. It has to licence the drug out to Western counterparts. The US regulator, the Food and Drug Administration, doesn't trust Chinese data, while there are also political sensitivities surrounding the process. As a result, Western firms' heads of R&D go to China to or three times a year to discuss such deals, which can be massive.

That is a transformative theme. At the epicentre is Jiangsu Hengrui. It is the Chinese biopharmaceutical equivalent of Nvidia. It is the biggest innovator. I mentioned that Jiangsu's number of R&D projects in clinical trials is second to Pfizer's, but if you include pre-clinical projects, it has the world's largest pipeline. I think it has another 500 projects. And the quality of its compounds is absolutely first-class.

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The view that utility companies are a safe haven for cautious investors is out of date. Today's market is far more active and complex than it was even five years ago. New regulations and a strong push from government to improve national resilience are driving this shift.

While headlines dwell on short-term political disputes, the bigger story is that the utility sector is being rebuilt. The drivers of this trend include a massive surge in demand for electricity driven by the digital economy, a regulatory overhaul of the water sector and a new partnership between private capital and the state with a view to lowering risk.

Utility companies come in two main flavours

You can divide the utility companies into two distinct groups. First are the companies that own and operate the heavy assets. They run the water pipes, electricity wires and pylons that keep the country functioning. Second are the service providers. These focus on data, billing and the technology that links the grid to the customer. Each group presents a different investment case.

The UK is at the start of a major, long-term infrastructure cycle and the work ahead is vast. The challenges range from meeting the energy demands of AI to modernising water networks. Both sides of the utilities sector are evolving in response and the market is recognising the growth potential of businesses once seen as dull.

Britain is currently overhauling its industrial strategy and utility companies have moved from the sidelines to the very centre of national-growth policy. For decades, investors treated the stocks in this sector as a set of bond proxies. The stocks were bought for their steady dividends and low volatility, but little else. A series of strategic shifts, driven by government policy, has changed that view.

The grid is the UK economy's main bottleneck

The first major shift is a crisis of capacity in our power networks. As John Pettigrew, the former chief executive of National Grid, has pointed out, the grid is becoming the main bottleneck for the economy. In 2023, he stated that the country needs to build seven times as much infrastructure in the next few years as it has in the past 30.

The problem is that the physical grid was not designed for the modern world. Engineers originally built most of this network to move power from large coal plants in the north down to the south. It was designed to serve houses and light up streets on a cold winter night. It cannot process the sudden, massive surge of electricity needed for the giant data centres that power the modern economy. This has created a backlog of projects waiting to be connected to the grid.

In 2026, the backlog of demand for data centres hit 50GW across 140 different sites. To put that number in perspective, the peak demand for electricity for the entire British grid is roughly 45GW. This means one single industry is now asking for more power than the entire nation uses on its coldest winter night when everyone is indoors using electricity. Global technology giants such as Amazon, Microsoft and Google are driving this demand. They have reclassified the UK as a primary growth zone, but they can't get the power they need because the old wires are at their breaking point.

National Grid has a multibillion-pound plan to reinforce the system. This includes building new substations and using advanced low-loss conductors. These technologies let the grid carry significantly more power without needing to put up entirely new pylons everywhere. This is a high-return path for growing assets because it avoids many of the planning headaches that come with new construction.

To handle the surge in demand, the government and the new National Energy System Operator have officially scrapped the old first-come, first-served model for grid connections. That old system let speculative projects sit on capacity for years, which stopped better-prepared data centres from getting online.

The new so-called Gate 2 reforms now prioritise projects based on how ready they are and how well they fit the national-energy plan. If a project misses its milestones, the operator immediately cancels its connection offer.

This allows National Grid to move from fixing things as they break to investing ahead of time and it can now justify building infrastructure before a data centre is even finished. This shortens the gap between spending money and earning a return, which is a clear win for shareholders.

The era of underinvestment in the water sector is over

A second major shift is happening in the water sector. The industry is moving away from a period of intense public and political tension. This was caused by years of underinvestment, resulting in frequent leakage and sewage spills that polluted rivers. The sector was essentially focusing on the short-term health of the pipes.

Adding to the pressure is the rise of AI; data centres do not just need electricity, they also require millions of gallons of water for cooling, making water companies a vital part of the tech infrastructure.

The 2026 White Paper, “A New Vision for Water”, is about making national infrastructure more resilient. The sector is starting a £104 billion investment programme for the five-year stretch that began in April 2025. This is nearly double what the companies spent in the previous five-year cycle. A single, integrated body that looks at both the environment and public health has replaced the previous fragmented oversight of Ofwat and the Environment Agency. This new regulator cares more about long-term results.

The Water Industry National Environment Programme is the main force behind this massive spending. It puts £24 billion specifically toward cutting sewage spills and cleaning up rivers. The programme requires companies to install thousands of monitors that track water quality around the clock. This ends the days when companies could essentially mark their own homework.

For investors, the focus has shifted from simple efficiency to whether these companies can actually finish such a mountain of work. The new rules introduce 25-year delivery plans to give pension funds the certainty they need by matching investment timelines to the long life of water pipes and plants.

Utility companies have a state-backed safety net

The third, and perhaps most important, shift is the emergence of a new partnership model between the state and utility companies. Historically, massive infrastructure projects were often considered too risky for private investors; if a project failed or stalled, the financial loss could be ruinous. To solve this, Great British Energy and the National Wealth Fund are now fully operational, reducing risk across the sector for investors.

With its £27.8 billion capital base, the National Wealth Fund has attracted more than £100 billion in private investment by offering debt guarantees and taking the first loss on higher-risk projects.

Essentially, the state acts as a buffer and makes projects safer for pension funds to back. This approach is especially valuable for emerging technologies such as long-duration energy storage and small nuclear reactors. Great British Energy also acts as a co-developer. It takes on the early risk of projects failing due to such things as environmental assessments. This leaves listed utilities free to focus on the high-margin work of building and running the assets. Because the state is now a partner in building core infrastructure, the investment risk to the whole system has dropped.

This state-backed safety net is also showing up in the retail energy market. The Great British Energy Local Power Plan provides cash for community energy projects that help keep the local grid in balance. This move toward decentralisation takes the weight off the distribution networks that the big utilities own. It lets these companies hold off on expensive physical upgrades and instead use digital tools to manage demand for power.

As more households pick up smart meters and tariffs that change based on the time of day, the whole system should work better. The shift to a data-heavy grid is turning the retail business into a high-margin tech platform. This change is a big reason why the outlook for the sector is better than it has been in years.

Key themes and plays for investors

The investment case for the listed companies is no longer just simply waiting for a dividend. It is about identifying which can most effectively turn this massive wave of state-backed capital into growing assets. For investors, the current market offers opportunities in companies that are becoming essential to the digital and green future of the country.

National Grid (LSE: NG) is the most obvious name to benefit from modernisation of the grid. As the sole owner of the transmission network across England and Wales, it is the physical gatekeeper of the emerging AI revolution. Under the RIIO-T3 regulatory framework that begins in April this year, the company has secured a real allowed return on equity of 6.12%. This is a decent improvement on the past, reflecting a need to attract more investment as well as the higher cost of funding the great grid upgrade.

Morgan Stanley recently pointed out that National Grid is moving away from being a low-growth utility and becoming a premium infrastructure investment. It highlighted that the company now has an asset growth target of 10% per year – well above the rate of inflation – and is heading toward earnings growth of 6%-8%. The firm is spending billions on 17 major projects to reinforce the north-to-south power corridors – essential for bringing power from offshore wind farms to the data-centre hubs.

The regulatory environment now allows for anticipatory investment. This means the firm can build ahead of demand. Doing so reduces the risk of stranded assets and ensures a steady stream of regulated income. As the asset base grows, the earnings potential of the company increases in a way that was not possible under previous rules. This shift from a yield-based valuation to a growth-based one is a key theme.

SSE (LSE: SSE) is another clear winner that has rebranded itself as a clean-energy champion. The firm is currently halfway through its ambitious investment plan, which involves spending £18 billion on offshore wind and transmission links. What makes SSE particularly interesting is how it has used the new state-utility partnership to lower its risk.

By working with Great British Energy, it can offload the early construction risks that used to weigh on its balance sheet, allowing it to maintain a strong credit rating while still pursuing aggressive expansion.

The partnership with the National Wealth Fund is also providing SSE with first-loss guarantees on complex projects. This is a significant advantage because it protects SSE from the cost overruns that often plague large infrastructure projects, lowering the overall cost of borrowing and raising returns for shareholders.

One could argue that SSE should be viewed as a high-quality infrastructure asset rather than a riskier power generator. This new reality hasn't escaped market attention – the shares have risen by 60% in just the last six months.

The winners in water and retail

In the water sector, the winners will be those who can navigate the new £104bn investment cycle. Severn Trent (LSE: SVT) and United Utilities (LSE: UU) are now working within a regulatory framework that puts long-term resilience ahead of short-term savings. This creates the potential for a large expansion in their regulated capital value, which is the base used to calculate their profits.

Severn Trent has already shown strong revenue growth following the latest tariff reset. The company is using a modular design for its assets, which helps keep construction costs low and delivery speeds high. This operational efficiency is a key driver of value.

United Utilities is also performing well, with a focus on its multi-billion-pound programme to reduce storm-overflow spills. Both companies are likely to benefit from outperformance payments if they hit their new environmental targets.

These companies offer a rare combination of inflation-linked returns and the security of a state-mandated investment cycle. The move to 25-year delivery plans provides the long-term visibility that institutional investors crave.

Centrica (LSE: CNA) and Telecom Plus (LSE: TEP) represent the technology-based, consumer-facing end of the sector. These companies do not own the heavy wires or pipes, rather the data and relationship with customers.

Centrica has moved far beyond its origins as a gas supplier. It is now a leader in flexible energy services, using smart data to help businesses and homes use power when it is cheapest. This capital-light model allows for high margins and strong cash flow without the debt burdens seen elsewhere in the industry. The company has a strong balance sheet and has been returning a lot back to shareholders through buybacks and dividends. Its move to a service-based model exposes it more to the economic cycle, but also provides the possibility of decent returns.

Telecom Plus, better known to consumers as Utility Warehouse, uses a similar approach by bundling energy with other home services. Its ability to use smart-meter data to lower wholesale costs has contributed to its higher levels of growth over the years.

By helping customers balance their own energy needs, it reduces the overall strain on the grid. This creates a win-win situation where the company earns higher margins and the customer pays lower bills. The scalability of this digital model is a significant advantage in a world where physical infrastructure is expensive and slow to build.

The heavy infrastructure is expensive and slow to build. The heavy infrastructure companies that form the core of this sector were stuck in a bit of a rut for a long time.

Over the last year or so, however, a clearer lead from the regulators has really lit a fire under their share prices. Because of that, most of the easy money has already been made, with some share prices rising by more than 50% in just a few months.

Still, we now have long investment horizons thanks to government policy. Patient investors who are happy to sit on these shares for years should see good rewards for the level of risk they are taking on.

National Grid is right at the front of this modernisation. It has gone from being a slow utility to becoming a much faster infrastructure business. It is never going to be a high-speed tech stock.

Nevertheless, its better growth outlook, along with those reliable dividends, offers a level of security that makes it one of the lower-risk stocks on the FTSE. It remains a vital part of Britain's energy future. For investors who wish to build a diverse portfolio of long-term, high-quality businesses, National Grid has a lot going for it.

The two big water companies, Severn Trent and United Utilities, have their own specific hurdles and opportunities to deal with. Both are updating their systems to meet new standards for clean water and service. They are getting a direct boost from the massive building phase the country is going through right now.

For investors looking for income, these are high-quality assets. They offer returns linked to inflation and benefit from a regulatory set-up that is far more predictable than the mess we saw in the early 2020s. There has always been little to choose from between the two as they tend to perform very similarly.

At the other end of the sector, Centrica and Telecom Plus offer a different mix of risks and rewards. These businesses depend much more on how good the management is and how the wider economy is doing. They also have to fight harder for customers in the retail market. However, they don't have to own all the heavy kit themselves.

This capital-light approach has let them keep up very high returns for shareholders through both buybacks and dividends. Telecom Plus, in particular, has shown it can grow even when things get tough by bundling home services into one efficient package.

Forced evolution brings opportunity

The utilities sector is entering a period of forced evolution. By clearing the infrastructure bottlenecks and establishing a clear partnership with the state, the industry is transitioning from being a defensive shelter to becoming a central pillar of national growth. For the patient investor, these companies offer a rare blend of stability and compounding growth, underpinned by the structural demands of the 21st-century economy.

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In today’s environment of elevated uncertainty and short-term noise, the Nedgroup Investments Contrarian Value Equity Fund offers a clear alternative for long-term investors. Our philosophy is rooted in high conviction and patience. We are not chasing controversy or buying what is merely cheap. We are identifying durable businesses with the capacity to compound earnings over time. Through a rigorous bottom-up approach, we build a portfolio of between 30 and 50 companies from around the world with resilient fundamentals: defensible competitive positions, clear growth paths, trustworthy management teams and robust balance sheets.

Investment returns in excess of the benchmark index, in our view, are earned through stock selection, thoughtful position sizing and valuation discipline, both at entry and exit. We assess long-term intrinsic value across a range of outcomes, with particular emphasis on downside risk, and build positions incrementally. This long-term, unemotional approach allows us to build conviction in contrarian times when others might retreat. We look for misunderstood firms where quality is mispriced and long-term earnings power is underappreciated. Three recent additions to the portfolio reflect this mindset.

Three stocks to watch

Amrize (NYSE: AMRZ) is a building-materials company newly spun-off from Holcin, and is focused on North America, where secular tailwinds (such as investment in infrastructure, the undersupply of housing and onshoring) are underpinning long-term demand. With more than 1,000 sites and deep mineral reserves, it benefits from scale, vertical integration and proximity to key markets.

We’ve known this management team throughout our long-term investment in Holcim, and believe that its disciplined capital allocation and operating efficiency will allow Amrize to boost earnings over the long term by expanding margins and making strategic acquisitions. As a standalone entity, Amrize remains underappreciated, creating a rerating opportunity as the market begins to recognise its true value.

Hoshizaki (Tokyo: 6465) is a global leader in commercial refrigeration and ice-making equipment, serving hotel chains, restaurants, supermarkets, and convenience stores. While it is domiciled in Japan, its reach is global. The company’s strong brand, reliable products and entrenched relationships with distributors create a durable competitive advantage in a fragmented market. Given steady demand for replacement products and long-term growth in the sector, Hoshizaki offers resilient profits. Its conservative balance sheet and engineering-led culture support margin improvement through automation and global sourcing.

Becton Dickinson (NYSE: BDX) is a “picks-and-shovels” business for healthcare: it provides essential products such as syringes, catheters, and laboratory instruments to hospitals, laboratories and research centres. These categories carry high regulatory and trust barriers, and Becton Dickinson is a global leader in many of them. Its recurring revenue base is less sensitive to economic cycles and more aligned with long-term demographic and healthcare trends. Disciplined mergers and acquisitions, a focus on patients’ safety and expansion into emerging markets support consistent earnings growth. Becton’s ability to innovate while maintaining operational discipline makes it a durable compounder in our portfolio.

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The Ashoka WhiteOak Emerging Markets Trust engages in bottom-up stockpicking to find great businesses at attractive valuations across emerging markets. The trust runs a portfolio that is generally balanced relative to the benchmark to reduce macro risks; stock selection drives performance.

Stocks are selected by a dedicated team of investment professionals and go through an internally developed framework assessing companies’ environmental, social and governance (ESG). The trust focuses on maintaining a well-diversified portfolio rather than making big individual bets on companies, sectors or countries.

Samsung Electronics (Seoul: 005930) is a South Korean leader in technology with strong positions in semiconductors, smartphones, displays and other electronic devices. In the computer-memory market, Samsung remains a major player in both the DRAM and NAND subsectors, with scale and cost advantages built over decades. The surge in demand for AI servers is driving higher memory content, providing structural growth opportunities.

Samsung’s foundry business is expanding through areas such as 3-nanometer process node (3nm): an advanced stage of semiconductor manufacturing where transistors are built in minute sizes. The group is therefore now in a position to capture market share beyond memory.

In smartphones, the company holds a leading position with its Galaxy series and is the pioneer in foldable devices, while its OLED (organic light-emitting diode) display business continues to benefit from increasing penetration into mobile and IT products. Backed by diversified revenue streams, consistent investment in research and development (R&D), and exposure to long-term themes such as AI, digitalisation and electrification, Samsung Electronics is well placed to compound value over the long term.

Growth stocks and the AI boom

Delta Electronics (Taipei: 2308) is the leading switching power supply company globally. It serves a wide range of markets such as telecom base stations, console games, PCs and servers. The industry is characterised by high barriers to entry with know-how built up over decades of experience. Recent growth has been driven by AI servers, which require a far higher power supply than conventional ones. New generations of AI servers have even higher power requirements. Beyond AI, Delta is also present in areas such as factory automation and supplying power trains for electric vehicles, demonstrating management’s ability to identify new opportunities.

Alibaba (NYSE: BABA) is a Chinese company specialising in e-commerce, cloud computing and digital media with a diverse business portfolio both in China and globally. It is the market leader in domestic e-commerce, payments and cloud infrastructure. Alibaba has an enduring competitive advantage thanks to its integrated ecosystem and substantial economies of scale, conferring pricing power and facilitating attractive incremental returns on capital.

In e-commerce, opportunities include rising e-commerce penetration in China and greater opportunities to monetise advertising. Surging demand for AI in China has accelerated cloud migration, bolstering Alibaba’s position as the go-to cloud infrastructure provider. Capable management also makes Alibaba an appealing long-term holding.

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After five years of miserable performance and with the shares trading at a 10% discount to net asset value (NAV), despite 20% of the share capital having been bought back, the directors of the Baillie Gifford Shin Nippon (LSE: BGS) trust have had enough. They have acknowledged the need for an immediate turnaround in performance and stated that if poor performance continues, they will explore “all available options”. This has been presumed to mean not just a tender for 15% of the share capital at a 2% discount in 2027, but also a possible change of manager and strategy.

In the last five years, the NAV has fallen 25% compared with a gain of 42% in the MSCI Japan Small Cap index, a 93% gain for the AVI Japan Opportunity Trust and 144% for Nippon Active Value. The question for BGS’s directors might be why they have been so slow to act. However, a study of precedents for changing managers and style is far from encouraging. The poster child for recent change was the switch in the management of Temple Bar from Investec Asset Management to Redwheel nearly five years ago. Since then, the investment return has been 148%, nearly twice the return of the All-Share index.

But the directors wisely decided that although they would change managers, the trust would continue to invest in “value” rather than “growth” stocks, even though the former had suffered terribly in the pandemic. Since then, value has far outperformed growth. It’s not obvious that the performance would have been too different had the previous manager, Alastair Mundy, been willing to continue to manage it.

Other changes, although ostensibly maintaining continuity of style, have been less happy. In 2021, the directors of Genesis Emerging Markets, tiring of Genesis’s pedestrian performance, switched to Fidelity. The new managers sought to inject some fizz into the performance with a disastrously timed foray into Russia. To its credit, Fidelity has since performed much better, so although the five-year record remains poor, three- and one-year performance is now good.

The board of Mid Wynd appointed Lazard as managers in place of Artemis in 2023, perhaps believing that its lead manager, Simon Edelsten, was about to retire. But Edelsten has since re-emerged at Harwood, alongside his former co-manager Alex Illingworth. Mid Wynd’s board probably thought that Lazard’s growth strategy, supported by a solid record, would provide the shareholders with continuity. Instead, the trust has returned just 10% since Lazard’s’ appointment against 35% for the MSCI AC World index. Lazards appears to rely on an inflexible process, while Edelsten and Illingworth made use of insight and flair. The board should hand the management contract back to them.

Have other investment trusts fared better?

Boards that switched not just manager, but also style, have fared no better. Keystone was once managed by the investment arm of S.G. Warburg, investing in UK equities. It shifted to Invesco in 2017 and thence to Baillie Gifford in late 2020, adopting a high-growth global mandate under the new name, Keystone Positive Change. Baillie Gifford’s style fell out of favour soon after, and Keystone was unable to bounce back. It was wound up earlier this year.

Schroders struggled to replace Richard Buxton as manager of Schroder UK Growth when he left for Old Mutual in 2013. Five years later, the board tired of Schroders’ failure to replace him with a quality manager and switched managers to Baillie Gifford. This has not been a success and the trust has dramatically underperformed the All-Share index in the last five years, although only moderately over one and three years. Perhaps “UK Growth” is just a contradiction in terms; in any case, time is running out.

MIGO Opportunities Trust moved with its managers from Miton to Asset Value Investors, but its lead manager, Nick Greenwood, has now retired and AVI propose a change of focus. Instead of investing in undervalued trusts, AVI now proposes a narrower, “activist” approach, seeking to compel companies it invests in to do something about the discount at which their shares trade. But this approach is expensive, time-consuming and often unsuccessful. Moreover, the time for it may have passed. Two years ago, discounts to NAV were wide, performances had flagged, but an upturn was imminent. Opportunities were plentiful, as Saba Capital realised. Now they are much scarcer and riskier. Hopefully, MIGO will continue as before.

It’s not all bad news. Edinburgh Investment Trust has found a stable home at Majedie and generated solid returns, while the shareholders of STS Global Income & Growth seem happy with Troy’s low-risk, modest returns approach. Trust mergers have generally been successful. Internal changes of manager, such as regularly performed at JPMorgan, have a good record overall, as has the ratcheting up dividends.

A change of management company and style, however, has a poor record. A new style is adopted and management company appointed when it is riding the crest of a wave. Then, the market changes gear, the new managers struggle and don’t have the embedded goodwill from past performance to carry them through difficult times. What, then, should the Board of BGS do? They need to recognise that smaller companies have performed poorly the world over in recent years. In Japan, the growth style has been heavily out of favour, which is why BGS’s two value-orientated rivals have left BGS trailing in the dust.

Yet BGS’s performance has picked up in the last six months while Baillie Gifford Japan (LSE: BGFD) has had a good year. It looks as if the growth style is returning to favour; if so, there is nothing to be gained and much to be lost from BGS changing strategy now. BGS could merge with BGFD, as JPMorgan’s Japanese Smaller Companies Trust was merged with JPMorgan Japanese, but better, surely, to give Brian Lum, BGS’s new lead manager, a chance to prove himself.

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The trust is an actively-managed investment vehicle providing investors with broad access to China’s growth opportunities, from established technology leaders to entrepreneurial private businesses yet to list. Chinese equities have advanced strongly this year despite US-China trade tensions and a subdued property market. Low initial valuations and improving sentiment towards sectors driven by innovation (following DeepSeek’s breakthrough AI model) have also helped.

We focus on identifying companies with scalable growth potential, a sustainable competitive advantage and strong execution by managers. These often align with beneficiaries of long-term structural growth trends, such as China’s expanding domestic consumption and rapid technological innovation.

A particular emphasis is also placed on smaller, under-researched firms, offering attractive opportunities in mispriced stocks with healthy prospects. Here are three businesses the trust currently invests in.

China's growth opportunities

Hesai Group (Nasdaq: HSAI) is the world’s leading automotive LiDAR [light detection and ranging] provider, uniquely positioned at the heart of the fast-growing autonomous mobility revolution. As LiDAR becomes an essential component in advanced driver assistance systems (ADAS), Hesai’s ability to deliver superior technology at competitive prices sets it apart. As the market expands, Hesai is set to benefit from strong demand in increasingly sophisticated ADAS, which should help lead to substantial volume growth. While the vehicle industry will drive growth for many years ahead, there is also strong potential in other forms of mobility and robotics in the longer term. In addition, significant scope for margin expansion exists as volumes ramp up.

Xtep International (Hong Kong: 1368) has established itself as a leading Chinese sportswear brand specialising in the fast-growing running segment. Benefiting from the trend towards trading down in sportswear, Xtep is well positioned, combining affordability with a relevant brand.

Its sponsorship of marathon events and recognition for its shoes’ performance strengthen the brand’s credibility, while the strong growth of its premium Saucony brand broadens the product mix and supports the expansion of margins.

In the meantime, the company is trading at compelling valuations, while a solid dividend yield underpins attractive total shareholder returns. With strong branding and exposure to one of China’s most resilient consumer categories, I see Xtep as a structural winner in the domestic sportswear market.

Full Truck Alliance (NYSE: YMM) operates as China’s dominant digital freight-matching platform, leveraging powerful network effects to match shippers with truckers more efficiently than traditional offline brokers. Its scale creates a strong “moat” (an enduring competitive advantage), with network effects set to extend the group’s lead thanks to greater efficiencies and lower costs.

As penetration deepens and take rates (the percentage of a transaction for facilitating a sale) rise, Full Truck Alliance (FTA) is well positioned to deliver sustained growth in revenues from commissions, underscored by a record of resilient earnings with robust recent quarterly results. Having first invested in FTA as a private company, I’ve retained my long-standing conviction in its business model and strong execution. Since its public listing in June 2021, it’s remained a key portfolio holding, offering durable growth potential as China’s logistics industry continues its structural shift online.

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Sometimes the best opportunities don’t come from firms in glamorous, fast-growing industries, but from well-run companies that have carved out a niche for themselves in lower-profile, but no less profitable, sectors. An example of this is food distribution, which involves making sure that food from producers, both ingredients and prepared meals, reaches wholesale customers such as restaurants, and large institutional consumers such as supermarkets and hospitals. In this industry, Sysco (NYSE: SYY) stands out from all the rest.

Since food distribution is a low-margin business, the key to success is keeping costs to an absolute minimum. Sysco’s status as the largest food-distribution company in the US, supplying nearly one in every five restaurants or commercial kitchens in the country, means that it can use economies of scale to do its work extremely efficiently. As a result, even though its operating margins are only around 3%-4%, it makes a 20% return on capital employed. The fact that the food-distribution industry rewards scale also serves as a barrier against any potential competition, helping to protect both market share and margins.

Should you invest in Sysco?

Sysco isn’t resting on its laurels. It has pursued a policy of international expansion and now operates in 90 countries. This enables it to reduce costs further when it comes to sourcing the cheapest food from around the world, and also allows it to continue growing by entering new markets. Furthermore, the company has acquired food-service companies in other countries, such as last year’s acquisition of Scottish meat and fish supplier Campbells Prime Meat. All this has made it the largest food-distribution company in countries ranging from Canada to the UK, as well as the third-largest producer in France.

Sysco has a solid growth record, with its international sales expanding by an average of 17% a year since 2021; overall earnings have jumped by around 50% since 2021. Adjusted earnings have quadrupled during the same period. Even if you use pre-Covid levels as the point of comparison, profits have still grown by a third since 2019. It has also managed to increase its dividend continuously during this period, one of the few companies in the industry to pay out money to shareholders. Despite this, it is still reasonably valued, trading at only 16.7 times estimated 2026 earnings and offering a dividend yield of 2.8%.

In spite of Sysco’s long record of growing both earnings and dividends, its share price has had a mixed record, fluctuating over the past few years. This might be about to change. The shares have built up momentum over the past few weeks as they are now trading above their 50-day and 200-day moving averages. I would therefore suggest that you go long at the current price of $78.41 at £40 per $1. In that case, I would put the stop loss at $54.41, which gives you a total downside of £960.

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AIM, which stands for Alternative Investment Market, celebrates its 30th anniversary on 19 June this year, after launching in 1995.

Back then, there were just 10 companies listed on AIM, with a combined valuation of £82 million.

Today, the figure is 679 – although at its peak, 1,694 companies were listed on AIM in 2007.

A sub-market of the London Stock Exchange (LSE), AIM is home to small and medium-sized companies looking to raise money, who might not meet the listing requirements of the main market.

According to the LSE, “AIM is the most active growth market in Europe, and over the last five years, 45% of all capital raised on European growth markets has been on AIM”.

However, while some investors have done very well by buying certain AIM stocks – or perhaps within an investment fund – the market is considered to be high risk and volatile, and there have been some disasters along the way over the past three decades.

Notable examples include Quindell, Purplebricks, and Affinity Internet, which faced issues like accounting irregularities, missing funds and eventual collapse.

Dan Coatsworth, investment analyst at AJ Bell, comments: “AIM has been called the ‘Wild West’ in the past and has had its fair share of disasters, yet it would be wrong to call the entire market a failure. It was designed to nurture growing companies, and the achievements of Hiscox and Genus prove it has been successful.”

The insurer Hiscox is now a FTSE 100 company, while genetics group Genus has ascended to the ranks of the FTSE 250.

“Anyone who bought Hiscox at its AIM IPO would have subsequently enjoyed a 2,650% total return, which factors in share price gains and dividends,” says Coatsworth.

He adds that investment trust Athelney Trust also made the move from being an AIM early bird to joining the main market.

AIM comes with some tax advantages, for example you can invest via an AIM ISA, while some AIM shares benefit from business property relief, meaning no inheritance tax is due provided the investment is held for at least two years. However, the tax relief will be cut from April 2026, meaning investors will be liable for 20% inheritance tax.

“While AIM’s 30th anniversary has been clouded by talk of how the market is shrinking fast, there are still reasons to celebrate its achievements. A good chunk of AIM’s original members have gone on to score a winning goal for investors’ portfolios,” says Coatsworth.

According to AJ Bell, 11 companies that joined AIM in its first six months of existence are still on the UK stock market today. Three of these companies are now on the main market, leaving eight on AIM.

Investors could have made significant returns with one of the “early bird” AIM stocks, while four of the companies have posted a negative total return over the past 30 years.

How have the original AIM stocks performed since 1995?

AJ Bell crunched the numbers to show how the eight AIM stocks that were listed in 1995 and still on the market today have performed over the past 30 years.

Source: AJ Bell, LSEG. Total return since respective IPO date in 1995 until 12 June 2025.

The best performer among those still quoted on AIM is Wynnstay Properties, which has delivered an astonishing 6,331% total return.

“Its history lies in developing and managing residential property in London’s Kensington area, but it switched to commercial property in 1972. While the business is still relatively small compared to many real estate stocks on the London Stock Exchange, the rich returns for investors speak for themselves,” comments Coatsworth.

The second-best performer is NWF. “Supplying animal feed to farmers and filling up domestic heating tanks with oil might not sound very glamorous, but it’s been a ticket to steady wealth creation for NWF. A 920% total return since joining AIM in September 1995 is not to be sniffed at,” says Coatsworth.

“AIM has been a good place for small companies to broaden their shareholder base and tap capital markets to accelerate their growth. NWF has made various bolt-on acquisitions over the past three decades, some of which have been part-funded by issuing new shares.”

At the bottom of the table, four companies have all made a loss over 30 years. Exploration company Bezant Resources has performed the worst, losing 99%.

The investment platform Interactive Investor also recently analysed the performance of AIM.

It found that there are 230 AIM companies that have been listed on the market for the past 20 years. Accesso Technology Group has delivered the best performance over the past two decades (a 13,900% return), with Judges Scientific coming in second with a 7,490% return.

The pair are also the top two performers for the whole of the London Stock Exchange over that period.

Investors need reminding that North America extends beyond the US. Canada, often overlooked but certainly not a laggard, is projected to be the fastest-growing economy in the G7 in 2025 and stands as a beacon of stability on the global stage in an era of uncertainty. This strength is rooted in its historic banking system, which has not missed a single dividend for 200 years – a feat unmatched by its counterparts in the US or the UK.

Ultimately, the most critical factor in long-term investment performance is the price paid for assets. From this perspective, Canadian stocks present a compelling opportunity, with the country’s exchange trading at its deepest discount to the US market in history. The market’s performance has already begun to broaden: the Canadian S&P/TSX Composite Equal Weight Index has outpaced the S&P 500 Equal Weight Index in 2024, gaining 17.8% compared with 12.3%.

At Canadian General Investments (CGI), North America’s second-oldest investment trust, we adhere to a disciplined buy-and-hold strategy. Our focus is on high-quality Canadian companies with US exposure limited to 25% of the portfolio. CGI offers a cost-effective gateway to Canadian stocks, which remain underappreciated despite Canada’s financial stability, vast natural resources and strong ties to the world’s largest economy.

How to invest in Canada

Industrials have benefited from increased infrastructure spending in the US, driven by trends such as nearshoring, electrification and decarbonisation. One standout in our portfolio is Stantec (Toronto: STN), a global leader in sustainable design and engineering. Stantec’s focus on operational efficiency and project execution has led to industry-leading margins, with strong growth prospects fuelled by public and private investments, particularly from US initiatives such as the Infrastructure Investment and Jobs Act.

While Canada’s economy is often associated with “old world” sectors like energy and banking, the country also boasts a rich technological legacy. From BlackBerry to Shopify, Canadian innovators have reshaped their respective markets. One standout example is Descartes Systems Group (Toronto: DSG), a global leader in software-as-a-service (SaaS) solutions designed to enhance the efficiency, security and sustainability of logistics-heavy businesses.

Descartes serves more than 26,000 customers worldwide, including major corporations such as Coca-Cola, Home Depot and Mondelez International, helping them streamline supply chains. With a history of 28 successful acquisitions since 2016, totalling US$1.1 billion, Descartes is well-positioned for continued growth. Its financial strength allows it to seek out undervalued assets patiently, ensuring strategic expansion while maintaining profitability.

Fuelling a nuclear renaissance

The 2011 Fukushima disaster led to a dramatic decline in uranium prices. But today the drive to cut carbon emissions has reignited interest in nuclear power. Demand for uranium is outstripping supply, and Canada, home to some of the world’s richest deposits, is uniquely positioned to capitalise on this trend.

CGI has established positions in both Cameco (Toronto: CCO), the largest publicly traded, uranium-related company in the world, and in the lesser-known NexGen Energy (Toronto: NXE). NexGen’s Rook I project, the largest development-stage uranium mine in Canada, is expected to begin production by 2029, potentially delivering up to 30 million pounds of uranium annually.

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We invest in attractively valued companies with the potential for positive change. This typically means investing in overlooked stocks where there is little or no value ascribed to any recovery potential. The market is often slow to recognise change in out-of-favour stocks, which gives us time to undertake our due diligence and build conviction in the positive change thesis. It can be centred around either internal or external change; ideally, a combination of both. If things improve as we expect, there should be significant upside as the consensus view changes and new investors buy into the story.

Overlooked European stocks

Imperial Brands (LSE: IMB) has undertaken a significant turnaround under new management, improving the execution of its strategy and strengthening its balance sheet. It is catching up with the competition in developing a range of less harmful next-generation products. Our investment thesis is two-pronged. We can make very strong returns simply from its generous dividends and share buybacks. Imperial is returning the equivalent of 16% of its market value to shareholders this year alone. 

However, if regulations governing next-generation products do tighten, as recent signs in the UK and, importantly, in the US suggest, then these categories can grow much faster and be far more profitable. Over time this could be transformational, as a much larger proportion of the firm’s products will boast far greater longevity than the current tobacco business. 

DCC (LSE: DCC) is a global distributor of liquefied petroleum gas (LPG) and oil, as well as medical and technology products. The group has proved its ability to build scale in fragmented sectors through a disciplined approach to mergers and acquisitions. It boasts a high-quality business, a strong balance sheet and a long record of generating attractive returns. 

However, its shares are trading on multiples usually seen at the trough of a cycle owing to investors’ concerns that its energy division will come under significant pressure as demand for fossil fuels declines. We expect the decline in demand to be slower than the market anticipates and offset by higher margins thanks to the consolidated nature of the market. Additionally, we believe that the company’s ability to distribute alternative lower-carbon-intensive energy sources to customers cheaply through its existing infrastructure is underappreciated. It should help the group sustain or even improve high returns.

Banks have been another unloved sector since the global financial crisis. However, more stringent regulatory oversight has forced banks to increase capital ratios, boost funding levels and refrain from riskier lending. Higher interest rates have allowed them to improve their profitability significantly. 

One of our largest holdings in the sector is Standard Chartered (LSE: STAN), a diversified banking group with a focus on emerging markets, especially Asia. Management is focusing on better cost control. Revenues should be supported by the group’s broad sensitivity to global interest rates and the structural growth of its wealth and financial markets divisions, which account for 40% of revenues. A strong start to 2024 and a plan to buy back a significant portion of its shares (around 9%) gives this story credibility.

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Our investment philosophy is to look beyond the economic and political noise to find continental European companies that can deliver superior returns over a three-to-five-year horizon. We look for firms that can deliver sustainable dividend growth, as history shows us that this characteristic is a marker of quality that can help to identify stocks likely to outperform the market. We seek to build a balanced portfolio and look for the best companies across sectors, favouring stocks with strong balance sheets, pricing power and a robust competitive position.

Top European stocks to invest in

Epiroc

Sweden’s Epiroc (Stockholm: EPI-B) is a global leader in underground and surface rock drilling. The company operates in an oligopolistic market and benefits from a very strong competitive position. Epiroc is well placed to capitalise on future commodity booms fuelled by long-term trends such as electrification and the growth of infrastructure. Meanwhile, a decline in the quality of ore is leading to a shift towards underground mining, which benefits Epiroc more than its peers owing to its superior product mix. The group’s customer base is extremely fragmented, which creates pricing power, and Epiroc also enjoys the benefit of repeated part replacements. As mining becomes more complex, Epiroc should be able to pass through higher prices and increase volumes. Epiroc is cash-generative and has low net debt, with an attractive and sustainable dividend. Given these positive fundamentals, we anticipate that Epiroc will be able to deliver high single-digit organic growth over the next five years.

Ryanair

Ryanair (Dublin: RYA), Europe’s largest low-cost air carrier, is the strongest player in a highly commoditised market. It has the best cost-management discipline of all European airlines and has historically delivered industry-leading returns on equity. The company has been the main European beneficiary of the post-pandemic recovery in demand for air travel as other suppliers (such as Wizz and Vueling) have struggled to boost supply due to their reliance on the delivery of new aircraft. This has supported pricing. Having stopped paying dividends during the Covid pandemic, Ryanair has recently announced a new dividend policy and share buyback programme. Emboldened by a secure balance sheet (the company has no debt) and high levels of cash generation, management has signalled its confidence in the firm’s ability to fund both buybacks and a progressive dividend policy.

Bankinter

Bankinter (Madrid: BKT), a Spanish domestic bank, is an example of where we like higher quality, best-in-class companies that operate in an otherwise average market. Management has a strong record of capital allocation and the business pays an attractive, mid-single-digit dividend yield. The shares are highly sensitive to interest rates, but we think the long-term outlook justifies this potential volatility. Bankinter is one of the few banks in developed markets where we see genuine opportunities for organic growth, thanks to its client mix and focus on high-net-worth individuals, along with the backdrop of consolidation and restructuring happening in the wider Spanish market. This enables Bankinter to gain new clients through attrition as other players combine. Meanwhile, management has been investing in emerging operations in Portugal and Ireland to drive future growth.

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Most economists and analysts were wrongfooted by macroeconomic developments in 2023, with many expecting a recession that didn’t materialise. This highlights the difficulty of basing an investment strategy on predictions of top-down factors such as GDP growth, interest rates or foreign exchange rates. 

It is far better to focus on analysing the fortunes of individual companies. However volatile the macroeconomic environment, it should pay to look to the long-term fundamental strengths of businesses and build diversification into a portfolio through different ideas that pay off at different times.

Top air travel stock to buy

Andy Headley at Veritas highlights European giant Airbus (Paris: AIR), one of two key manufacturers of airframes, operating in a duopoly with US firm Boeing. Air travel remains robust and continues to grow, with an estimated 80% of the global population yet to set foot on a plane. 

The company’s most important product is its short-haul, single-aisle plane – the A320 – which competes with Boeing’s version, the 737. This new generation of planes is flying off the shelves on account of 20% greater fuel efficiency when compared with older planes, as airlines seek to reduce their carbon emissions. 

We believe Airbus’s products are currently superior to Boeing’s. The group’s plan to increase production capacity by 50% should pave the way for strong growth and share-price performance over the medium- to long-term.

Top equipment rental to watch out for

Meanwhile, Jonathan Mills at Metropolis examines Ashtead (LSE: AHT), a large industrial and construction-equipment rental company, operating in the US, Canada and the UK. It buys a wide variety of equipment such as cranes, diggers, floor cleaners and even film-studio equipment, renting it to businesses for industrial and commercial purposes. 

For individual firms, rentals usually reduce costs as equipment tends to be fairly specialised and therefore infrequently used, and storage and maintenance is expensive. What’s more, if equipment can be shared and more efficiently used, it’s friendlier for the environment.

An important part of the business model is that Ashtead is able to use its scale to purchase equipment in bulk at attractive prices and, therefore, rent it out on good margins. Ashtead is one of two leading companies within this sector, and with around 13% market share, there is plenty of room for growth.

A revolution in diabetes management

Finally, Sunil Thakor at Sands Capital highlights the medical device company Dexcom (Nasdaq: DXCM). It is a high-quality growth business and a leader in the field of continuous glucose monitoring. Diabetes affects an estimated one in eleven people around the world and is a potentially deadly disease. 

Dexcom is one of the leading manufacturers of continuous glucose monitoring (CGM) devices, which are attached to the skin and track glucose to an app on your phone on an ongoing basis. These devices are revolutionising the management of diabetes, leading to fewer complications, greater longevity and a higher quality of life. Within this oligopolistic market, Dexcom offers a particularly strong product and associated software, and distributes them effectively through strong marketing and sales. As a result, Dexcom boasts a steadily growing market share, and we believe the company has strong and improving financials.

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May was a positive month for the stock market, and DIY investors took advantage to increase their exposure to growth stocks and funds.

Despite the ‘Sell in May’ adage, major indices rose during the month. The S&P 500 soared 5.1%, while the FTSE 100 made modest gains of 0.3%.

Data from investment platform Interactive Investor (ii) shows DIY investors on its platform piled into artificial intelligence (AI) stocks and funds in particular. Semiconductor company Micron Technology (NASDAQ:MU) was the most-bought stock among ii’s DIY investors during May.

“A combination of surging AI demand, supply shortages and price hikes have pushed [Micron’s] stock to fresh highs and ignited heavy buying among ii customers,” the company’s head of investment, Victoria Scholar said.

Meanwhile, the most-bought active funds and exchange-traded funds (ETFs) reflected a divide between investors minded towards protecting their wealth and those seeking growth.

Which other stocks and funds were the most popular among DIY investors last month?

The most-bought stocks in May

Besides tech megacaps like Micron and Nvidia (NASDAQ:NVDA), the rest of ii’s most-bought stocks during May reflect investor appetite for staple UK companies.

“FTSE 100 heavyweights like BP (LON:BP.), Legal & General (LON:LGEN), Lloyds Banking Group (LON:LLOY) and Glencore (LON:GLEN) were popular choices among ii customers last month,” said Scholar. “NatWest (LON:NWG) was a new addition while FTSE 250 low-cost carrier easyJet (LON:EZJ) dropped off the list.”

^{Source: Interactive Investor}

The most-bought funds and ETFs in May

Money market funds have been popular picks for defensively-minded investors throughout much of this year, and that remained the case in May with the Royal London Short Term Money Market Fund topping the list of the most popular open-ended funds.

But alongside this, more adventurous strategies such as technology funds were popular among DIY investors, with new entrant VanEck Semiconductor UCITS ETF (LON:SMGB) proving the fourth-most popular passive fund.

“Many semiconductor shares have posted impressive returns so far this year, increasing the demand for funds in this sector,” said Tom Bigley, fund analyst at Interactive Investor.

Bigly noted that Micron, the top holding in VanEck semiconductor, has risen more than 200% so far this year as demand for high-bandwidth memory for AI servers has exceeded supply.

^{Source: Interactive Investor}

Technology was a prominent theme among actively-managed funds too, with two forms of the Polar Capital Global Technology fund appearing in the top 10 list as well as WS Blue Whale Growth Fund.

The most-bought investment trusts in May

Tech and innovation-focused investment trusts were also popular with DIY investors during May. Innovation-focused Scottish Mortgage (LON:SMT) retained top spot from the previous month: the trust’s largest holding, SpaceX, is expected to IPO in June, and as such was the focus of much investor hype during the month.

Investing in the space theme was clearly flavour of the month, as Seraphim Space (LON:SSIT) was the third-most popular investment trust on Interactive Investor, just behind the Polar Capital Technology investment trust (LON:PCT).

^{Source: Interactive Investor}

The MoneyWeek investment trust portfolio was set up in 2012 with a simple principle: to help readers build a global, all-weather, set-and-forget set of investments. We chose six London-listed investment trusts covering various investment styles, assets and countries.

We’ve made some changes to these trusts over the years, but the underlying approach has always remained the same. The six choices are currently Personal Assets (LSE: PNL), Mid Wynd (LSE: MWY), Scottish Mortgage (LSE: SMT), Caledonia (LSE: CLDN), Law Debenture (LSE: LWDB) and AVI Global (LSE: AGT).

The portfolio returned 9.3% on an equal-weighted basis in 2024, compared with 11% for the FTSE All Share and 22.1% for the MSCI World index. Still, these figures only tell half the story. On an underlying basis, using net asset value (NAV) rather than share price, the portfolio added 12.3%.

The gap between NAV and market performance is particularly apparent at Scottish Mortgage and Caledonia. The latter’s share price returned just 0.6% in 2024, while its net asset value increased by 9.6%, thanks to the strong performance of its listed equity portfolio and direct private investments. Scottish Mortgage returned 24% in 2024 on an underlying basis, but a share-price return of 16.8%.

Discounts persist

The continued disconnect between underlying investment returns and share prices has become a persistent and concerning trend for the investment trust sector. The sector’s weighted average discount to net asset value (NAV) has hovered between 15% and 20% for the past two years. While some discounts narrowed last year – notably Edinburgh Worldwide and Baillie Gifford US Growth – the performance of Caledonia and Scottish Mortgage illustrate investors’ continued caution. Caledonia’s discount to NAV expanded from around 30% at the beginning of 2024 to nearly 40% by the end of the year. Before 2020, the discount rarely exceeded 20%.

On the plus side, AVI Global has been making the most of this disconnect. The value-focused trust has built a portfolio of companies and other trusts trading at a deep discount to the underlying NAV. Its biggest winner last year was US private equity giant Apollo, which it sold in November for a total return of 166% over three years – a 41% annualised gain.

At the other end of the spectrum, Law Debenture has traded at a premium to its net asset value for much of the year, and despite its UK value focus, it clocked up the second-best performance in the portfolio. The trust produced a total return of approximately 14.3% (NAV return 12.2%).

Substantial positions in NatWest, Marks & Spencer and Rolls-Royce helped its performance – Rolls-Royce and NatWest returned 92% and 83%, respectively. These results are a great reminder of why value investing is still relevant, especially in unloved markets.

Gold glitters

Personal Assets chalked up a return of 6.6% on a NAV basis and 6.2% on a total return basis. The trust started the year with 10.7% of its portfolio invested in gold bullion, a well-timed decision as the yellow metal returned 27% in 2024. Exposure to high-quality equities (28% of NAV at the end of November) also helped the portfolio, while short-dated bond exposure provided stability. Exposure to inflation-protected bonds (just over a third of the portfolio at the end of November) proved a drag.

Aside from Caledonia, the biggest disappointment in the portfolio was Mid Wynd. We’ve been closely watching this trust – the smallest in the portfolio – for the past three years.

Towards the end of 2023, the trust’s board replaced long-standing portfolio manager Artemis with Lazard Asset Management, which replaced all but two holdings in the portfolio. The changes have yet to yield the desired results. The trust returned just 8% on a NAV basis in 2024, underperforming its benchmark by 14% for the third year in a row. We’ll be keeping an eye on this trust to see if Lazard can turn the performance around.

This article was first published in MoneyWeek's magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.

Yesterday night (UK time), after US markets had closed, streaming giant Netflix (Nasdaq: NFLX) came out with earnings figures that massively disappointed investors. How massively? The share price dropped 25%.

The big problem is that Netflix reported a fall in subscriber numbers for the first time in a decade. And there’s no sign that things are going to get easier. The share price has now fallen by almost half since peaking in mid-November last year.

There are lots of reasons why the sector is “facing headwinds” as analysts put it, or “in trouble” as normal people might say. In fact, my colleague Rupert is currently working on a more detailed piece about the streaming industry right now.

But I wanted to take a quick look at what the reaction implies about the overall market “tone” – in other words, how investors are feeling about different types of stocks.

We’ve already noted a number of times that the bubble in “just cross your fingers and believe” stocks burst quite some time ago. That peaked back in February 2021, as a glance at the share price of Cathie Wood’s ARK ETF (which is quite literally a faith-based investment) will demonstrate. Companies with big ideas but no profits and often not even much by way of revenues are no longer popular with investors.

Those were the “longest duration” stocks you could get, and thus very sensitive to shifts in interest rates. (“Duration” is a term normally used in connection with bonds – the longer the duration, the further into the future the cash flows sit, which makes the asset’s value all the more sensitive to interest rate changes).

But it now looks as though the “build it and they will come” model is reaching the end of the line too. There’s far more to this than just the end of the pandemic. That certainly plays a part (is watching TV really your priority now that the sun is out and you might have a hope of going on holiday for the first time in two years?)

But there are deeper forces at play. With interest rates rising and inflation picking up, investors are becoming less patient – they literally can’t afford to be as patient as they were when interest rates were low and falling. As a business, if you can’t provide them with growing revenues, then you’d better provide them with growing profits.

What does that imply? I suspect it means that the likes of Netflix are going to have to concentrate on quality over quantity, on margins over revenue growth. Maybe spending on content will slow, with more going on specific shows. That might be bad news for the TV and film (“content creation”) industry which has enjoyed a boom as streaming services have chucked money at producing more content to attract subscribers.

On top of that, subscribers can expect to be charged more. And not just in this business – across all of those businesses that have been based on “build now, monetise later” models. There are a lot of these companies about. You could argue that this is the basic business model of online grocer Ocado, for example. It was also how Amazon grew to its current scale, although clearly the online behemoth started building an awful lot earlier than anyone else and is in a correspondingly better position now.

As far as the investors are concerned, the building phase is over – now it’s “later”. And woe betide any business that can’t make good on that promise of “monetising” the audience.

Anyway, the point is, growth for growth’s sake is out. Bear that in mind when you’re looking at your portfolio. If there are individual stocks or funds in there which are heavily built on growth without an eye to profitability, it might be time to reconsider.

Welcome to the latest issue of Asia Investor. This week, I'm going to be doing a full review of the entire portfolio and updating you with my latest views on each stock.

Before I begin, there are a couple of points I should mention up front. The most important is that after reviewing the situation at dairy and catering firm Etika further, I now recommend that you cut your losses and SELL. Please see below for full details.

There are no other recommendation changes to other stocks, but the buy limits on a few have been revised with excellent prospects ahead for Hsu Fu Chi, Vitasoy, Ara Asset Management and Petra in particular.

In fact today I'd like to add something new to the quarterly review. I'd like to spell out my targets for the potential gain on each stock in the portfolio over the next two-three years. As I've often said, I regard forecasting as a highly inexact business, so please don't take this a strict target it's solely a very rough indication of what I think the potential is on the balance of probabilities.

But I hope it will give you a good idea of just how much potential there is for some of the stocks over the months and years ahead.

Eredene could double within three years

There have been no major updates from Eredene Capital, our Indian infrastructure play, since I reported back to you on the interim year results briefing in my last quarterly review (Asia Investor #13, 8 th December 2010). That's no surprise, since at this stage most of Eredene's portfolio of projects are still under development or at an early stage of operations and there should be little to say.

The only news is that the firm's non-executive chairman has stepped down due to ill health and the senior independent director has temporarily taken over the role while the firm recruits a replacement. The main effect of this is that plans to raise new capital for the investment in the Ennore Container Terminal project have been delayed until a new chairman is appointed.

Eredene has been one of the worst performers in the portfolio, down 5.4% since recommendation nine months ago. I don't believe this reflects problems with the company, but rather a shortage of attention-grabbing news added to the general weakness of markets (especially with regard to India). The intention to raise fresh capital is also hanging over the stock, since this will probably be done via a large private placement (Eredene would like to bring in a strategic investor with a name in ports and shipping); this could involve some dilution for existing shareholders.

This investment is likely to remain a bit of a slow developer, with 2014 looking like the key date by which most of its current projects should be largely up to full speed; despite being a listed company, it is in many ways like a private equity investment with most of the pay-off coming at the end of a multi-year wait. Nonetheless, I'm optimistic that we may see it making an operating profit by the end of this year and ready to pay a dividend by the end of 2012 as milestones along the way.

My best estimate of share price potential over a two-three year period is 30-35p. Key risks that might upset this are execution error on its projects and difficult raising capital if markets go into another severe spin. For now, I retain a BUY recommendation up to a limit of 22p.

Silverlake is set for a rerating

Silverlake Axis, the Malaysian financial and commercial software developer, released its second-half results in February and I covered them in the last issue (Asia Investor #18, 15 th February 2011). To recap briefly, they showed strong earnings growth as recent contract wins fed into sales, while the outlook for new deals is good.

The controlling shareholder has also sold down a substantial portion of his stake in recent months, which I believe is probably a prelude to transferring the stock from the Catalist small cap board to the main board at some point. This would significantly increase visibility and investor interest and hopefully lead to the stock being rerated.

I've updated my estimates in the table below. I've brought down the estimate for this year a bit, but this represents slower revenue recognition from announced wins and higher costs from marketing and new hiring for expansion rather than any bigger disappointments.

My best estimate of potential is around S$0.6-0.8 over the next two-three years, with fairly healthy dividends being paid as well Silverlake pays out 40-50% of its earnings. Key risks include banks pulling back on spending due to another global crisis, the failure of its new ventures such as cloud computing to develop as hoped and the transfer from Catalist to main board not happening (this would not impact the business but would make re-rating less likely). I retain a BUY recommendation up to a slightly increased limit of S$0.45.

Hard not to get excited about Hsu Fu Chi

Our Chinese confectionary investment Hsu Fu Chi released far-better-than expected results in early February, as also covered in Asia Investor #18. I've reworked my numbers to take account of the current trends and my estimates have risen substantially the new ones are in the table below.

It is always dangerous to get too excited about a business because it's been performing well lately, but I am very intrigued by the potential of this company. To recap very briefly, it is the market leader in its segment of the market, but I believe it has a share of around 6% (probably a bit more by now). In developed markets, this kind of industry has tended towards oligopoly in the long run with three-four businesses having 20-30% each, and I believe it's likely that China will eventually do the same. Thus Hsu Fu Chi could have many years of strong growth ahead powered by rising incomes and market share gains.

My two-three year estimate would be for a potential price of around S$5.25-6.5. Key risks include raw material costs, tougher competition and brand damage (such as a contamination scandal, always a risk for even the best food firm). It remains a BUY with a revised limit of S$4.10.

Vitasoy on course for rapid sales growth

There have been no updates from Hong Kong soymilk and soft drinks firm Vitasoy; like many Hong Kong firms, this business only reports half-yearly, with the next update likely to be in June.

So there are minimal changes to my estimates in the table below since my last update in Asia Investor #13. Profit growth is likely to be muted this year due in part to capacity limits in its China production plants; once a new factory is in operation in later this year the rapid sales growth it's seen there in recent years should resume.

My estimated price potential for the next two-three years is around HK$9-11, although I don't think looking at this alone does justice to Vitasoy's prospects of growing its sales steadily for many years in China. Healthy dividends are also likely to continue. Key risks are similar to Hsu Fu Chi: raw materials, competition and brand damage. My recommendation is to BUY up to a limit of HK$7.00.

A very encouraging outlook for ARA

Real estate fund manager ARA Asset Management announced results for FY2010, with earnings per share rising 32% year-on-year to 9.14 Singapore cents. This slightly overstates the underlying earnings, since one-off fees earned on Suntec Reit's purchase of a stake in the Marina Bay Financial Centre contributed to a 134% rise in acquisition and performance fees.

Nonetheless, it was a good set of numbers and the outlook for ARA is very encouraging. Assets under management as at end December stood at S$16.9bn, maintaining its strong growth rate and putting the firm well on track for its target of S$20bn by end 2012. As previously discussed in Asia Investor #13, ARA is working on three new real estate investment trusts and plans to launch Asian Dragon Fund II, its second private equity fund, by the first half of this year.

The firm also announced a final dividend of 2.5 Singapore cents per share, which together with the interim dividend of 2.3 Singapore cents per share amounts to a payout ratio of over 50%.

I've slightly increased my estimates to reflect the faster growth of its asset base and the revised ones are in the table below.

My estimate of its two-three year share price potential is around S$1.9-2.35. Key risks are problems in global markets making it hard to raise finance for future deals, damage to its relationship with Hong Kong conglomerate Cheung Kong, which provides the assets for many of its funds, and the key man' risk of its dependence on the contacts, reputation and expertise of CEO and founder John Lim.

ARA remains an excellent way to get exposure to the growing global interest in investing in Asian assets, as well as buying into the real estate sector at lower risk than property developers or direct ownership. However, it seems a little too expensive to me at present to justifying a buy rating. I recommend you continue to HOLD andonly look to invest or add at S$1.47 or below.

ICICI Bank remains a strong contender

India's largest private sector bank is always in the news since it's by far the largest stock in our portfolio. However, there's been little of significance since my last update on its third quarter results (Asia Investor #17, 1 st February 2011). These showed earnings continuing to recover as I'd hoped.

The Indian market has had a tough few months on the back of scandals such as the corrupt awarding of telecoms licenses, plus the threat of inflation and the obvious need for the Reserve Bank of India to tighten policy further. This has hurt most stocks, with interest rate sensitive ones such as banks suffering the most.

However, it makes little difference to the fundamental outlook in my view. ICICI's earnings should continue to recover as bad loan provisions from its overstretch in the last cycle reduce and margins recover towards the levels enjoyed by peers such as HDFC Bank. My latest estimates, which are not substantially changed from the last ones, are shown in the table below.

I estimate that ICICI has price potential of around Rp1500-1600 over the next two-three years. We're invested through the US-listed American Depositary Receipts, so that translates to a price of US$62-US$71 at the current exchange rate (each ADR gives you rights over two India-listed shares).

Key risks are a further global financial crisis, a major downturn in the Indian economy that leads to soaring bad loans and an ongoing lack of confidence in the Indian market that leads shares to underperform regardless of what earnings are doing. At present, I rate ICICI a BUY up to US$50.4.

Petra profits up 81%!

Chocolate and cocoa specialist Petra Foods delivered an expectations-thumping set of results, with sales up 26% year-on-year and profits up 81%. The cocoa ingredients division saw returns improve substantially on higher sales of premium ingredients and the continued improvement in margins at its revamped European plant. Ebitda yield averaged US$215/tonne, from US$119/tonne last year.

Branded consumer the division we're really interested in requires a little more analysis. Headline sales grew at 22% in US dollars, with its core market of Indonesia up 27% and other regional markets up 13%; operating profit was up 41%. However, digging into the detail, much of the revenue gain represented currency effects from stronger regional currencies and in local currency terms sales growth was a more muted 9%.

Within that, Indonesian sales growth seems to have been around 15% in local terms, in line with my long run assumption. Other markets was a more muted 5%; however, this seems to be largely due to a sharp drop in sales in Singapore (where Petra is mostly a distributor of other firms' products), while the Philippines market where the long run potential is maintained a healthy growth rate that I'd estimate at 25-30% for the full year.

Despite bean cocoa prices which require higher working capital to finance inventories, even though the effect of price movements on margins is hedged out the balance sheet continued to improve. Net debt to equity stood at 1.72 from 2.02 at the end of 2009, while the figure excluding inventory financing stood at 0.34 from 0.7.

The firm announced a final dividend of 2.18 Singapore cents per share, adding to an interim dividend of 1.6 Singapore cents for a full-year payout ratio of around 40%. This will be paid in May.

I've updated my estimates to reflect the latest numbers and you can see the revised figures in the table below.

My two-three year estimate of the share's potential is around S$2.35-2.7. As with the other branded consumer firms, key risks include raw material prices, tougher competition and brand damage; because of Petra's high dependence on trade finance for the cocoa ingredients inventories, we should also add further financial shocks to that. I continue to see this as a BUY up to a limit of S$2.00.

Great growth and dividend prospects for Xinhua Winshare Publishing

There has been virtually no news from Xinhua Winshare, the Chinese publisher and distributor of educational and other media, since I first recommended it (Asia Investor #6, 20 th August 2010). This is no surprise, since the firm's investor relations efforts outside of annual and interim reports are very poor.

The one major piece of news related to arranging a loan for a subsidiary that will be developing a real estate project on a piece of land it owns in the centre of Chengdu, which suggests this development is moving forward. As you'll recall from my initial briefing, I regard this as a non-core irritant but some real estate interests are almost inevitable with any Chinese firm. In this case, the land is in a prime location and Xinhua Winshare was gifted it by its state-owned parent before listing, so the project should be relatively harmless and deliver some returns for shareholders.

Consequently, there are no changes to my estimates in the table below as I await the full year results, which should be published in April.

I estimate that Xinhua Winshare could potentially reach HK$6-7 in the next two-three years, in addition to a substantial ongoing dividend yield of around 7-8% on the current price. Key risks include the relative lack of transparency, the difficulty of knowing how a politically driven process of such as the consolidation of the Chinese publishing sector will ultimately proceed and the highly unlikely but extremely damaging prospect that it could lose its cash-cow monopoly over distributing educational materials to schools in Sichuan province. I retain a BUY on this stock up to a limit of HK$5.00.

How can investors ignore YHI?

I confess to being rather perplexed by the latest full year results from auto wheel and battery distributor YHI. The firm announced a 21% rise in revenue and a 45% rise in earnings, far better than expected. Net profit margin improved from 5.9% to 7.1%. The firm announced a dividend of 1.69Singapore cents, amounting to a payout ratio of 30%.

Thus YHI is currently on a price/earnings ratio of 5.7 and a dividend yield of 5.3%, yet the results attracted absolutely no interest from buyers. This is the kind of situation that can make you question your analysis of the firm and look for something you've overlooked. Yet in this case, there are no obvious red flags: for example, cashflow is very healthy and net debt to equity is just 14%.

The biggest gripe that I could make about YHI is that the management's announced goal of roughly doubling revenue to S$1bn focuses on expanding both the distribution business and its alloy rims manufacturing division, with the latter focusing especially on the Chinese auto industry. I like the distribution business a great deal, whereas the manufacturing business is less appealing; in fact, the entirety of the earnings growth this year came out of the distribution business, with manufacturing earnings actually falling on the back of higher raw material costs and currency effects.

Frankly, I would be perfectly happy if YHI were just to focus on the distribution side of things and handed spare cash back to shareholders. But at this price, one can live with a bit of sub-optimal capital allocation. My only explanation for the continuing lack of interest in this stock is that it's a small firm in a fairly dull line of work a classic small-cap value situation.

My revised estimates for YHI are shown below.

My estimate of this stock's two-three year potential is around S$0.5-0.7 and investors should also pick up some fairly decent dividends alone the way. Major risks look to be raw material costs, competition given relatively low barriers to entry in its industry and perhaps management missteps in expanding manufacturing. I'm keeping it on a BUY recommendation up to a limit of S$0.35.

A nice deal for First Reit

Our mostly Indonesia-focused healthcare real estate investment trust made one announcement last week. It's selling one of its Singapore properties, the Adams Road cancer centre, to Indian group Fortis Healthcare for S$33m.

I didn't know this deal was in the pipeline and I'm slightly surprised by it, because when I met the management in October I understood that they were looking to increase not decrease the Singapore portion of the portfolio. However, it represents a decent return to First, at a cash gain of around S$8.3m on its costs and a S$4.8m premium to the assessed value of the property at year-end, so it looks to be a good opportunistic deal.

The effect on distributions payable to shareholders is slight; the proforma adjustment for the year just finished points to a reduction of just 0.14 Singapore cents. And First's net gearing will fall from 17.6% to 14.2%, increasing its flexibility for future acquisitions. So overall, my first impression is that is a small but shareholder-friendly move by the manager.

Other small points to note with First is that its sponsor, Indonesian conglomerate Lippo, has announced that its hospital in Jambi has opened for business; this looks likely to be injected into First in the future (as are subsequent Lippo healthcare developments). And the stock is now under coverage at a major Singapore broker, OCBC, which should increase its profile among investors.

My latest estimates for First are shown in the table below.

I anticipate only a relatively small potential price gain for First over the next two-three years to around S$0.9-0.95; the main attraction is a large and fairly defensive income stream, with a prospect distribution yield of almost 9% on the current price. Further acquisitions of new properties on shareholder favourable terms could drive up both of these and are likely, but too uncertain in size and timing to factor in. Key risks include a bust in the Indonesian economy, troubles in financial markets making it hard to renew existing financing or raise money for new deals and problems at its sponsor Lippo. First remains a BUY up to a limit of S$0.8.

Breadtalk continues strong growth

Bakery and restaurant operator Breadtalk's results delivered what looks like a good full-year performance, with revenues up 23% and earnings down only slightly (by 4%) despite start-up losses at new ventures, thereby beating my expectations.

All divisions bakery, food courts and restaurants appear to be growing well, and I am continually reading about new Breadtalk outlets opening in new markets as the group expands into more countries through franchises. Given that this stock is a relatively recent recommendation, it's difficult to put much context on its progress so far, but overall things continue to look very encouraging. My revised estimates are shown in the table below.

I'd estimate that this share has the potential to reach S$0.9-1.2 over the next two-three years. Key risks include higher raw material costs, overstretch as a result of its fast expansion and renewed competition as other firms trying to latch on to higher discretionary and entertainment spending in markets such as China. I retain a recommendation to BUY up to a limit of S$0.72.

Why I'm selling Etika

Turning to the main disappointment of the portfolio so far, Malaysian condensed milk and catering supplies firm Etika is down almost 19% on my initial recommendation. As reported in my last issue, this is due to a shocking set of first-quarter results; to recap, net profit was down 80%, partly due to some one-off foreign exchange and staff costs but also due to a severe deterioration in margins caused by rising raw material costs. This was completely unexpected given that management had sounded fairly positive on the firm's ability to pass on costs in its full-year update.

Subsequent to the results coming out, Etika announced that its finance director had left the firm; he had been in the position for several years and the reason given was the bland and uninformative "pursue personal interests". He was the primary investor relations contact at the company. Since then I've tried to get further details about the results and also about his departure, but the firm has not provided me with any further information. (In fairness, I should say that his replacement was announced this morning, so communication may now improve.)

This puts us in a difficult situation when it comes to analysing the outlook for Etika. It's certainly possible that the firm will succeed in rebuilding margins and delivering an improved performance in the second quarter and beyond. Management sounded hopeful on this point in the results commentary, although their credibility is a little more questionable now given this shock result.

Conversely, the earnings miss may be a result of overreach as management try to integrate its new acquisitions. The sudden departure of a senior member of management adds an extra complication. At worst, it could reflect issues regarding the finance department or financial reporting that are of concern to shareholders although there are of course plenty of much more innocent explanations that are more likely.

I am also slightly concerned about the cashflow situation. Etika demonstrated weak operating cashflow in FY2010 as a result of its rapid expansion. I expected this to improve after year-end, but cashflow remained very low in the first quarter. This may well be due to increased inventory costs for raw materials and higher working capital needs due to the new businesses that will be resolved quickly, but cashflow problems can also often be an early warning that a business has overstretched.

I moved Etika to a hold immediately after the results came out while I tried to address my concerns. Having looked at it in detail, I believe that it is entirely possible that the second half results will be much better, that the shares will recover and the upbeat investment case I outlined in my initial note is still completely intact. That said, I have enough experience as I'm sure you do with investments that go wrong and shares that grind steadily lower while promising to turn the corner at any point.

And when a share has fallen, it's very tempting to anchor on the price that you invested at and hold on, believing that the price will inch back up and you'll be able to get out at a reduced loss. Tempting, but a classic trap in behavourial finance. In my view, the aim of successful investing is to cut your losers ruthlessly and run your winners; too many people do the opposite.

When a share has fallen below your initial purchase price on bad news, you need to ask yourself whether you would still be willing to buy at this price if you didn't already own it. If you wouldn't, you are not making a rational investment decision.

Had the latest news come out before I recommended the stock, I would not have recommended Etika to you. Consequently, my recommendation is to take the loss you have already incurred and SELL Etika.

Why Uni-President China has been knocked

There have been no updates from Taiwanese-controlled China-based soft drinks and noodles firm Uni-President China since I initially recommended it (Asia Investor #16, 18 th January 2011). The shares are down around 10% since then, but this isn't specific to UPC. Close peers Tingyi and Want Want are down by a similar amount.

There are two obvious reasons behind this. The first is the general sell-off in emerging markets; this can hit higher profile stocks such as these - which tend to be more widely owned by foreign investors than the typical Asia Investor pick - harder than the rest of the portfolio. The other is specific fears about the Chinese economy and inflation that are seen as hitting consumer stocks such as UPC harder than most.

I have no new concerns about the long run prospects for UPC though, other than the risks initially outlined in my recommendation. In fact, if this sell-off continues I would regard it as an opportunity to invest Tingyi and Want Want as well excellent businesses that have been a bit too expensive ever since Asia Investor began.

My current estimates for UPC are detailed in the table below there are no changes since my initial recommendation.

I'd estimate share price potential of HK$7.5-10 over the next two-three years. Key risks include raw material costs, competitive pressures and the success or failure of the group's aggressive strategy to regain surrender market share. UPC remains a BUY up to a limit of HK$5.70.

CSE Global sees 14% jump in earnings

My latest recommendation CSE Global, which produces specialist software for the oil & gas, healthcare and other industries, released its results in late February. These were pretty much in line with my expectations, with revenue up 11% to S$448m and earnings per share up 14% to 10.47 Singapore cents. However, this was somewhat below market consensus, which was more optimistic than me.

The company announced a final dividend of 4.0 Singapore cents per share, in line with my expectations and amounting to a payout ratio of around 40%. This will be payable in May.

But the shares have not done well in recent days, slipping around 11% from when I recommended them to S$1.21 at present. The fact that earnings were market assumptions probably played a part in this, but the bigger issue is the Middle East; any company with extensive earnings from the area is seen as an obvious sell and as an oil and gas services firm, CSE is obviously exposed. In fact, the company says that its operations in Qatar, Saudi Arabia and the United Arab Emirates have not been affected, but it has put off the planned acquisition of a Middle East firm while the troubles continue.

There are no fundamental reasons to change my view on the firm from any of this news. My estimates in the table below are unchanged, but now include figures for FY2012E.

I'd estimate that CSE has the potential to reach S$1.9-2.5 over the next two-three years. Key risks include a sharp fall in oil & gas company investment spending, a severe and prolonged escalation of the problems in the Middle East and the possibility that future acquisitions will not be as successful as past ones. I'm keeping the stock on a BUY recommendation up to a limit of S$1.53.

I've been looking to invest in an Asian tech stock for some months now. I must have scoured through a few kilograms of company reports. And when I was last in Asia before Christmas, it was one of the main questions in almost every discussion I had. Very few firms can scale up like a successful tech business, making it one of the best growth areas around.

But there is a very good reason why I haven't added a clutch of decent tech stocks to the Asia Investor portfolio already. It is very hard to find the right one at the right price.

That there is huge potential for growth in Asian tech is undeniable: a wealthier population will mean more gadget-buying, more use of the internet, more shopping and other transactions taking place online.

However, the problem with is that it's a fiercely competitive sector, needing constant innovation and investment to stay on top. It's also glamorous and very high profile, meaning that companies often float at steep valuations and then just get more expensive.

For example, China's Tencent which runs internet portals, online messaging and games - trades on a trailing p/e of 42. Baidu, the dominant local search engine, is on a p/e of 84. Business-to-business trading portal Alibaba is on 53, while travel site Ctrip is on 39.

Why glamour won't do you any good

Instead, when I look for software and technology investments, I generally look for firms that are much less glamorous operating in industries that most people don't even think about. They're usually far cheaper. And many of them have very specialised expertise or a tied-in customer base that makes it much harder for them to be overtaken in the way that former darlings such as Aol, Yahoo and Palm were.

We've already got one such stock in the Asia Investor portfolio in Silverlake Axis, which is a leading supplier of systems to banks and financial institutions in Southeast Asia. And the stock I'm going to look at today is equally specialised. Much of its revenue comes from a niche that most of you have probably never thought about.

In fact, until a few years ago I only have a limited amount of knowledge of this industry myself. Somehow I had ended up at a three-day conference in Florida dedicated to the subject. And to be honest, it wasn't the most exciting trip I've ever made.

But I absorbed enough that when I first saw what my new recommendation, I was instantly interested

Today I also have a run of company results for this quarter: decent news from Silverlake Axis, very strong numbers for Hsu Fu Chi and disappointing ones for Etika. You can find these updates at the end of the letter.

But first the new recommendation a software stock that I think could make you 130% from here.

The unglamorous software that's critical to Big Oil

Singapore's CSE Global is one of the world's leading systems integrators. In a nutshell, this means that it provides software and hardware for linking together existing systems that were not designed to work together in the first place.

For example, in an oil refinery, the plant may have been built in stages, with each part controlled by a different software system from the lighting to the cooling systems and the controls on the distillation chambers.

The systems integrator brings all these together, displaying the output from each system within one interface to make it easier for the control room to keep track of what's going on.

The data collected can be saved into a database and fed into other, high-level ones to let management optimise their product between different plants, model the firm's financial position and outlook with real-time data and much more. This can obviously lead to huge improvements in areas such as safety and efficiency.

I've used the example of an oil refinery above, but this could apply to many different situation, industrial and otherwise. In fact, Silverlake Axis clearly has to perform some systems integration between its own solutions and others systems in the financial sector, although it's not predominately a systems integrator.

CSE Global is, though. The firm provides a range of control & automation solutions along the lines described above for refineries, oil rigs, pipelines and other facilities, as well as installing telecoms and surveillance systems for the energy industry. It also operates in healthcare, mostly in the UK, where the integration is about linking together a patient's case notes, appointments, treatment plans and so on. Smaller lines include electrical engineering (designed, engineering and supplying protection, conversion and control systems, mostly to the energy and mining industries) and thermal engineering (industrial furnace systems).

Oil and gas is the largest single division, while healthcare is a fast-growing contributor. Although a Singapore-listed firm, the vast majority of its revenues come from outside the city-state. Revenues are roughly equally split between Asia-Pacific, the Americas and Europe, Middle East & Africa.

Profits have been growing 33% a year

Despite the specialised nature of its business, CSE is no start-up. It's a very established and successful business with a wide client list of oil majors and large contractors.

Thanks to a combination of strong organic growth and smart acquisitions, revenues grew at an average of 16% per year over the last 10 years and 11% per year over the last five, even with the global crisis hitting investment spending in 2008-2009. Net profits have averaged even stronger annual growth of 33% and 18.5% over the respective periods.

The order book stood at S$415.3m at end September 2010. Energy, mining and infrastructure accounted for around 68% of this, and prospects for adding to this look good as investment in natural resources continues to ramp up: management seem to be particularly excited by opportunities from Australia's huge liquefied natural gas (LNG) projects.

But healthcare is likely to grow even faster in the near term. The current UK government's decision to tear up its predecessor's National Programme for IT in the NHS and devolve more responsibility for implementing new systems to local trusts should provide plenty of potential for CSE to win more business for its systems; it's already well established in many areas through a tie-up with BT, one of the two main providers on the current programme.

Overall, I think CSE could double in size over the next five years and on a p/e of just 11.5 times my estimated earnings for FY2011, it looks cheap given its potential. Writing the systems to control oil wells or store patient records may not be at all glamorous, and this stock isn't going to double overnight. But I think there's an excellent chance that it could deliver far better returns than more high profile Chinese internet plays over the long run.

It is also has the kind of structure that I look for in an Asia Investor stock

A long history and a wide shareholder base

One of the things that I look for see in an Asia Investor stock is at least a few years' profitable track record I'm not keen on profitless start-ups (the only real exception at present is Eredene, which is more of an investment vehicle). CSE has a reassuringly long history; it began trading in 1985 as part of Singapore Technologies, a government-controlled defence and engineering group. It was taken private in a management buy-out in 1997 and listed in the Singapore Stock Exchange in 1999.

Tan Mok Koon, who led the MBO, remains managing director and the largest single shareholder, with a stake of 13%. Apart from the large positions held by institutional shareholders that you can see in the table below, there are also a few others with smaller holdings, including the Scottish Oriental Smaller Companies investment trust, a fund I've often featured in MoneyWeek Asia. This makes CSE rather different to most Asia Investor recommendation, where there might be just a couple of specialist funds invested.

This wide ownership provides us with more protection than usual against the possibility of minority shareholders being ripped off. The board also has plenty of experienced directors who hold reputable positions elsewhere. So unusually, our main concern is not that we might be buying into a company with governance issues, but rather that we might be looking at one that's already too well known and might be running out of upside.

However, CSE's valuation is still very reasonable given its growth potential, while a market cap of S$690m means that it's still too small to interest most funds. So I don't think this is yet an overexposed story.

Free float is around 35% based on Bloomberg data, while average daily volume over the past year has been around 1.5 million. For the purposes of any private investor, the stock is highly liquid and you will have no trouble taking a position of any size.

Three risks to remember

In addition to the usual risks of Asia Investor recommendations, I would stress three specific factors to be aware of with CSE:

First, CSE's revenues depend on oil and gas firms to invest in new projects or modernising old systems. A collapse in the oil price would probably lead to far fewer contract wins for the firm. I don't believe that this scenario is likely; however, more shocks to the global financial system perhaps caused by issues such as Eurozone defaults could lead to credit becoming harder to get and force projects to be postponed again.

Second, CSE has grown partly through making good acquisitions and integrating them well. It seems likely that management will look to acquire more businesses in future and there is always a risk that these don't go so smoothly. However, the firm's track record so far is encouraging on this score.

Third, CSE is showing good levels of profitability at present; its return on equity is typically in the high twenties to mid thirties. It has competition from firms such as Swiss-Swedish power automation specialist ABB and US engineering conglomerate Honeywell, but clearly competition is not cutthroat.

So there is a possibility that this level of profitability could attract aggressive new entrants, perhaps from India's impressive IT sector or China's growing one. Given that many of the areas that CSE operates in are mission critical systems where doing the job properly is vital, CSE's track record, experience and reputation may help to protect it from this. But it is a possibility that we'll have to keep an eye on.

CSE is still much cheaper than its peers

The table below shows recent results and my estimates for CSE. This stock is relatively well covered Bloomberg shows five analysts following it and my estimates are rather more conservative than the consensus, which is for 11 cents in the year just completed and 13.6 cents in FY2011.

On its current share price, CSE trades on a p/e of just 11.50 times my FY2011E (since FY2010 is now over, it makes little sense to focus on it). The company doesn't have an explicit dividend policy yet, but seems to be targeting a payout of around 40% of earnings or just under. Thus I'd estimate it will pay out around 2.9% this year on the current price (dividends are typically paid just once a year, announced at the final results).

Checking the balance sheet for any red flags, CSE appears to be in sound shape for growth. The current ratio - current assets to current liabilities, a measure of short-term liquidity stood at a solid 1.97 as at end September. Borrowings had began to mount at the end of 2009 as a result of acquisitions, but cashflow from operations and the sale of treasury shares has helped to pare this; net debt to equity was down to 7.4% at end September from 38.6% nine months before.

Valuation-wise, CSE has traded on a p/e above 15 in the past, and even above 20 at the peak of the market in 2007. The systems integrator peer group is not a homogeneous one, but Bloomberg data suggests a median p/e of just under 20.

That seems a little high to my mind, but I think a p/e of 15 is justifiable given CSE's position, track record and prospects: over the next five years or less, I think earnings could double. And as the business grows and the stock becomes large enough to interest more institutions, I would expect it to rerate towards that multiple.

Thus I think we could be looking at a potential gain in the order of 130% or so in the medium term, although I would expect this to be steady appreciation rather than an overnight jump.

For a starting point, I'm going to value CSE initially on around 15 times my FY2011E, discounted back by one year at my minimum target rate of return of 15%. This gives us a buy limit of up to S$1.53 now.

Recommendation

Buy: CSE Global

Ticker: CSE (Bloomberg), CSES (Reuters), 544 (SGX and many brokers)

Exchange: Singapore (main board)

Market cap: S$690m

Bid/mid/offer prices: S$1.35/S$1.35/S$1.36

Buy limit: S$1.53

52-week low/high: S$0.82/S$1.43

Lot size: 1,000 (most brokers will only trade the shares in multiples of this amount)

ISA eligible: Yes (broker permitting)

Let's turn now to the updates

A 59% jump in revenue for Silverlake Axis

Results season is now in full swing and I'm expecting most of our stocks to have their updates out in time for my next full quarterly portfolio review at the beginning of March. But with three already out in the last couple of days, let's take a quick look at them.

Silverlake Axis turned in a decent set of second half results, posting a 59% increase in revenue and a 48% increase in net income for the first six months of the current year. The effects of its S$210m new contract wins in 2010 are now starting to come through. Management continue to sound optimistic about the outlook, reporting growing interest from its core clientele of banks and financial institutions, while also looking at opportunities to supply IT solutions to conglomerates and retail groups.

Overall, prospects here continue to look encouraging for growth. And with relatively low capital needs, Silverlake can be a respectable dividend payer at the same time; the firm announced a second interim dividend of 0.3 cents, to add to the 0.2 cents declared in the first quarter a payout ratio of around 50%.

I'll update my numbers fully in my review, but for now, Silverlake remains a BUY up to a limit of S$0.4.

Very disappointing numbers from Etika

First quarter results from Etika, the Malaysian dairy and food group we recently added to the portfolio were less encouraging in fact, they were pretty shocking. The company posted revenue growth of 26% year-on-year, ahead of my expectations, yet net profit plunged by 78%.

What happened? Digging into the detail, there were two main factors. First, rising commodity prices sugar, milk, palm oil and tin (for cans) clobbered margins. Cost of goods sold rose 44%, pulling down the gross margin from 29% in the same period last year to 19% this year. Separately, expenses also rose sharply as a result of foreign exchange effects and expensing employee stock options; this added around 17% to operating expenses on top of increases in admin, selling and distribution expenses that would be expected in line with the rise in revenue.

I'm not so concerned about the second problem, since this doesn't represent direct operational issues notional forex gains and losses frequently reverse from quarter to quarter. But the commodity price issue is much worse than I expected. I noted in my original report that commodity prices could be a headwind in the near future, and in my estimates had allowed for margins to slip five percentage points or so but Etika has lost twice that.

It looks as if management's relatively upbeat stance towards the end of last year on their ability to pass on price increases to customers may have been optimistic. Reading between the lines, I suspect that trying to do this is having to take second place to building and defending market share. That may not be a bad thing in the long run, but it doesn't make for pleasing earnings in the short term.

I still think Etika is an extremely interesting medium-term story with great growth potential. I'm certainly not going to write it off on the basis of a poor quarter and I think there's every prospect that the second half of the year will be much better. But while a bit of short-term earnings volatility doesn't worry me too much, I need to look into this carefully and try to make sure that management hasn't overstretched integrating its new acquisitions and taken its eye off the core business.

So I'm moving Etika to HOLD while I review the numbers and try to get some answers from management. I'll update you in two weeks, or sooner if I feel we need to take urgent action (which I believe is unlikely).

A storming performance from Hsu Fu Chi

Etika's struggle to pass on costs reinforces the distinction between a decent commodity business and a genuine dominant consumer firm. On the latter score, we saw that our Hong Kong soymilk superbrand Vitasoy seemed to be coping okay in its latest results, but I was more concerned about our confectionary group Hsu Fu Chi, where underlying margins seemed to be slipping a little.

Well, Hsu Fu Chi just seems to have put those concerns to rest with some spectacular second half results. The company reported a 41% increase in revenues and while margins suffered a little cost of goods sold was up 48% - it still managed a 43% increase in net profit. That's a first half earnings per share of 59 renminbi cents, versus my full year estimate of 79. The fact that Chinese New Year Hsu Fu Chi's peak sales season fell earlier this year helped, but it's an impressive performance by any standards.

I'm increasingly enthusiastic about the potential of this firm, which I think has every prospect of being one of those stocks that you end up holding for a very long time. I'll do a fuller update in the next issue the results only came out last night so I haven't had time to rework my numbers fully yet. But my tentative revised estimate for this year is around 95 renminbi cents per share; on a p/e of 20, that points to a buy limit of S$3.7, moving the stock back to a BUY.

Cris Sholto Heaton

ASIA Investor

Prices as of 15/02/11

* Adjusted to assume take up of the five for four rights issue at S$0.5 announced in November 2010. First purchase price was S$0.955

(Singapore tickers vary between brokers. The three common ones are listed for each stock.)

Sources used to prepare this report:

CSE annual reports 1999-2009

CSE Q3 FY2010 results

CSE Q3 FY2010 results presentation

CIMB research report on CSE 02/12/2010

Silverlake Axis Q2 FY2011 results

Etika Q1 FY2011 results

Hsu Fu Chi Q2 FY2011 results

Data from Bloomberg

Welcome to this week's issue of Asia Investor. There's been quite a lot of volatility in the Asia Investor portfolio over the last couple of weeks our paper price gain is down around five percentage points since the previous issue. In most cases, this doesn't reflect any news that I'm aware of rather it's general nervousness in the markets. That's partly coming out of the protests in Tunisia, Egypt and elsewhere, which are making investors less confident in emerging markets generally.

The next major round of news will be the next set of quarterly results, which should start to roll in from early February. But today I'll be catching up on some recent news from a few of our portfolio stocks.

First though, I want to take a look at the Asia Investor survey I sent round a couple of weeks ago. I was very pleased to see that most of you are finding the reports useful. And I think its well worth addressing some of the queries today.

One in particular caught me eye. It's a question that gets right to meat of the Asian Investor strategy and why we have the upperhand on most investors looking to stake a claim in Asia's rise.

You need to know what you are buying

A couple of issues ago I wrote about the history of top consumer staples brands: how the best firms in areas like food & beverage and household goods defied their unglamorous reputation to outperform the S&P during the great American consumer boom. And why history suggests that it makes more sense to pay higher prices for these kinds of businesses in Asia today than any other kind of stock.

As you'll have seen, top consumer brands are one of the two main principles behind the Asia Investor strategy (the other being overlooked small caps if we can get the two together, as in a firm like Hsu Fu Chi, it's even better). But one reader asked me what I thought of using Lyxor's fairly new London-listed MSCI Asia ex Japan Consumer Staples ETF as a way to invest in this story. Is this a better low-cost solution than buying individual stocks?

I think not. I don't think it's a bad ETF and if you're not willing to buy your stocks directly, I think it will probably do well enough over the long term (assuming it hangs around for the long term, which isn't guaranteed). But there are a couple of serious problems with it.

The first is the breakdown of the index. I should say I've arrived at this by deduction: MSCI don't disclose the make-up of their indices unless you buy a licence and Lyxor doesn't disclose the reference portfolio for the fund. But Deutsche Bank does disclose the portfolio for its broader MSCI Asia ex Japan ETF, so it's possible to work out what Lyxor's ETF should cover.

There are 36 stocks covered by the ETF. The full list is shown below.

The problem with this basket is that not all of these stocks are what we would consider consumer brands. Around 13 of them are plantation companies, which grow agricultural commodities such as palm oil and also typically have extensive real estate operations, commodity processing and trading groups, and meat processors.

Obviously, you may well want to own these stocks, especially at times when commodity prices are rising. But they are not the same as a top consumer brand and in all likelihood do not have the same potential to earn high long-term returns so it's probably a mistake to treat them the same.

In fact if you were to build an index of high-potential consumer brands, it would look quite different to MSCI's consumer staples index. First, you would drop these commodity businesses, which includes many of the largest stocks. Secondly, you would include quite a number of stocks that don't currently feature.

I compiled the list below off the top of my head. It isn't exhaustive there are plenty of others that you could justify including. But this represents 30 or so stocks that don't appear in the index but have extremely strong positions or growth potential in their markets.

In most cases, the problem is size or liquidity and some of these would be impossibly awkward investments for a tracker.

Take Fastfood Indonesia. This must be one of the world's most maddening companies. It owns the KFC franchise for Indonesia - and chicken-based fastfood in a predominantly Muslim country that's developing the income levels for massmarket casual eating, looks to me like a license to print money. But it's highly illiquid, trading only a few thousand dollars of shares a day, and management has no interest in engaging with small outside shareholders.

Some of them also suffer from the common problem of using any kind of indexing there's no screening for quality. For example, Universal Robina is a well-positioned business, but in common with many Philippines companies I hear only bad things about governance standards.

Others, like the Indian-listed subsidiaries of the multinationals are very attractive an excellent track record, the support of a huge parent, yet a dedicated play on a single economy. But the Indian market is currently closed to any outside individuals who don't have Indian ancestry, putting them off limits to most of us even as individual investors who don't need to worry about high liquidity too much.

But some are readily available to us. Vitasoy, already in the Asia Investor portfolio, is a good example of a very well run business with excellent potential that's too small to make it into an index or most managed funds. Hsu Fu Chi is another great example. Up 38% since I recommended it, the company continues to be neglected by fund managers because it is too small to meet their requirements.

That's why I think investing in solid, small-cap stocks is the best way to invest in Asia's explosive rise. Index funds and managers will spend the next ten years crowding into trades that have very little exposure to what is happening in Asia.

But by scoping out the unheralded stories the sweet makers, the bakeries, the condensed milk suppliers we can build our wealth alongside the rising tide of middle classes in cities from China to Indonesia.

Just take some of companies I am updating on today by way of example

Silverlake Axis may be eyeing a main board listing

The main development at Malaysian software group Silverlake Axis was that founder Goh Peng Ooi sold another round of 50,000,000 shares, following a similar placement in October. His stake in the firm has now dropped to 74.7%.

There are two positives to this. First, one of the main problems with Silverlake is the lack of liquidity, so any moves to increase the free float could make the stock more attractive to potential investors.

Second, and more significantly, I think this is probably a step towards moving the firm's listing from the Catalist growth stock board to the main board of the Singapore Exchange. With a free float of around 25% and a market cap of around S$700m, following its restructuring in 2010, the company is now of a size that would make this sensible.

I need to stress that this is my hunch rather than official information from the company Silverlake is not good at communicating its plans to outside shareholders. But I think there is a good chance that we will see further moves on this front in 2011.

This would boost Silverlake's profile substantially and make it more accessible to institutional investors. Combine that with the likelihood of much stronger earnings as S$210m of already-announced contracts begin to feed in and banks continue to ramp up investment spending, and I think we could see fairly substantial progress in Silverlake's shares over the next year. My recommendation remains a BUY up to a limit of S$0.4.

Keep ARA on hold

Real estate investment trust (reit) manager ARA Asset Management got off to a storming start in 2011, rising 18% in the first half of January before giving most of that back as market fears grew. The catalyst for this? Virtually nothing as far as I can see.

There was one story in late December that could have some relevance to ARA. Bloomberg reported that Hong Kong billionaire Li Ka-shing is planning what will be the city's first renminbi-denominated IPO in 2011, a reit backed by his Oriental Plaza development in Beijing.

ARA wasn't mentioned in the story, but Li's Cheung Kong holding company has a 16% stake in ARA and the firm already serves as the manager on Cheung Kong's three existing reits. And during my meeting with ARA in October, I was told that a China reit was one of the main potential additions to its current line-up. So if this IPO comes off, it wouldn't surprise me if ARA were the manager.

It may also be that some investors had assumed that ARA would be the manager of another Li-related IPO, the Hutchison Ports Holding Trust, which is expected to set a new record for a Singapore IPO when it floats in the next few weeks. But this was never on the cards; operating ports is outside ARA's area of expertise and Hutchison Ports Holding the current direct owner of the assets is going to remain the manager.

So while ARA's prospects continue to look good, I see no justification for major share price moves at the moment. At current levels, it's not insanely expensive given its record of growth and the way that its business can be scaled up. But the fact that it is to some extent a one-man band, highly dependent on CEO John Lim, makes me reluctant to put too high a valuation on it. For now, I'm keeping it a HOLD.

Why I see a 60% upside for ICICI Bank

India's largest private sector bank has been the worst underperformer in our portfolio of late. Having peaked at over $57 in early November, it's now back to around $43, cutting our paper gain on the initial recommendation to around 14%. That's despite third quarter results last week that beat expectations and showed the bank's earnings are continuing to recover as I'd hoped.

The reason that ICICI has been weak has little to do with the company specifically, and is all about wider conditions in India. The scandal over the corrupt awarding of telecoms licences that broke in November shook market confidence. More recently, fears have been growing over inflation, which is uncomfortably high: weekly food price inflation hit 18% recently after a sharp rise in the price of staples such as onions.

It looks likely that the Reserve Bank of India will need to tighten policy further, which may hit growth and consumption this year. So I think the Indian market may well remain weak over the next few months, with interest rate sensitive stocks such as banks likely to do worse than average.

But looking further ahead, ICICI remains an attractive prospect. Having overstretched itself during the last boom, it's now cleaning up its balance sheet, which is holding down profitability relative to peers such HDFC Bank. Once this process is complete, profits should rise significantly. I think the stock offers potential upside of around 60% on a two-year view, and remains a BUY up to US$50.4.

First Reit builds towards S$1bn in assets

Lastly, we saw fourth quarter results for Singaporean healthcare trust First Reit, which contained absolutely no surprises. With the acquisition of its two new Indonesian properties now complete, the reit is expecting a distribution per unit of 6.4 Singapore cents in 2011.

With these deals complete, there are no more immediate acquisitions in the pipeline, but the CEO has said that the reit intends to grow assets to around S$1bn in the next two-three years, from S$613m now. Since its sponsor Lippo Karawaci intends to grow its healthcare business substantially, this should be very achievable.

First Reit should be a low-hassle part of the portfolio, providing a steady income, with distributions paid quarterly. For investors who bought in at the initial recommendation and participated in the rights issue, the forecast payout offers a prospective yield of around 9.1%. On the current price, it amounts to around 8.4%.

In addition, there's a good prospect of capital gains, since it's likely that as the reit continues to grow in size and profile, more investors will be attracted by its higher-than-average yield and the defensive nature of its healthcare assets, pushing up the unit price.

For now, I'm keeping a BUY recommendation, up to a limit of S$0.8.

The Asia Investor Survey

Finally, I'd like to address some of the specific queries from the Asia Investor survey.

There were a few comments and suggestions that came up more than once, so it might be simplest if I answer them in the letter. For more specific questions, I'll be replying to them individually by email.

1) Several readers asked if I could specify the board lot size when recommending a share. For anyone who doesn't know this term, in many Asian markets, shares are typically traded in orders that are multiples of a certain amount it may be possible to trade odd lots' that don't fit this, but it will typically be more awkward and expensive.

I have been including this in recent issues, but it's usually been in the text above the price chart and perhaps wasn't very clear. In future, I'll add it to the summary data at the bottom of the recommendation. As a rule of thumb, Singapore lots sizes are 1,000 shares, while the minimum for UK, US and European markets is one share. Hong Kong varies by stock and can be found on each company's profile page on the HKEX website here.

2) There were several suggestions regarding updates on portfolio stocks. In general, my approach is to do a regular review of the portfolio performance once per quarter. For individual company updates, I'll often include the latest update in that review, since that coincides well with the quarterly results for many of the portfolio stocks. Otherwise, I'll cover them in an intervening email, as in today's issue.

Just to reassure anyone who's wondering about this, I monitor all the portfolio stocks constantly and if there is urgent news, I'll send a special alert. That said, the newsflow on a lot of the Asia Investor portfolio stocks is relatively quiet because these are fairly established, stable businesses although many of them are small, they're not like oil explorers or tech start-ups where make-or-break news is frequent.

A couple of you asked about making it easy to find the latest update on each stock and I'm looking into the best way of doing this.

3) The frequency of recommendations was a topic with some very varied responses. Some of you asked if the frequency could go up to one an issue, some felt the current frequency was about right and others asked for fewer suggestions because they wanted to make larger investments in each.

In addition, I'm reluctant to throw out too many recommendations because I want to keep standards high. My aim is to provide higher quality, higher confidence ideas rather than a high volume of more speculative ones. There are a limited number of companies like this around and finding and researching them takes time.

This is always a difficult compromise, but looking at it overall, I'll be aiming to increase the frequency slightly from now on.

4) Some of you asked about including estimated or target prices in the portfolio table. I have very mixed feelings on this, because target prices always seem to me to be spuriously precise. Just because I say a stock is worth S$10 doesn't mean that it is worth that much or that the share price will get there, but the exactness of the figure encourages us to anchor on it.

As you'll have seen in each recommendation, I tend to think more about a range of what I think the stock might be worth under different scenarios to reflect how uncertain forecasting is. This is much harder to sum up quickly in the table.

However, this is clearly something that a number of you want, so I'll think about the best solution and add something in the next couple of issues.

5) A few of you mentioned including commentary on market conditions, such as looking at which markets and currencies might be undervalued as opposed to individual stocks. I aim to do this in MoneyWeek Asia, which I assume that most of you probably receive (if you don't, it's a free weekly email and you can sign up here).

In a similar vein, some of you also asked whether Asia Investor will always focus exclusively on stocks or whether I'll also be recommending funds. Again, I think funds coverage fits better into MoneyWeek Asia.

With Asia Investor, I'm very conscious of trying to provide you with the best value I can for your subscription. That means I feel I should focus on specific stocks that you would rarely find covered elsewhere, plus topics that are very closely related to the strategy. If you have broader topics that you'd like to see covered, please feel free to let me know and I'll try to work them into an issue of MoneyWeek Asia.

6) There were some questions about trading Asian markets other than Hong Kong and Singapore I hope the MoneyWeek Asia I did on this subject after the survey went out helped with this. Please let me know if you have any questions about finding a broker that I can help with.

A couple of months ago, I wrote about the possibility of introducing recommendations from other markets. At present, the feedback from most of you is that you're not in a position to do make use of these. The vast majority of Asia Investor readers use TD Waterhouse, giving you access to Hong Kong and Singapore but not other markets (yes, I'm continually asking them if they're going to cover more of Asia, but no luck yet).

So I'm not planning to do this immediately, but will keep the possibility open. I'm also looking into a couple of firms that provide similar research to mine for some of these markets, with a view to referring anyone who's especially interested. I'm not sure anything will come of this, but I'll let you know if it does.

That's it from me this week. I'll be back in a fortnight with a new recommendation I'm looking at a few possibilities including a software in a very specialised niche.

Do you remember the British Cola Wars? During the 1990s, Coca-Cola and Pepsi Cola suddenly found themselves under attack from two upstarts: Virgin Cola and Sainsbury's Classic Cola.

For a while, the battle was fierce. But today, it's as if it never happened. When did you last actually notice the label on a bottle that wasn't Coke or Pepsi?

That's the strength of a top consumer brand. Once established, it's almost impossible to depose them. A deep-pocketed rival might make an impression for a while with heavy advertising and novelty but it's very hard to make it last.

That's why spotting the great investments from the Asian consumer boom will be about identifying early on which brands are set to endure. Eventually, most consumer sectors seem to settle down into a near-oligopoly of a few firms with a huge stable of brands. If you think about soft drinks in the US, it's Coca-Cola, Pepsi and Dr Pepper Snapple. If you look at chocolate in the UK, it's Cadbury's, Mars and Nestl. The major players vary between markets, but the pattern is typically three-four heavyweights.

As we saw with the Cola Wars, this process is well advanced in the developed world. But there's a lot more to play for in developing markets such as China, where many industries haven't fully consolidated.

And that means that success in these markets can't simply be measured in terms of one year's earnings. It's more important to build and defend market share, and ensure that you're one of the long-term winners in a market that has decades of growth ahead of it.

That's what the stock I'll be looking at this week is doing right now. It's trying to fix some mistakes it made in the past to be certain of being one of the big players in the future.

But that's hurting profits and the market isn't keen on that. Its shares are down more than 25% over the last year.

But I think that's a very short-sighted way to look at it. This looks like a very good buying opportunity one that I think could double your money over the next two years.

The history of an expensive mistake

This recommendation begins with a failure. When Taiwanese companies were moving into China in the late 1980s and early 1990s, one firm looked well placed to dominate the enormous market for instant noodles. Uni-President was the leading food company in Taiwan and with its expertise and deep pockets, it should have had little trouble transferring that to the mainland.

But management miscalculated. They decided to run the China business from the Taiwan headquarters and didn't pay enough attention to local conditions. So when they tried to launch shrimp-flavoured noodles on the mainland at a slightly lower price than in Taiwan, for example, they made a big mistake. Neither the flavour nor the price was right.

This left an opportunity for rivals and in particular, a small Taiwanese cooking-oil company called Ting Hsin. Unable to beat Uni-President in Taiwan, Ting Hsin's owners, the Wei brothers, bet heavily on the mainland. Three of the brothers moved there and began developing their products based on what they encountered on the ground.

The gamble paid off. Today, Ting Hsin's China division Tingyi is the dominant player in instant noodles in China with a market share of around 56%, far ahead of rivals such as Uni-President, Hualong and Baixing. It's also a heavyweight in soft drinks. And as one of the few sizeable independent China consumer businesses, it's an investor favourite, trading on a 2009 price/earnings ratio of 36.

Tingyi has done extremely well it's undoubtedly a fine company. But it's not the subject of this week's recommendation. While it may sound surprising giving the history I've relayed above, I'm inclined to think Uni-President's China division (UPC) represents the better opportunity at the moment

UPC won't stay cheap for long

It took Uni-President a while to understand what it was doing wrong. And by that point, there was no chance of overtaking Tingyi. But it's still managed to build a sizeable business in China.

The firm is number three in instant noodles behind Tingyi and Hualong with a market share of around 9% at the end of 2009. That business is currently loss-making as it tries to gain further share, but the beverages divisions is earning healthy profits. UPC is number two behind Coca-Cola in diluted fruit juice and number two behind Tingyi in ready-to-drink tea.

And while the firm's track record isn't as impressive as Tingyi or Want Want, another high-profile Taiwanese-owned food and beverage firm, it's still seen some good profit growth. Over the last five years, earnings have grown at an average of 29% per year.

So why then is UPC so much cheaper than Tingyi and Want Want? The stock trades on a p/e of 18.6 times 2009 earnings, against 36.7 for Tingyi and 38.4 for Want Want.

What's causing the difference? Well, earnings this year are going to be disappointing: analysts' consensus is for a fall of 16%, against a rise of 13% for Tingyi (and I think that could be optimistic). Unsurprisingly, the market isn't very happy about that.

But if we dig into the details, I think this may be a good thing. Let me explain why.

UPC goes on the offensive

If we look at recent results, we can see that UPC has delivered some solid profit growth, but has lagged on revenue. That average five-year compound annual growth rate of 29% for net income is in line with Tingyi and Want Want, but its average revenue growth of 9% is way behind (see chart below).

The implication is that UPC hasn't been focused enough on chasing market share against rivals and is ceding ground. Yes, it's still getting good profit growth out of greater efficiencies and underlying market growth, but at this stage it's even more important to strengthen its position in preparation for the point when the industry consolidates. Obviously you still want to be profitable, but the goal is not to maximise short-term profits at this stage.

The good news is that management realises that they've been slipping up here. So over the past year or two, UPC has begun competing more aggressively on market share, especially in specific niches where it believes it can build a leading position. And the numbers suggest that they're doing well. Interim results showed revenues up 36% on the same period in 2009, with noodle sales up 53.5% and drink sales up 30.1%. That's substantially faster than the firm has managed at any other point in the last few years.

The downside to this is that it's pushed up promotional and marketing costs, and with this coming on top of higher raw materials costs, profitability took a big hit. Interim profits were down 30%, while profit for the first nine months which is not directly reported by the company, but has to be divulged by its parent under Taiwanese reporting rules seems to have been down 24%. Having been on a steadily improving trend, net income margin has fallen back to 4.8% from 7.75% the previous year.

The good news is that this should be short-term pain for long-term gain, strengthening UPC's market position. Obviously, rivals such as Tingyi and Coca-Cola may fight back with price wars and promotional drives of their own. But this trend should favour the biggest players in the long run, forcing out the smaller suppliers and accelerating sector consolidation around three or four top brands with UPC likely to be one of them.

While this is ultimately good for all the potential oligopolists, UPC probably has the most to gain from it in the shorter term. The company has already brought down its profit margins to gain share, putting the stock out of favour with investors. If it succeeds in this and net margins begin to pick up back towards the 7% area in the next couple of years, it will be doing pretty well against low expectations. On the other hand, if Tingyi wants to fight it all the way on market share, it will probably have to sacrifice some of its much fatter margins to do so.

And so UPC seems to me to have much more potential upside right now than more in-favour plays like Tingyi and Want Want. As we'll see below, if it gets things right I think the stock could double over the next one-to-two years.

But first let's take a close look at who owns the company

Why you can trust this Taiwanese titan

Uni-President China is a Hong Kong-listed company, having first floated in 2007. It's a spin-off from its Taipei-listed parent Uni-President, which remains the controlling shareholder. Management is headed by Alex Lo Chih-Hsien, the son of Uni-President founder Kao Chin-Yen, who is also a non-executive director.

The second-largest shareholder is US investment manager T Rowe Price, followed by a large number of other institutions with small stakes. I know that Arisaig Partners, who are shareholders in our existing portfolio stocks Hsu Fu Chi and Vitasoy, also hold a stake; this is an encouraging sign from a governance point of view, since this fund seems to be closely engaged with what goes on at its investments.

I also regard UPC's Taiwanese background and the parent's long history as a positive for outside investors. As I've mentioned before, I prefer companies run by Taiwanese or Hong Kong management teams when it comes to investing in China, since corporate governance standards tend to be higher than in mainland companies.

Obviously this isn't universally true. There are perfectly legitimate mainland companies and plenty of extremely dubious ones from Taiwan. But there's little doubt in my mind that the overall standard is significantly better, thanks to a longer history of capitalism, better rule of law and different attitudes towards outside investors.

Clearly, with a single shareholder holding almost three-quarters of the company, the free float isn't enormous on a percentage basis, at under 10%. But this is a large stock by Asia Investor standards, with a market cap of HK$15.5bn and average daily volume of around almost 3.6 million over the past year. So by our standards, this is highly liquid and there won't be any limits on the size of the position you'd be able to take.

A few risks to remember

In addition to the usual risks with Asia Investor recommendations, I'd like to flag up the following:

First, like all food and beverage plays, Uni-President is subject to cost pressures from raw materials and wages and the more that it's focusing on market share, the less able it will be to pass these on to consumers. We saw this in the latest interim results, where gross margin dropped to 34%, from 42% in the same period last year.

This is principally a short-term risk rather than a long-term one. It can cause swings in earnings from time to time that may disappoint the market and lead to short term share price volatility. But over time, companies in this type of business have generally been able to pass on costs and maintain good margins.

The bigger strategic risk is whether Uni-President's current strategy succeeds in strengthening its market share and positioning it as one of the major players as its markets consolidate over the years and decades ahead. To be clear, I don't believe that the firm is going to overtake Tingyi or Coca-Cola for market leadership. But to be a well-placed number two or three in these long-term growth markets is still a very attractive proposition - and I think Uni-President has a good chance of doing that.

However, there is no guarantee of this. It might be that Uni-President continues to lose market share and is overtaken by other smaller players, until it lacks the critical mass and economies of scale to compete effectively. I think this is unlikely, but clearly not impossible. We'll have more visibility on this over the next year or so, when we see if the group has succeeded in regaining market share which is what its sales growth suggests.

Third, with a dominant majority shareholder such as UPC's parent, there's always a risk that it will act in ways that benefit it, but not minority shareholders. I don't see any history of this or any reason to suspect that it will be the case. UPC is a fairly straightforward, well-focused business. But obviously there is always a slight risk of this.

A potential 90-150% gain in the next couple of years

The table below shows recent results and my estimates for Uni-President China. FY2010 is now over, but we don't yet have the results for it, hence it's still an estimate.

On a current price of HK$4.3, Uni-President China is trading on around 25 times my FY2010E (based on the current RMB/HKD exchange rate) but only around 13 times my FY2011E. We only have two years of dividend payouts to go by, but the firm seems to be targeting a payout ratio of around 50%, which would point to a prospective yield of 2% for next year and 3.8% the year after.

The balance sheet looks in very solid shape. UPC has no bank borrowings and cash on hand was RMB2.45bn as at end June. The current ratio (short-term assets to short-term liabilities) was two, above what would usually be considered necessary. Cashflow from operations has been consistently positive, as you'd expect in a business like this. That puts it in a good position to absorb the cost of its promotional push and still maintain dividends.

What's the potential for UPC if it recovers as I believe it can? In the past, the stock has at times traded on a p/e of 30 or over, like its peers. I think that if it shows the short-term sacrifice of margins for sales is paying off next year, it will rerate back towards that area. (As I showed in the last issue, history suggests that p/es of 30 or even 40 aren't insane for dominant consumer staples companies, although I confess I find it hard to buy a share on a multiple like that.)

Putting a multiple of 25 times earnings on my estimate for FY2011 would point to a potential price of about HK$8, or around 90% upside from here in a year or so. If we assume that margins can then improve a bit further to around 7-7.5% (in line with the 2009 results ) and put it on a similar p/e to Tingyi and Want Want (ie around 30), that suggests a more bullish case of up to HK$11, or about 150% potential upside over a couple of years.

That said, there is some uncertainty about this outlook. I think we already have some evidence that UPC can regain market share from its sales figures but it's less obvious how quickly and how far it will be able to bring up margins. So I'm going to set an initial buy limit of HK$5.70, which is equivalent to a p/e of 17.5 on my FY2011 estimates, and shouldn't be too much of a stretch even if margins remain much lower than I expect. I'll consider raising this when we have the results for the second half and can see what the trend in margins is.

Recommendation

Buy: Uni-President China Holdings

Ticker: 220

Exchange: Hong Kong (main board)

Market cap: HK$15.5bn

Bid/mid/offer prices: HK$4.31/HK$4.31/HK$4.32

Buy limit: HK$5.70

52-week low/high: HK$3.81/HK$6.00

UPC is listed on the main board of the Hong Kong stock exchange and so will be eligible for an ISA if your provider allows foreign stocks to be held in one. The standard lot size is 1,000 and most brokers will refuse orders that are not an exact multiple of this amount.

Other updates

Before I go, one brief change to the portfolio stocks. Vitasoy has had a strong couple of weeks since the start of the new year, which has taken it through my buy limit. Consequently, it moves to a HOLD.

Thanks to all of you who completed the Asia Investor reader survey last week - if you didn't and you'd like to, there's still time to do so. The feedback was extremely helpful and I'll answer some of the main questions and suggestions that came up in the next issue.

There are also some recent updates from portfolio stocks to bring you. And if I have space, I plan to expand on the recent issue where I talked about the power of top consumer brands to look at some of the best-placed companies in Asia.

I'm sure you've watched it happen many times. You find an investment story that you hope will deliver healthy returns for a few years. You settle on the best way to invest. And then suddenly the stock catches the public imagination.

Within months, a stampede of investors has sent the stock far beyond any reasonable valuation. And you fret about getting burned.

I'm sure that most of you were investing during the dotcom bubble, so you know that anxious feeling well. Those overheated years probably had a permanent effect on you. They certainly did for me.

Right now, there's no doubt what the hottest story around is: the emerging market consumer. No one seems to have any doubts about the potential of billions of new consumers joining the global economy in the decades ahead. And that should make us ask some careful questions.

I don't have much doubt about what's going on on the ground. Not every emerging market has got its act together, but many are making rapid progress. Incomes are rising, living standards are changing and the consumer boom is very real and will run for a long time.

But the internet boom was also founded on real breakthroughs that are delivering benefits even now. The problem the bubble came because people believed the hype and paid too much to be involved in the action.

Could the same happen again this time? Yes. Has it? I don't believe so.

In this week's issue, I'm going to look at why history suggests that we should be willing to pay more for some top consumer companies than we would for most stocks. We shouldn't get carried away but there is some evidence to suggest that they can deliver much stronger long-term returns than we might expect.

At the end of the letter, I'll also be giving you the key information from my meeting with Petra Foods, one of the Asia Investor consumer plays, and updating my buy limit to reflect the latest results.

But first let's have a look at why consumer stocks might warrant a higher valuation than most other stocks.

The power of a great brand

A top consumer brand can be a very powerful thing. Makers of snacks like Mars Bars, drinks like Coca Cola, household goods like Domestos, medications like Nurofen and personal care products like Crest, as well as those old standbys of cigarettes and alcohol, have done extremely well over the long run.

Why? First, they're bought, used and replaced on relatively short cycles (that's why they're often called Fast Moving Consumer Goods). Shoppers display brand loyalty, buying the same type each time. People continue to purchase these goods even during recessions. All this results in stable demand.

Second, competition isn't too ferocious. These industries tend towards oligopoly, with a small number of firms controlling many brands and not fighting aggressively with each other on price. Each firm is the sole producer of its brand and it's tough for potential new entrants to build a brand that shoppers instinctively reach for. Technological developments don't often make existing products and brands obsolete. So solid margins can be sustained and investment requirements are not onerous.

Third, higher incomes mean increased consumption of many of these goods, including the tendency to trade up to higher-value products once consumers can afford them. And the way that most of these goods seem like necessities once a consumer begins using them plus the relatively low absolute price each time they go to buy makes it easier to raise selling prices. So producers are able to pass on higher costs and benefit from greater wealth, ensuring steadily rising real earnings over the long term.

Contrast this with durable goods, like refrigerators, music players or cars. Each consumer only buys one occasionally and demand falls during recessions. There is typically little brand loyalty (except perhaps for the occasional firm like Apple). Competition is tough: because the price point is higher, consumers shop around for discounts. Life cycles are short: new research and development is needed to keep up the competitor's new model, meaning high investment requirements. Yes, people will certainly buy more of these goods as they become wealthier but that may not translate into strong profit growth over the long run.

So it seems likely that staid-looking makers of ice cream and tissues might deliver better returns than much more exciting looking industries over the long run. Of course, we can't just assume this we need to look at the evidence.

Unfortunately, long-term sector studies are pretty thin on the ground. But Jeremy Siegel of Wharton has done some work based on the fate of the original members of the S&P500 when it was created in 1957. The following table comes from a study by him and Jeremy Schwartz published in 2004, and summarises the average annual performance by sector between 1957 and 2003. (Where firms were taken over, the study assumes the proceeds were invested in the buyer if it was listed, or in the overall index if it was taken private.)

The results are in line with what we expect. The type of firms we're looking for are typically classed as Consumer Staples or Healthcare there's a lot of overlap between and we can see they're the two top sectors. The outperformance between these and less strongly performing sectors adds up substantially over time: in this data set, the average gain over 10 years is about twice as large for Healthcare as for Utilities.

Not only were these sectors the top long-run performers, they also seem to have been fairly reliable, as we speculated they should be. I don't have a decade-by-decade breakdown for the entire period, but the data below from David Rosenberg of Gluskin Sheff shows sector performance in the S&P500 over the last three decades. Consumer Staples and Healthcare weren't always number one, but they were consistently decent, even producing positive returns over the last decade.

But we're interested in something a bit more specific than the overall sector. We're really looking for dominant consumer companies the market leaders and top brands rather than any old producer of sandwich bread or bottled milk.

This is a slightly harder thing to measure, but if you go back to Siegel's work and look at the very top performers in the S&P500 from his study, you'll notice something interesting. Of the top 20 performing stocks that survive from the original 100, 18 out of 20 of them are Consumer Staples or Healthcare companies that own strong brand names - the exceptions being oil firm Shell and engineering group Crane.

What should you pay for this growth?

Valuing stocks is a very inexact business. There are lots of tools that we can use, but ultimately, all of them come down to trying to estimate what will happen to a business in the future something we can't do with any degree of certainty.

When I'm looking at a stock I try to recognise that I can't predict the future and avoid the temptation to be misleadingly exact. Instead, I aim to satisfy myself that this is a good business. Then I think about different possibilities for how it might change more conservative ones and more optimistic ones. Then I come up with a range of future valuations based on that and I set my buy limit which needs to be a concrete number in line with the more conservative end of that.

Usually, these businesses will be established, stable and profitable, if often small. They're non-cyclical, secure in their markets and have some protection from a new low-cost competitor moving in. They should have reasonably low capital requirements and not be threatened by improvements in technology. Management should be capable and committed to the company (I like family businesses for this reason). The balance sheet should be solid, and the firm should be generating cash and paying dividends. Earnings growth should be sustainable for several years at a high single-digit to mid double-digit pace.

If a business like this is on a p/e of under 15, I'm probably interested in looking further. If it's under 10, I'm likely to be very interested. And if it's over 20, I'd probably consider it too pricey unless it operates in a handful of very specific areas.

Consumer staples are one area I am prepared to pay over 20. And another fascinating study by Jeremy Siegel implies I am right to do so. In this study Siegel examined the fate of the Nifty Fifty a group of high-growth companies that investors were extremely excited about in the late 1960s and early 1970s, bidding them up to p/es of 40-50 or more in many cases.

In the study, Siegel calculates the return on each between 1972 and 1995 and also calculates both the original p/e at the time and what the warranted p/e' would have been (ie the p/e that would have produced long-term returns in line with the market average).

You can see the results below. It's clear that Consumer Staples and Healthcare firms commonly justified the high valuations placed on them and managed to deliver above-average returns from strong earnings growth, while other firms typically didn't. And if you're questioning whether the overall market was expensive at this time ie the Nifty Fifty were less expensive relative to the market than they seem the market p/e in 1972 was 19.3, against an average of over 40 for the Nifty Fifty.

Now, obviously we need to be careful with our conclusions from this. First, this is solely based on the experience in the US (that's where the data is best and most consistent, and it's where researchers tend to study the most). Although it seems reasonable to suspect that what happened in the great American consumer boom has a fair chance of being repeated in an even bigger Asian consumer boom, we can't be certain of that.

Second, although the consumer stocks outperformed in the long run, they had ups and downs. The Nifty Fifty had a tough time in the mid 1970s and underperformed the overall market. Those steep valuations may have been justified for some in the long run, but that was no consolation to those who'd bought in near the top and didn't have a couple of decades to wait.

Third, all that this suggests is that top consumer brands may outperform the market in the long run. It doesn't mean that any old consumer firm will do so and it doesn't guarantee that we will pick the winners.

That said, I don't think it's insane that we should be willing to pay more for the best consumer companies in emerging markets than we would for most other kinds of stocks. Obviously, the 50, 60, 70 times earnings that some of the Nifty Fifty subsequently justified would be a huge gamble on everything going right. But should we be willing to pay in the 20s or even 30s?

That doesn't seem to be too much of a stretch. It is difficult to be completely confident in the analysis, especially since long-run data in most emerging markets is pretty sketchy but most of what I see points in the same direction. For example, according to one fund that holds Nestl's and Colgate Palmolive's Indian subsidiaries - which are independently listed in the country, due to historical regulations there - these two stocks have traded on a forward p/e of around 30 for three decades and have still returned an average of 28% and 27% per year respectively over that period, excluding dividends.

It's because of this potential that consumer staples firms are a key part of the Asia Investor portfolio. While I don't restrict the kinds of stocks I cover too much because I want to have the scope to recommend anything that I think is attractive, there are two types of investment that are going to be more common than others.

The first is good quality small and mid caps, because these are typically under-researched and often cheap - I'll be writing about this separately in MoneyWeek Asia on Thursday. And the other is these stocks that are or could become some of the top consumer brands in Asia.

What are these potential future heavyweights? Well, we have a few in the portfolio already, such as Vitasoy and Hsu Fu Chi. And we'll adding more in due course. I've compiled a list of about 50 or 60 names that are worth knowing.

I'll look at the list in detail in a future issue. But now, let's move on to a quick update on Petra Foods.

Why I'm raising my buy limit on Petra

Petra is an interesting business that has elements of both a high-priced consumer firm and a cheaper, less glamorous one. As you may remember from my original note, this Singapore-listed firm is a specialist in cocoa and chocolate, with a dominant position in the Indonesian market.

I was able to get a meeting with Petra's finance director on my latest visit to Singapore, which was extremely helpful in clearing up some points about how the company operates. So I'd like to update you on that and alter my current recommendation to reflect the latest results and outlook.

To recap briefly, Petra has two main divisions, cocoa ingredients and branded consumer. Although these both spring from the same raw material, they are very different, to the point where Petra is effectively two separate business, as we'll see below. In the first nine months of 2010, the two sides contributed roughly equally to Ebitda (earnings before interest, tax, depreciation and amortisation) as the chart below shows.

Petra doesn't break down earnings at a lower level than this, but based on the respective assets of each division and some assumptions when allocating debt, I would estimate that cocoa ingredients accounted for around 30% of overall net income and branded consumer for 70%. That's because the cocoa ingredients division is more capital intensive and has higher depreciation and finance expenses.

The cocoa ingredients business produces intermediate products cocoa liquor, cocoa butter and cocoa powder that are sold on to manufacturers such as Nestl and Mars, who are increasingly outsourcing these operations.

This wasn't the side of the business that originally attracted me to Petra: it seemed a fairly generic processing business. But I'd satisfied myself that it didn't have the faults of many processing business: while it's fairly capital intensive, it doesn't have the enormous cyclicality and exposure to price swings that makes industries such as steelmaking so unattractive. Petra produces ingredients to order, on committed contracts with creditworthy leading multinationals, and hedges its cocoa bean price risk using futures when orders come in.

It seemed a respectable, if unexciting business. But I was interested to know why Petra thought it worthwhile. So what did I learn? First, there's obviously increasing long-run demand for cocoa ingredients as sales of chocolate-based products grow in emerging markets. As Nestl sells more Milo - a chocolate drink very popular in many Asian markets it needs more cocoa powder to make it.

And it doesn't just need any cocoa powder, but a specific grade so that taste remains constant. A global firm like Petra which has processing plants in Asia, Europe and Latin America that can deliver consistent-quality ingredients is the supplier that the multinationals need.

So why are the big vertically integrated manufacturers like Nestl outsourcing this part of the chain, rather than adding production in house? The answer apparently is down to product balance: getting the right combinations of each ingredient according to your needs. If a manufacturer that requires more cocoa powder as sales of one product increase, but has no increased demand for anything that uses cocoa butter, increasing processing to produce more powder will leave it with excess cocoa butter.

Outsourcers like Petra are better placed to balance the mix of products and also seasonality of demand and asset utilisation because it has many different customers with different needs. And because its own chocolate division takes only a small part of the output ingredients, it doesn't run into the same problem that a firm producing mainly for itself would.

I also wanted to know more about potential problems with excess grinding capacity and plant shutdowns this has happened before, especially in West Africa (where many cocoa growers are) in 2002 and 2006. But apparently this hasn't been a problem for Petra in the past. Its plants are located close to customers rather than suppliers, putting it in a stronger position when demand is slacker. So far, it has never had to shut down plants and has always run at high capacity. Margins have come off slightly sometimes, but grinding has still made money.

In terms of the outlook for this division, as mentioned in my first report, the newly upgraded European plant is undergoing quality assurance tests with customers. As these are completed and Petra can increase production of premium ingredients, margins will increase to be in line with the Asia and Latin America facilities that's likely to take a couple of years. There are no plans for another major project of this scale, but it's possible to add some extra capacity to existing plants, which could allow capacity growth of 10% a year over the next two-three years.

Overall, my view on the cocoa ingredients division is a bit more enthusiastic than it was beforehand. It's not capable of the same kind of long-term capital-light growth that the consumer division is, and it doesn't offer the same ability to earn excess returns from a powerful brand. It is a commodity business and will always have lower margins than the consumer segment. But I can definitely see the appeal of this to a specialist firm and understand why Petra thinks it's worth being involved - and once the European plant is fully optimised, its contribution to the bottom line should start to look much more respectable.

Turning to the branded consumer division, Petra's number one in Indonesia, with around 58% of the market, thanks to famous brands like its Dairy Queen chocolate and cashew combination, which is where the whole business began in the 1950s. Mars, Nestl and Cadbury's combined have less than 10% of the market.

I thought I had a fairly good idea of Petra's potential here but in fact it may be greater than I assumed. As mentioned in my original report, chocolate consumption in Indonesia is estimated at around 0.3kg per person per year, compared with 0.9kg in developed Singapore. That seems to offer plenty of potential for growth.

Interestingly though, Petra estimates that only a small portion of the population currently eat chocolate maybe 15-20 million out of a population of around 235 million. But among those that do, there is a very strong chocolate culture, which comes from the former Dutch colonial influence. So existing chocolate consumers eat a great deal much more than the headline statistics suggest. And as incomes rise, that consumer base is likely to spread.

So Petra's core market may have even more growth potential than I expected. And its current growth rate of 15-20% might be sustainable for a very long time.

The other very promising market is the Philippines, where it bought some long-standing brands in 2006 that had a market share of around 5% and has since doubled that. In contrast to Indonesia, where it covers the whole market, in the Philippines it focuses mainly on the low end. In the same way that it extends its brands into every niche in Indonesia, it may well be able to go upmarket by adding higher-end products to existing brands in time. For now, sales are apparently growing at over 30% a year here.

To my mind, it's clear that Petra's consumer business merits a fairly high valuation the kind of dominant consumer brand that we discussed in the first section. The ingredients business seems a decent business but doesn't have quite the same potential and should trade at a lower valuation. With two separate businesses that other than top management have completely separate teams, this is perhaps best viewed as a sum of the parts' stock.

My updated estimates for Petra are in the table below. Although we don't have the results for FY2010 yet, they relate to the year just finished, so it makes more sense to base the valuation on my FY2011 estimate. (Note that Petra reports in US dollars my calculations below are based on a current exchange rate of US$1= S$1.285.)

My updated buy limit for Petra is S$2. This corresponds to an overall p/e of 20, or approximately 10 times my estimated earnings for the cocoa ingredients division and 25 times my estimate for the branded consumer one, in line with my rules of thumb in the first section. Thus Petra, which has been on hold pending review thanks to recent strong price gains, moves back to a BUY.

That's all for this week. I'll be back in a fortnight with a new recommendation. In the meantime please keep your eyes open for the reader survey which I'll be sending out in the next few days. I'd be really grateful if you could complete this. Your feedback will help me improve Asia Investor.

Watch a Malaysian food-stall holder preparing the national drink of teh tarik and you'll get quite a show. It's no good just dumping tea leaves in hot water and pouring a bit of milk on top: as the name teh tarik ("pulled tea") suggests, the mix needs to be poured from jug to jug, letting it fall as far as you can each time, to get the right foamy, frothy texture.

You can't just use any milk, either. Teh tarik needs condensed milk, which has been processed to make it far sweeter and thicker than it was when it first came out of the cow.

And that leads to a bit of a quirk in the condensed milk market. Normally, condensed milk is cheap, basic nutrition it sells best in places were people are poor and can't afford fresh milk. Once incomes rise, they switch away from it.

Except in Malaysia, that is. Despite being well past the poverty stage, the country's teh tarik obsession means that it's still one of the world's most enthusiastic consumers of condensed milk.

And that fact is what led me to this week's recommendation which didn't entirely turn out how I expected. As I headed to a meeting in the suburbs of Kuala Lumpur a few weeks ago, I thought I was going to see a cheap, stable business in a sector that's about as defensive as you can imagine. And it is all that but it also has a lot more growth potential than I expected

10 years of impressive growth

Etika International Holdings dates back to 1997, when three Malaysian stockbroking brothers teamed up with three former executives from the dairies division of Singaporean conglomerate Fraser and Neave (F&N) to build a new condensed milk business. F&N was the market heavyweight, alongside tough competition from other firms such as Nestl and local dairy Dutch Lady.

Etika was starting from scratch, with 0% of the market in 1999. A decade later, it's the second largest player after F&N, claiming a market share of 20%. And in the segment of the market where it's focused most selling to food stalls and other trade businesses the company says that its Dairy Champ brand is neck and neck with F&N. It's also built a solid export business, notably to Africa where poor logistics and refrigeration make condensed milk the only milk product that can be easily shipped around (the high sugar levels means it doesn't go off).

Overall, from 2005 (when the firm first listed) to 2010, revenues have grown by 35%/year on average and profits by 44%/year. This was a pretty good start and an impressive accomplishment on the part of the management. But more recently, the company has been expanding beyond condensed milk and Malaysia, as it aims to build a diversified regional food and beverage group and that's where the future growth prospects I mentioned above come in.

Its first deal in 2006 was to buy Pok Brothers, a long-standing Malaysian wholesaler of frozen and premium foods to clients such as supermarkets, restaurants and hotels. This gave Etika new product lines such as meat and bread but more importantly an established distribution network that could take it to new customers. As the chart below shows, revenues and profits grew very strongly in the aftermath of the deal.

Now it's aiming to repeat the trick through a series of acquisitions that should overlap in expertise, distribution and raw materials. For example, management think there's a great deal of potential in the Indonesian condensed milk market, which Etika estimates to be 1-2 times the size of the Malaysian one but is still highly fragmented. However, getting a foothold there has been tough: distribution is extremely difficult, not helped by the fact that Etika must import all its products.

So last year, it bought a distribution business in Jakarta. This year, it purchased an instant noodle maker with a disused factory that it plans to convert to producing condensed milk. The two businesses by themselves are small, but Etika believes that putting them together and adding its own expertise will let it build a platform for growth in condensed milk in Indonesia.

Simultaneously, it thinks it can turn around the loss-making noodle business by improving how it operates in Indonesia and by supplying it with an export market through its supply chain in Malaysia. Growing the noodle business will also overlap with plans to grow its baked goods business in Malaysia, since the two share the same raw material (flour) and a larger Etika will have greater purchasing power when buying these inputs.

It's also keen on the fast-growing Vietnamese market, where it recently bought a small dairy company. This mostly produces products for the lower end of UHT (long-life) milk market, which are sold in cheap Tetra Fino packaging (basically a plastic bag filled with milk).

Etika believes it can expand the Vietnam business in two directions. First, it can grow its condensed milk sales, which makes sense to me: Vietnamese coffee is a condensed milk-based drink like teh tarik, so Etika would be selling its product into a similar niche to the one it occupies in Malaysia. Secondly, it may try to go upmarket with UHT milk, moving into selling milk in Tetra Pak cartoons, which cater to less price-conscious shoppers and carry better margins.

This should overlap with a new joint venture to bottle UHT milk in Aseptic PET packaging in New Zealand for its own sales and third party brands. The company is also aiming to move into UHT milk in Malaysia to expand its dairy product range there into higher value-added areas.

Etika could easily double in size

As the chart below shows, dairy products are still the core of Etika's business with a smaller contribution from the frozen foods business. I won't go into too much detail about the other two divisions: packaging makes cans for its condensed milk but also sells to a few external customers, while nutrition makes sports and weight loss products from milk powder. Etika bought this business from New Zealand's Fronterra in 2007 and it's small, but solidly profitable, being number one in its market in New Zealand and selling well in Australia too.

That's not going to change but geography probably will. At present, Malaysia is still the biggest contributor (see chart below); however, this is a fairly mature market. Etika can try to gain more market share and move into new lines, but it will be difficult to transform the size of the business from here.

But Vietnam and Indonesia have much more potential these are much early stage markets and offer much more opportunity for growth. Etika only needs to win a small share of these to have a major impact on its earnings.

Obviously, there is no guarantee that Etika's expansion plans will pay off. Sometimes, synergies that appear to be there just don't materialise. With management trying to pull together several new acquisitions, there is a risk that they will be stretched too thinly.

In some of these markets, competition could be tough. Indofood dominates the Indonesian noodle sector, for example, while expanding upmarket in UHT milk in Vietnam would mean competing with Vinamilk, often said to be the best-run company in the country.

That said, management has a good track record in starting from scratch and taking on incumbents in Malaysia. And the company does not aim to be the market leader; if it can just take a few percentage points of these large target markets and run them efficiently and profitably, it will make a very big difference.

I think it's entirely possible that Etika could double in size over the next five years or so. And given that it currently trades on a p/e of 8.5 times and offers a dividend yield of 4%, it looks cheap for its potential even taking into account these execution risks.

Institutions are starting to show interest

Why is Etika so cheap? Until recently, it's been struggling to attract much in the way of institutional shareholder interest, probably due to its small size (market cap of S$238m) and fairly unglamorous business. That looked like changing earlier this year, when a private equity fund at Templeton Emerging Markets (headed by high-profile investor Mark Mobius) was in talks to invest through a convertible bond. In the end, Etika and Templeton were unable to agree on terms and the deal fell through but the fact that a major institution was looking is encouraging.

For now, the Tan family remain the controlling influence with a combined shareholding of 50.82%. Two of the ex-F&N executives who co-founded the group also have stakes of over 5%. Members of the Pok family, former owner of Pok Brothers, have a number of individual holdings totalling slightly over 5%.

Among other shareholders of note, PPB Group controlled by Malaysian billionaire Robert Kuok has a holding of just under 5%. I also know the NT Asian Discovery Fund, which is a shareholder in a couple of other Asia Investor portfolio stocks, has a small stake.

This is a fairly small stock, with a market cap of S$238m, and suffered from very low trading volumes when it first listed in 2004. This has improved more recently and over the last year, it's had an average daily volume of about 280,000. The free float is around 25% according to Bloomberg data, although this may be an overestimate since stocks like this often have a number of small long-term holders who aren't interested in selling.

So like most Asia Investor stocks, this is a small cap with the usual liquidity risks, but you shouldn't have trouble taking any reasonably sized position.

In addition to the usual risks when investing in Asia Investor companies, I'd stress the following for Etika:

First, I must re-emphasise that there is significant execution risk when trying to integrate a number of new acquisitions and expand into new markets. I'm encouraged by the management's track record, but there can be no certainty of success. On the plus side, it has the buffer of a stable, defensive business in its Malaysian dairy, giving it that reassuring combination of a solid core business and growth prospects that I always like to see in a company.

Second, Etika is a heavy user of raw materials such as milk, sugar, flour, palm oil and other commodities, and as such is exposed to price rises in these. These could impact margins, which have fattened in recent years as the company gained scale: gross margin was almost 26% last year, from 14% five years ago.

The company says that it believes that it will be able to pass on raw material price increases to customers, and I think its record of profit growth through the commodity price spike in 2007-2008 suggests good cost control measures. That said, its strategy has been to grow market share though being slightly better value than the market leader. Thus, its pricing power may be ultimately be more limited than that of some of the leading consumer brand producers in our portfolio, and its earnings will be more vulnerable to commodity price volatility.

A potential 200% gain if all goes well

With so many new acquisitions and changes taking place at Etika, it's pretty hard for an outsider to estimate how they're likely to affect earnings until we see at least the first half of FY2011. I think it's entirely possible that the firm could double in size over the next five years or so, but timing is uncertain.

So the table below includes my base case, which I believe is reasonably conservative. For comparison, CIMB, the only broker covering Etika at present, is estimating that earnings ramp up much more quickly, with net income of RM82.6m in FY2011 and RM96m in FY2012.

Note that Etika carried out a 1:1 share bonus issue in October in an effort to improve liquidity by increasing the number of shares, thus my estimated EPS is actually a like-for-like rise of 10% rather than a fall.

Etika is on a price/earnings ratio of around 8.5 times FY2010 and 7.8 times my FY2011E (at the current SGD/MYR exchange rate). That looks very reasonable given its growth potential, even allowing for its small size and execution risks.

The company declared a final dividend of 1.25 Singapore cents per share at the results announcement in November, following an interim dividend of 1.0 cents. Adjusting for the impact of the bonus issue, that's a total dividend of 1.75 cents, up from the equivalent of 1.4 cents the previous year and a healthy 3.9% yield on the current price. Given the firm's steady record of increasing its dividend, I would expect that to rise next year if all goes well with the expansion strategy.

Turning to the balance sheet, the only point that raises the eyebrows slightly is that net debt to equity is up to 0.8 (from 0.6 last year). Again, this reflects recent expansion: cash paid for acquisitions, investment in new facilities and higher working capital needs, including build-up of inventories. It's a bit higher than I would usually want in a company, especially a small one, but it's justifiable given the expansion strategy and I would expect to see it come down next year, so for now I'm comfortable with it.

There are no signs of financial stress at present. The current ratio (short-term assets to short-term liabilities) of 1.4 as at end September 2010 doesn't raise any concerns about short-term solvency. Cash on hand has been rising steadily over the years, and stood at RM26m, while the firm arranged an RM368m financing facility with three Malaysian banks earlier this year (total bank borrowings at present under this and other facilities stands at RM197m, so it has plenty of headroom).

One common threat with fast-growing firms is that receivables due from customers get out of control ie the business isn't good enough at collecting what it's owned and so runs out of cash even while booking more and more sales. Etika's receivables have ticked up in the last year as the business expands and cashflow was down, so this bears watching to ensure that the cash comes in next year - although I think the management should be too experienced to let this get out of hand.

Overall, this seems to be a good quality business with a very solid, defensive core business and excellent growth prospects in markets like Indonesia and Vietnam. So what would be a fair price for it?

One thing that's important to bear in mind is that for all its strengths, Etika is not a leading consumer brand like some of food and beverage stocks already in the Asia Investor portfolio. It sells mostly business-to-business and doesn't have the same degree of brand loyalty and pricing power that a dominant consumer firm does. As a result, an investor shouldn't pay the same price that they would for Hsu Fu Chi or a Vitasoy, because a business like Etika is unlikely to be able to maintain the same kind of profit growth over the very long run.

However, if it succeeds in growing earnings as well as I expect from the acquisitions, it's likely to attract much more investor interest and trade on a higher valuation. If earnings were to double over five years, as I believe is possible, and the stock rerate to a p/e of around 12.5 to reflect that growth, we could be looking at a potential price gain of around 200%.

Obviously, we're not willing to pay that now. But I think an estimated p/e of around 10 is justifiable, weighing Etika's growth potential against the risks and its small size. Based on my FY2011E, that implies a buy limit of S$0.57.

Recommendation

Buy: Etika International Holdings

Ticker: ETK (Bloomberg), ETIK (Reuters), 5FR (SGX and many brokers)

Exchange: Singapore (main board)

Market cap: S$238m

Bid/mid/offer prices: S$0.445/S$0.445/S$0.45

Buy limit: S$0.57

52-week low/high: S$0.2-S$0.53

Etika is listed on the mainboard of the Singapore exchange and so will be eligible for an ISA if your provider allows foreign stocks to be held in one. As with most Singapore listed stocks, the standard lot size is 1,000 shares and most brokers will refuse orders that are not an exact multiple of this amount.

Just a quick portfolio update before I go. ARA Asset Management has passed my buy limit again in the past week, so my formal recommendation changes to a HOLD.

That's it from me this week and indeed this year. I'll be back with the next issue in early January, when I'll be looking in detail at why I expect the kind of consumer staples business that are the core of Asia Investor to do better than almost any other kind of company over the long run. And as part of that, I'll give you the fuller update from my meeting with Petra Foods that I mentioned in the last issue.

Before I go, I'd like to thank you for subscribing to Asia Investor over the last few months and wish you a prosperous 2011.

Towards the end of my trip a couple of weeks ago, I was in a shopping centre in Hong Kong. I was between meetings and badly in need of a quick snack. I fancied some toast with kaya (coconut jam) and when I saw the familiar sign of a caf chain known for this, I headed straight towards it.

I was highly disappointed. Not by the kaya toast but because I never got to taste it. The caf was so busy there wasn't a seat free anywhere. Business was clearly booming.

I dropped in on this chain several times in several cities along the way. And it was usually a similar story. Not quite as hectic most times I got served. But it was clear sales were very healthy.

Now, this is a company I've had my eye on for a while. But I've never been convinced that it could spread far enough and get big enough to be worth our while. This time, though, seeing how many new outlets it had and how well they seemed to be doing, I decided it was time to take a closer look.

Why food stocks dominate Asia Investor

By now you'll have noticed that quite a number of stocks in the Asia Investor portfolio so far are food and beverage groups. Companies like snack maker Hsu Fu Chi, soft drinks group Vitasoy and chocolate specialist Petra Foods.

But that's a very much a deliberate decision. Firms like this are very well-placed to tap in to rising consumer spending in the years and decades ahead. As people become richer, they diversify their eating habits, buy more packaged and processed food and are willing to pay a bit extra for top brands.

In my view, this kind of firm has an almost unequalled ability to earn consistent long-term returns from the growing spending power of Asia's middle class.

This week's recommendation is related to the same story, but comes at it from a slightly different angle. It's a little riskier than the stocks above but its near-term growth potential is even greater. If all goes to plan, I think we could be looking at a gain of around 100-140% over the next three years.

Before I get into the details of this, I want to remind all investors in First Reit about the company's rights issue. At the end of this issue, there's a bit of background that should cover what you need to know about. If you've invested in First, I recommend that you read this carefully.

But first, the next Asia Investor stock

Let me start by explaining how radical changes in Asian eating habits are playing into the hands of this rapidly expanding franchise.

Cashing in on Asia's hungry shoppers

There are two main stories to get to grips with here. First, as you may well have seen if you've visited wealthy Asian countries like Singapore, Hong Kong and Japan, consumers there have a real appetite for baked goods. There seem to be almost as many bakeries as there are on the streets on Paris, although some of the recipes would leave a French boulanger in shock.

Take the pork floss bun: a sweet bun, filled with something that tastes slightly like mayonnaise and topped with meat that's been stewed and then dried until all the fibres come apart and it becomes fluffy. It actually tastes better than it may sound I really like them. But even if you don't fancy sampling one, pop into any Asian bakery and you'll quickly see how popular they are.

Still while fresh-baked buns aren't exactly luxury goods, they're the kind of thing you can only really sell on to urban consumers with a bit of disposable income. In fact, they're well suited to busy urban lives as a way to grab a quick snack on the go.

So unsurprisingly, bread consumption is much higher in developed Asia countries than in markets like China. But the emerging urban middle class in poorer countries is showing strong signs of developing the same tastes: the Chinese baking industry has been growing at an average 20% pace in recent years, according to data from JP Morgan analysts, citing the local trade body.

So that's the first part of this story. The second is understanding mall culture' and eating out in Asia. In Britain, most of us don't like to hang around shopping centres that much. Get in, buy what you want, get out. But in much of Asia, high-end shopping malls can be much more of a leisure destination.

And that applies to the food as well. I don't think anyone in their right mind has ever gone to a British shopping centre for a decent meal. But in a modern Asian mall, the food court often offers pretty good, freshly-cooked food in a wide range of different styles.

Perhaps even more surprisingly to British eyes, mall eating is not just stalls and canteen-style tables. Many expensive malls are also home to upmarket restaurant chains, sometimes even ones with a Michelin star.

Again, this is also a likely to be a good growth market in years ahead. Growing urban populations with more spending power will shop more and spend more time in malls. That will include eating in the food courts and dining out in the restaurants.

So these are the two themes that my recommendation this week taps into.

Sales are growing 27% a year

Breadtalk is a Singaporean firm that runs bakeries, restaurants and food courts in shopping malls. Founded in 2000 by husband and wife team George Quek Meng Tong and Katherine Lee Lih Leng, both experienced catering management executives, the firm has expanded rapidly over the past decade.

It's their strategy for expansion that appeals to me franchising a very popular brand across Asia's shopping malls and food courts. We've seen before how a powerful a top brand can be in powering growth. Hsu Fu Chi, Petra and Vitasoy have been able to establish a dominant position in their home territory, then use the expertise, networks and cashflow from that to roll out their key brand out to new consumers elsewhere.

And by choosing to franchise just as McDonald's or Burger King expanded Breadtalk can earn far higher margins as they grow. The advantage of franchising for growth in the catering industry is that it limits your risks: if a new outlet doesn't take off, it's the franchisee that takes most of the loss. That makes it a good way of expanding quickly into new markets and testing the waters. What's more, the firm can grow its network substantially with limited need for new investment and scalable, capital-light businesses are exactly what I like to see as an investor.

When it listed on the stockmarket in 2003, Breadtalk had just 22 bakeries in Singapore and a single franchise in Jakarta. This has since grown to over 400 outlets today, through a mix of direct ownership and franchises. It now operates in 13 countries across Asia and the Middle East, with the core markets being Singapore and China.

Incidentally, the rest of the world is more important to profits than its 7% slice of revenue suggests, because the majority of this is revenue from franchises. But Breadtalk doesn't break profits down by geography in the same way.

The firm has managed to combine that rapid expansion with a history of profitability, which isn't always the case when trying to grow quickly. It's made money every year since it was formed, except in 2004. From 2005 to 2009, revenues grew at 27%/year and net income by 81%/year.

Let's take a quick look at the firm's three main divisions and what they do.

Division 1 The successful bakery franchise

The eponymous Breadtalk bakeries and the Toastbox cafes attached to many of them are the heart of the group. In the first nine months of this year, they accounted for 45% of revenue and 35% of operating profit.

Having built a successful concept and brand in Singapore, the company is now mostly relying on franchising to grow the number of outlets and spread across the region, although it uses direct ownership in certain key foreign markets that it knows well, such as Shanghai and Beijing. As of end September, there were 354 bakeries, of which 142 were directly owned and 212 were franchises.

Division 2 A very profitable restaurant chain

Breadtalk's second division is restaurants, where there are three brands within the group at present, operating somewhat different strategies. First, it has the Singapore franchise for Din Tai Fung, an award-winning chain originally from Taiwan but now expanding across Asia. There are 8 restaurants in Singapore and the firm is also expanding into Thailand, with a first outlet now opening in Bangkok.

The company also has the master franchise for US burger chain Carl's Jr. in China and is currently opening its first three outlets there. Meanwhile, the third brand is its own label, a Japanese-style noodle chain called RamenPlay, which Breadtalk has developed in a joint venture with Japanese restaurant group Sanpou. This will initially be rolled out in Singapore and China and currently has six open outlets. Din Tai Fung is currently profitable, while the Carl's Junior and RamenPlay lines are still incurring start-up losses.

Restaurants are a higher margin business than bakeries, so as this division grows, so should Breadtalk's profitability. They're also more strongly exposed to the newly affluent, who are likely to dine out in premium restaurants such as Din Tai Fung more as their incomes rise. On the downside, higher-end restaurants are typically more cyclical: people cut down on restaurant spending when the economy slows much more than they do for snacks and fastfood.

Division 3 Chinese food courts

Lastly, the food court business which operates under the Food Republic brand began in China (it was an earlier business founded by the CEO which was merged into Breadtalk in 2004). The majority of its 30 courts are based in China, but it also operates five in each of Singapore and Hong Kong and one in Malaysia.

Under this business model, the company operates the overall food court and leases space to the individual stalls that prepare and sell the food. Rental income is part fixed rate and part based on a stall's sales. Breadtalk focuses mostly on higher-end malls in prime locations and appears to put a lot more effort into dcor and ambience than many other food court operators.

That's the business today what of the future?

1,000 bakeries in the next 4 years

Breadtalk has grown strongly from the outset, but the management have ambitious plans to expand, involving more than doubling the number of outlets in each division. First, it hopes to have 1,000 bakeries in the next 3-4 years, with most of that growth coming from the franchise model.

Second, it plans to have around 80 food courts over the same period. Most of this expansion is likely to be in China. And third, it hopes to have around 200 restaurants, probably over a slightly longer period. This should include rolling out Carl's Junior across a number of Chinese cities and franchising its own RamenPlay brand widely, especially in Singapore and China.

These are ambitious plans and there is no certainty of success. I would be inclined to regard the restaurant expansion as the most likely to fall short, since much of this is less tested than the Breadtalk and Food Republic businesses: Carl's Junior is late to China compared to other major American burger chains, while the RamenPlay brand has yet to be established anywhere.

On the plus side, my perception is that Breadtalk has generally met or exceeded its targets in the past. And the intelligent use of franchising should mitigate some of the risks that come with rapid expansion.

Most importantly, the firm has an experienced management team with a track record of success. Let's take a closer look at the owners.

A smart and prudent family-run business

The founders continue to own the majority of shares in the business, as the table below shows. Chen Kuo Hua, who holds a smaller stake, is a non-executive director who formerly worked in management in the food courts division and with the founders in Taiwan before Breadtalk was set up.

As I always note, there are risks and advantages to investing in a family- or founder- controlled business. On the plus side, management's personal wealth is likely to be tied up in the business, which should encourage them to take a prudent, long-term view. On the downside, the presence of a controlling shareholder can lead to corporate governance abuses that damage the interests of minority investors.

Ideally, I like to see a significant holding from an activist fund as evidence that there's someone on the roster to watch out for outside shareholders' interests: there are a handful of names that I look out for particularly in Asian small caps. Unfortunately, I don't know a great deal about Keywise Capital Management, but I am aware that it's a Hong Kong-based small cap specialist that runs several Asia and China focused funds, so I think it's likely that it's this kind of investor.

There are smaller holdings by a number of institutions, including Wasatch, a US-based small cap specialist. The independent directors include a lawyer at a leading Singaporean firm and a member of parliament. And from reviewing the company's history, I don't see any obvious red flags, so I am reasonably comfortable with the governance situation here.

Average daily volume in Breadtalk is around 500,000 over the past year, although I think that includes a number of block trades: a more representative average would probably be around 200,000. This should be plenty of liquidity for the average private investor. Judging by Bloomberg data, the free float is around 25%.

A few risks to keep an eye on

In addition to the usual risks of investing in the shares recommended in Asia Investor, I'd stress the following for Breadtalk:

First, the company's ambitious expansion plans create a clear risk of execution problems. Management's track record and franchising strategy mitigate this somewhat. But there are always risks that the firm could overstretch in some ways.

For example, earlier this month, the firm disclosed an apparent staff fraud in a Malaysian subsidiary. Such problems can crop up from time to time in any firm but could conceivably indicate inadequate internal controls as a result of rapid expansion.

Second, as with all our food and beverage plays, Breadtalk is exposed to changes in the cost of raw materials such as flour and cooking oil. The firm is also vulnerable to rising labour costs and indeed reports pressure on wages in the China operations at present.

When input price increase, its margins will be hurt unless it's able to pass on higher costs through prices rises or bring down costs through other means such as bulk purchasing or efficiency gains.

On the plus side, Breadtalk has kept gross margins in a relatively stable range (54%-56%) in the past five years. This suggests that it operates good cost control strategies and is well placed to deal with such price pressures.

Third, Breadtalk operates in an industry that is highly fragmented, with many small players and a few larger peers in most of its markets. Competition is tough. Barriers to entry are low, especially in bakeries, although slightly higher in food courts by virtue of limited locations and higher-end restaurants. And in China in particular, a number of other domestic and international chains are also expanding quickly as they try to establish a leading position in this potentially enormous market.

Successful firms will need to establish strong brands, keep refreshing what it offers so that customers don't become bored and maintain high quality standards. Breadtalk's management have shown vision in finding ways to make their business stand out: notably the use of glass-fronted kitchens at its bakeries that lets customers view the baking process, which both helps attracting interest from passersby and reassuring shoppers about food hygiene (which I believe is a particularly strong selling point in China).

Fourth, there is economic risk. A prolonged slump in its markets especially China at a time when the firm is expanding quickly could be very damaging. The expansion plans into the more cyclical restaurant sector increase this risk. That said, its established Singaporean operations should provide some protection against the risks in its fast-growth markets.

On the basis of my valuation, we will also be getting that growth at a very reasonable price

Why there's potential for 140% gains

The table below shows recent results and my estimates for Breadtalk. As you can see, this year's profit will be depressed on account of the start-up losses at Carl's Junior and RamenPlay, write-downs on closing two loss-making food courts in China, and a provision for loss on the fraud in Malaysia. Generally, while Breadtalk has shown strong long-run growth, this growth has been volatile on account of the timing of expansions and associated costs.

Income should recover sharply in 2011, although the size of the rebound will depend somewhat on the timing of new outlet opening and how long the Carl's Junior and RamenPlay start-ups take to break even. (The fact that EPS for this year is likely to be lower than in 2008 while net income is projected to be higher is because the firm did a bonus issue of shares to existing shareholders earlier this year to increase the number of shares in issue and hopefully boost liquidity.)

The stock currently trades on around 13 times my estimated earnings for next year, which doesn't seem excessive given its track record and prospects. Although you don't look towards a growth story like this for income, it has been paying a small dividend since 2007; last year's was S$0.01, amounting to a trailing yield of around 1.6%.

The balance sheet looks in reasonable shape to support growth. The total debt to equity ratio was 27% as at end September and the company has held it in a 25-30% range since 2007. Interest coverage (the ratio of earnings before interest and taxes to interest expense) in the first nine months of the year was a very comfortable 19. Operating cash flow is consistently positive and the company had a cash balance of S$55m as at end September.

One thing that might stand out though is that Breadtalk has a current ratio (current assets to current liabilities) of 0.89. A current ratio of under one is often a warning sign that the firm is struggling to pay its bills, piling up unpaid liabilities at its suppliers. While it varies between industries, a ratio in the range of 1.2 to two is usually considered desirable.

So is this a sign of financing issues? No. For cash businesses such as restaurants and retail, it's not uncommon when they're expanding quickly: because their customers pay upfront, they will have received cash for the goods they sell before they've even paid their suppliers.

MacDonald's' current ratio was never above 0.8 from 1987 (the earliest results I can get) until 2005. Tesco notorious for its ability to squeeze suppliers for longer payment terms has never had a current ratio above 0.75 in the 23 years of results I have, and ran one below 0.4 for much of the 1990s. So given that Breadtalk's balance sheet looks fine in other respects, this does not look like a red flag to me.

So what about my valuation of this firm? Initially, I'm going to value Breadtalk on a p/e of 15 times my base case for FY2011 so a buy limit of S$0.72.

This may look a little low given the kind of growth potential that I've suggested the firm has. And it's a marked discount to Hong Kong-listed stocks such as Caf de Coral. This firm is perhaps its closest peer, running fast-food restaurants and bakeries across Asia, with a particular focus on Hong Kong and China. It trades on a forward p/e of 19-20 times.

But even though Breadtalk's track record so far is good, there is clear execution risk in its expansion plans. So it makes no sense to pay this kind of valuation: Caf de Coral is a significantly larger firm, with slower but steadier growth. A multiple of 15 times is quite enough for Breadtalk at this stage.

But if the business grows as hoped, I think earnings could be around 6.5-7.5 Singapore cents per share in FY2013. The company would be around twice the size it is today and in my view would likely trade on a higher multiple of 20 or so if its growth prospects continued to look strong.

So on a price of around S$1.30-S$1.50 then, representing a potential three-year price return of around 100-140%, looks quite achievable although I need to stress again that this comes with slightly greater risk than usual for Asia Investor.

Recommendation

Buy: Breadtalk Group

Ticker: BREAD (Bloomberg), BRET (Reuters), 5DA (SGX and many brokers)

Exchange: Singapore (main board)

Market cap: S$178m

Bid/mid/offer prices: S$0.62/S$0.63/S$0.63

Buy limit: S$0.72

52-week low/high: S$0.43/S$0.72

Breadtalk is listed on the mainboard of the Singapore exchange and so will be eligible for an ISA if your provider allows foreign stocks to be held in one. As with most Singapore listed stocks, the standard lot size is 1,000 shares and most brokers will refuse orders that are not an exact multiple of this amount.

First Reit rights issue: important information

Before I finish this week, I want to go over some of the details of the announced rights issue in First Reit. If you've invested in this stock and you're not familiar with dealing with rights issues in foreign shares, please read this following carefully.

As I mentioned in my last email, First Reit has agreed to acquire two new facilities in Indonesia from its sponsor Lippo Group: a general purpose hospital and a specialist cancer centre. We already knew about this deal it's been in the pipeline for a while (please check my original report for the full background on the properties).

The deal looks to be slightly more favourably priced than I anticipated. The total cost should be around S$210m, marking a combined discount of around 15% to the properties' assessed value. This should ensure a solid boost to First's yield.

According to the company's figures, had the acquisition and rights issue taken place at the start of last year, the FY2009 payout would have been equivalent to a yield of 8.83% compared with an actual yield of 8.02% (based on the unit price as at the start of November). So I view this as an attractively priced deal. As discussed in my original report, I hope First should continue to profit from similar yield accretive deals with its sponsor in future.

First will be funding this through a five-for-four rights issue, priced at S$0.5/unit. That's a discount of 48.5% to the current unit price. The theoretical ex-rights price or TERP (the price at which units should trade when the issue is completed and the new units issued) is just under S$0.71 (based on the current unit price)

How a rights issue works

In a rights issue, existing shareholders are granted nil paid' rights. Nil paid means that the right to subscribe for the new shares is being sold without the necessary payment for the shares being made: in other words, on exercising the rights, they will need to pay the issue price (S$0.5 per new share, in this case).

Shareholders can choose to take up their rights and pay for the new shares. Alternatively they can instruct their broker to sell the nil paid rights on their behalf at any point during the nil paid rights trading period (which will be 8 th December 16 th December in this case). If they do neither, the rights will be sold on their behalf and they will receive the proceeds of this sale, less costs.

The value of the nil-paid rights depends on how much demand there is for the rights issue. But assuming it's fully subscribed, it should be roughly equal to the theoretical ex-rights price, less the issue price.

A shareholder's financial position immediately after the issue is approximately the same whatever they do. If they take up the rights, they own an increased number of shares at a lower average price, which should be close to the TERP of S$0.71, assuming nothing happens to move the share price does not much in the meantime.

If they don't take up the rights issue, the value of the existing shares is obviously diluted: they will drop from S$0.97 to around S$0.71 (in theory) after the rights issue is completed. But shareholders should receive a payment that works out to roughly S$0.26 per share (before costs) for the nil-paid rights, which of course is equal to the difference between S$0.97 and S$0.71.

There is also technically an option to renounce the rights. In this case, the holder receives no new shares and no payment for the nil paid rights. So their existing shareholding is diluted, the price of the shares falls to around S$0.71 after the rights issue is completed and they receive no compensating payment. Clearly, this is almost never a good idea.

I continue to rate First as a Buy at present. For portfolio purposes, the formal recommendation is to take up the rights issue was taken up and the purchase will be adjusted on the basis that this is done.

Whether the best option for those of you who are invested in First is to take up the rights or sell them depends on individual considerations such as how much of your portfolio should be allocated to First. I'm not permitted to provide individual advice on that and if you have any doubts as to what you should do, I can only recommend that you consult an independent financial advisor.

Make sure your broker knows what they're doing

However, a couple of readers have mentioned to me that their broker seems to be struggling to deal with a rights issue in a foreign stock. In particular, this section in the announcement seems to be causing some confusion:

The Rights Units will be issued to eligible Unitholders, being Unitholders with Units standing to the credit of their Securities Account and whose registered addresses with The Central Depository (Pte) Limited (" CDP ") are in Singapore as at the Rights Issue Books Closure Date or who have, at least three Market Days10 prior to the Rights Issue Books Closure Date, provided CDP with addresses in Singapore for the service of notices and documents and such Unitholders who the Manager, on behalf of First REIT, and in consultation with Oversea-Chinese Banking Corporation Limited and Credit Suisse (Singapore) Limited, as the joint lead managers and underwriters for the Rights Issue (the " Joint Lead Managers and Underwriters "), in its sole discretion determine, may be offered Rights Units without breaching applicable securities laws ("Eligible Unitholder")

This doesn't mean that the rights issue is only available to Singapore residents. The condition is that the CDP (Singapore's securities depositary, which keeps records of who owns which shares) needs to have been provided with an address in Singapore to which relevant documents can be sent at least three trading days before the closure date (which is 5pm on December 3 rd).

Having a local service address is a standard condition with rights issues in Singapore and many other markets. Usually, the announcement makes it clear that this is to make dealing with paperwork practical, but for some reason First left out this explanation. Your broker's local office or partner's office in Singapore is perfectly suitable for this purpose.

In my view, any broker who deals foreign shares should be familiar with this process and know what to do to ensure that you're on the books. But since it sounds like some UK brokers aren't as efficient with this as they might be and I can't speak for which of them will handle it flawlessly and which won't.

So it's worth making sure everything goes smoothly. If you have shares in First and wish to take up the rights, I recommend that you call up your broker to check exactly what you need to do and how they'll handle it.

The obvious question now is: What happens if the CDP doesn't have a service address for you? In that case, you won't be allocated rights. But you shouldn't lose out financially.

Rights that would otherwise be allocated to foreign shareholders who don't provide a service address and so can't be allocated them will be sold nil paid' on the market. The proceeds from this - less costs - will be paid to the foreign shareholders. So they will be in the same position as someone who gets their rights entitlement allocated but chooses to sell the rights or allow them to be sold on their behalf.

I hope this clarifies the background. But if you are uncertain about what your broker will do, I recommend you contact them to check.

This week, I'm writing to you from the city of Kaohsiung in the south of Taiwan. I've arrived here from Guangzhou in China and will be on the move again to Taipei on the last leg of my trip very shortly.

It's been an eventful few weeks. One minute, I've been sitting in a high-rise office, listening to a man tell me his plans to make a splash in noodle soup. The next, I'm clambering through the crowd at a heaving railway station for another long train ride to another distant city.

I've seen a lot of changes in the short time since I was last in many of these countries, and had many interesting conversations. After five weeks on the road, my notebook is almost completely full. And I think I have the outline for some stories that will really interest you on my return.

For example, there's a little Singaporean company that caters to Asia's growing taste for baked goods. I've known about this company for a quite a while. But on this trip, I've been struck by how visibly it's expanding across the region and how busy all its outlets seem to be.

I also came across an opportunity at the bottom of a glass of teh tarik, Malaysia's signature drink. In Kuala Lumpur, I caught up with the firm that's one of the two big suppliers of the condensed milk that goes into teh tarik and was hugely impressed by the management's ambition and track record so far.

I'll be returning to these companies in the coming issues. And there are a host of others I want to tell you about. But these will have to wait until I get back. There's a lot of work still to be done and I'm not certain which ones will make the cut yet.

In the meantime, there have been a number of developments that I would like to update you on. Starting with a great fortnight for ARA Asset Management.

ARA and Petra move to "Hold"

I'm sure you noticed that a couple of our stocks have now moved through their buy limits and will be moved to "hold" in the portfolio for the time being at least until I've had a chance to assess these developments.

The biggest mover is investment manager ARA Asset Management, which has risen 17% to S$1.56 since my last email a fortnight ago. We're now sitting on a paper profit of 43% on my original recommended price on this stock.

The big news on this was related to one of the real estate investment trusts that ARA manages. Suntec Reit is to acquire a one-third stake in a prime development in Singapore's Marina Bay, subject to the approval of Suntec's investors. This will benefit ARA because it will earn acquisition fees as a result of the deal, together with ongoing management fees on the assets.

This is exactly why I like ARA: as the funds it manages grow larger, that directly grows ARA's earnings without the company needing to put its own capital at risk. Next week, I'll take a look at what impact the deal will have on earnings and update you with some background I got from a meeting with the company when I was in Singapore earlier on this trip.

Chocolate maker Petra Foods has been loitering around my buy limit for a few weeks now, and as of this update it's slightly over S$1.6, which moves it to a hold. I suspect that investors are anticipating a decent set of results in mid-November. I also had a chance to meet Petra in Singapore and will fill you in on some of the background I got from that discussion. So far, our paper profit on this position is 12.5%.

ICICI Bank was already on hold, having passed my limit some time ago. But it's risen further since, releasing second quarter earnings that beat the market expectations. Our paper profit is 50%. I don't anticipate raising my buy limit on this one but my feeling is that there's value in continuing to hold it for now. However, I'll be looking at it again more closely and will update you fully.

Elsewhere, we've seen a bit of weakness in software firm Silverlake Axis, with shares gradually slipping back to S$0.325 currently, from a high of S$0.39 this year, reducing our paper profit to around 12%. The approach of the ex-dividend date for the special dividend may have played a part in this, but it also looks to have been related to a placement of 50,000,000 shares by the controlling shareholder at S$0.32.

Although the price is weak, any increase in the free float is probably good news in the long run, since Silverlake's big problem is the low liquidity and the size of the founder's stake. In other encouraging news, the company announced a new contract win. I'll discuss all this in more detail next time. For now, it remains a buy.

SILV five year performance: 2005 -31.25%| 2006 +165.45%| 2007 -17.81%| 2008 -85.00%| 2009 +261.11%| 2010 +6.18%

Although there's been no news on the stock, I know that some of you have been disappointed by Eredene Capital, which is undoubtedly the laggard of the portfolio thus far. It's showing a paper loss of 2.7%, despite being the longest standing recommendation in Asia Investor.

This is a slightly different type of investment to the rest of the list, so I'll be taking a look at when we might expect it to begin performing. It remains a buy, although I should stress again that investors in this stock may need to be quite patient.

ERE yearly performance since listed: 2005 (Feb) -24.32%| 2006 +2.68%| 2007 -28.70%| 2008 -29.27%| 2009 +12.07%| 2010 +13.85%

Finally, I've just this minute seen that First Reit is about to carry out a rights issue of S$172.8m to fund the S$205.5m acquisition of two new hospitals in Indonesia from its sponsor Lippo. This is the same pipeline deal as I discussed in my recommendation on this stock a fortnight ago.

All this was expected, but my initial impression is that the terms on this are slightly more favourable for First than I anticipated. The shares ticked up marginally today, despite the rights issue being at a large discount to the current price, suggesting that other investors feel the same. I'll be going through the numbers in detail next time. For now, it remains a buy although I reiterate that investors in this need to be willing to take up this rights issue and most likely subsequent ones as well.

FIRT yearly performance since listed: 2006 (Dec) +7.04% 2007 +1.32%| 2008 -47.40%| 2009 +101.23| 2010 +18.07%

One that got away but there'll be more

Unfortunately, I also have a bit of a mea culpa for you this week. Because I wasn't quite quick enough on a recommendation, I'm afraid I failed to net you a 76% gain in just a few weeks. The only good news is that the Asia Investor strategy means it shouldn't be the last opportunity of its kind we see.

You'll remember a couple of weeks ago that I was planning to tip a medical investment but unfortunately two passed my buy limit, while the third turned up some issues at the end of my research.

Well, one of the two I thought had got too expensive was the company below: Thomson Medical Centre, a maternity hospital and womens' and childrens' clinic operator in Singapore and Vietnam.

Source: Bloomberg

Look at that gain in the last couple of weeks. What happened? Peter Lim, the Singaporean investor who was one of the unsuccessful bidders for Liverpool Football Club, bought out the founder and made a takeover bid for the whole company at S$1.75 a share, a 62% premium to the undisturbed price.

To be frank, I don't understand what he's doing here. I think this is a great company. And with most buyouts, there's extra value the buyer gets from being in control that makes the shares worth more to them than ordinary investors like you and I this is known as the control premium. But a trailing p/e of 32 times earnings seems a bit too much.

However, I'm obviously now highly aggrieved that a matter of a few cents and a couple of weeks made the difference to me getting you in on this deal.

So what is the tiny crumb of comfort in this? Well, Thomson is a pretty typical Asia Investor company. It's a bit smaller than usual, but it's a well-established, high-quality operation that's been built up by controlling shareholder or family exactly the kind that my approach tends to draw me towards.

Firms like this make attractive takeover targets for a multinational, private equity firm or in this case a wealthy individual. Meanwhile, the founder or family has most of their wealth tied up in the company's shares and after many years working on the business are often keen to cash out.

With the enthusiasm and ability to buy into growth stories very much alive in Asia, I've always believed that some of the Asia Investor stocks will end up as takeover targets at very healthy prices and Lim's expensive-looking deal gives me further encouragement that I'm right about this. Of the ten stocks in the portfolio at the moment, I'd say that over half of them have the potential to be involved in a deal like this eventually.

Obviously, I don't think all of them will be. But I'd be very surprised if it doesn't happen to at least some of the stocks I've already tipped or have on my shortlist at the moment.

That's it from me this week. The night markets are open and I'm off to have some of the island's legendary stinky tofu.

Prices as of 8/11/10

(Singapore tickers vary between brokers. The three common ones are listed for each stock.)

Sources used in preparing this report:

First Reit announcement 09/11/10

ICICI Bank shares jump 6 pc as Q2 results beat view - Economic Times 29/10/10

Silverlake Axis announcements 13/10/10, 25/10/10 and 27/10/10

Suntec Reit announcement 26/10/10

Thomson Medical Centre announcement 29/10/10

Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Shares recommended in Asia Investor may be small company shares. These can be relatively illiquid and hard to trade and there can be a large bid/offer spread. So if you need to sell soon after you've bought, you might get back less than you paid. This can make them riskier than other investments. Some may be denominated in a currency other than sterling. The return from these may increase or decrease as a result of currency fluctuations. Always seek personal advice if you are unsure about the suitability of any investment. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Editors may have an interest in shares recommended.

Full details of our complaints procedure and terms & conditions can be found on our website, www.moneyweek.com.

Asia Investor is issued by MoneyWeek Ltd. Registered office 7th Floor, Sea Containers House, Upper Ground, London SE1 9JD. Customer services: 020 7633 3780. Registered in England and Wales No 04016750. VAT No GB629 7287 94. MoneyWeek Ltd is authorised and regulated by the Financial Services Authority. FSA No 509798. www.fsa.gov.uk/register/home.do

2010 MoneyWeek Ltd. All Rights Reserved. The content of this email may not be reproduced without the written consent of MoneyWeek Ltd. Registered Office: Sea Containers House, 7th Floor, 20 Upper Ground, London, SE1 9JD. Registered in England No. 04016750. VAT No. GB 629 7287 94.

This week's Asia Investor comes to you partly from beautiful island of Penang. And partly from somewhere rather less luxurious.

I spent the weekend overlooking the ocean at the famous Eastern & Oriental Hotel, once popular with Noel Coward and Rudyard Kipling. Five star living doesn't usually come with the Asia Investor budget, but Malaysia is cheap and the off-season discounts are in full-swing; at the price, I couldn't turn down the opportunity to stay in one of Asia's most elegant locations.

With my report half-finished, I jumped on a sleeper train to Bangkok, slightly concerned that although there was only one type of ticket available, it was still labelled "second class". I was right to be worried: while the bed was better than it might have been, the train was badly late and so was the food. Even the plates of elderly chicken that hawkers kept offering us at the stations began to look edible after a while.

But worse, there was only a single power point in the middle of the coach and monks were staking out a claim on it as they recharged their mobile phones. With not much battery in my old travel laptop, I didn't get a lot of work done until I finally made it to my hotel. But thanks to plenty of strong Thai coffee last night, I've got an interesting addition to the Asia Investor portfolio ready for you.

As I mentioned yesterday, it's an Indonesian healthcare investment. I think it will be a very solid addition to the portfolio. And as we'll see, one that pays a very handsome dividend.

So let's take a quick look at the background to its business, before diving into the details of the stock.

Why you shouldn't fall ill in Indonesia

As in many emerging markets, Indonesia's healthcare system is extremely underdeveloped. The country spends around 2.5% of GDP on healthcare, compared with around 4% in Singapore and Malaysia.

Resources such as hospital beds and doctors are inadequate compared with better systems in both developed countries and many emerging ones, as the charts below show. And hundreds of thousands of patients go abroad to countries such as Singapore and Malaysia for treatment each year.

According to Department of Health figures, Indonesia has 1,406 hospitals: 721 state-owned and 685 private. Many of these will be very small or basic facilities. It estimates that the country needs an extra 420 hospitals.

Insurance coverage remains low, with more than half the population lacking coverage. However, this is expanding, both under government programs and private providers. And rising incomes also increase people's ability to spend out-of-pocket on healthcare, if it's available at the right price.

So on the supply side, we have a shortage of healthcare provision, while on the demand side, the ability to pay for treatment should be rising. This is a situation that has considerable promise for investors.

Of course, Indonesia isn't alone in this. I think that most emerging markets have promising healthcare trends. However, this isn't a difficult story to wrap your head around and investors have caught on. Most healthcare investments are now looking quite expensive. So rather than chase expensive growth stories, I've been looking in a different direction.

This week's recommendation is a bit different to the stocks we've looked at so far, because it is primarily an income play. But I think it has unique characteristics that add some modest but steady long-term growth, plus some potential for capital gains. And because it's operates in such a non-cyclical sector, it should offer a very solid and dependable stream of dividends.

Add the fact that it currently yields 8% a year, and it begins to look pretty compelling

Flagship hospitals in a thriving healthcare market

First Reit is a Singapore-listed real estate investment trust, specialising in healthcare properties. The trust currently holds eight properties, four in Singapore and four in Indonesia. However, the Indonesian assets account for the vast majority of asset base and income, as the chart below shows and as we'll see below, future growth is likely to come here.

Consequently, the Singapore properties are relatively unimportant and I'll only summarise them briefly. They consist of three nursing homes and a cancer centre that's currently under redevelopment for completion in mid-2011. The lessee on two of the nursing homes and the cancer centre is Pacific Healthcare, a Singapore-listed healthcare provider.

Having a stable, long-term tenant is quite important for a reit operating specialised facilities such as healthcare, because there are fewer potential replacement tenants than for another type of property asset such as an office. Leases on all are for 10 years with the lessee having the option to renew for another 10. The first renewal date falls in 2017 and rents will increase by a fixed 2% per year during the course of the lease.

The Indonesia side of the asset base is much more important, since this is where First's sponsor is based. If you're not familiar with how reits operates, the sponsor is a major shareholder with a pipeline of assets to inject into the trust.

In First's case, the sponsor is Lippo Group, a major Indonesian conglomerate controlled by the Riady family that focuses on property development. Lippo is known for high-end "planned community" developments such as its flagship Lippo Village to the west of Jakarta, which incorporate retail, schools, healthcare and other facilities as well as housing.

First currently holds four Lippo-originated assets in Indonesia: a 188-bed hospital and 197-bed hotel in Lippo Village, a 192-bed hospital in Kebon Jeruk, also in Jakarta, and a 157-bed hospital in Surabaya, Indonesia's second largest city. These assets are leased to Lippo's Siloam Hospital division on a 15-year lease with a 15-year renewal option. The first renewal date is in 2021.

Rents on these are paid in Singapore dollars at a fixed rate eliminating SGD-rupiah exchange rate uncertainty and are determined by two formulas. First, there's a base component that increases each year by the rise in the Singapore consumer price index, with a floor of 0% and a cap of 2%. This base component amounted to around $24.1m at time of listing, and dominates the overall rental revenue at present (for comparison, total rents from Indonesia last year were $26.1m).

Second, the reit also receives a variable component based on growth in the hospital revenues: 0.75% of revenues for an increase between 5% and 15%, 1.25% of revenues for an increase between 15% and 30% and 2% of revenues for an increase over 30%. Overall revenues at Siloam Hospitals are growing at around 20% per year and based on present state of the Indonesian healthcare industry, I think this kind of pace is could be sustained for a long while.

Obviously, much depends on inflation and revenue growth, but overall I would expect First's revenue and distributions growth on the existing portfolio to average around 3% a year for the medium term, with this rising gradually as revenue sharing plays a larger part.

That's not spectacular, but it's a reasonable starting point to help keep ahead of inflation, and allied to an 8% starting yield, it starts to look very attractive. Further growth in payouts will depend on acquisitions at good prices so let's take a look at what's in the pipeline.

The emergence of a medical empire

Lippo intends to expand its healthcare operations substantially to meet the market for better medical facilities in Indonesia. So I met with Siloam management in the Lippo Village facility to get some idea of how it operates, what its plans are and how this will affect First.

Siloam is one of three major major healthcare players in Indonesia, owning seven hospitals at present and ground broken on the construction of two more. Australian group Ramsay Health Care has three and Mitra Keluarga lists nine. As noted above, long-term prospects for the industry seem good and the lack of tough competition suggests that early movers could build up a very strong position.

Apart from those properties already sold to First, Siloam's most significant asset is the new 210-bed Mochtar Riady Cancer Centre in central Jakarta, which is being completed at present. This is only the second cancer centre in Jakarta and the most specialised in the country: it should attract many of the patients who currently travel abroad for cancer treatment.

There is also a 120-bed hospital in the Lippo Cikarang township, east Jakarta, a small hospital in Jambi province that is being redeveloped, and another more recent acquisition at Balikpapan, also under redevelopment. More will be added in the years ahead: In total, Siloam plans to have 15 hospitals by end 2011 and 22 by end 2012, some of which will be new builds and some acquisitions.

Notable projects include a teaching hospital at Lippo Village, which will use the existing Lippo Hospitals facilities for treatment but offer much lower-end accommodation. This is part of Siloam's strategy of branching out from catering to wealthy Indonesians and expats and tap into a wider market. Management say that this follows a successful model of bringing down costs through high volume already used by Indian healthcare providers in a similar environment.

Siloam plans to circle Jakarta with hospitals to capture the widest market there, while also building a presence in other key cities. To deal with the shortage of top doctors in many disciplines, it will build the key facilities into centres of excellence on various disciplines for example the Lippo Village hospital will be neuroscience and cardiology for example and operate a hub and spoke' model, with other hospitals consulting these specialists and referring patients to them for treatment.

Another S$250m expansion in the pipeline

Not all of Siloam's new developments will necessarily be injected into First, but there is likely to be a steady stream of acquisitions in the years ahead, since a sale and leaseback deal on existing properties is Siloam's strategy for raising funds for new developments and expansion. The confirmed pipeline consists of the MRCC and Lippo Cikarang; management is negotiating on this at present and the sale is likely to be closed this quarter or early next year.

Details on the price of these assets aren't finalised, and management won't give guidance beyond confirming that it will be substantial relative to the existing asset base of S$340m and market cap of S$263m. But I've seen estimates that the value of these assets is likely to be somewhere in the region of S$250m.

Aside from Lippo properties in Indonesia, First can also acquire healthcare and medical assets elsewhere (and has done in a small way with the Singaporean assets). Management has looked at other deals, including two hospitals in China, but these haven't gone through.

This reflects the fact that First needs to be comfortable with the quality of the assets and the quality of the tenant, as well as getting the property at a price that is "yield accretive" ie it grows the yield that existing unitholders are receiving. For this reason, the majority of its future acquisitions are likely to be in Indonesia and from the Lippo pipeline, since there's a better alignment of interests to do good deals between reit and sponsor than with third parties.

Acquisitions will be funded through a mixture of equity and debt. Under Singapore's reit rules, a reit without a credit rating which includes First - can have maximum gearing of 35% (those with gearing are allowed to have up to 60%). First's current gearing is 16.5% and redevelopment costs for the Singapore cancer centre will raise this to 20%.

However, management aren't comfortable going as high as 35% and want a cushion, thus 25-30% is likely to be the upper limit. So First will be issuing new units to pay for most of the cost of its planned acquisitions. Investors should be aware of this and prepared to participate in future rights issues, assuming the terms are good enough.

A few risks to keep an eye on

As the sponsor, Lippo is the largest shareholder with a stake of just over 20%. The next largest shareholders are Penta Investment, which is a central European private equity fund, Raiffeisin Zentralbank Osterreich, an Austrian banking co-operative, and CIM Investment Management, a boutique value-based fund manager.

Although it looks as if the public float should be fairly large, in reality most of the shares are probably held by long-term investors and are not available. In practice, the free float is probably closer to around 20%. Average daily turnover in the past year has been 268,976 shares per day. The free float and liquidity should hopefully increase as a result of rights issues for acquisition, but even at these levels most Asia Investor readers should not have any trouble dealing in the shares.

Management-wise, First is managed by a small team of around 10. This includes experienced executives who have previous worked within Lippo's healthcare division and at Parkway, Singapore's largest healthcare company. To clarify, a reit's management is supposed to act in the interests of all shareholders, not just the sponsor. In reality, this depends on how professional the reit management are and how much influence other reit shareholders have. In this case, the signs are good but please see the risks section below.

In addition to the usual risks on Asia Investor recommendations, I'd stress the following specific ones for First:

The trust is heavily exposed to a single master lessee, Lippo's Siloam Hospitals for its Indonesia assets. While I think Lippo's healthcare prospects are good, if it were to hit trouble and struggle to meet its rental obligations, this would have a major impact on First. In addition, if Lippo were to decide not to renew its leases on expiry, First might struggle to find another suitable tenant (although given that these buildings are key to Lippo's healthcare plans, non-renewal seems unlikely).

First is also virtually a pure play on Indonesia and the growth of Indonesian healthcare. Obviously, this is one of the reasons I like it as an investment. But this means it could be vulnerable to economic or political problems there, or other factors that could disrupt the development of the industry such as terrorism or natural disasters. From a market point of view, the shares could be hit if the current positive sentiment on Indonesia reverses.

Lastly, First is obviously closed tied to Lippo and it has to be said that the words "Indonesian family conglomerate" and "honesty" do not always go together. And while Lippo has by no means the worst track record, if you look around you will find a few past controversies involving the Riadys. Personally, I would be disinclined to invest in one of Lippo's Indonesia-listed vehicles such as Lippo Karawaci or retailer Matahari.

However, First has a Singapore listing, a professional management team and directors, a clean structure, a majority of outside shareholders and seems to be important for funding Lippo's healthcare plans. All this argues against it being sold poor quality or overvalued assets. So I would expect everything to remain above board and I'm not greatly worried about this risk.

Earn 8.4% next year on prime property

With reits, the key number is the distribution per unit (DPU) ie the dividend which is based on the revenue it receives from property rental less property costs, administrative overheads and manager and trustee overheads. Earnings per share are often less meaningful, since they frequently included paper gains or losses on revaluing the property portfolio, which obvious does not represent cash available for distribution to unitholders.

Recent numbers and my estimates for First are shown in the table below. Because details of any deal are uncertain, the estimates do not factor in the likely acquisition of the MRCC and Lippo Cikarang, although I'll make an adjustment for this later on in the valuation.

The main valuation metrics for a reit are price/book value and distribution yield. Other than in a takeover situation, I would tend to regard price/book as not especially useful. For reference, First's price/book ratio is currently 0.98.

The distribution yield for the trailing twelve months is currently 8%. My estimates for 2011 suggest a yield of around 8.4% next year.

That's fairly attractive in this low-rate environment and I suspect that many investors are going to be assessing this investment on its yield alone. But it also holds out the potential for a respectable capital gain.

Valuations on Singaporean reits have risen markedly since the global crisis as one of the smallest reits, First Reit was trading at around a 20% yield at the height of the crisis. We're not going to get a yield squeeze as big as that again, but I think there's still room for some further rerating. First should benefit from investors' hunt for income, a higher profile and larger size following the likely acquisition and rights issue, and continuing investor enthusiasm for the Indonesia story.

Singapore's other healthcare reit, Parkway Reit, trades on a yield of around 5%. It's larger, better known and owns major properties in Singapore, so a premium to First is not surprising. But it seems likely that First will close the gap somewhat I think it could trade on a yield as low as 7% or so in a year.

Finally, there's also the likelihood of the yield getting quite a decent boost from the probable MRCC and Lippo Cikarang acquisition at a favourable valuation. Obviously, all this depends on factors like the price of the assets, the yield they offer, how much debt and equity are involved in the purchase and so on. But assuming a S$250m purchase price and a 9% net yield on the properties, I reckon that with the acquisition factored in and a rerating to around a 7% yield, First could be worth up to S$1.20 in a year's time.

With Asia Investor recommendations, I usually set a minimum hurdle of a potential 15% annualised capital gain. Based on this, I'm setting an initial buy limit for First of $1.04.

I should stress one final thing with regard to an investment like this. As mentioned, First will have to raise capital for acquisitions, which looks likely to be through a rights issue. Rights issues will almost invariably be carried out at a large discount to the prevailing price.

As and when any rights issues are carried out, I will recommend what course of action to take in Asia Investor. But as a general principle, you should be prepared to subscribe for these rights when the time arrives in order to avoid your investment being diluted.

Recommendation

Buy: First Real Estate Investment Trust

Ticker: FIRT (Bloomberg), FRET (Reuters), AW9U (SGX and many brokers)

Exchange: Singapore (main board)

Market cap: S$26 3m

Bid/mid/offer prices: $0.95/S$0.95 0/S$0.955

Buy limit: S$1.04

52-week low/high: S$0.7/S$0.97

First Reit is listed on the mainboard of the Singapore exchange and so will be eligible for an ISA if your provider allows foreign stocks to be held in one. As with most Singapore listed stocks, the standard lot size is 1,000 shares and most brokers will refuse orders that are not an exact multiple of this amount.

Yearly performance (since listed): 2006 +7.04%; 2007 +1.32%; 2008 -47.4%;

2009 +101.23%; 2010 +14.46% (to date)

Sources used in preparing this report:

Meeting with Victor Tan, CFO, First Reit, 15/10/10

Meeting with Ho Sun Yee, Director and Giri Subramaniam, Director of Strategic Planning, Siloam Hospitals Group, 13/10/10

First Reit annual reports 2007-2009

First Reit Q3 2010 results

First Reit Q3 2010 results presentation

First Reit IPO prospectus December 2006

First Reit press release 20/09/10

First Reit website

CIMB research report on First Reit dated 18/01/10

CIMB research report on First Reit dated 25/10/10

CLSA research report on Lippo Karawaci dated 20/10/10

OSK DMG research report on First Reit dated 24/05/10

Siloam Hospitals press release 12/05/2007

World Health Organisation Statistics 2010

(Singapore tickers vary between brokers. The three common ones are listed for each stock.)

Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Shares recommended in Asia Investor may be small company shares. These can be relatively illiquid and hard to trade and there can be a large bid/offer spread. So if you need to sell soon after you've bought, you might get back less than you paid. This can make them riskier than other investments. Some may be denominated in a currency other than sterling. The return from these may increase or decrease as a result of currency fluctuations. Always seek personal advice if you are unsure about the suitability of any investment. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Editors may have an interest in shares recommended.

Full details of our complaints procedure and terms & conditions can be found on our website, www.moneyweek.com.

Asia Investor is issued by MoneyWeek Ltd. Registered office 7th Floor, Sea Containers House, Upper Ground, London SE1 9JD. Customer services: 020 7633 3780. Registered in England and Wales No 04016750. VAT No GB629 7287 94. MoneyWeek Ltd is authorised and regulated by the Financial Services Authority. FSA No 509798. www.fsa.gov.uk/register/home.do

2010 MoneyWeek Ltd. All Rights Reserved. The content of this email may not be reproduced without the written consent of MoneyWeek Ltd. Registered Office: Sea Containers House, 7th Floor, 20 Upper Ground, London, SE1 9JD. Registered in England No. 04016750. VAT No. GB 629 7287 94.

How Asia's motorists could make you 60% in 2 years

Dear Subscriber,

Today, I want to show you the smart way to play the new Asian auto boom.

I'm not about to recommend you get directly into the treacherous car making industry, though. For me that business is full of potential pitfalls we're better off avoiding.

But there are some businesses that should benefit well from the growing demand for cars in Asia. And I've found a stock that could more than double your money over the next two to three years.

However, first, I'd just like to give you a quick heads-up on my plans for the next few weeks.

I'll be travelling in Asia in October and much of November. The plan is to catch up with a few companies we might well end up investing in. And also just to get a feel for what's happening on the ground in some of our favourite regions. There's going to be a lot to report back on.

But this will be the first time I've tried to write Asia Investor on the road. I'm not quite sure how it's going to work out.

I'll aim to send you each issue as normal, fortnightly on a Tuesday. But because of meetings and flights, it 's possible that the schedule will shift around a bit. It's as well that you know that in advance. Of course, I'll let the team back at HQ in London know. That way, they can keep up to date if I'm facing delays

I aim to travel a few times a year and I'm still working out how best to integrate Asia Investor around those trips. So please bear with me. As ever, if you have any feedback you can drop me a line on asiainvestor@moneyweek.com.

Now, let's get straight into our new recommendation.

The greatest car boom the world has seen

If you want one chart that sums up the difference between emerging markets and the developed world, I think this one from UBS is a pretty good choice. It shows what's happened to car sales in the developed world and the top 25 emerging economies of the global economy over the last few years and what a gulf there is.

To be fair, quite a lot of the incredible growth in emerging markets is down to China, as the next chart makes clearer. Helped by government subsidies, car sales there have been growing at a spectacular pace up 60% year-on-year in August.

But many other markets are also doing pretty well. August sales were up 33% year-on-year in India and 35% in Indonesia, for example. In short, unlike western countries, these markets are by no means saturated. So it's no wonder that so many investors get excited about the potential of hundreds of millions of new consumers being able to afford their own cars in the years and decades to come.

I don't doubt that we're going to see a multi-decade boom in car sales in emerging Asia. And this story fits very well into the Asia consumer theme that is the core of the Asia Investor portfolio. But I have three reservations about trying to cash in on it by investing directly in the automobile industry.

First, cars are the biggest of big-ticket items the second largest purchase most people will make after a house. This makes them highly discretionary and cyclical. Sales boom when times are good and plummet when they're not.

Discretionary items aren't always a bad investment. But carmaking is also capital intensive. And cyclical and capital intensive is a combination I prefer to avoid, except right at the bottom of the cycle.

Second, the auto industry doesn't have a great history of delivering value for shareholders. That's because competition is tough. Everyone remembers that Henry Ford made a fortune from the business. Fewer remember that the US auto industry featured hundreds of manufacturers back then, most of which went bust along the way.

And in this new great auto boom, the competitive situation seems even worse.

The American manufacturers lost a lot of ground to the leaner Japanese firms in the last few decades and at least firms like Toyota were focusing on making some money. Now everyone is betting on China and emerging markets. But these countries want their own national champions in the industry and margins may well take second place to prestige. So the demand may be there but the competition could be brutal and returns much worse than many expect.

Third, I'm unsure about the technological outlook. Quite a lot of money is now going into areas such as electric cars and hybrids, with China playing a major role. It's entirely possible that the car of a decade's time will have changed substantially from what we use today and manufacturers will have to invest a great deal in new technologies to survive.

Some investors would conclude that this is a reason to go into stocks like the Warren Buffett-backed BYD, which is developing an electric car. To me, this is not attractive. We're talking about another capital-intensive scramble to develop a new technology with no certainty about who will come out on top and who might be bankrupted.

So I'd prefer something less cyclical, less capital intensive, less political and with less tied up in any given technology, yet at the same time able to hitch a ride alongside Asia's newly motoring middle class. And that points to businesses such as car service chains or parts distributors.

There aren't many listed firms in this space in Asia yet, either in the retail or the wholesale segments of the market. But after some searching, I think I've turned one up and at a very reasonable valuation too. So let's take a look at Singapore's YHI International

Keeping the car story on the road

YHI is a much simpler business than some of the ones that have featured in Asia Investor, so this week's analysis is going to be unusually short. The firm distributes automotive products such as tyres, batteries and wheels in markets across Asia.

Most of these parts are made by third parties. But the firm has its own manufacturing operation for alloy wheels, with plants in Shanghai and Suzhou in China, Taoyuan in Taiwan and Sepang in Malaysia.

Sales are roughly equally divided between Northeast Asia (mostly China, Hong Kong and Taiwan), ASEAN (with Singapore and Malaysia being the largest markets) and Oceania & Others (which is Australia and New Zealand, although with a growing European business). Northeast Asian sales come mostly from the manufacturing division, while those elsewhere are mostly distribution.

YHI's sales and profits were not immune to the global recession But they held up fairly well, as the charts below show. In particular, profits in the distribution business were down just 6.25% from 2007 to 2009. Manufacturing suffered more, although profits began to rebound somewhat in 2009. And the firm now looks to be back on the growth track: First half results showed a 24% recovery in sales and a 32% rise in profits.

Overall, the group has managed a 12% compound annual growth rate in sales and a 19% rate in profits during 2000-2009. Generally, it seems to be a solid business in a good niche, covering a wide range of markets and not being over exposed to any single one.

One thing that particularly appeals to me is that the management appears to understand the importance of branding. As well as distributing leading brands like Pirelli and Hitachi, the firm is also trying to establish its own house marque in wheels (Advanti Racing), tyres (Neuton Tyres) and batteries (Neuton Power). Too many Asian firms in this kind of business focus on trying to maximise sales at low prices, ignoring the extra margin that can be eked out of distinguishing your product from the low-cost competition.

The main weakness of YHI recently has been falling margins. The net profit margin has fallen to 5.45% in 2009 from around 7% in 2006 and before. Its return on equity is similarly down from around 20% to 12%. This reflected higher raw material and other operating costs in manufacturing and some unfavourable foreign exchange movements, as well as investment in new capacity.

For this reason, the distribution business, with its greater stability, lower capital requirements and lower vulnerability to raw material costs, is always likely to be the more attractive side of the business to my mind.

However, there is considerable growth potential in the manufacturing side and margins should improve substantially as new capacity comes into use increases and productivity improves. So we should see margins pick up again in the next couple of years.

Overall, I would expect that YHI will be able to grow earnings at double digit rates for many years to come if it gets its strategy right, albeit with a bit of volatility in the manufacturing side of the business. On a current price/earnings ratio of 7.1 times last year's earnings, that strikes me as attractive. And if all goes well, I think it could make us 60%-120% over the next 2-3 years

A 60-year history, but little outside interest

YHI dates back to a tyre retailer set up in Singapore in 1948 by the father of chief executive Richard Tay Tian Hoe. From the 1970s onwards, the firm began securing import and distribution rights for major Japanese brands and expanding into distribution in other Asian markets. In 2003, the Tay family grouped together the different distribution and manufacturing businesses and floated the combined group on the Singapore stock exchange.

Tay and his family remain the group's largest shareholder, as the following table shows. Investing in a firm with a controlling shareholder carries certain risks, as I'll discuss in the following section.

YHI has a market cap of only around $160m. And it operates in a line of work that's about as unglamorous as it gets. So it's not attracting a lot of institutional interest these days. Having said that, Singaporean sovereign wealth fund Temasek was a shareholder for a while after the float.

The largest outside shareholder is the NT Asian Discovery fund, a small cap-focused value fund based in Bangkok. If you have an exceptional memory for details, you may recall that this fund is also the largest outside shareholder in Silverlake Axis, our banking software play. That's not too surprising: with a relatively limited number of funds focused on small and medium sized Asian firms, a handful of names tend to crop up a good deal among the stocks I look at for Asia Investor.

Unsurprisingly, liquidity is not high in this stock but I don't anticipate you should have trouble taking a reasonably sized position. Average daily volume over the past year has been just over 200,000 shares.

A few of the potential risks

In addition to the usual Asia Investor risk warnings I'd stress the following for YHI:

First, this is a family company, as are many firms in the portfolio. As I always say, there can be major advantages to investing in a well-run family business; with their personal wealth tied in the business, the family will hopefully take a long-term, prudent approach to managing the company.

However, the presence of a single controlling shareholder can lead to the minority shareholders being disadvantaged by related party transactions or restructurings that benefit the controlling interest rather than them. This is always a risk; however, thus far YHI shows no history of doing so. Indeed, it seems to have followed a policy of rewarding shareholders well through dividend payments since listing, as we'll see below.

Second, there are no enormous technical or regulatory barriers to entry in YHI's industry. Neither does the firm have the kind of powerful consumer brands that we see with firms such as Hsu Fu Chi. Its main strength is the experience, expertise, network and customer and supplier relationships that come with having been operating in its markets for many decades. These can be overcome by determined competitors, but their value shouldn't be underestimated.

Lastly, its manufacturing segment will be vulnerable to any rise in raw material costs in particular aluminium and upward pressure on wages. And with the firm focusing on increasing the amount of production that it does for car manufacturers (OEM business) as opposed to sales that go to retail outlets, sales will probably become somewhat more cyclical in the years ahead.

Good value on every measure

The table below shows recent results and my base case for the next two years: as you can see, YHI currently trades on a trailing price/earnings ratio of 7.1 for FY2009, and on 6.1 times my base case for FY2010. It also sports a fairly attractive dividend, on a trailing yield of 4.25%.

The balance sheet is pretty solid. Net debt to equity stood at 14% at end June, with a healthy current ratio of 1.9. In some respects, YHI looks like a classic value play, trading at below the value of its assets: the net asset value per share is S$0.34, putting it on a price/book ratio of 0.8 times.

The big disadvantage of a stock like YHI is that while I think it has good long-term earnings potential, it doesn't have many obvious catalysts for rerating. It's unlikely that the business will ever be high profile enough to be rewarded with a high Asia consumer' valuation like some of the stocks in the Asia Investor portfolio.

However, it traded on a trailing p/e in the 8-12 range for the three years before the global financial crisis. And I don't think it's a stretch to suggest that it might get into that territory again in a couple of years. Add that to the potential of some strong earnings growth, and I think this stock could deliver us a surprisingly good gain.

For my base case, I'm going to assume a p/e of around 8.5 times my FY2011E in two years time, or S$0.46. That would be a potential gain of around 67% on the current offer price. Discounting back at my minimum target rate of return of 15% a year gives a current buy limit of S$0.35. In a bullish scenario, I think we could see FY2011 EPS of around S$0.06 and a p/e back to 10, giving the potential for a 2-3 year gain of up 120%.

Recommendation

Buy: YHI International

Ticker: YHI (Bloomberg), YHII (Reuters), Y08 (SGX and many brokers)

Exchange: Singapore (mainboard)

Market cap: S$158m

Bid/mid/offer prices: S$0.27/S$0.27/S$0.275

Buy limit: S$0.35

52-week low/high: S$0.19/S$0.29

YHI is listed on the mainboard of the Singapore exchange and so will be eligible for an ISA if your provider allows foreign stocks to be held in one. As with most Singapore listed stocks, the standard lot size is 1,000 shares and most brokers will refuse orders that are not an exact multiple of this amount.

Five-year performance history: 2005 +11.72%; 2006 -4.94%; 2007 -6.49%; 2008 -51.39%; 2009 +34.29%; 2010 +14.89% (to date)

That's all from me this week. I'll be back in a couple of weeks, when I should be writing to you from Singapore and Jakarta. As ever, if you have any queries in the meantime, please email me on asiainvestor@moneyweek.com. You can also access the ASIA Investor archive on the MoneyWeek website by clicking here. The password for the next fortnight is Dollar

Regards,

Cris Sholto Heaton

ASIA Investor

(Singapore tickers vary between brokers. The three common ones are listed for each stock.)

Sources used in preparing this report:

Chart of the Day: Whoops - A Better Car Chart - UBS 30/06/10

The Auto Theory of Everything Revisited - UBS 03/09/10

China Aug car sales surprisingly robust, policy helps - Reuters.com 01/09/10

Car sales in India rise 33% to record on Nissan, Volkswagen's new models - Bloomberg.com 09/09/10

Indonesia's car sales up 35 pct in Aug frm yr ago - Reuters.com 24/09/10

YHI International annual reports 2003-2009

YHI International listing prospectus June 2003

YHI International second quarter earnings announcement 2010

Temasek Holdings to take up 6.16% stake in YHI International - SGX regulatory announcement 02/03/04

NTAsian Discovery Fund investments update July 2010

Data from Bloomberg

Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Shares recommended in Asia Investor may be small company shares. These can be relatively illiquid and hard to trade and there can be a large bid/offer spread. So if you need to sell soon after you've bought, you might get back less than you paid. This can make them riskier than other investments. Some may be denominated in a currency other than sterling. The return from these may increase or decrease as a result of currency fluctuations. Always seek personal advice if you are unsure about the suitability of any investment. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Editors may have an interest in shares recommended.

Full details of our complaints procedure and terms & conditions can be found on our website, www.moneyweek.com.

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2010 MoneyWeek Ltd. All Rights Reserved. The content of this email may not be reproduced without the written consent of MoneyWeek Ltd. Registered Office: Sea Containers House, 7th Floor, 20 Upper Ground, London, SE1 9JD. Registered in England No. 04016750. VAT No. GB 629 7287 94. MoneyWeek is a registered trade mark owned by MoneyWeek Limited.

I'd stress the following for YHI:First, this is a family company, as are many firms in the portfolio. As I always say, there can be major advantages to investing in a well-run family business; with their personal wealth tied in the business, the family will hopefully take a long-term, prudent approach to managing the company.However, the presence of a single controlling shareholder can lead to the minority shareholders being disadvantaged by related party transactions or restructurings that benefit the controlling interest rather than them. This is always a risk; however, thus far YHI shows no history of doing so. Indeed, it seems to have followed a policy of rewarding shareholders well through dividend payments since listing, as we'll see below.Second, there are no enormous technical or regulatory barriers to entry in YHI's industry. Neither does the firm have the kind of powerful consumer brands that we see with firms such as Hsu Fu Chi. Its main strength is the experience, expertise, network and customer and supplier relationships that come with having been operating in its markets for many decades. These can be overcome by determined competitors, but their value shouldn't be underestimated.Lastly, its manufacturing segment will be vulnerable to any rise in raw material costs in particular aluminium and upward pressure on wages. And with the firm focusing on increasing the amount of production that it does for car manufacturers (OEM business) as opposed to sales that go to retail outlets, sales will probably become somewhat more cyclical in the years ahead.

21st September 2010

Petra shouldn't underperform for long

Dear subscriber,

Welcome to this week's Asia Investor, which for a couple of reasons hasn't quite worked out the way I planned. First, I've been struggling to shake off an illness, which has cut down my working time. And secondly, my recommendation shortlist has been causing some unexpected problems.

You'll remember that I cancelled my planned recommendation last week because the stock I had lined up had moved above my buy limit. Unfortunately, the same happened to the alternative recommendation I was working on for this week.

I had another alternative in mind and I've almost completed a report on it but in finalising the details, I became concerned about something the management seemed to be glossing over: briefly, they appeared to be downplaying the potential importance of some recent problems in its business and more importantly not treating it as an event that needed to be notified to investors.

For this reason, at the very least I'd want to see how the business responds to this over the next couple of quarters. What's more it also raises potential governance and transparency issues, making me feel that the business should perhaps trade at a lower valuation to reflect this.

I'm not happy to have to delay my next recommendation twice. But I'd never consider recommending a company that I don't think represents good value or where I have unresolved concerns about its business purely to meet a deadline.

I'm working on a new stock that's looking very attractively valued at this stage, and I should have the full report with you next week. But in the meantime, there are a couple of status changes on two of our portfolio holdings. I've also had a couple of questions concerning Petra Foods that may be interesting to some of you, so now seems a good time to go over them.

Hold your 34% paper gain on Hsu Fu Chi

If you hold our Chinese confectionary play Hsu Fu Chi, you'll have noticed that the stock has moved to S$3.11, above my buy limit of S$2.85. That's a paper gain of 34% since we added it to the portfolio at the beginning of June.

I think this is a great company and a very strong long-term investment. It's certainly not time to sell. But as I discussed during its last results update, the question is whether it's time to raise the buy limit to reflect those strong results, or whether the stock may have got ahead of itself.

The difficulty is this. I believe Hsu Fu Chi has benefited from favourable commodity price movements over the last year and has seen its margins expand. It's not immediately clear whether it can defend these wider margins, or whether raw material costs and higher wages will bring them back down again.

Given Hsu Fu Chi's potential market and its strengths, I don't think the stock is too expensive. It currently trades on a trailing p/e of around 21, which seems reasonable. But there is some scope for disappointment and weaker earnings if margins shrink back.

Consequently, I want to see the next quarter's results and see how Hsu Fu Chi is responding to price pressures before I decide whether to increase my valuation. For now, the stock moves to a HOLD.

ICICI is a hold after 28% paper gains

The other big recent mover has been our Indian banking play, ICICI Bank. We're investing in this through the US-listed American Depository Receipts, which are now trading at $48.92, above my buy limit of $44.4. The ADRs have seen a price return of 28% since mid July. Almost all of this has been due to the rise in the underlying shares, rather than changes in the rupee-dollar exchange rate.

You might recall my argument for ICICI. After overreaching itself and incurring some bad loans during the boom, the bank is now getting back into shape and profitability should recover strongly in the next few years. But because earnings for the next year or so were likely to be sluggish compared with peers, the market is taking a short-term view and overlooking the enormous long-term potential of India's leading private-sector bank.

Investors now seem to be reassessing its prospects. The stock has been handily outperforming the Indian market in the last few weeks. But ICICI is now trading on a trailing p/e of 27, which I regard as fairly high for a cyclical such as a bank even one with such good growth prospects. As I said before, ICICI's earnings should pick up solidly in the next couple of years. But I'm not currently confident that they'll rise enough to deliver my minimum 15% target annual rate of return for new investments from this price level.

I'm happy to keep ICICI for the long-term at these levels. However, I think for new investments there are better value financials elsewhere. Investors may well have an opportunity to buy ICICI at a lower valuation in the future. It's certainly not highly valued enough to sell yet, but I'm moving it to a HOLD.

Petra chocolate shouldn't underperform for long

Finally, let's take a look at our cocoa and chocolate investment, Petra Foods. This is actually the worst performing stock in the portfolio so far and one of two that's in the red, down around 9% since I initially recommended it.

There's no obvious reason in terms of company news for its underperformance. The stock had a strong run-up before we bought it, and that momentum may simply have run out of steam for now.

But my suspicion is that the cocoa price may be playing a part. Petra is not a proxy for cocoa. It tries to pay on raw material prices in its consumer division, while its cocoa processing division sells capacity on cost-plus contracts and hedges the cocoa price. I've said that I think that it may be able to get slightly higher margins as bean prices rise, but the direct impact on earnings should be muted.

Nonetheless, the fact that it rose strongly as cocoa soared this summer and is now falling back as cocoa weakens makes me feel that some investors have been buying into the stock on the assumption that it's highly geared to higher prices and have sold out as prices declined.

I'd expect this weakness to be short-lived. Petra's trading on around 19 times my base case for the current year and 13 times my base case for next year. Given its very solid set of second half results, I think my estimates have a good chance of being conservative. So I continue to think Petra is a strong long-term prospect and it remains a BUY up to S$1.6.

Source Bloomberg

Five year performance: 2005 -+30.91% | 2006 +66.67% | 2007 -14.44% | 2008 -75.32% | 2009 +171.05%| 2010 + 26.67%

A closer look at the case for Petra

This a good opportunity to discuss a couple of questions about Petra that I've received from subscribers. Before I begin, let's quickly recap Petra's business.

As you may remember, the company has two divisions. The first is cocoa processing for third parties in Asia, Europe and Latin America. The other is the manufacturing, distribution and sale of its own and third party chocolate brands in Southeast Asia. On the branded goods side, it's the dominant player in Indonesia. Its strong brands and enviable distribution network make it an obvious partner for foreign firms entering the market.

Some readers have said that they like the look of the consumer business, but are not keen on the cocoa processing division, which has higher capital requirements and lower margins. So why does Petra stay in this line of business, and why is the stock attractive in comparison to pure branded goods plays such as Vitasoy and Hsu Fu Chi?

It's a very valid question and one that I have thought about in some depth. I've discussed some aspects of the question in past issues, but let me expand on them in more detail.

Firstly, as I mentioned in the original report, it's certainly Petra's branded goods operation that interests me. And it's true that firms such as Vitasoy and Hsu Fu Chi in the portfolio (and other names such as Tingyi and Want Want that I haven't included on valuation grounds) offer purer exposure to this EM consumer theme than Petra, since they lack a third-party processing division.

On the other hand, I think it's important to be diversified within themes. That means that I don't want all my consumer exposure to be to China. I'm striving to keep the portfolio balanced, as I discussed in the recent quarterly review.

I want Indonesia and SE Asia to feature in the portfolio and these markets are harder to access via stocks listed in Hong Kong, Singapore or the West. Consequently, I regard Petra as an attractive easy way to invest in Indonesia and SE Asia consumption for most investors.

That said, I wouldn't recommend it if I thought that the other side of the business was bad. I'm not going to chase diversification at the expense of quality. I view the processing division is a perfectly decent business with good prospects. It's just not as interesting as the consumer division and not of interest to me by itself.

It makes sense to ask whether Petra would be a better investment if it divested the processing arm and became a pure branded goods firm. It's a very logical question from a business strategy point of view. But in this case, I'm not sure that it would.

In particular, there are quality control issues attached to sourcing ingredients. The prospect of contamination or poor quality materials getting into the supply chain is one of the biggest brand risks for consumer companies. Given the lower quality assurance standards within many Asian markets, it makes sense Petra would want to keep control over its inputs.

To ensure their needs are met, consumer firms in the region often choose to integrate more than those in Europe or the US might. For example, Hsu Fu Chi's expansion plans include investing in a packaging plant to have better control over costs in that part of the supply chain.

Given that Petra has processing expertise in-house, it makes sense to capitalise on that expertise by being an outsourcer for firms like Nestl and Mars. These diversified groups have a much stronger argument for shedding their processing divisions. They operate in hundreds of categories and cocoa processing is much more of a niche to them than it is to a chocolate specialist like Petra.

That said, margins in cocoa processing are always going to be lower than in branded consumer goods. Capital requirements are greater. To see this simplistically, note that the cocoa ingredients division had assets of almost $770m as at end of June, while the branded consumer division had assets of around $205m. Yet both reported roughly the same operating profit. This includes both fixed capital requirements and higher working capital requirements. Inventories, which are mostly cocoa beans for processing, amounted to around $450m.

However, as an investor I don't mind this as long as I'm not overpaying for this side of the business. We can think about Petra as the sum of two parts. Let's assume that Petra's FY2011 earnings are split roughly fifty-fifty between processing and consumer. Then on my FY2011E base case, we are hypothetically paying 10 times next year's estimates for the relatively low-growth ingredients business, and around 16 times next year's estimates for a strong consumer business with much stronger long-term growth prospects. Both parts of this seem fair to me.

What we may need to be concerned about with firms with two different divisions is the different risk profile of each division's earnings. Volatile earnings are an issue with many capital-intensive processing businesses, which are exposed to commodity price movements, output price movements and abrupt changes in demand for your products. This can potentially leave you with an expensive new expanded plant and very weak sales as the economic cycle turns down.

This is very true of businesses like steelmaking, which is why I generally don't like investing in these industries. But cocoa is a little different. As I've mentioned, Petra operates a cost-plus business on committed contracts, while demand for chocolate is relatively though not totally defensive in recessions. So although this is a processing business, there isn't the same degree of earnings risk attached.

Of course, one other concern with processing businesses can be the debt used to fund its capital needs and in particular working capital for inventories, which in Petra's case are obviously very sensitive to cocoa prices and rose in response to higher prices. There is obviously a risk of a capital squeeze during a crisis.

That said, Petra's cocoa bean inventories are a highly liquid asset and purchased for committed contracts hence they are the kind of asset that banks are usually happy to provide trade finance for. And perhaps more tellingly, Petra made it through the global financial crisis, which is probably the biggest stress test we'll see for a long time.

So while the cocoa processing division doesn't have the combination of long-term, low-capex growth prospects combined with defensive demand that make consumer staples business so attractive, it doesn't have the kind of qualities that should give me sleepless nights either.

I certainly wouldn't pay as much for Petra's processing business as for the consumer goods. And I wouldn't be interested in it as a standalone business since it doesn't fit my strategy (other than at a very low price).

But I don't think the presence of the processing business detracts from Petra's merits. Given the strength of the consumer business and the exposure Petra offers to Indonesia and Southeast Asia, I think the stock is a valuable part of the Asia Investor portfolio.

That's all from me this week. Again, my apologies for the delay in bringing you a new recommendation and I'll be back next week with a new report. In the meantime, you can email me on asiainvestor@moneyweek.com if you have any questions.

Regards,

Cris Sholto Heaton

ASIA Investor

(Singapore tickers vary between brokers. The three common ones are listed for each stock.)

Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Shares recommended in Asia Investor may be small company shares. These can be relatively illiquid and hard to trade and there can be a large bid/offer spread. So if you need to sell soon after you've bought, you might get back less than you paid. This can make them riskier than other investments. Some may be denominated in a currency other than sterling. The return from these may increase or decrease as a result of currency fluctuations. Always seek personal advice if you are unsure about the suitability of any investment. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Editors may have an interest in shares recommended.

Full details of our complaints procedure and terms & conditions can be found on our website, www.moneyweek.com.

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2010 MoneyWeek Ltd. All Rights Reserved. The content of this email may not be reproduced without the written consent of MoneyWeek Ltd. Registered Office: Sea Containers House, 7th Floor, 20 Upper Ground, London, SE1 9JD. Registered in England No. 04016750. VAT No. GB 629 7287 94. MoneyWeek is a registered trade mark owned by MoneyWeek Limited.

This week I'll be reviewing the performance of the Asia Investor portfolio so far, picking apart the returns on our recommendations, and outlining where I plan to take the portfolio in the months ahead.

I intend to do portfolio reviews for Asia Investor roughly once a quarter, in a lot more detail than I can squeeze into a weekly portfolio table. I don't attach any signifwww.moneyweek.comicance to the actual quarterly performance, because in the short-term share price movements often have very little to do with company fundamentals.

But I would like to address exactly how my strategy for Asia Investor is developing. Today I'll explain why the portfolio is heavily weighted towards Singapore listed stocks. Why I think Southeast Asian stocks are seriously underappreciated. And I'll point to one very promising area that I am reviewing for my next recommendation.

In the second half of the letter, I'll be catching up on earnings and dividend announcements from Eredene, Silverlake Axis, Hsu Fu Chi, Petra Foods and ARA Asset Management.

But first, let's see where we are with the portfolio

The performance so far

Overall the Asian Investor portfolio is showing a total average return of 6.72% so far. The table below shows a breakdown of that return. In addition to the usual share price return, I'm including total returns both just including payments and also factoring in the effect of reinvesting those dividends in the shares.

Although we're mostly looking at growth businesses in Asia Investor, most recommendations pay a reasonable dividend. While the difference is small at the moment, over time dividend payments and the growth of the dividends should make up a major part of our returns.

I've added returns on the MSCJ Asia ex Japan index at the bottom of the table for comparison. I'm always cautious about benchmarking: obviously I don't aim to track an index and the kind of companies I'm recommending are often quite different from those in the AxJ. But this is an easily tradable index that invests in a broad range of Asian markets and companies; while I don't expect to outperform it in every quarter, the Asia Investor portfolio needs to do so over the long run to be worthwhile. So it's only fair to have it there for long-run comparisons.

(Data as at 27th August 2010.)

The portfolio is notionally doing slightly better than the MSCI Asia ex Japan, but it's much too soon to read anything in to that. And of course, buying individual shares will normally have incurred more costs than buying a single AxJ-tracking ETF.

Given that the portfolio has only been running for a short while, I'd rather focus on the structure of it and what we're working towards. First, the table below shows the breakdown of the portfolio by country of listing. You can see that half my recommendations so far are Singapore listed.

As we'll see when we look at where they actually do business, this isn't very meaningful, except perhaps for one thing. You'll see that we have a heavy bias towards Singapore listings. This isn't deliberate, but valuations in Singapore tend to be a bit lower than in many Asian markets for example, the trailing p/e on the Straits Times index is currently 11.75 versus 13.2 for the Hang Seng. Since we're looking for good value, I think the portfolio is likely to continue to have a high Singapore element.

But what about where our companies do business? I've tried to summarise that in the chart below, which shows revenue (or assets for firms like ARA) by country, as disclosed in each company's financial filings. Some always give a lot more detail than others, so much of the allocation is approximate.

Obviously revenue share doesn't always mean the same as profit share, but revenue disclosure is much more consistent among companies than profit disclosure. So this is the most practical way to approach it and should produce sensible answers in aggregate.

As you can see, we are roughly evenly split between Greater China, India and Southeast Asia in business terms. I'm aiming to keep it this way as much as possible, since my strategy views these as being the three distinctive legs of the long-run Asia story.

China and India obviously need no explanation, but I think the potential of Southeast Asia and in particular the potential that comes out of greater regional integration is still underappreciated. Silverlake Axis is an unorthodox example of a firm that could benefit from regional integration, as we'll see later in the news review.

When it comes to sectors, I'm focusing mainly on a handful of key themes, such as consumer goods and services, education, healthcare, financials and infrastructure/real estate.

The largest group so far is food and beverages. This is a deliberate decision, since I think food and beverages and other fast-moving consumer goods such as toiletries are one of the most promising sectors. Top consumer goods brands should have an unequalled ability to earn excess profits over the long run from the growing spending power of Asia's middle classes and we're aiming to end up holding at least a couple of future heavyweight names.

I will be adding more to all sectors in the future, but for now, I'm focusing on getting a couple more themes represented in the portfolio. In particular, we have no weighting in healthcare, which is a very promising area; I'm looking over a few candidates and that may well be my next recommendation.

Finally, let's take a look at valuations. The table below shows the price/earnings ratios for the last financial year, forecast p/e for the current financial year and the dividend yields covering the last 12 months. (I'm showing consensus earnings estimates rather than my own in this table, since this is what the market is looking at.)

(Data as at 27th August 2010.)

On a forecast p/e of 16.3, I don't think our portfolio is expensive given the growth potential in most of our stocks. But it is higher than the index average, which reflects the fact that investors are starting to recognise the potential of consumer sectors.

So far, I've avoided the most famous names in the Chinese consumer story such as noodle giant Tingyi and personal products manufacturer Hengan. I think they're good companies but I struggle to justify the high valuations they command (currently a p/e of around 35), which reflects both their high profile and the fact they are among the few Asian consumer plays that are large and liquid enough for big funds to take a meaningful position in. I'm hopeful that at some point we will get a chance to buy into them more cheaply; if we have a large market sell-off, they're right at the top of my list.

Our portfolio's trailing yield of 3.22% is higher than the index (and this includes Eredene which is currently not dividend-paying but should begin to deliver a very good income stream in the next 2-4 years). This includes some special dividends, which several of these firms pay frequently. The figures don't include dividends declared but yet to be paid, which I'll run through in the updates below.

Unlike Western firms, which tend to aim to increase dividends slightly each year, Asian firms typically aim to pay out roughly the same percentage of earnings each year. This makes dividends more volatile but should ensure they rise strongly if earnings do.

And now, let's take a look at recent news from some of our portfolio stocks

Eredene gets ready for next phase of expansion

Eredene Capital, our Indian infrastructure play, released its full-year results a few weeks ago. The details are shown in the table below, but at this stage are meaningless. The company is in the process of setting up its projects and most of the accounts reflect asset value changes rather than trading sales and profits.

Source: company reports

I caught up with chief executive Alastair King a couple of weeks ago for a detailed update on the company's progress. While there have been some delays and issues as you'd expect when trying to do work of this kind in an environment like India generally things seem to be going well, at least on the infrastructure side.

At the time we spoke, four projects were generating revenue: the MJ Logistic warehousing and distribution centre near Delhi, the Vichoor Container Freight Station (CFS) in Tamil Nadu, the Pipavav CFS in Gujarat and its new investment in a port services firm, Ocean Sparkle (of which more below). Two of these Vichoor and Ocean Sparkle are dividend-paying.

The Haldia logistics park in West Bengal and the Kalinganagar logistics park in Orissa should begin commercial operation soon. The Conware CFS near Chennai is scheduled to be operational by March 2011, while construction on its container terminal at Baroda in Gujarat should start by the same time.

The two non-core projects the Sribha IT office in Bangalore and the Matheran low-cost housing project near Mumbai have suffered bigger issues. Eredene has made its full investment into Sribha and construction is almost complete. However, its development partner and future anchor tenant is dragging its heels on fulfilling its further funding commitments; the company's owner is concerned about the cost of occupying this new office space at a time when his outsourcing business is weak, says King. Eredene's risks here should be limited, since it has a pledge over the partner's holding company and if he fails to meet his obligations, the firm can enforce that.

Eredene's intention is to offload this project within the next year or so. Because of the problems, the project has been heavily marked down: Eredene's total investment has been £2.1m, but it's carried on the balance sheet at £0.49m. However, King hopes to achieve a price closer to or even above cost.

The firm is also now looking to exit Matheran sooner rather later at a good profit. To recap, this is a potentially very large low-cost housing development in an area that has a severe shortage of blue-collar housing. It has plenty of potential, but is a legacy project from several years ago when Eredene was initially focused on real estate and many investors felt that it didn't fit into the company's revised ports and logistics strategy.

Construction is ongoing and the first families should be moving in relatively soon. However, progress has been slowed by a dispute with the former CEO of the subsidiary, who retains a stake in the business and has secured an injunction preventing the development using debt, obliging Eredene to fund construction from equity and sales deposits.

Previously, Eredene had considered spinning off the development in an IPO once it was large enough but now the plan is to sell the project as soon as the dispute is resolved to free up capital for new projects such as the Ennore port development (of which more below). King says that the firm has received a good offer for Matheran with the dispute in-situ and is confident of earning about the target rate of return on its £12.7m investment.

Overall, I see the decision to exit these two projects as a positive. While Matheran could have been a much larger project in the long run, it makes sense for Eredene to divest non-core developments. Apart from freeing up time and capital, it also makes the company appear more a more focused pure play on infrastructure to potential investors.

As I said before the firm was part of the winning consortium for a project to develop a 1.5m TEU/year container terminal at Ennore port at Tamil Nadu. This is a high-profile, credibility-building project for Eredene and it should also be a valuable complement to the Conware CFS nearby, since Eredene will be able to use to direct traffic towards Conware. The total investment will be up to £23m.

It also took an 8.2% stake for £7.3m in Ocean Sparkle, which operates 82 tugs and other service boats in 18 of India's ports. Despite the odd name, this looks a very solid business and Eredene believes it got a good price from the seller, a Swiss private equity fund that had to exit because it was reaching the end of its life.

This is by far India's largest private sector operator in its field (the next largest has 14 boats) and should have good growth potential in its own right, as well as the strategic value of providing Eredene with access to and information about other ports. King expects the firm to list in India before long it tried to do an IPO in 2008 before the bottom fell out of global markets.

The pipeline of potential deals is over £100m and Eredene will need to raise more capital to fund these, including funding for the Ennore development. Previously, the firm was considering raising money into external infrastructure funds that it will manage, but for at least some of the deals, it's now planning to incorporate these into the company.

This reflects the fact that the raising external funds from new investors is still difficult in this environment, while Eredene's major shareholders have said they would prefer to put new money directly into the company. The fact that Eredene now trades at a discount to net asset value of about 10% (compared to around 50% some time ago) means that the problem of destroying value for existing shareholders by raising money directly has gone away, while a larger Eredene should also hopefully see a higher profile and more liquidity in its shares.

The next round of fundraising is likely to take place within a year. It may aim to bring in a new shareholder with shipping associations to reinforce its credibility in the ports sector King says that it has a possible investor in mind.

Overall, things appear to be going well at Eredene. My initial valuation was very rough and ready, and I plan to refine it soon to take account of project progress and the changes to its strategy discussed above. For now, I'm confident that my buy limit of 22p remains an underestimate and I'm keeping it unchanged. (For comparison, the net asset value at end March was 23p and accountants tend to be very conservative in these situations.)

Eredene is not yet paying a dividend. I'd expect this to begin in a couple of years. Maintain BUY up to a limit of 22p.

Yearly change: (listed February 05) 2005 -24%; 2006 +3%; 2007 -29%; 2008 -29%; 2009 +12%; 2010 (to date) +23%

A very strong year from Hsu Fu Chi

Our Chinese confectionary investment turned in a very strong set of full-year results. Earnings of RMB0.76 were not only some way above my expectations for FY2010 (RMB0.68), but also well above my RMB0.69 base case for the now-current year and not far behind what I'd hoped for in FY2012.

It's especially encouraging that the company turned a fourth-quarter profit of RMB27.5m, against a small loss in the same period last year. That's notable because Hsu Fu Chi has always been heavily dependent on sales earned at Chinese New Year and the last quarter has then recorded a loss as sales drop off.

You can clearly see this pattern on the chart below, which shows the contribution of the first three, six and nine months' profits to the full-year profit. This year, for the first time since listing, the final quarter made a positive contribution.

That may partly reflect a slightly later-than-usual Chinese year, pushing back the peak season a bit. But I think it also reflects the firm's progress in trying to increase snack sales outside its traditional peak season; as I mentioned in my initial analysis, higher year round sales and capacity utilisation should have a real impact on its profitability.

The firm continues to expand its distribution network, with sales offices rising from 97 to 110 over the year. Remember that Hsu Fu Chi is the leader in its segment but only has a market share of around 6%; there's enormous potential for long-run growth as it uses this national reach to take market share from other firms.

Clearly there's a very good case for upping my FY2011 base case and looking at my buy limit again. However, Hsu Fu Chi has benefited from some favourable commodity price movements in the past year, while it's now guiding that it "faces challenges of increasing raw materials cost and employees' salaries in the coming year", so margins which gave expanded recently - may come under pressure.

I think it's likely that it will be able to pass these added costs on and maintain or increase its current level of profits. But to be conservative, it makes sense to see what happens over the next quarter before adjusting any numbers and perhaps increasing my valuation.

Hsu Fu Chi declared a regular dividend of RMB0.38 and a special dividend of RMB0.37 (against a regular dividend of RMB0.29 last year). That amounts to around 15 Singapore cents or a yield of 5.4% on the current share price. In this case, I don't have any reason to expect the special dividend to be repeated, so we're looking at a recurrent payout of around 2.6%. Maintain BUY up to a limit of $2.85

Yearly change: 2005 -31%; 2006 +165%; 2007 -18%; 2008 -85%; 2009 +261%; 2010 (to date) +13%

A big contract win for Silverlake

Full year results at Silverlake Axis, the banking software systems developer, were more mixed. EPS of 3.02 sen was broadly in line with my base case, but I had hoped this would prove pessimistic and that sales would have picked up more strongly in the final quarter.

Digging into the detail, the core business seems to have done slightly better than headline suggests. For example, around RM6.1m of losses were contributed by its share of associate e-Petrol Silverswitch; this is part of a Malaysian start-up that aims to tie a cashless payment system to the national identity card. My instinct is that this company is not going anywhere, but there's nothing riding on it; Silverlake acquired a stake in 2008 in return for licensing some software to it.

Meanwhile, the Japanese credit-card processing business is now a full subsidiary after Silverlake bought out its partner late last year. This division has plenty of potential and seems to be going in the right direction, but is still in its early stages and loss-making, which depressed reported profits compared to a year ago (since its full results weren't consolidated into Silverlake's while it was just an associate).

Nonetheless, there was little to catch the eye overall, with perhaps the most important number being the breakthrough in SIBS licensing revenue in the last quarter. SIBS is Silverlake's core banking system and the cornerstone of the company. Licensing revenues tend to be lumpy from quarter to quarter, but were rising strongly before the global crisis hit, as the chart below shows. Since then, SIBS revenue has been almost non-existent, so it was encouraging to see sales coming through again.

But the big news on this came out just after the results. Silverlake has been hinting for a couple of quarters about "a major core banking software upgrade by a large Southeast Asian bank". This always sounded like its existing client CIMB, Malaysia's second-largest bank and the fifth largest from Southeast Asia, and we finally got confirmation of that last week.

Silverlake is to provide the core banking system for a new IT system that will tie together CIMB's operations across the region, which currently include major subsidiaries in Indonesia, Malaysia, Singapore and Thailand. You may remember from my initial report that banking consolidation in Southeast Asia and the resulting IT investment needs is one of the key reasons I think Silverlake's business is attractive, so this is a very good win on a contract that reportedly had plenty of interest from other providers.

Details are confidential, but CIMB's overall investment programme is on the order of RM2.1bn over the next five years, while the banking platform that Silverlake's software will help to power will be cost around RM1.1bn in total. CIMB's CEO said that the deals signed so far with the four key suppliers Silverlake, Accenture, IDS Scheer and IBM signed last week account for around 40% of that RM1.1bn.

Silverlake says it's also in advance discussions on further SIBS licensing deals, has signed a strategic relationship with Chinese conglomerate HNA Group and recently agreed to collaborate with Hitachi Information Systems to provide software development and outsourcing services in Japan. So I remain confident that business is poised to pick up and I'm keeping my estimates for next year unchanged.

The company declared a regular final dividend of 0.6 Sinapore cents and a special dividend of 0.5 cents, following an interim dividend of 0.5 cents and an earlier special dividend of 0.1 cents, taking the total payout for the year to 1.7 cents (against 0.6 cents the previous year) and giving a full-year yield of 4.7%. Although the special dividends were a one-off to pay out excess cash following the group restructuring earlier this year, Silverlake's pre-crisis dividend policy makes me think we'll receive a similar-sized regular payout next year if earnings are as solid as I hope. Maintain BUY up to a limit of S$0.4.

Yearly change: (listed November 06) 2006 +35%; 2007 -6%; 2008 -21%; 2009 +153%; 2010 (to date) +26%

Stronger margins at Petra Foods

We also had a couple of half-year results, which are worth reviewing quickly. Chocolate and cocoa specialist Petra Foods reported strong first-half EPS of 3.32 US cents. In particular, profitability in its cocoa processing division was better than my base case, with an six-month average Ebitda/ton margin of US$198, up from US$156 at the first quarter. This suggests that the newly upgraded European plant is making quicker progress than expected.

Meanwhile, the branded consumer products division saw sales in Indonesia and other regional markets up 31% year-on-year in US dollar terms and 13% in local currency terms. Gross margins expanding by 1.9 percentage points. Since it's the consumer aspect of Petra that we're interested in, I regard this as more significant.

There's no strong seasonality to Petra's earnings, so this suggests the firm is well on target to beat my EPS base case of 5.3 US cents for this year. But it's worth being cautious given the recent volatility in cocoa prices.

The processing division operates on a cost-plus basis and hedges cocoa prices to minimise the impact on margins from cocoa volatility; hence there's no close relationship between prices and margins, as the chart of margins for the Asia and Latin America plants below shows.

But at the same time, cost-plus businesses can sometimes get a boost from higher prices by raising their own fees in line with the higher materials (ie, their rates are less flat-fee' and more percentage of costs'). This extent of this depends on the industry and their processors' pricing power and I don't know enough about cocoa processing to have much idea if that's going on here but it strikes me as possible. In which case, the fact that cocoa prices are showing signs of weakening suggests that Petra's high margins could come back a bit later in the year.

So I think Petra's earnings outlook may well be stronger than my base case, but I'm not rushing to raise my target. That's especially because it's the consumer division that we're really interested in and I don't want to be tempted to overpay on the basis of extra strength in the processing division, which is not central to my investment case.

The interim dividend was 1.6 cents, up from 1.48 cents the previous year. Including the previous final dividend of 1.43 cents, Petra is now on a trailing yield of 2.1%. Maintain BUY up to a limit of S$1.6.

Yearly change: 2005 +31%; 2006 +67%; 2007 -14%; 2008 -75%; 2009 +171%; 2010 (to date) +36%

Slow and steady at ARA

ARA Asset Management, which is our proxy for the potential of the investment management industry in Asia, turned in first half results of 3.59 Singapore cents, putting it in line to match or just beat my base case for this year.

There was little dramatic in the results, but there rarely is with ARA. The Asia Dragon Fund (ADF), its main private fund, is now around 70% invested. Management guided elsewhere that ADFII should launch in the next few months with a target of raising US$1bn in assets under management.

The company has also taken a stake in APN Property Group, an Australian fund manager with A$2.6bn in assets under management. This investment should have substantial strategic value, giving ARA a partner in the Australian real estate funds sector, which includes the second-largest real estate investment trust market in the world, after the US.

ARA declared an interim dividend of 2.3 Sinapore cents, in line with last year. Including the previous final dividend, ARA is on a trailing yield of 3.9%. Maintain BUY up to a limit of S$1.35.

Yearly change: (listed November 2007) 2007 -14%; 2008 -63%; 2009 +138%; 2010 (to date) +57%

Finally before I go, an important risk warning

I've had a few questions from readers about how much they should invest in Asia Investor shares. Unfortunately, I can't give you any guidance on this because under UK investment regulations I'm not allowed to give individual financial advice.

I can't even suggest a minimum amount that would be reasonable given the dealing costs you will incur, because the appropriate minimum investment doesn't only depend on costs but also on the amount that you can safely afford to invest (and potentially lose) in higher-risk investments of this type. This can only be determined from detailed knowledge of your financial circumstances and constitutes individual advice.

So if you have any doubts about whether shares like those in Asia Investor are suitable for you and how much you should invest in them, I very strongly recommend that you consult an independent financial adviser (IFA). For UK readers, you can search for a local IFA through this website: https://www.unbiased.co.uk/

Please also make sure that you have read the general Asia Investor risk warnings document here {link} and that you fully read and understand each recommendation (including the specific risk warnings for each stock) before taking the decision to invest.

While I obviously believe that the Asia Investor portfolio will produce profitable returns over the long term, there is no guarantee of this. Furthermore, it is almost certain that we will lose money on some recommendations. And please remember that Asia Investor recommendations are only intended to be held as part of the higher-risk portion of a balanced portfolio that contains other, less risky assets.

That's all from me this week. I'll be back in a fortnight with a new recommendation, but until you email me on asiainvestor@moneyweek.com.

Regards,

Cris Sholto Heaton

ASIA Investor

(Singapore tickers vary between brokers. The three common ones are listed for each stock.)

Sources used in preparing this report: Eredene Capital annual report 2010

Eredene Capital full-year results presentation 2010

Interview with Alastair King, chief executive, Eredene Capital

Silverlake Axis full-year results 2010

Silverlake Axis announcement 10th August 2010Silverlake Axis announcement 9th July 2010

"CIMB invests in RM2.1b banking platform system" Malaysian Star,

24th August 2010

CIMB Group press release 23rd August 2010

Hsu Fu Chi full-year results 2010

Petra Foods half-year results 2010

Petra Foods first-quarter results presentation 2010ARA Asset Management half-year results 2010

ARA Asset Management announcement 22nd July 2010

Research report by DBS 13th August 2010

Historical price and company data from Bloomberg

Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Shares recommended in Asia Investor may be small company shares. These can be relatively illiquid and hard to trade and there can be a large bid/offer spread. So if you need to sell soon after you've bought, you might get back less than you paid. This can make them riskier than other investments. Some may be denominated in a currency other than sterling. The return from these may increase or decrease as a result of currency fluctuations. Always seek personal advice if you are unsure about the suitability of any investment. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Editors may have an interest in shares recommended.

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If you want your country to keep getting richer, education matters. Otherwise you're doomed to stay a low-cost source of labour. China understands this and it's investing heavily in the sector. It's written in law that government education spending must grow faster than tax revenue.

But individuals know this too and they're dipping into their own pockets. Enrolment into mostly private vocational training courses is growing at 5% a year, even as demographics top out and entrance to state universities declines.

So it's no surprise that Chinese education is already a popular idea with investors. US-listed New Oriental Education is the long-time darling of the sector, trading on a price/earnings ratio of 48 times.

And right now this sector appeals to me as well. I like its combination of solid growth and defensive trends. People rarely cut back on it during downturns because it's an investment in their or their children's future. Indeed, in the West, adult education spending often goes up when the economy turns down, because people believe that new skills will help them find a better job.

But you don't have to pay 48 times play this sector. In fact I've found an emerging publishing powerhouse that looks deeply undervalued one that I think could treble your return over the next five years.

How to avoid the lunatics in this cut throat industry

I've been an English language teacher and I know from experience that this is a highly competitive business with low barriers to entry. Worse, it seems to attract a striking number of lunatics who lack the business sense to realise that constantly undercutting each other on price is not the way to make money in the long run.

I would be happy to add a schools network to the portfolio but it has to be at a low, low price. I'm currently doing research on one elsewhere in Asia. I met the chairman a couple of weeks ago and was impressed by their operation and plans. The only disadvantage is that it's tiny it would be by a long way the smallest firm to feature in Asia Investor. I'll report back to you on that when I've finished my review.

But in the meantime, my China education play is going to go in a slightly different direction. As you'll probably know if you had to buy educational books or teaching materials recently, they can be pretty expensive. And while they're certainly not free to make specialist authors need to be paid successful book series can deliver pretty good margins.

This is a business that can reward scale. Big education, training and publishing groups like Pearson have strong market positions, defensive earnings and limited capital reinvestment needs, meaning sizeable dividend payments to shareholders.

That strikes me as much more attractive prospect that New Oriental Education on 48 times earnings. So I went looking for a potential future Pearson of China. And I think I've found one, thanks to some very helpful policies from the Chinese government.

The gold underneath all the cryptic Chinese jargon

Sichuan Xinhua Winshare Chainstore isn't good at explaining to outsiders exactly what it does. The annual report seems to have been written by career bureaucrats and translated with crushing literalness.

A quick skim will tell you that it has four main businesses, named in full "Product", "Retailing", "Subscription" and "Zhongpan". Delve into the management discussion and you'll be brought up short by enlightening sentences like "the overall strength of the publishing industry was further enhanced by the publishing system reform entering into a new stage of open diversification and intense vertical dissemination".

So it's no surprise that investors haven't paid that much attention to this firm. It took me two days of research to get a solid grip on exactly what it does. And I'll admit that the only reason why I was prepared to put in the time was because I noticed that three very different but independent-minded and credible groups of investors hold or have held shares in it, so I knew there must be something interesting underneath it all.

So what does Winshare (as I'll call it from now on) do? In a nutshell, it publishes, distributes and sells books, with a particular focus on the education market in its home province of Sichuan. But in the long run, it stands a good chance of becoming a lot more than that. To understand why, we need to look at what these cryptically named divisions do.

"Product" refers to its publishing division. Technically speaking, the firm doesn't have full rights to be a publisher so it does this through "co-operative" agreements with other firms that have the necessary permissions. This is why the division is so vaguely named but this restriction should be changing soon.

"Retailing" refers to its chain of 191 bookstores through Sichuan under the Xinhua Bookstore, Wen Xuan and Times Xinhua brands, plus one in the city of Xi'an and one in Chongqing municipality.

This is the least attractive major division to me, partly because there are better retail stories in China I'm doing some research on the food and convenience store sector at the moment and hope to have a recommendation for you there. But more importantly, the management of this division is (or was) pretty poor at their job. Historically, the division has been breaking even at best and is currently loss-making when all overheads are factored in.

"Subscription" refers to the distribution of educational materials. And this is where the lights really start to come on, since the core of this is a cosy monopoly. Winshare has the exclusive distribution rights for textbooks for primary and lower secondary schools in its home province of Sichuan, which are almost entirely subsidised and paid for by the government, meaning a very dependable income stream.

It also has the exclusive rights to distribute the non-subsidised textbooks for upper secondary and vocational schools. And on the back of this relationship with schools, it has a very strong (but non-exclusive) position in the market for supplementary educational materials.

Finally, "Zhongpan" is the distribution business for its own products and increasingly for those of other publishers. The company is aiming to build a nationwide distribution network to act as the middleman between China's hundreds of publishers and retail outlets and other customers.

The charts below breaks down revenue and profit by division. Revenue allocation in this kind of vertical business is probably rather arbitrary - and in this case, I suspect driven by tax breaks on some divisions. But you can see clearly that education supplies is the dominant part of the company.

This should continue to be a very solid cash-generating core business. However, it's those smaller publishing and distribution businesses that make the firm's growth prospects so interesting.

But to understand why, you need to understand the Chinese government's stated goal of revitalising and reforming the "cultural sector". Contrary to what you might think, this does not mean liberalising publishing rules and trying to increase competition. In fact, it's quite the reverse.

Winshare could become China's Pearson

Publishing and distribution is obviously a politically sensitive area in a country that has extensive censorship and thus China wants its national interests to be protected. So while policymakers are forcing state bodies to become commercially orientated and encouraging private investment, the goal is not to end up with lots of small competing firms. Indeed the industry is already very fragmented. Rather, the aim is to establish a handful of larger, more powerful firms that have the clout to protect Chinese cultural interests.

Conceptually, it's perhaps a little like continental European governments' efforts to protect their local cultural industries from a perceived glut of English-language output. Except this is on a much bigger scale. The Chinese publishing industry is already estimated to be the largest in the world, and growing affluence (and literacy) should see it continue to grow.

So, Chinese publishing and distribution businesses are being pushed to merge into a handful of much larger integrated publishing groups that span different areas of the industry, and go across province borders. Within the next five years, China hopes to have a handful of firms with sales of at least Rmb10bn each. That's around three times current sales at Winshare, which is in turn already one of the largest of the publishing groups.

Given its current size and clear plans for expansion, Winshare stands a good chance of being one of the winners from this process and evolving into a major nationwide publishing and media firm. There are three main parts to its strategy:

First, it's going to become a full publishing business. It recently announced a long-in-the-offing deal to acquire a group of 15 publishing companies from a company owned by the provincial government (which is also ultimately Winshare's controlling shareholder). This will bring the right to publish in-house and remove the need for co-operative deals. The price tag for this business is RMB1.255m, which amounts to 11 times 2009 earnings. That looks a pretty favourable price.

Second, it's expanding the Zhongpan network nationwide, acting as a middleman distributor between China's hundreds of small and medium-sized publishers and retail chains and other buyers around the country. With the industry still relatively fragmented, I think it's clear that a firm that builds a nationwide distribution chain could end up in a very powerful position, given the economies of scale that it could offer publishers and retailers.

Winshare doesn't divulge much about the growth size of its network in company filings, but I gather that it now has regional offices in 24 provinces, covering 397 cities (60% of its target) and serving around 2,000 bookstores (for context, I believe there are something in the region of 10,000 bookstores in China). However, it breaks out investment in each division and it's clearly investing seriously in this; last year, capex for Zhongpan amounted to RMB165m or 70% of total capex.

Third, it intends to sell its supplementary education materials outside Sichuan. It can't market textbooks in other provinces because the exclusive rights for that are held by other provincial firms. But there are no such restrictions on other materials. As I understand it, the company goal is to become the leading publisher and distributor of these types of products nationwide. In principle, this goal should combine well with its new in-house publishing division and the development of the nationwide distribution network.

Importantly, expanding the unsuccessful retail business is not part of the plan. Originally, it planned to use some of the proceeds raised in its IPO to expand outside Sichuan. But the continuing poor performance of the chain has meant that this plan has seems to have been quietly dropped in favour of a much more sensible focus on publishing and distribution.

So to recap briefly, what I like about Winshare is the fact that it has a lucrative local education monopoly with nationwide growth potential in both education and other publishing thanks to government policy. It seems quite possible to me that within five years or so, it could be three times larger than it is today.

Crucially, I think the nature of this "cultural reform" is not a concept yet really grasped by the market. Once the outcome becomes clear i.e. bigger profits for a select few Winshare could see more investor interest and a higher valuation. So this makes it an interesting long-term play, both on education and the wider publishing business.

What's more, the publishing acquisition is using cash from its IPO in 2007 that's currently just earning a very low rate of interest in the bank. As we'll see later, adding this into the business on favourable terms should lead to a substantial jump in earnings next year, which I don't believe the market is yet pricing in. So we could be looking at a potential gain of around 40% within the next year, regardless of the longer term.

A complex history with many stakeholders

The history of Winshare is almost as complicated as its business. The firm is part of China's extensive Xinhua Bookstore network, which you can see all over the country. In case you're wondering, this has nothing to do with China's well-known Xinhua News Agency. In fact, the term Xinhua is present in quite a few unrelated business names it's rarely that anyone bothers to translate it but it means "new China", which refers to communist China.

The first Xinhua Bookstore was set up by Mao in 1937 and was ultimately expanded into a nationwide network that controlled most of the distribution and retail of printed materials in China. At one point, the entire network was controlled by a head office in Beijing, but after Deng Xiaoping took power in 1978, control of each province's network was delegated to the provincial government. However, all regions continued using the same national brand.

So Winshare controls the network for Sichuan. Its controlling shareholder is Sichuan Xinhua Publishing Group, which is ultimately owned by the State-owned Assets and Supervision Commission of Sichuan, part of the Sichuan provincial government. Thus it is a state-owned firm, which carries risks that I'll discuss below.

The company floated on the Hong Kong stock exchange in 2007, listing around 39% of its total capital as H shares. (If you're not familiar with different types of Chinese shares, H shares are the Hong Kong listed shares of companies incorporated in the mainland.) The remainder is held as non-tradeable shares by various state shareholders and by Chengdu Hua Sheng, a company controlled by one of Winshare's directors.

Notable major H share investors include the National Council Social Security Fund, one of China's state pension funds, and Atlantis Investment Management. The latter is an Asia-specialist fund group whose China funds are managed by the highly regarded Yang Liu, who I know scrutinises companies in great detail before investing. These two account for 9.09% and 4.84% of the H share float respectively.

Ideally, I like to see a well-known independent director or representative of a major investor on the board when investing in little-known companies. We don't really have that comfort here, but one of the independent directors is an experienced Hong Kong accountant who serves on a number of boards, including BYD Electronic and cement maker Anhui Conch.

The freefloat is around 30% per day, while liquidity is good at an average of 2.2 million shares traded per day over the last year.

Some risks to consider

In addition to the usual Asia Investor risks, I'd emphasise the following:

Winshare is a state-owned firm. As always with any company that has a controlling shareholder, the interests of minority investors may divulge from those of the one that can call the shots. In particular with state firms, national or provincial interests may take precedence over making a profit. My feeling is that this is unlikely in this case since the national interest is to create large, profitable publishing groups, but it's not impossible.

Even if the interests of investors and the firm are aligned, there is an increased risk of poor execution with a state-controlled firm. Many of the staff and management will have spent all of their careers in a state-directed business environment and may not be good at dealing with more market-orientated strategy.

That said, in Winshare's case, some senior executives were reshuffled in 2008 and the director responsible for the underperforming retail division turfed out. I regard this as a promising sign that the state-owned parent company will push management to deliver commercial results (as many of the better state-owned enterprises are now doing in China).

There are also political risks. We're investing in a story that's ultimately driven by China's desire to have a handful of large publishing groups. It's possible that this objective will change and it's also possible that even if it doesn't, policymakers might want the eventual winners in this process to be firms other than Winshare. However, at present, there is no sign of this.

On the political front, you should also be aware that were Winshare to lose its exclusive distribution rights within Sichuan, it would have a very serious impact on its prospects, since this monopoly is at the heart of its business encouraging. This is possible, although I consider it unlikely.

I understand that the Xinhua Bookstore chains have always had this role in each province due to their wide distribution networks and have no obvious rivals. In addition, the fact that Winshare is backed by the same provincial government that grants this contract argues against local politicians undermining what could become a flagship local company.

Winshare benefits from tax breaks granted to key companies in the cultural sector and consequently pays little VAT or corporate tax. The VAT break has been extended every year so far, while the corporate tax breaks are supposedly assured until at least 2013. It seems very likely to me that the government will continue to offer these tax advantages as it tries to push cultural sector reform. However, were these to be withdrawn there would certainly be a substantial impact on Winshare's profits.

Finally, there are higher-than-usual information risks when it comes to shareholders being certain what is going on. Winshare is Hong Kong listed and subject to the usual disclosure rules for companies on this exchange. The consolidated accounts are audited by Ernst & Young.

Nonetheless, this is a mainland company as distinct from one run by a Hong Kong or Taiwanese entrepreneur. As a rule of thumb, this increases the risk of hidden fraud or incompetence, since mainland China does not have such long-standing capital markets or culture of corporate governance.

In particular, mainland firms both state-owned and private tend to have a weakness for speculating in property or the stock market or making unfocused investments. In this case, there are a couple of non-core holdings one equity and one real estate - that I'll look at below. These date from 2007, should both ultimately be profitable investments and there seems to be no indication that management is going further in this direction.

Winshare's status under provincial government control and relatively high profile actually makes me more comfortable than I might be with a business set up by an entrepreneur. Close state oversight can have some benefits in keeping managers honest if the state wants a good quality flagship listed company. And there is a clear long-term strategy with obvious provincial government support, which reduces the risk of management going off the rails strategically.

However, you should be fully aware of the distinctions between this firm and our other China investments so far such as Vitasoy and Hsu Fu Chi. Although I see no evidence so far, I am obliged to stress that the potential for hidden mismanagement is greater. However, I believe that given the company's potential, the current valuation compensates us for these risks.

The five year outlook says earnings could double or better

The last three years' results and my estimates are shown in the table below. Note that the 2007 profit was inflated by the timing of tax rebates - due to a change in the tax rules, effectively the company got two years' worth of VAT concessions within the same year.

So the firm currently trades on a p/e of around 11.7 times last years earnings and around 10.7 times my estimate for the current year (based on the current Hong Kong dollar/renminbi exchange rate of 1.14).

Last year it paid a final dividend of RMB0.08 and a special dividend of RMB0.2, putting it on a trailing yield of 7.5%. The firm also paid a special dividend of RMB0.21 in 2007 and RMB0.12 in 2008 on top of the regular dividend. There's no guarantee, but healthy cashflow and large cash reserves suggest that large payouts should continue for now.

The firm had RMB2.5bn in cash and term deposits as at end December. After completing the publishing purchase and allowing for other small commitments, I'd estimate that it has around RMB1.1bn on hand, giving it plenty of scope for further investments. Key balance sheet measures look solid; as at end December, it had no long-term debt, while the current ratio - liquid assets divided by short-term liabilities - stood at 2.22.

In addition to its core business, the firm has a number of other assets. The first is the remaining cash mentioned. This should hopefully be channelled into other earnings-boosting investments in the near future, including a planned RMB420bn investment in new logistics centre. In the meantime, based on my estimate of remaining cash, it amounts to around RMB0.97/share (HK$1.10).

There are also a few non-operating assets. Winshare owns a 6.85% stake in another large publishing and distribution firm, Anhui Xinhua Media, which listed on the Shanghai stock exchange in January this year. On current valuations, that's worth around RMB0.73 (HK$0.84) per share although to me the stock looks overvalued and I might estimate a fundamental value at half that.

Anhui Xinhua makes sense as a strategic investment, but there's less rationale behind a 2.46% stake in the unlisted Bank of Chengdu one of the two non-core holdings I mentioned earlier. This was purchased for RMB240m in 2007 when the bank was raising capital; other investors include Malaysia's Hong Leong Bank and a large Chinese private equity group. It's not clear when this bank might float, but I'd estimate that Winshare's stake might be worth twice or more what it paid for it perhaps about HK$0.5 per share.

Finally, when the company was prepared for listing, its parent injected a 62.5% stake in a prime patch of land in the centre of Chengdu into the business. This is quite common with Chinese privatisations and the land should be worth far more than it's currently carried at on the books. Winshare plans to work with its parent (which holds the remaining 37.5%) to develop this into a large commercial, retail and residential complex.

Frankly, I prefer to see my publishers stick to publishing rather than getting involved in real estate, but it's rare to find a firm in mainland China that has no real estate assets. And in this case, given the way that the site was handed to Winshare, it should be profitable regardless of the state of the property market. I'm not in any position to value this, but I've seen estimates (from 2008) of HK$1-2/share, depending on how it's developed.

However, I'm not factoring any of these assets into my valuation, because I regard looking for hidden value as a risky game unless there's a real prospect of activist investor getting control of the firm to unlock it which isn't possible here due to Winshare's state-owned parent. In theory, these assets could give considerable further upside, but we don't know if management will handle these in way that delivers real benefits to shareholders. So I'm focusing purely on the operating, dividend-paying business and regarding anything else as a bonus.

In my view, the enlarged Winshare group should trade on a p/e of around 12 times estimated earnings by mid 2011 as effect of the publishing deal becomes obvious. On my estimates for FY2011E, that points to a price of around HK$5.7. Including a likely dividend payout of around 7.5%, this suggests a potential one-year return of around 40% on the current price, which is attractive. I'm setting the buy limit as HK$5, based on my usual 15% a year minimum target return on the share price.

I'm taking an unusually short-term view on this firm, because I want to see evidence that its strategy is developing beyond the immediate earnings boost from the publishing deal. But in terms of long-term potential if industry consolidation goes well, I think earnings could double or triple over five years and the stock would be likely to get a sizeable rerating to p/e of 15 or better in that situation. So a five-year target of HK$10-15 looks very possible.

Recommendation

Buy: Sichuan Xinhua Winshare Chainstore

Ticker: 811

Exchange: Hong Kong (mainboard)

Market cap: HK$4,825m

Bid/mid/offer prices: HK$4.25/HK$4.25/HK$4.28

Buy limit: HK$5.00

52-week low/high: HK$2.61/HK$4.84

Yearly change: 2007 (part year) -11%; 2008 -64%; 2009 +94%; 2010 (to date) +40%. Sichuan Xinhua Winshare Chainstore was listed in May 2007.

For UK readers, Winshare is listed on the main board of the Hong Kong exchange and so will be eligible for an ISA if your provider allows foreign shares to be held in one.

That's it from me this week. Winshare is the eighth addition to the Asia Investor portfolio, so for the next issue I'll be taking a break from recommendations to carry out a quick review of the portfolio to date. I'll be catching up on recent results and news from a number of stocks, and also talking about the structure of the portfolio so far and how I plan to develop it over the next few months.

Until then, as always you can reach me on asiainvestor@moneyweek.com.

Regards,

Cris Sholto Heaton

ASIA Investor

(Singapore tickers vary between brokers. The three common ones are listed for each stock.)

Sources used in preparing this report: Sichuan Xinhua Winshare Chainstore - IPO prospectus 2007, annual reports 2007-2009, interim reports 2007-2009, regulatory announcements 30/07/08, 08/06/09, 29/12/09, 01/04/10, 24/04/10, 18/05/10, 22/06/10 & 28/06/10

Research note on company - OSK 29/09/08

Research note on company - OSK 11/06/09

Research note on company - Guoco Capital 12/06/09

Research note on company - Guoco Capital 23/06/10

Publishing's Shrinking Page - Caixin.com 11/01/10

Private education, changing needs - FT China Confidential 15/07/10

(loosely "Xinhua Winshare's skillful restructuring increases value by several hundred million renminbi in six months") - People's Daily Online 03/02/10 (Chinese language only)

Scholar calls for tough action to boost investment in Chinese education to 4% of GDP - People's Daily Online 21/02/10

Bank of Chengdu Logs H1 Net Profit of RMB 770 mln - Business China 17/08/10

Stock prices and data from Bloomberg

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A great way to cash in on Indonesia's addiction to chocolate

I've sampled my fair share of strange snacks on my travels around Asia. There was the carton of salted soymilk I drank in Guangdong. And the curry paste filled donut I bought in a Japanese bakery. But the "Silver Queen" (pictured below) is right up there with them.

An unexpected mix of chocolate and cashew nuts, this bar did absolutely nothing for my appetite. I like milk chocolate. And I like cashew nuts. But the combination seemed a good way to ruin both of them.

Still tens of millions of consumers completely disagree with me. Silver Queen is one of the top selling bars in Southeast Asia's biggest and most promising chocolate market Indonesia.

And just like the soymilk and curry donuts, that mouthful of chocolate-and-cashew brought home a useful lesson for my investment strategy. What sells in one market may be totally different to what people like a few hundred miles away.

Many investors make the mistake of ignoring this fact - thinking about Asia as one block. In reality, there are many more differences between countries than you find in Europe. That's why I am looking to find three-to-five stocks for each of our key themes consumer goods, healthcare, financial services, education and infrastructure - so that we can invest in as many different markets as possible.

So far, we've had a couple of recommendations from China and a couple more in India. There's also some exposure to the financial sector in Singapore and Malaysia. The point is that it's vital that we keep diversify far and wide across Asia.

And that's where this week's stock and the Silver Queen come in. Not only does this Indonesian-focused chocolate maker bring us into a new country. But it is also the dominant player in a market that grew by 27% a year on average between 2000 and 2008.

The company is called Petra Foods. And I think its share price could rise by 39% from here.

The Indonesian success story that is spreading right across Asia

Petra Foods is a Singapore-listed firm working in two different parts of the chocolate industries: cocoa ingredients and branded consumer products. Although both ultimately come down to cocoa beans, they are very different businesses.

The cocoa ingredients division is a processor and supplier of products such as cocoa liquor, cocoa butter and cocoa powder. In short, it takes cocoa beans and turns them into intermediate foodstuffs that food producers then use in their own finished goods.

This is quite a specialised business and one that's growing. While major chocolate manufacturers such as Nestl and Cadbury used to have their own processing divisions, in recent years they have begun outsourcing some of this work to firms like Petra who have been building up capacity in response.

Currently, Petra is number four in the world in cocoa-grinding capacity, behind Archer Daniels Midland and Cargill from the US and Swiss firm Barry Callebaut.

But although the cocoa ingredients arm accounts for around half of profits, it's actually the other half that we're interested in. It's Petra's branded goods division that makes it such an appealing consumer play for the Asia Investor portfolio. This involves selling own-brand such as Silver Queen, Cha Cha, Top and many others directly to consumers.

There are three factors that make the branded goods division such an exciting prospect - a fast growing home market. Some very successful ventures across Asia. And partnerships with some of the worlds biggest confectionary groups. Let's take the home market first.

Petra's core consumer market is Indonesia, where the firm was first set up several decades ago. Petra has a combined market share across its brands of around 50%, way ahead of any competition. But there's still considerable growth potential: the market grew at 27% a year on average in 2000-2008, yet chocolate consumption per capita is still on 0.3 kg per capita per year, compared with around 0.9 kg in Singapore and 1.1 kg in Japan.

Rising incomes, increased marketing and better availability including modern retail chains with air-conditioning and cold storage should help propel sales for some while yet. And while Indonesia doesn't have the profile of China and India in international investors' eyes, a population of 235 million and youthful demographics makes this a very promising long-term consumption story.

Indonesia dominates sales for this division, as the chart below shows. But other regional markets Malaysia, Singapore and the Philippines are growing in importance, at 34% of sales last year from 7% in 2004.

The most interesting of these three is the Philippines, where Petra currently has around a 10% share, concentrating on lower-cost products. Again, this an appealing long-term market with similar current consumption levels to Indonesia and a population of around 94 million.

As well as producing and selling its own brands, Petra also uses the distribution channels its built up to sell products made by other firms, such as Toblerone and Guylian. Building a sales and distribution network in an emerging market is not an easy business, especially across an archipelago with shaky logistics like Indonesia. So it makes sense for outsiders to partner with firms like Petra rather than trying to do it themselves. Last year, the split between own and third party sales was around fifty-fifty.

The consumer business has long been a strong performer, posting good growth year-after-year, even during the global crisis. Gross margins are solid and stable at around 30% and its market position in Indonesia in particular is enviable.

Unfortunately, Petra has been held back a little in recent years by its ingredients business, as the chart below demonstrates.

But those problems won't hold Petra back for long.

Why Petra is poised for a rebound in sales

In fact, the cocoa ingredients issues really come down to one market: Europe. The Asia and Latin America segment continued to grow profits throughout the crisis. Petra currently has four plants in Asia, two in South America and two in Europe. Its newest plant in Hamburg was bought three years ago and has been undergoing an extensive investment and upgrading programme.

But the process of upgrading the new plant in Hamburg seems to have taken longer and cost more than expected. Consequently, Europe has been a steady drag over the last couple of years.

The good news is that this should be over. The upgrade is now complete and the factory is now producing generic cocoa products. More importantly, customers are starting to complete their quality assurance checks on the plant; once these are done, the plant will be able to sell much more high margin customised ingredients that will make the whole investment process worthwhile.

So over the next couple of years we should see a step up in sales and margin in cocoa ingredients as this division gets back on track. Meanwhile, sales in the consumer division continue to run at a very solid pace, up 18% year-on-year in local currency terms in the first quarter.

A solid family business with the right contacts

The roots of Petra Foods go back to the 1950s, when the current chief executive's father began producing Silver Queen chocolate bars in Indonesia. The group was set up in its current form in 1984 and is headquartered in Singapore, where it listed on the stock market in 2004. CEO John Chuang and his family are the controlling shareholders, with a combined stake of just over 50%. Several institutions hold smaller stakes.

The free float is around 25% and the average daily volume over the past 12 months has been a little under 500,000 shares, although this includes a number of large block trades a figure more reflective of typical trading would probably be in the 100,000-200,000 range. While this is not highly liquid, I don't anticipate that Asia Investor readers will have trouble filling any normal-sized orders.

Petra is a family business, with the risks to minority shareholders that having a single controlling shareholder brings. As I've mentioned before, the Asia Investor strategy will often involve investing in family firms, since the corporate sector in the region is still dominated by family or state-controlled groups. So I look for a long business history, a good reputation or reliable investors or board members as indications that outsiders will be treated fairly.

There can never be any guarantees, but with Petra the signs are encouraging as they should be with any stock that makes it into Asia Investor. The family have a long history in the industry and seem highly committed to the business, while the management team includes plenty of experienced staff recruited from elsewhere.

Meanwhile, the board has four independent directors from solid professional backgrounds, most notably Davinder Singh, who is a former member of Singapore's parliament and also acts as the personal lawyer of Lee Kuan Yew, the founding prime minister of Singapore. Unlike many Asian governments, Singapore is largely free of petty corruption, so the presence of senior establishment figures is usually a positive. (Arguably there are elements of institutional corruption in its political system, but that's a different matter.)

There's one small potential conflict of interest involving ongoing transactions with firms owned by the Chuang family that operate in other segments of the chocolate business (mostly industrial chocolate and very low end unbranded chocolate sold by hawker stalls). In general, I dislike any related party transactions since it can be a sign that management or controlling shareholders are taking advantage of minority shareholders, but they're common in Asia and it's sometimes necessary to compromise. In this case, the compromise seems small and the firm appears to be handling matters in an exemplary way.

The deals are not alarming in scope. The amounts involved are small relative to Petra's revenues, at $23m compared to total sales of $1.2bn in 2009. The firms do not compete directly with Petra and the businesses don't look especially attractive on the limited information available, so it doesn't seem that shareholders are being disadvantaged by them not being part of the Petra group.

From a governance point of view, the transactions are clearly and transparently disclosed in the firm's reports. In addition, there is a covenant whereby the independent directors can oblige the Chuang family to sell their interests in these firms either to Petra or to third parties if they conclude that these businesses are competing with Petra.

One might have doubts about whether such covenants would be enforced. But even the presence of them is unusual. Combined with a credible set of independent directors, this suggests that the firm is doing its best to keep everything above board.

A few risks to consider

In addition to the usual Asia Investor risk warnings, I'd emphasise the following:

Like all food producers, Petra is exposed to rising prices in commodities such as cocoa, sugar, milk, paper (for packaging) and so on. The risk is that it may not be able to pass these increases on fully. On the positive side, the firm has shown good ability to use its brand strength to raise selling prices in recent years when needed.

The situation with cocoa for processing is a little different. This is more or less a cost-plus'business, with the primary cost being cocoa beans. Rising cocoa prices increase headline revenue, but the nature of contracts and Petra's hedging policy minimises the impact on profitability.

However, higher prices increase the working capital needed to purchase inventory for processing before the finished products are sold on to customers and the cash for them received. Thus Petra's short-term debt level has risen sharply as a result of the recent rise in bean prices and this bring some balance sheet risks, in the form of potential difficulty raising the necessary finance.

On the positive side, beans are highly liquid assets purchased to meet committed sales contracts the kind of deal that banks are usually keen to lend against. Petra has room to spare within its current financing facilities and is moving to strengthen its balance sheet, as I'll discuss below. Thus the danger of liquidity problems seems low, but this exposure to higher working capital demands is an intrinsic risk of its business model that investors should understand.

Most of Petra's businesses are well established and are only subject to the usual businesses risks reputation, increased competition and so on, which the firm should be well placed to respond to. However, success with the new plant in Hamburg is dependent on it meeting customers' quality standards for premium ingredients.

So far it's received a number of certifications from customers, but more are yet to be completed. There's no reason to expect that this process won't be fully successful, but if it weren't, that would hurt Petra's plans to focus on premium products and would thus reduce profitability at the plant.

Foreign currency risk will be a factor with all Asia Investor recommendations and I don't attempt to forecast currency movements other than a general view that Asian currencies will rise against developed world ones over time. In Petra's case, the firm does business in a range of currencies, including local Asian ones, US dollars and euros, while reporting its results in US dollars and having shares quoted in Singapore dollars.

Clearly in the short term, there is potential for currency fluctuations to have an effect on profits, although over periods of a couple of years or longer, I would expect these to even out. The firm's operates a prudent policy of hedging some currency risks by matching borrowings to liabilities: ie US dollar investment producing US dollar revenues will be funded by US dollar borrowings.

Finally, the firm is in a dispute with the Indonesian tax office over allegations of transfer pricing (where a company transacts between subsidiaries at distorted prices to move profits out of a high tax area into a lower one). This could potentially lead to a back tax bill of $7.6m. Petra is contesting the assessment, arguing that its sales were done in accordance with OECD transfer pricing guidelines. It's impossible to know what the outcome of the case will be.

Why Petra could make you 39% while protecting your portfolio

At first glance, the most off-putting thing about Petra is the balance sheet. Net debt to equity stood at a rather eye-popping 235% as at end March 2010. This headline figure is a little misleading however: as mentioned above, much of it reflects increased short-term debt to fund the higher cost of inventories due to cocoa price rises and the ramp up in operations at the Hamburg plant. Absent another large rise in cocoa prices, this debt should fall quite rapidly as Petra delivers the processed goods to its customers and receives full payment.

Excluding inventory financing, adjusted net debt to equity was at 62% in March, down from 70% in December. Since then, the firm has carried out an S$85.2m (US$63m) share placement to raise further funds for investment and working capital, while also planning to diversify its borrowing sources and extend the maturity of its debt to reduce liquidity risks. Finally, with the Hamburg factory coming on stream, all major business will be profitable and generating cash. So management appear to have a sharp focus on managing financial risks and the trend in the balance sheet should be an improving rather than deteriorating one over the next year or so.

Petra's recent results and my estimates for the next two years are shown in the table below. (There's no revenue estimate because it's largely irrelevant to profitability in the cocoa ingredients business, while also being dependent on volatile cocoa prices and thus not usefully predictable; my estimates for this division are based on volumes and margins.)

For comparison, the average of analysts' estimates from Bloomberg is for around US6.5 in FY2010 and US8.5 in FY2011, putting mine towards the conservative end of the range.

In valuation terms, the stock currently trades on around 20 times my estimates for FY2010 (based on a SGD-USD exchange rate of 1.35). Weighing up the potential of its consumer business versus the lower growth prospects of the cocoa ingredients division beyond the point when profitability has recovered, this looks about the right multiple. Any significant rerating upwards would probably require it to be seen as more of a pure consumer play that's possible in the long run if the consumer division share of earnings continue to expand, but probably not for some years.

So I would keep Petra on a p/e of around 20 and look forward to FY2011 as the point at which the investment in its European plant has begun to pay off. On my estimates, that would indicate a potential price of around S$2/share then, or upside potential of a bit under 40% on the current share price. Discounted back to today at a minimum required rate of return of 15% per year gives a buy limit of S$1.6.

Unlike some Asia Investor recommendations, Petra clearly isn't vastly underpriced. The potential return would still be attractive, but other stocks in the portfolio have higher prospective upside if all goes well.

However, my goal with Asia Investor is not to just to pick stocks with triple-digit potential returns, but to build a portfolio that benefits from Asia's key trends while balancing risk. A stock like Petra is useful for this because it has limited exposure to China or India and gives us access to a major consumer market that is largely independent of both. As such, it fills an important niche and makes a valuable addition to our portfolio.

Recommendation

Buy: Petra Foods

Ticker: PETRA (Bloomberg), PEFO (Reuters), P34 (SGX and many brokers)

Exchange: Singapore (main board)

Market cap: S$880m

Bid/mid/offer prices: S$1.4/S$1.42/S$1.44

Buy limit: S$1.6

52-week low/high: S$0.72/S$1.44

Yearly change: 2005 +30%; 2006 +67%; 2007 -15%; 2008 -76%; 2009 +197%; 2010 +29% (to update)

For UK readers, Petra is listed on Singapore's main board and so will be eligible for an ISA if your provider allows foreign shares to be held in one.

That's all from me this week. If you have any queries, please drop me a line on asiainvestor@moneyweek. Otherwise, I'll be back in a fortnight with another recommendation at present I'm looking at a few possibilities for our first investment in the healthcare and education sectors. In the meantime, you can access the ASIA Investor archive on the MoneyWeek website by clicking here. The password for the next fortnight is continental.

Regards,

Cris Sholto Heaton

ASIA Investor

(Singapore tickers vary between brokers. The three common ones are listed for each stock.)

Sources used in preparing this report: Petra Foods first quarter 2010 presentation, Petra Foods annual reports 2004-2009, Petra Foods listing prospectus, Petra Foods website, regulatory announcements and results from Petra Foods, reports from DBS Vickers, Standard & Poor's, SIAS Research, data from Bloomberg, 2010 World population data sheet

Your capital is at risk when you invest in shares - you can lose some or all of your money, so never risk more than you can afford to lose. Shares recommended in Asia Investor may be small company shares. These can be relatively illiquid and hard to trade and there can be a large bid/offer spread. So if you need to sell soon after you've bought, you might get back less than you paid. This can make them riskier than other investments. Some may be denominated in a currency other than sterling. The return from these may increase or decrease as a result of currency fluctuations. Always seek personal advice if you are unsure about the suitability of any investment. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Editors may have an interest in shares recommended.

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Nowhere in emerging markets is the growth potential more obvious than in banking and finance. Just take a look at the chart below which shows mortgage debt as a percentage of gross domestic product across the world.

As you can see, there's a huge amount of room for lending to grow in countries such as China and India before it's even on a par with the rest of emerging Asia - let alone the developed world.

And of course, it's not just in mortgages. Or car loans. Or credit cards. Insurance, investment and a huge range of other financial services will flourish as these countries become richer.

It's a powerful investment story - but investors need to be selective. China clearly has huge potential as a banking market. But as an investment, it ticks all the wrong boxes for me. The major banks are all state-controlled and take direction from the government as to which sectors they should be lending to. That makes then a poor prospect for investors, since they'll always be forced to put national interests first.

On the other hand, India is much further ahead with developing a modern financial system. Yes, there are a large number of state-controlled banks from the country's socialist period.

But there's also a thriving, fast-growing private sector that are taking the lead in modernising Indian finance - especially in consumer sectors. These banks are reasonably free of government interference. And they are likely to deliver very attractive returns for shareholders over the next decade. I'm very keen to add an Indian banking play to the portfolio.

Today I want to recommend a seriously underappreciated Indian bank one that I think could make you a 75% return on your money.

Why big Indian banks will thrive over the next decade

I'm taking a slight detour with the recommendation I'm making today. With Asia Investor my recommendations usually range from small to medium-sized companies. The kind of stocks that are usually overlooked by emerging market investors. In most industries, I think these have the best long term potential. But that approach doesn't make a lot of sense with banking.

Over time, size tends to win out in banking. The big firms can take advantage of economies of scale and their extensive branch networks to outcompete smaller firms. The industry tends to consolidate into a few larger groups. And in India, with almost 100 commercial banks, 200 regional ones and many local co-operatives, there's likely to be a lot of consolidation in the years ahead.

So today's recommendation is a relatively large firm that you may well have heard of already. It operates in a sector which I believe has strong growth prospects. It's a leader in its field. And it's surprisingly cheap on a long-term view, for reasons we'll see in a minute.

So if you don't know it already, let me introduce you to ICICI Bank

The explosive growth in consumer lending across India

ICICI is India's largest private sector bank. It's the leader in retail lending, with around 30% market share across the whole consumer finance segment. The majority of its consumer loans are mortgages and vehicle loans (see below), but it also has a corporate division and several international business, most significantly the UK and Canada.

There are also subsidiaries in other areas of financial services, such as life insurance, general insurance, stockbroking and asset management, although their current contributions to profits are small.

All this makes it a promising play on the development of the Indian financial system. It has broad exposure while being rooted in consumer finance, the most promising segment of all over the next few decades.

That's because consumer finance is a relatively new segment. The chart below shows the breakdown of loan books at Indian lenders in 1996 and 2008. Don't worry too much about all the details - some of the categories are pretty arcane. But notice the huge growth in mortgages as a share of lending over little more than a decade. And see how new categories such as education and credit cards are cropping up.

As the first half of the chart suggests, lending in India used to be almost exclusively to companies. Until a couple of decades ago, commercial banks weren't allowed to make residential mortgages.

Today that's changed. The government relaxed the rules, a wealthier middle class emerged demanding new financial products and services and the whole shape of the economy changed. So did banking, with ICICI in the forefront of the revolution. But as that tiny mortgages/GDP ratio in the first chart at the top of this issue suggests, there's still a very long way for it to grow

With a commanding foothold in the Indian banking sector, you would expect ICICI to be thriving as the Indian economy recovers. But that hasn't been the case. In fact for the last year, ICICI has been all but left behind by its competitors. Let me explain exactly why.

How ICICI became India's least favourite bank

ICICI did not have a great Financial Crisis. During the boom of the last decade, the bank got somewhat carried away. It was the most aggressive in expanding in India, which for a bank almost inevitably means that you end up with a sharp rise in bad loans when the economy turns down.

And it let its international ambitions grow out of control. In FY2008 net new loans at overseas branches grew by 96% compared with growth of 15% for the overall group. But margins in these were much lower than in its home market.

What's more, to support its rapid growth at home and abroad, it funded itself with expensive and fickle wholesale borrowings rather than stable deposits from retail customers. That's broadly the same mistake that many Western banks made and paid heavily for it. All this was well known, so it's no surprise that at the peak of the crisis, text messages and internet postings were making the rounds claiming that ICICI was on the edge of collapse.

It wasn't while it may have overstretched itself, the underlying business was solid. Still, the legacy of that too-fast growth is that non-performing loans doubled as percentage of assets, as the chart below shows.

And as the bank deals with those, return on equity has collapsed from high historic levels. In the past year, ICICI had a return on equity of 9.5%, compared with 16-19% at private sector rivals like HDFC Bank and Axis Bank.

But it won't lag behind for long. The last year has prompted an enormous response by the banks management a fact that has so far gone unnoticed by investors.

ICICI is primed for a spectacular rebound

In the last year, ICICI's management has battered the business back into shape. The loan book has been shrunk, especially in areas such as credit cards and personal loans where the biggest problems turned up. Operating costs have been cut. Now as these measures take effect as provisions for bad loans tail off, profitability should rebound strongly to be more in line with peers.

Credit growth should resume in FY2011 - management are expecting the loan book to grow by 15-20%. But this will be done in a more prudent way under a more focused strategy. The bank has focused on building up a low-cost deposit base, with current and savings accounts (CASA) now accounting for 41.7% of deposit, up from 28.7% in 2009.

CASA deposits attract lower rates of interest, meaning that a higher CASA ratio pushes up the bank's net interest margin (the difference between what the bank pays for its funds and what it earns on loans). ICICI's net interest margin is below that of peers; as this changes, profitability will improve.

The company plans to grow its network of 2,000 branches the largest among private-sector lenders and to use the infrastructure more effectively to source deposits and sell to customers. To this end, it recently announced a takeover of the Bank of Rajasthan, a troubled lender with major governance issues (to put it politely) from the northwest of India.

ICICI certainly seems to be paying a full price for BoR based on the bank's current level of business. But the deal will add more than 450 branches to ICICI's network and is the only target of its kind available in the region. On a per branch basis it doesn't look so expensive and so should make long-term sense if ICICI makes full use of the expanded network.

Meanwhile, consumer lending will focus more on mortgages and vehicle loans, with much tougher standards on credit cards and personal loans. And indiscriminate growth in the international business has been abandoned. Instead, ICICI says it will focus on serving the large non-resident Indian population and on lending to Indian businesses abroad, which makes sense it's in a good position to dominate this niche.

So management seem to be moving in the right direction quickly and decisively. However, it could take two-three years for the effects of this to filter through and profitability to return to a stronger level.

So despite having every chance to be one of the dominant financial groups in a huge market in the long run, ICICI is somewhat out of favour with investors right now. Instead, the spotlight is on peers, who are showing much more impressive results. To me, this looks exactly the kind of opportunity that rewards the patient investor prepared to look past a few weak quarters of earnings.

Three risks to consider

ICICI is unusual in that it is one of the few major Indian companies not controlled by a founder or one of the country's business dynasties or by a foreign multinational. Founded as the Industrial Credit and Investment Corporation of India in 1955 to provide foreign currency loans to Indian businesses, it set up a retail banking division in the 1990s as India began to liberalise its financial sector.

The firm has been listed in the US as an American Depository Receipt since 2000. An ADR is essentially a certificate giving you rights over share traded abroad in this case India. We're investing via ADRs because most foreigners aren't allowed to invest directly in the Indian markets.

The biggest single direct shareholder is Life Insurance Corporation of India, a government-owned firm that is the country's largest insurer. Singaporean sovereign wealth fund Temasek is also an investor, followed by smaller holdings from a number of institutions.

Around 28% of the shares are held as ADRs. Liquidity on the ADR is very good, at around 2.45 million shares per day on average over the past year. Note that in this case, the ADR gives the holder rights over two underlying shares in ICICI, so the price of the ADR should be equal to twice the price of the India-listed shares.

As usual, let's take a look at the risks. In addition to the usual Asia Investor risk warnings, let me flag up the following:

First, banking is a cyclical business. You make more loans when times are good and then watch them turn down when growth slows. That makes ICICI different to most of the stocks that will be in the Asia Investor portfolio. Over the long run, growth should be very strong, but it will be more sensitive to the economic cycle than my usual recommendations.

Second, it's easy for banks to overstretch themselves while expanding, generally through relaxing lending standards too much in the pursuit of growth. ICICI did that; its peer HDFC Bank, on the other hand, was more conservative and sailed through without trouble.

That's a clear error of ICICI's management and strategy. But they should have learned a hard lesson from it and hopefully won't make the same mistakes next time. This is something I'll be keeping an eye on as the cycle develops.

Third, I mentioned earlier the structure of India's banking system and how foreign banks are restricted. In the case of ICICI and HDFC Bank, because more than 51% of their equity is controlled by foreigners, they were recently classed as foreign-owned Indian-controlled companies. There has been some speculation that this could restrict their ability to invest in certain sectors where there is a cap on foreign investment.

However, the latest statements from government officials are that they will not be treated any differently to other Indian-owned. So there appears to be no threat here at the moment. Still, it emphasises the fact that India's rules on foreign investment are quite restrictive and often arcane, some it's possible that ICICI's new status could cause trouble in future. That said, given the size, importance and obvious "Indian-ness" of the firm, I consider it unlikely.

ICICI's governance at the top of the firm seems good, reflected in the fact that it has a full sponsored ADR listing and has to comply with strict SEC disclosure regulations. But in an emerging market like India, there is always a risk of problems suddenly emerging at lower levels.

In particular, the Indian press sometimes features headline-grabbing accounts of recovery agents for defaulted loans behaving unethically, harassing borrowers and even turning violent. This is not uncommon as financial systems develop, but sometimes leads to tighter regulation although generally the biggest organisations benefit from this in the long run, because more regulation often makes it hard for smaller firms to compete. More generally, financials are always subject to the risk of regulation and government intervention, although this seems less likely to be on the rise in India than in most developed markets.

Finally, there seems a high chance that the bank will discover major issues at the Bank of Rajasthan post takeover and have to spend some time sorting them out. However, at 4.5% of ICICI's total assets, the impact is unlikely to be significant - and as noted, ICICI is buying the firm for its branch network and franchise rather than the loan book.

Why you could make 75% as this bank rebounds

ICICI is rather different to my usual recommendations. Often, we're looking at stocks where there will be no broker coverage or they might be number 20 out of 20 on the coverage list for some very overworked junior analyst. But ICICI has 45 analysts covering it, so it's scarcely a hidden gem whose prospects remain under-researched. I'm adding it to the portfolio not because I believe that I know something about the company that the market doesn't, but because in my view its medium-term value is being overlooked because of its weak short-term profitability relative to its peers.

As the table below shows, earnings growth picked up in FY2010 after the problems of 2007-2009, but has only just passed its 2006 peak. Analysts' consensus forecasts are for Rs45/share in FY2011 and Rs57/share in FY2012.

But I'm more interested in the point a year or so beyond that. At that point, net interest margins should be rising, loan loss provisions should have dropped and efficiency should have improved. So profitability should be starting to rise back towards the same levels as its peer group, which as I mentioned earlier is around 16-19%.

I'm going to take a fairly basic top-down approach to this and in my base case, I'd assume that return on equity rises to around 15% in FY2013 (from around 10% next year and 12% the year after). That would point to EPS of around Rs80/share.

At that point, I think the company is likely to trade on a price/earnings ratio of at least 20. In most markets, that's high for a cyclical like a bank, but it's at the lower end of historic valuations for ICICI and its peers and seems fundamentally justifiable given its enormous long-term potential.

That would point to a share price of Rs1,600 in 2013, giving potential upside of around 75% from the current level. Discounting Rs1,600 back at a minimum required rate of return of 15% gives a current buy limit of Rs1,050.

At the current exchange rate, Rs1,050 translates to $22.2. Each ADR gives the holder rights over two shares in ICICI, so this translates to a current buy limit on the ADR of $44.4, although this will change if the INR/USD exchange rate moves substantially.

A more bullish case might see ROE get up to around 18%. If that happened by 2013, that could point to a share price in the Rs1,900 region but that would be an optimistic scenario and I think it would be likely to take longer.

In terms of balance sheet strength, it's important to be aware that bank balance sheets are highly complex. If the global crisis taught us anything, it's that that apparently healthy numbers can conceal huge problems

That said, the Indian banking system came through with few problems and is generally regarded as pretty solid. The Reserve Bank of India is a capable, conservative and prudent regulator and its rules helped prevent any firms from getting into serious trouble. On a company-specific level, ICICI made big mistakes, yet the underlying business was still solid enough for it to come through.

The core measure of a bank's financial strength is its tier one capital ratio, which is the measure of equity capital to assets. This is intended to provide the buffer to absorb unexpected losses. By international standards, Indian banks are generally well-capitalised. And with a tier one capital ratio of 12.92%, ICICI is well above average for the overall sector.

The one area in which the firm may look disappointing by international standards is the dividend, where the yield is around 1.33%. That reflects the fact that in India, banking is very much a growth business, rather than a utility-type industry in the developed. So for now, payout ratios will be lower because the banks need to retain capital for expansion. In due course, the dividend is likely to rise significant.

As mentioned earlier, we'll be investing in ICICI through American Depository Receipts. These are listed in New York and quoted in US dollars, but entitle us to the full rights of an India listed share.

Recommendation

Buy: ICICI Bank (American Depository Receipts)

Ticker: IBN

Exchange: New York

Market cap: $21.2bn

Bid/mid/offer prices: $37.95/$37.96/$37.97

Buy limit: $44.4

52-week low/high: $28.53/$45.95

Yearly change: 2006 +36%; 2007 +45%; 2008 -67%; 2009 +91%; 2010 (to date) -5%

For UK readers, ICICI will not be eligible to be held in an ISA. Although the New York Stock Exchange is a recognised stock exchange under HMRC rules, for ADRs the underlying share must also be traded on a recognised stock exchange and no Indian exchanges currently qualify as such.

Updates

A couple of quick updates on the portfolio this week. First, Silverlake Axis announced a strategic tie-up with HNA Group, a Chinese conglomerate that signed software and services contracts with it earlier in the year. HNA will purchase a stake of up to 11.6% in Silverlake from the company's controlling shareholder, Goh Peng Ooi.

Silverlake says that this relationship is intended to lead to further business with HNA and opportunities to sell its products and services to other firms in China. Obviously, this could be a positive in the long run, but for now theres; no way to know it will make a difference.

Meanwhile, Eredene Capital announced a £7.3m investment in an Indian port services firm. The company's results will be out by the next issue of Asia Investor, so I'll look into progress on its portfolio and how this deal fits into the strategy in a fortnight's time.

That's it from me for this issue. As ever, if you have any questions, please email me on asiainvestor@moneyweek.com. I'll be back with another investment idea in two weeks.

Regards,

Cris Sholto Heaton

ASIA Investor

(Singapore tickers vary between brokers. The three common ones are listed for each stock.)

Sources for information in this report: Bloomberg terminal, Citigroup Global Markets, Angel Securities, The Hindu, Reserve Bank of India, World Bank, Banco Central do Brasil, ICICI Bank 2008 2010 Annual Reports, presentation 2010 results and website, Silverlake Axis, Eredene Capital

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Welcome back to the latest issue of Asia Investor. This week's letter is all about money and the serious opportunity for profits as Asia learns to invest it for the first time.

Right now hundreds of millions of people across Asia still live completely outside the modern financial system. Many have no bank account. Many more have never taken out a mortgage or called a stock broker.

But that all changes as society becomes wealthy. Higher incomes in Asia are likely to have two effects on investments over the next decade. First, greater wealth will push up asset prices. As incomes escalate, local buyers will seek out and drive up the price of everything from stocks to new build apartments.

Second, more widespread wealth creates huge demand for assets. The very poor keep cash in a tin under the bed. But beyond a certain level of wealth, people begin putting some of their savings in non-cash assets shares, funds, real estate in the hope of earning a return on their money, rather than just keeping it safe.

Much of Asia will cross that threshold for the first time in the years ahead. And this will create a great opportunity for one sector: asset management. As people latch onto asset investing, managers enjoy a double whammy. More people with more money to invest will both increase demand for investment products and push up the price of the underlying assets.

And since these managers earn fees as percentage of the assets under management, they benefit twice over. They make more sales and earn higher profits on each investor.

That's why the likes of Fidelity, Dreyfus and Franklin did so well in the US during the bull market of the 1980s and 1990s. Not only were stocks going up, but more and more investors were switching from holding stocks directly to investing in funds, having being convinced by the industry that this was safer and better to entrust their money to professional managers.

I expect to see a similar shift to happen in Asia in the years to come. And this week's recommendation is in a perfect position to capitalise on it. Over the last four years, it's seen assets under management more than double and there's enormous scope for future growth. Let me explain why I think this group could more than double your money over the next three years.

Why investors are flocking to this property kingin

The firm is ARA Asset Management, a Singapore-listed manager of real estate funds. This is a useful sector to be in, because many investors in Asia tend to regard real estate as sounder and a better long term bet than stocks investing in stocks.

The investment case for ARA is more about its ability to build a fund management franchise and earn high fees from that than about the individual funds it manages at present, so I'll be relatively brief with the background about these.

At present, the firm manages five real estate investment trusts (reits), which are publically listed and open to all investors. Reits are popular income plays with both retail and institutional investors.

Two of ARA's reits Fortune Reit and Prosperity Reit are Hong Kong funds, investing in retail and office property respectively. Suntec Reit includes prime retail and office property in the heart of Singapore, together with a stake in the Suntec convention centre. While the recently launched Cache Logistics Trust holds logistics facilities in Singapore. AmFirst Reit is a vehicle for commercial property in Malaysia.

In addition to the listed funds, ARA also manages three private equity real estate funds. The Asia Dragon Fund is a pan-Asia investment vehicle, mostly funded by institutions. The Harmony fund is a single asset fund invested the Suntec convention centre, marketed to high net worth individuals. And the smaller Asian Asset Income Fund is a fund of funds that invests in reits and infrastructure and utilities trusts.

There's also a smaller division that provides management services to properties outside its funds. Overall, assets under management have risen at an average of 30% a year since 2004.

Revenues have risen similarly rapidly. Even in the teeth of the global crisis, ARA managed to maintain relatively stable revenues. There are at two reasons for that.

First, the group had been enjoying a very healthy year-on-year increase in assets under management (AUM). This was already in place before the worst of the crisis hit. But it also reflects the fact that ARA's income is based on the funds asset values and the revenues they bring in. That tends to be more stable than the listed market value of the Reits. Performance fees and acquisition/disposal fees are a relatively low proportion of revenue, as the latest quarterly figures below show. This gives ARA fairly stable and robust earnings.

More important than the existing portfolio though is the pipeline: new funds that ARA can list or market to increase AUM and fees.

A $2bn pipeline is just the start for ARA

At present, ARA working on a $1bn Reit with Qatar's Regency Group that will be compliant with Shariah (Islamic law) in order to tap into the growing demand for Islamic investments. ARA recently set up, ran and divested a Shariah-compliant real estate fund, Asia's first, so it has a track record in this promising sector. And once the Asia Dragon Fund is fully deployed, ARA will be aiming to raise $1bn for Asia Dragon Fund II.

This pipeline will give a substantial boost to earnings in the next 1-2 years. The firm should also be able to earn acquisition and management fees when its existing reits acquire new assets (Cache in particular seems likely to acquire assets across the region). It can also earn a fresh round of revenue from its existing asset base by floating assets from the Asia Dragon private equity funds as reits when those funds reach the end of their terms and need to divest properties, wind up and return money to shareholders.

But the growth potential for property funds is much greater than this $2bn+ pipeline. We can see this most easily by looking at the extremely rapid development of Asia's reit market, where Singapore has the leading role.

The first S-Reit listed in 2002. Today the market has grown to 23 funds, with a handful more in the pipeline. But demand both within and outside Asia mean there's huge scope for further growth. As ever, growth forecasts should be taken with a large pinch of salt. But for example, the head of HSBC's Asia real estate advisory division recently said that he expects the number of Reits in Asia to double over the next three or four years, with Singapore seeing the most activity.

So ARA seems very well positioned: in the right sector and the right place at the right time. Its funds came through the global crisis in good shape, which has helped cement its reputation. The firm says that a number of new partners have approached it to work on establishing new Reits: logistics firm CWT was one, resulting in the recent float of the Cache Logistics Trust.

As you can see above, ARA's AUM has more than doubled over the last four years. Together, the favourable tailwinds for Asian real estate investing, rising valuations and ARA's growing profile suggest to me that it should equal or beat this growth in the years ahead.

So that's the outlook. As usual, let's take a look at the business history, management and shareholders and risks.

A few risks to consider

ARA was set up in 2002 by John Lim, an experienced Singaporean real estate executive, and a subsidiary of Cheung Kong, the conglomerate and real estate developer controlled by Hong Kong billionaire Li Ka-shing. It listed on the Singapore stock exchange in 2007 and Lim and Cheung Kong remain the two largest shareholders. There are no other similarly sized shareholders, but a number of institutions have smaller positions.

The stock is still fairly small the market cap is S$760m but liquidity is adequate at an average of more than a million shares per day over the past year. I don't anticipate that Asia Investor readers would have any trouble taking positions in it. The company is aiming to increase liquidity through issuing bonus shares (effectively a form of stock split) regularly; this is useful in that higher liquidity make the stock more attractive to institutions and will make them more likely to invest once as the firm's profile grows.

In addition to the usual Asia Investor risk warnings, I'd flag up the following risks for this stock.

First, there is a significant 'key person' risk with top management personnel. In a business like ARA, much depends on the reputation and contacts of a handful of experienced individuals. The loss of some of these in particular founder John Lim could be very difficult to cope with. This risk should diminish as the firm grows, but for now it remains significant. In addition to management, ARA's relationship with the Cheung Kong group is also important, since this underlies the two Hong Kong reits and the prospect of establishing reits based on Cheung Kong assets.

Second, ARA's revenue comes from the fees it earns on real estate asset values and rents, with a proportion of them coming in the form of units in the reits, which it then sells.

In addition, ARA provides seed capital for some of its private funds and holds long-term stakes in AmFirst Reit (12.5%), Suntec Reit (1.9%) and Cache (1.9%).

Thus it's dependent on conditions in the real estate market and a prolonged downturn would hit ARA's existing revenues (the evidence of 2008 suggests that it's relatively resistant to short-term problems) and the value of its direct investments. In addition, this would probably cause a souring of investor sentiment on Asian real estate, making it difficult for ARA to raise new funds or float new reits.

Obviously I don't anticipate this happening: I think most Asian real estate markets are likely to perform well in the long run. And on the plus side, this gives ARA considerably upside exposure to any bubble that develops in Asian markets. But if such a bubble were to develop, we would need to be prepared to get out before it bursts; this is not a stock to hold through a major real estate slump.

Third, the fund management business is competitive. The actual level of fees tends not be much fought over: there are certain standard fee levels and firms don't tend to compete that much on price. Instead, the difficulty is acquiring investors in significant numbers and assets at a price that will give good returns, in order to grow AUM to as large a size as possible.

Success in this will be dependent on ARA's contacts and reputation, which in turn is dependent on key staff as mentioned above. Initial barriers to entry in this business are low and we can expect to see a large number of new funds and management companies setting up in years to come. In order to grow profits as quickly as I expect, ARA will need to distinguish itself from the crowd and continue establishing itself as a leader in its sector.

Finally, there are risks connected with specific funds and reits. These could run into trouble through problems with underlying assets, with their levels of borrowing or other factors. ARA could be removed as the fund manager either because of performance issues or because shareholders think another firm offers a better deal. Since ARA has a relatively small number of funds, the loss of one would have a noticeable affect on its earnings.

Why you could make 74% inside three years

Revenue and profit growth at ARA has been rather lumpy, as you can see below. Partly this reflects the global recession, but also the fact that each individual new fund is relatively large compared to the existing AUM and don't arrive in a steady and predictable manner. So while I anticipate strong profit growth in the years ahead, it may well be of '1% one year', '30% the next' type.

The firm is under coverage at four brokers. For comparison, their estimates are 7 to 7.6 Singapore cents per share for FY2010 and 7.4 to 8 Singapore cents per share for FY2011.

ARA currently trades on a price/earnings ratio of 15 times my FY2010 estimates. Given its growth potential, this seems very reasonable. And because the business is asset-light and highly scalable, the need to reinvest profits is very limited and growth will put little strain the balance sheet. Total debt to equity stands at 14.5%, and that almost entirely consists of a loan from AmInvestment Bank used to buy the 12.5% stake in AmFirst Reit.

Consequently, the firm is able to return most of its profits to shareholders. The dividend payout ratio is around 60-70%, putting it on an estimated yield for FY2010 of about 4.5%. Management guidance indicates the firm intends to keep the per share dividend relatively constant for now, while issuing bonus shares to increase liquidity as noted above.

Thus the dividend that each shareholder receives and the value of their holding should increase steadily, although the per share price may not change that much as long as the bonus issues continue. (I'll be adjusting the figures for bonus issues as we go along so that the portfolio reflects the actual return we receive as investors.)

So what about valuation? For my base case, I'm going to assume that assets under management and earnings roughly double from 2009 year-end levels by 2013. On current margins, that points to earnings of around 12.5 to 13 Singapore cents per share by 2013.

In the absence of an obvious catalyst for rerating, I'd assume that the stock remains on a forward price/earnings ratio of 15. That equates to a share price of around S$1.9 then, which would be a potential gain of around 74% on the current price, even ignoring what should be a fairly solid stream of dividends. (In practice, the bonus issue policy may mean that this translates into us holding a larger number of shares at a lower price than this, but the net effect on our profits will be the same.)

For an initial buy limit, I'll set my usual minimum required return of 15% a year. Discounting back at that rate gives a buy limit now of around S$1.35.

As you know, I also usually sketch a bull case for my recommendations, based on more optimistic assumptions for valuations. They're never intended to be used as a buy price or as targets, just an indication of the potential if all goes well. Not every recommendation will achieve this potential, but if just a few do, our returns should look very healthy.

With ARA, the business is extremely scalable and has minimal capital requirements of its own, because the capital involved is other people's. Thus growth of 50% in a year is as viable as growth of 5% it all depends how many investors it can pull in.

As I discussed above, I think a doubling of assets in the next three-four years or so is quite likely based on historical trends and forecasts for the sector. But it could easily be substantial more than that, especially when it comes to demand from European and US investors: Asian real estate assets offer a good combination of yields and growth at a time when developed world rates are likely to stay low for a long time.

So revenues tripling or quadrupling over a few years is not completely out of the question and so ARA could well have significant further potential, since the majority of that flows straight into profits. And that's one of the major attractions of the stock. It offers good core growth, reasonably robust earnings, a strong dividend and essentially unrestrained upside exposure to any bubble that develops in its sector. That's an unusual package and as such I think it's a valuable addition to the portfolio.

Recommendation

Two encouraging updates

There are a couple of short updates on the portfolio. Eredene Capital was a member of the winning consortium for a bid to build and operate a container terminal at Ennore Port in Tamil Nadu, a state in southern India. This is a big project; the total value is £207m and Eredene's stake of 22% is equivalent to an equity commitment of £23m over four years, its largest single investment yet. It will undoubtedly have to raise capital to cover this at some point, although there are few details yet.

I'll wait until the company's results are out in a couple of weeks and we can see what progress has been made on other projects before fully factoring this into my recommendation. But it's clearly encouraging that Eredene can partner with major firms to win large projects, and reinforces the fact that the value of the company's expertise could add considerable upside to its existing portfolio of investments, attractive though these are on their own merits.

Second, Silverlake Axis announced the second part of its special dividend to clear out spare cash following the group restructuring. It will pay 0.5 Singapore cents per share, with the book closure date being 13th July and payment date being 30th July.

In addition, the stock recently regained analyst coverage, being added at broker CIMB-GK. While this has no impact on my view of whether the company is a good investment or not, broker coverage is helpful for raising its profile and increases the chance of it being rerated at point. Based on previous years, the full year results are likely to be out around the end of August and will hopefully show that banks' investment plans are continuing to recover.

My plan for Asia Investor

Finally this week, I've had a few emails from readers asking about the overall strategy and how I'll be building the portfolio. Essentially, I'm looking to invest in 20-30 stocks that are plays on key long-term themes that should do very well from Asia's development. These include consumer goods, infrastructure, financial services, healthcare and education among others.

These are mostly the kind of companies that are underrepresented in local indices (although financial services is usually pretty well represented, but often through poor-quality state-backed companies). So the goal of Asia Investor is to build a portfolio of stocks that you typically won't have much exposure to in the average Asia fund, but where there is good reason to believe they're likely to outperform.

We're going to be quite concentrated in a small number of sectors. For example, I've already recommended two food and beverage firms and we'll definitely be adding more. That's because I believe there's a limited numbers of sectors that genuinely add value for investors over the long run: most destroy value through mismanagement or through competition.

In particular, I look for industries where top firms have some protection from competition. That might be regulatory barriers, a shortage of capital for investment, ownership of a top brand, unusual expertise or contacts, or valuable intellectual property rights, among other things.

My strategy is focused on long-term investment. If a recommendation shoots up a long way very quickly and we can realise a large profit, that's excellent. But because I'm looking at small to medium sized firms, often unglamorous and with a low profile, we can't rely on that happening.

So I always assume that we will hold some of these investments for some time. Thus I look for good quality firms where I'm comfortable doing this and I favour those that pay a reasonable dividend, since this ensures that we're still be rewarded while waiting for capital gains.

And just one last thing before I go. If you're a new reader and you're looking for details of the recommendations so far, you can download my 'Hidden Seam Stocks' report here. It includes all four of the previous Asia Investor recommendations.

That's all for this issue. I'll be back in a fortnight with a new idea; I'm currently looking over a couple of retail plays, some education and healthcare ideas and a way in which it might still be possible to make some money from the rather overhyped emerging market auto story. In the meantime, if you have any queries, please let me know at asiainvestor@moneyweek.com.

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Legendary small cap investor Peter Lynch always says that the best ideas come from what you see around you everyday. I completely agree. My investment recommendations often start from seeing what shoppers are reaching for or leaving on the shelves or even what I'm buying myself.

This week's pick definitely falls into that category. It's an Asian consumer play that I first became interested in because I have something of an addiction to its products.

Every time I pop into a 7-Eleven or Circle K convenience store in Hong Kong I seem to leave with one of its distinctive cartons in my hand. I even happily pay the sizeable mark-up they fetch in the stores in London's Chinatown.

What am I talking about? The flavoured soy milk drinks chocolate, malt, red bean and many more made by Vitasoy, one of Hong Kong's oldest consumer brands. If you don't know Hong Kong, you probably won't be familiar with these but in it's home market, this company has the same kind of profile that you might associate with Coca-Cola or Pepsi. I have been following this company for years.

The good news is that there has never been a better time to invest in Vitasoy. Five years ago, this was a small company that sold its well-loved brands to a local market. Now it's a totally different animal a company undertaking a hugely successful expansion right across Asia.

So far the market has failed to notice this remarkable transformation. But not for long. Let me explain why I think you could make an 85% gain inside 3 years.

Asia's answer to Coca-Cola

Vitasoy's core business is soy milk-based drinks, which account for around half its sales. Soy milk made by grinding up soybeans with water is a very popular drink in Asia, where large numbers of people have some degree of lactose intolerance.

Unlike in the West, where it's usually served plain, in Asia it's used to produce a huge range of flavoured drinks, both sweet and savoury. So this isn't just a health product, but a major soft drink market along the lines of coke.

Apart from soy milk, tofu another soy-based product makes up another 10% of Vitasoy's sales, while bottled tea drinks account for the same. The balance consists of various other non-alcoholic beverages and a school tuckshop and catering business in Hong Kong.

Vitasoy is a long-established business with a very strong brand in Hong Kong. It's a pretty solid, defensive stable business and given that it pays an attractive dividend, it initially looks like a good income play. But it's when we look where the firm is selling that its real attractions become clearer.

The chart below shows the breakdown of sales for the year just ended and five years ago. As you can see, Hong Kong and Macau is still the biggest single market but that's changing. There's an strongly-growing contribution from mainland China which is quietly transforming this mature stalwart into a powerful play on Chinese consumption and the market is only just catching on to this.

As with most consumer products, the Chinese business has a huge amount of potential growth. I'd advise always taking estimates like this with a large pinch of salt, but I've seen estimates that per capita soymilk consumption in China is around one-fifth of the level in culturally similar but wealthier Taiwan.

And when I visited Guangzhou last year, I noticed Vitasoy products taking over much more shelf space in the supermarkets.

At present, much of the Chinese market consists of dry soymilk powder, a segment dominated by a firm called Weiwei. Many consumers also make their own. But as consumers become wealthier, they're likely to increase consumption of the kind of prepared packaged drinks made by Vitasoy as part of a general trend to consume more flavoured soft drinks.

Sales are rocketing across China

So far, Vitasoy has focused on southern China, principally Guangdong province, which borders Hong Kong. It's followed a fairly conservative strategy which it calls "core business, core brand and core city", meaning that its focused on building awareness of a few key lines and the Vitasoy name in major urban centres. This has included products catering specifically to local tastes, including a saltier black bean flavoured drink which has apparently sold extremely well.

From here, it's expanding aggressively into eastern China. After average sales growth of almost 50% a year over the last three years, it's running up against capacity constraints in its current plants in Shenzhen and Shanghai and recently announced a RMB300-400m (HK$340-460m) investment in a new plant in Nanhai, which should double potential output. This should come into operation in 2011/2012.

The soymilk market remains fragmented and ripe for long-term domination by a couple of major firms. Vitasoy is one of the few big players and is by some way the market leader in its core southern China market. It has a solid position in eastern China, where it recently pushed Singaporean rival Yeo Hiap Seng into second place in the Shanghai market.

Three thriving ventures the market is ignoring

China is the key reason why we're interested in this stock, but one of its attractions is that it's a diversified business with a range of profitable divisions elsewhere. Hong Kong and Macau is a mature soft drinks market and one with tough competition, but Vitasoy has a strong position and a powerful brand. The long-term prospects are probably for low-to-mid single digit growth.

Australia and New Zealand is a relatively recent expansion where the soy milk market still has a lot of room for growth. Working in partnership with a local dairy firm, Vitasoy has taken around a fifth of the market. Sales growth has averaged over 20% a year over the last five years and should be capable of a decent pace for some time.

In Singapore, the main business is tofu manufacturing for the local market and export, following the purchase of local tofu producer Unicurd a couple of years ago. This is a small but profitable operation and the Vitasoy CEO has said the company would be interested in other acquisitions like this. Like Hong Kong, the growth prospects here are probably steady low-to-mid single digits.

The one blot has been North America. Vitasoy's brands such as Nasoya and Sansui are strong in their markets, but the division was still losing money for nine years. Last year, it took the decision to exit the local soy milk market and focus on markets like tofu. Local sales dropped 9% as a result, but the division finally turned a small profit again in the latest results and hopefully will continue to improve.

Vitasoy's sales has been expanding quickly in recent years (see chart below), thanks to the growth markets of China and Australia. With these accounting for an ever larger share of revenue, continued strong growth here will push up the headline rate of growth.

Mid-to-high teens growth should be common for a number of years to come. But at present the market continues to view Vitasoy more as an income play and less as a China growth story. As that changes, the stock should perform strongly.

A few risks to keep an eye on

So what are the risks? In addition to the usual warnings about emerging market investment, I'd emphasise the following:

As a food producer, Vitasoy is vulnerable to rises in the price of raw materials, such as soybeans. It's also exposed to higher labour costs, especially in mainland China where wages have been rising sharply in recent months. The strength of its brand should give it some ability to pass these on, especially in the long run. But there's always there's the possibility of some short-term hit to margins during a price spike.

Competition in most of Vitasoy's markets is fierce. Even in the high-growth market of China, it faces both other soy milk producers such as Yeo Hiap Seng and Weiwei and other firms such as Coca-Cola and Huiyuan aiming to establish a strong position in the soft drinks market. Chinese dairies, which saw sales plummet in the wake of the melamine contamination scandal in 2008, are now fighting to regain sales lost to soy milk and other drinks. In mature markets like Hong Kong, it needs to ensure that it's brand remains fresh and fashionable among consumers.

Vitasoy's ability to earn strong margins in the long term will depend on it establishing and maintaining a strong brand. So far this seems to be going well, but that often requires it to invest heavily in advertising and brand-building. And with brand being one of the most important assets for firms like this, there is always the risk of consumer trust being destroyed by problems like contamination (in the past, the firm has dealt well with any issues like this).

Continued rapid growth in China carries special risks, requiring investment in new production, bringing its products to consumer attention across a wide and diverse area and fighting off many competitors all keen to get access to this huge potential market. While it's starting from a good position and I believe that it has a strong chance of building the same dominant position on the mainland that it has in Hong Kong, there can be no guarantee of success.

Strong management with a great track record

Finally, let's take a quick look at the management and shareholders. The business that later became Vitasoy was founded in 1940 by the late Dr KS Lo. It floated in Hong Kong in 1994 and is still very much a family business: his son serves as executive chairman and two daughters on the board. However, the family has brought in outside directors and management, including the current CEO.

Overall, management and directors have a history of running the firm prudently and well. There are no obvious issues of corporate governance and a number of respected independent directors. Outside shareholders have been treated well over the years.

Collectively, the Lo family and the KS Lo foundation are the largest shareholders, but a number of institutions have substantial stakes. These include Arisaig Partners, which is also a major shareholder in Hsu Fu Chi, my recommendation a fortnight ago.

The free float is around 40% and the stock is liquid, with average daily volume over the past year of more than one million shares. You should have no difficulty building any reasonably-sized position.

Why we could see an 85% return inside three years

Vitasoy currently trades on a price/earnings ratio of 23.5 times last year's earnings. For FY2011, I'm assuming earnings in the region of HK28.5/share, which would put it on a forward p/e of just under 21.

Four analysts cover this stock at present and their estimates for the current year are around HK29-30/share. Mine are lower, since I suspect that competition may be tougher in China next year as the dairies try to regain market share. In addition, commodity prices may offer less of a tailwind. I may be pessimistic on this score; in any case I expect growth to pick up again strongly thereafter.

Vitasoy isn't as obviously cheap as Hsu Fu Chi, last week's Chinese consumer recommendation, but I still think it represents excellent value. As I've said before, I believe that the ability of dominant consumer companies to squeeze excess margins out of their brands over the long run makes them extremely good investments.

In this case, we have an attractive combination of a strong, stable low-risk business in a mature market that generates steady profits and extremely good growth potential in an emerging market that promises to transform the size of the business in the long run.

Very few people recognise the outstanding growth story here. Most investors view Vitasoy as an income stock. Given that the firm is a steady cash generator, has a track record of rising regular dividends and a large amount of spare cash on its balance sheet that's being returned to shareholders through special dividends, that's not surprising.

Vitasoy currently offers an attractive yield of 3.7%. I suspect that as the China business grows and requires more investment, excess cash will instead be diverted to this or to opportunistic acquisitions like Unicurd. But in the meantime, this high income is an attractive bonus for the portfolio.

The balance sheet is in excellent shape. Apart from the cash surplus, total debt to equity amounts to just 6%. That leaves plenty of scope for additional borrowing if needed to fund extra production capacity in China.

My base case valuation is for HK37/share in FY2012 and a slightly higher p/e of around 25, as the China growth story becomes more apparent. That would point to a value of HK$9.25/share in two years' time, or around 55% upside from here.

Discounting that back at a minimum required rate of return of 15% a year gives me a buy limit of HK$7.00 now. In a more bullish scenario, I think the stock could reach around HK$11 over the next two-three years, offering around 85% upside.

Recommendation