Asia has come a long way over the last two decades. The Asian Financial Crisis, which began 20 years ago this month, was the catalyst for a period of widespread reform in Asia – leading to greater economic stability, improved growth and declining interest rates. These tailwinds enabled the strong investment cycle of the 2000s.
One of the major vulnerabilities of Asia two decades ago was the levels of external debt, but this has improved significantly with the expansion of the economy. Despite higher overall debt levels in the region today, most of this is in local currency. Learning the lessons of the past, many Asian countries embarked on the creation of more flexible exchange rates, as well as the implementation of structural reforms across the financial sector and improving standards in corporate governance.
As for the corporate sector, companies in the region embarked on a spending spree in the years following the Asian crisis, effectively catching up on years of underinvestment. However, for a long time, too many Asian companies ignored margins, enjoying the benefits of rising top-line revenues.
Massive capex during boom years
Encouraged by the greater stability, many Asian companies initiated massive investment programs aimed at boosting productivity and sales. As such, a lot of the earnings growth of the past has been achieved by expanding sales in an environment of robust economic growth.
However, the party could not last forever. It was not until Asian economic growth began to slow from 2011 that the results of this behaviour began to show. In the rush to spend, history shows us that much of this was poorly invested by ill-disciplined and over exuberant management teams and often financed by mispriced capital.
The result of this irrational spending was supply gluts, excess inventory, overcapacity, and, ultimately, falling prices and contracting margins. Today, companies are finally adjusting to the new economic reality, with management teams modifying practices to account for the new environment in which they are now operating.
Attractive ‘self-help’ opportunities
One area where this has been particularly evident is in the way company management teams are allocating capital. Greater discipline in relation to capex should have a material impact on the amount of free cash flow that Asian companies are generating.
Companies are realising they can no longer rely purely on economic growth to drive revenues. Companies that succeed in introducing new products to drive their top-line, while managing costs effectively should deliver solid growth over time. This type of ‘self-help’ is an important factor we look for through our research process.
We are clearly seeing signs of improvement emerging, which could potentially result in sustained optimism for Asian equity markets. Reduced costs are flowing through to expanding company margins, while greater capex discipline is likely to continue improved return on capital, as well as allowing companies to potentially return more cash to shareholders via dividends or by buying back shares. Investors will most likely be prepared to pay for the prospect of greater capital returns, leading to a potential further positive rerating of the Asian equity market.
Eric Moffett is portfolio manager of the T. Rowe Price Asian Opportunities Equity fund