The black box that gets the best from red chips

Q: What changes have you made to the fund over the past year? A: When I came to Investec, they were moving the investment management out of Hong Kong, aiming to get investment management in one place. This was considered more valuable than having people dotted all over the world. Initially, it was a question of asking questions to make the existing emerging markets process stronger and more disciplined. But then we wanted to tie the process in with the Sigma process used by the global team. The fund became more large-cap focused. We are now fully reliant on the Sigma process, which seeks out companies that generate returns above the cost of capital, that are being upgraded and are on reasonable valuations. We then adapt that and apply it to the Asian environment. Q: How much do you have to adapt the process for Asia? A: As we put the process in place, we found it worked well in the Asian environment. But we created more limitations. We can be plus or minus 10% of the EAFE ex Japan index for each industrial sector. It dragged us into technology initially, then dragged us into financials and now it’s dragging us into property. It has made us make good bottom-up calls and appears to be effective. In Asia, the thing to be careful of is the corporate governance, so we had to put in measures to make sure that was being dealt with. Q: What is your sell discipline? A: We keep positioned at the top end of stocks – those with the highest scores. We hold around 30 stocks from a universe of 100. We always keep fairly concentrated, with around 25-40 stocks. Q: How has that been done? A: If a company is scoring highly on all our measures, we then do a lot of due diligence. If the corporate governance isn’t right, we avoid it altogether. It means we meet companies, whereas those on the UK side in Investec don’t. It is a much more fundamental factor in Asian investing. We need to know what we are investing in. It is important to have a disciplined process in a market that is highly rumour-driven and full of small-cap and more exotic investments. The process has delivered this year and should get better as we get to know why it is effective. Q: How do you determine the weightings between Hong Kong and China? A: Because it is a large-cap fund, it tends to be in the Hong Kong-listed H shares and the “red-chips”. This is where the basic liquidity is. Q: How do you achieve diversification within this tight remit? A: There is a natural over-emphasis on certain areas in the region – like real estate. But there is a still a large spread of companies. The toughest thing for us is that despite these 1.3 billion Chinese consumers, it is difficult to get hold of the Chinese consumer. There is a dearth of listings. The big areas are the exporters and the capital goods sectors. The opportunities have got broader, but the consumer is still difficult. Q: Is this changing? A: There are more IPOs. The market has gone mad. The Chinese government has to recapitalise the financial system. There is around 25% bad loans, which may be a conservative estimate, and there is inadequate capital. They also need to raise new equity from overseas investors. Recent IPOs such as China Life, which is the biggest life assurer, was 40 times oversubscribed. It could even be seen as a worry. There is lots of paper, meaning lots of supply, which could have a short-term dampening effect. At the moment, there’s so much enthusiasm. They have a small allocation and they cry for more. Q: Is there a Chinese bubble? A: Not yet, but I do worry about certain things. At the moment, there is huge investment and that is not sustainable. The demand for new cars and new steel products must decline over time. There is too much capacity being built. Other areas get the opportunities. There again, valuations don’t look extended. Historically, China has always been a boom/bust economy – I see no reason why that will change in the near term. We would have to worry when there is inflation. We are seeing it rise a bit and it is probably going to have to tighten. Q: Where do you see opportunities? A: At the moment, it is property. Hong Kong was flat on its back until recently. It had been kicked by Sars and there was massive deflation, with 50 months of negative RPI numbers. Suddenly, the border with China was opened up and the Chinese came across with money in their pockets. They wanted luxury goods. Also, Hong Kong became a desirable place to live. This caused a major change in sentiment. Luxury apartments were built. Inventories were built up again. The psychology changed. Buy-to-let is now the hottest thing. This put an end to deflation as people were actively going out to borrow. The outlook for asset-based things was so horrible for so long, but is now improving. The property side is going up. We’re right down on utilities. There is no momentum. We are upping our weighting in Chinese telcos – we’ve been buying Hutchison Whampoa because of the association with 3G. The take-up is quite high. Q: Does this fund tend to perform especially well or badly in certain markets? A: The Chinese market is a volatile environment. I hope the factors we’ve selected mean that we will capture the major market trends. But if there are very rapid changes in the market, we won’t be there. We are not chasing short-term trends. While styles are bouncing around, we will have a tougher time. Also, we are large-cap and more diversified. We hope to capture the long-term success of the region with less volatility. It will not blow up relative to the marketplace. The major risks are at the short-term end. Q: What are the greatest risks in the region at the moment? A: Bird flu is an obvious one. I suspect the Chinese will be accused of being inadequately prepared. But I think it is a mild short-term cyclical phenomenon. Overall, the risks in the region remain political and that will probably continue to be the case. There have been pro-democracy demonstrations in Hong Kong. There is pressure on the mainland. An outside risk is China’s relationship with Taiwan. There are also issues with trade. In the US, the Democratic nominees have been talking about protecting the US textile industry. A more protectionist US would be a bad thing for the region. Q: What has been your greatest lesson in fund management? A: Never get carried away thinking you’re a genius during the good times. Humility is very important. Also, you need a process and discipline as to how to invest. Without it, you will end up on the scrap heap. It is about consistent application of belief and process.