Bottom-up approach keeps manager in the picture - SCMP

Uncertain times call for nerves of steel for fund managers who must stay focused on the long term

INVESTORS DRIVEN by broad market trends in recent years will have ridden a roller coaster of emotions - and returns - as sentiment lurched through one crisis after another.

For a fund manager, therefore, the key to long-term outperformance is an ability to hold your nerve and avoid becoming a slave to market sentiment.

'It's fair to say over the last five years that the macro side of things has been very confusing,' said Martin Lau, director of Greater China Equities for First State Investments (HK).

'Investors have been confronted with concerns about the US economy, the Hong Kong property market, global demand, hard landings for China, a revaluation of the yuan, a collapse of the Hong Kong currency peg - the list goes on.'

Troubled and uncertain times they might have been, but few of these crises ever materialised.

Managing the US$194.6 million in assets in the First State Greater China Growth fund and the US$135.1 million in the First State Hong Kong Growth fund was made easier against this background by the 'bottom-up' approach to stock selection.

Over the past three years, the China Fund generated an award-winning 191.6 per cent cumulative return, barely changed from a cumulative return over five years of 191.4 per cent.

The Hong Kong Fund returned investors 157.7 per cent over three years, and 95.1 per cent over five years.

'We keep the macro picture in mind, but don't use that as reason to invest. Sure, if the global economy is doing great, we wouldn't mind buying a company that is sensitive to rates. But in this scenario, it must be particularly well insulated from interest rate risk or present some compelling reason why it would continue to do well even if the economic growth picture changed.'

With such a bottom-up approach to investment decisions, a target company would be closely examined with respect to criteria, such as whether its market share was growing because of a competitive cost structure, or whether it had 'pricing power' and was able to pass on increased costs to its customers.

This long-term focus might mean that stock picking leaves the two funds under Mr Lau's management vulnerable to short-term volatility, but underperforming rivals in quarterly growth reports is something that the investment team is quite content with. If investors wished to cut and run based on a quarterly report, they were welcome to do so, Mr Lau said. The manager's eye will remain fixed on long-term results.

'Those who are slaves to market sentiment get caught in the middle, and for our team it comes down to two things. When the market is performing strongly - as it was in January, for instance - there is a prospect we may underperform because in these circumstances a monkey can outperform by simply picking the highest beta stock.'

Educating First State investors, therefore, was a job for the fund manager.

'The last thing you want is to allow clients to drive what you do every day. Chinese banks, for example, have recently been going up strongly and a manager might be tempted, because of the momentum, to climb aboard,' he said.

'But the way we look at this is from absolute perspective. If you buy Chinese banks today you are increasing absolute risk, and you shouldn't be buying just because others are buying.

'The way to outperform the benchmark peer group over time is to have a keen understanding of what you are doing and to avoid situations where you allow clients or indexes to put you under pressure.'

Investing decisions for the China Fund, for instance, were based on the understanding that consumption would be the key driver of both macroeconomic growth and corporate earnings growth. At about 28 per cent a year, investment growth was unsustainable.

So the China Fund was light on commodities - foregoing the supercharged returns that might have been made over the past 12 months - and had a bias towards consumer stocks.

Meanwhile, concerns over a yuan revaluation triggered a popular aversion to Chinese exporters, based on the argument that a more expensive yuan would price their products out of their export markets.

'Ask people what they want to avoid in China and the most popular answer is avoid exporters,' Mr Lau said. 'But because of our bottom-up approach, we can pick those undervalued stocks up because we investigate to establish whether their share prices have overcompensated for the risks.'

Accordingly, export-oriented stocks are well represented in the China Fund's top holdings, with a prime candidate being Lung Kee.

The choice illuminates that bottom-up process favoured by Mr Lau, since Lung Kee is not an exporter but the domestic Chinese companies to whom it sells its moulds use them to manufacture for the export market. By Mr Lau's estimate, this means that about 70 per cent of its revenues are therefore export-oriented.

It is also a dominant player and hence possesses that elusive pricing power concept.

The Lung Kee price chart shows plenty of short-term volatility. But shut out the noise and the stock moved from a 12-month low of $4.92 to a 12-month high of $6.15. At the time of writing, it was priced at about $5.80.

In Hong Kong, the challenge was the same - taking a long-term view and holding one's nerve as property prices surged 70 per cent from their Asian crisis trough, hauling office rentals in their train.

'That sort of growth is unsustainable and we looked instead to the next driver for Hong Kong earnings,' Mr Lau said.

Management quality tops the list of criteria. This means management must be incentivised with share option schemes and be sympathetic to the concerns of minority shareholders. Over the long term, the key ingredient would be exposure to China.

'Hong Kong is quite a mature economy. But companies here know how to do business and, hopefully, better than some [mainland] Chinese companies, and the future of Hong Kong is in China.'

Indeed, as a fund manager he is already having a little difficulty distinguishing between the two.