Scottish Oriental Smaller Companies Trust Makes Update Note

OREANDA-NEWS. July 20, 2016. This is the second semi-annual update on the Scottish Oriental Smaller Companies Trust plc ("The Trust" or "Scottish Oriental"). Our aim is to provide a general update on some of our current thoughts and views, insights about existing holdings, and changes to the portfolio over the period.

How we invest

Scottish Oriental is managed by the First State Stewart Asia team, an independent investment management team within First State Investments. The team manages a range of Asia Pacific equity strategies on behalf of institutional and wholesale clients globally, with offices in Hong Kong, Singapore and Edinburgh.

The Trust aims to achieve long-term capital growth by investing mainly in smaller listed companies across the Asia region; that is companies with market capitalisations of below US\\$1.5 billion, or the equivalent thereof, at the time of first investment.

We are conviction-based, bottom-up stock selectors with a strong emphasis on high quality proprietary research. Our investment approach adopts an absolute return mind-set and is inherently conservative, focusing on capital preservation as well as capital growth. By focusing on the potential downside (not just the upside) when making any investment decision, the risk to long-term client returns is significantly reduced. We are long-term investors and prefer to invest in quality companies that we can hold on to for many years.

The most significant source of investment ideas for the portfolio comes through country and company visits. As a team, we conduct more than a thousand direct company meetings throughout the year, seeking to identify a small sub-set of quality companies that meet our investment criteria. We place a clear emphasis on frequent visits to countries in the Asia region and on meeting the management of those companies in which the Trust is invested, or might invest.

While cultural, political, economic and sectoral influences play an important part in the decision-making process, the availability of attractively-priced, good quality companies with solid long-term growth prospects is the major determinant of Scottish Oriental's investment policy. Our country weightings bear no relationship to regional stock market indices and we do not consider ourselves obliged to hold investments in any individual market, sector or company. As a result, our asset allocation on a country and industry level is a residual of our stock selection process. 

Current portfolio positioning

	Scottish Oriental	Benchmark*
Sector weightings	%	%
Consumer Staples	18.3	5.7
Consumer Discretionary	16.5	9.3
Consumer	34.8	15.0
Industrials	13.3	8.2
Information Technology	13.3	26.2
Financials	12.9	29.3
Health Care	7.6	2.6
Materials	5.7	4.2
Utilities	3.9	4.0
Telecommunication Services	3.8	6.4
Energy	0.7	4.1
Gearing	-6.6	0.0
Cash	10.6	0.0
Total	100.0	100.0

Source: First State Investments. As at 30 June 2016.

*MSCI AC Asia (ex Japan)

Having focused on Scottish Oriental's country weightings in our previous update we will now try to provide some colour on how the Trust is positioned by sector. This is more difficult to do, particularly with smaller companies, as there is not universal agreement on sector classification. Also, conglomerates can muddy the waters when success in one segment outstrips what was the historic driver, changing the effective classification by stealth. We try not to reclassify holdings as it makes comparisons with prior periods less helpful. And finally, there can be quirks, such as an acceptance that auto manufacturers are Consumer Discretionary stocks (people buy cars and they are a discretionary purchase), which seems fair. But this then stretches to manufacturers of auto components, which are also generally classified as Consumer Discretionary stocks despite looking and feeling like Industrials businesses. Because of these quirks, we will also try to draw on some themes that sit within the Trust's portfolio rather than just stick to rigid sector classifications in our discussion.

One of the advantages of investing in smaller companies in Asia is that there is a wide selection of domestically-focused companies the Trust can invest in that are not available to investors with a larger company mandate. The trade-off for this is fewer banks, insurers, telecoms, electric utilities and oil companies in our universe. This seems like a fair exchange to us.

10 Largest Holdings	% of Net Assets	Country	Sector
Minth Group	3.5	China	Consumer Discretionary
Amorepacific Group	2.9	South Korea	Consumer Staples
Tong Ren Tang Technologies	2.9	China	Health Care
Raffles Medical	2.6	Singapore	Health Care
Standard Foods	2.6	Taiwan	Consumer Staples
Delfi	2.5	Singapore	Consumer Staples
Towngas China	2.5	China	Utilities
Taiwan Familymart	2.4	Taiwan	Consumer Discretionary
Marico	2.3	India	Consumer Staples
Kansai Nerolac Paints	2.1	India	Materials
	26.3

Source: First State Investments. As at 30 June 2016.

More than one third of Scottish Oriental's portfolio is invested in consumer companies with the lion's share of this focused on direct domestic consumption. Several examples of these businesses can be found in the Trust's top ten holdings, namely Amorepacific Group, Standard Foods, Delfi (the renamed Petra Foods which we have held for more than a decade), Taiwan Familymart and Marico. All of these were introduced in our previous note.

Amongst Scottish Oriental's holdings some are slightly more international, with Minth, the Trust's top holding, being a good example of this. Minth produces automobile body parts, with its customers holding a combined total of 80% of the global auto market. 60% of Minth's sales are made in China and 40% outside China mostly in North America. A decade ago, only 13% of sales were made outside China but having forged relationships with international auto manufacturers operating in China it has now followed these companies home and has manufacturing plants in the USA, Mexico, Thailand and Germany - all notable auto manufacturing hubs. So Minth is part domestic consumption, part exporter and part international business.

Our 11^th largest holding, Luthai Textile (China, Consumer Discretionary), is a further example of a more internationally-focused consumer company. It sells its fabrics internationally but predominantly within Asia. However, it is very much part of a global supply chain and perhaps should be classified as an exporter rather than a domestic Asian business.

How we think about Scottish Oriental's portfolio

We have attempted to classify the Trust's portfolio holdings into one of four categories according to economic activity. Some companies may inevitably straddle across more than one category, in which case we have endeavoured to split the company's business activities across these categories. Our analysis shows that Scottish Oriental has the following exposure:

Economic activity	Approximate exposure %
Direct Asian consumption	41
Derived from Asian consumption	27
Exporters	21
International, trade-related or domestic capital-related	7
Net cash	4
Total	100

 

Source: First State Investments. As at 30 June 2016.

Direct Asian consumption

Most of the Trust's holdings that are directly exposed to Asian consumption fall within the consumer sectors, with five of these in the top ten holdings as mentioned above. We include the Trust's three Telecommunication Services holdings in this category as well as three of its four Health Care stocks. Two of these Health Care stocks - Raffles Medical and Tong Ren Tang - are in the top ten holdings. The Trust's property stocks, totalling around 5%, are also included in this category.

Derived from Asian consumption

It is perhaps a slightly tenuous distinction, but our second category is comprised of companies that, whilst domestically-focused, are broadly one step removed from direct Asian-based consumption. Scottish Oriental's exposure to banks and finance companies, totalling 9% of the portfolio, are prime examples of this - people buy a car or a home and then take out a loan/mortgage; but these companies have other performance drivers so the link is not quite so direct.

Our largest holding within this category is Public Financial Holdings (Hong Kong, Financials). This company is majority-owned by Public Bank of Malaysia, whose management are both excellent stewards and bankers. Like most of the Trust's bank and finance company holdings, Public Financial has struggled in the low interest rate environment, but we prefer to back such companies that are more concerned about the proverbial return of our capital than the return on our capital. We appreciate the 5% dividend yield whilst it continues to manage its loan book well.

We would also include both Utilities holdings, some components of the Trust's Consumer Discretionary stocks (e.g. part, but not all of the Scottish Oriental's position in Minth) and several Industrial holdings or components thereof.  This is where things start to get complicated as holdings like courier company Blue Dart Express and logistics company Container Corp of India benefit directly not just from India's rising domestic consumption, but also the increase in exports.

Exporters

Exporters are predominantly comprised of Scottish Oriental's Information Technology stocks as well as several of its Consumer Discretionary companies. Here we tend to favour companies with a proven track record, a defensible franchise and an ability to generate cash, rather than low margin businesses chasing bottlenecks.  Reflecting on our position sizes for exporters, it is of note that none sit within the top ten holdings, the largest holding among such companies being Luthai Textile.  This perhaps shows that we do not have quite the same level of conviction in these holdings as we do in the more domestically-focused Asian companies. Nevertheless there are some very good businesses in this category such as the Trust's three Indian IT outsourcing companies (Hexaware, Mphasis and Tata Consultancy Services), point-of-sale terminal producer Posiflex (Taiwan, Information Technology) and camera lens and module producer Sunny Optical (China, Information Technology). Our reticence at having larger positions in such stocks is that they are more prone to providing us with surprises than their domestically-focused counterparts given that they can be prisoner to the external environment.

International, trade-related or domestic capital-related

Our final classification is a bit of a catch-all category. It includes a portion of some of Scottish Oriental's holdings that have overseas subsidiaries selling to overseas customers, with the most obvious example being Tata Global Beverages (India, Consumer Staples) and its overseas subsidiary Tetley Tea. It also includes Pacific Basin Shipping (Hong Kong, Industrials), Ezion Holdings (Singapore, Energy) and Tat Hong Holdings (Singapore, Industrials). The largest position we have included here is Linde India (Materials), which is controlled by Germany's Linde AG. Linde India manufactures and supplies industrial gases as well as building gas plants in India. Arguably, we could split it into three of our categories but industrial gas businesses tend to do well when an economy is growing and significant capital investment is being made. Linde India is positioned very well for when such investment resumes in India.

Undoubtedly, we will have made some errors or over-simplifications when undertaking this exercise, but we think it is broadly right that almost 70% of Scottish Oriental's portfolio is exposed to Asian consumption, with the balance being more globally-focused. We are positive on the long-term investment opportunities in Asia, given the well-rehearsed arguments of superior demographics, an emerging middle class and stronger economic growth, and are happy to be positioned accordingly. We can also find a good selection of stocks among domestically-focused Asian equities, with the strong management teams and defensible franchises that provide us with the predictable cash flows our investment process seeks out. The global exposure acts as a hedge should Asia and its currencies underperform, but primarily reflects investments in companies that we believe will enjoy a long-term competitive advantage over companies in the West.

Recent notable changes to the Scottish Oriental portfolio

	30-Jun-16	31-Dec-15
Sector weightings	%	%
Consumer Staples	18.3	19.3
Consumer Discretionary	16.5	16.4
Consumer	34.8	35.7
Industrials	13.3	14.7
Information Technology	13.3	11.9
Financials	12.9	13.1
Health Care	7.6	7.2
Materials	5.7	5.6
Utilities	3.9	3.0
Telecommunication Services	3.8	3.5
Energy	0.7	0.7
Gearing	-6.6	-7.5
Cash	10.6	12.1
Total	100.0	100.0

 

Source: First State Investments

Consumer Staples

We have made minimal changes to the Trust's Consumer Staples holdings over the period.

We reduced Tata Global Beverages on the realisation that the drag caused by their international strategy means the holding should not warrant such a large position. We also sold almost one third of Scottish Oriental's position in Marico. The company continues to execute well but share price appreciation has resulted in expensive valuations.

Consumer Discretionary

We made more significant changes to the Trust's Consumer Discretionary holdings with two new positions and two complete sales. We initiated a position in Suprajit Engineering, India's largest manufacturer of mechanical automotive cables. Over time, management has successfully diversified its business beyond just India and mechanical cables. We also bought Makalot Industrials (Taiwan), a garment manufacturer with an impressive track record. The company predominantly manufacturers in Southeast Asia which is increasingly seen as a better alternative to China for garments.

We exited Dickson Concepts, the Hong Kong-based luxury goods retailer. We lost money on this investment which is disappointing. The slowdown in high-end retail has taken its toll on the company and although the stock is very cheap when compared to the value of its assets we see little likelihood that this value will be realised any time soon. We also sold Tao Heung which operates restaurants in Hong Kong and China. Profits have been hit by rising rents and payroll costs as well as greater competition and a weak economy. Tao Heung was an even worse performer than Dickson Concepts. Although Tao Heung is a very competent operator it is difficult to see the business improving given the overall economic outlook so we decided to cut our losses.  

We also added to APM Automotive (Malaysia), an auto components manufacturer which has been struggling given poor sentiment in Malaysia, and travel agent/tour operator Hana Tour Service (Korea), where start-up losses in its duty free segment have weighed on the share price.

Industrials

Overall, we reduced the Trust's weighting in the Industrials sector completely selling out of three holdings. AirTac (Taiwan), a producer of pneumatic components, was sold following a strong rebound in both its orders and its share price. We approximately broke even on this holding so did not cover ourselves in glory. We perhaps underestimated how cyclical this company is and although it has been gaining market share it is still dependent on capital investment in China for long-term growth, and we are nervous here. We also exited Interplex (Singapore), taking the privatisation offer from private equity made last year for a modest overall gain. Finally, we exited from Singapore Post for another modest gain. Here we had been backing the chief executive to build up an Asian-focused logistics business. However, his resignation late last year as well as subsequent senior management departures dampened our enthusiasm for the group.

We bought one new holding during the period: Acset Indonusa (Indonesia), a contractor specialising in high-rise building foundations. United Tractors (part of Hong Kong's Jardine group) became Acset's controlling shareholder in 2015. We have huge respect for the Jardine Group's knowledge of Indonesia and expect them to grow Acset into a much bigger business. We also completed building the Trust's position in Blue Star (India), which was the unnamed company from our precious update. Blue Star is India's leading air-conditioning and commercial refrigeration company, with a history dating back to 1943.

Finally, we added to Scottish Oriental's position in bulk shipping company Pacific Basin Shipping (Hong Kong). We were again too early in doing so and towards the end of the period further added to the position by taking up the Trust's entitlement in a rights issue carried out by the company. The rights issue should ensure that the company has the time it needs for the market to recover. Pacific Basin has been a painful investment for us and is a reminder that no matter how good a management team is, there is only so much that can be achieved within cyclical industries when times get tough.

Information Technology

Technology was our strongest source of new ideas over the period, with holdings in four new companies initiated. Hana Microelectronics (Thailand) has been held in the Trust before and is a well-managed electronics manufacturer. The share price had fallen during 2016 on a somewhat muted outlook but with a dividend yield of 6.7% at the time of writing we are being paid to wait for things to improve. Hexaware Technologies (India) is an IT outsourcer which we believe is set to grow faster than the industry. iFast (Singapore) is a funds/investment platform with potentially a very scalable business model as fund distribution in Asia moves away from retail banks. Wistron Neweb (Taiwan) is a networking equipment manufacturer with expertise in radio frequency and antenna technologies. It is benefitting from the increasing prevalence of "smart home" and "smart auto".

There was one complete sale during the period. Wah Lee Industrial (Taiwan) has been a longstanding holding in the portfolio. It provides plastics and chemicals to the technology sector in Taiwan and China. Although the company has steadily grown its revenues, it has struggled to grow its profits and we do not see this margin pressure relenting. The Trust's returns on this stock have been limited to its dividend yield and this alone is not reason enough to hold on to it. We also significantly reduced the position in IT outsourcer Tata Consultancy Services (India) preferring the more nimble Mphasis and Hexaware. Finally, we reduced the Trust's holding in testing equipment manufacturer Chroma ATE (Taiwan) when it rose sharply on an encouraging outlook, reminding ourselves this time that, whilst an excellent company, it operates in a highly cyclical sector.

Financials

We made one new investment in the Financials sector, Commercial Bank of Ceylon (Sri Lanka), which is in our opinion the best-run bank in the country. Although Sri Lanka has more than its fair share of economic woes at the moment, in our experience quality prevails and these woes have returned the bank to a more reasonable valuation. We also continued adding to China Banking Corporation (Philippines) and added to Bank OCBC NISP (Indonesia) which is controlled by Singapore's OCBC, a sensibly-run bank that we know well.

We significantly reduced the Trust's position in Mahindra Lifespace (India), preferring Godrej Properties (India) which we have been adding to via its holding company Godrej Industries (India, Materials).

Other sectors

We continued adding to Indian pharmaceutical producer Indoco Remedies (Health Care) and also to the Trust's holding in Godrej Industries. We also added to XL Axiata (Indonesia, Telecommunication Services) via a rights issue, which has bolstered a balance sheet that was somewhat stretched following the acquisition of competitor Axis in 2014. Finally, we continued adding to Towngas China (China, Utilities) for the same reasons documented in our last note.

Scottish Oriental investment performance

	3mth	6 mth	1 year	3 years	5 years	10 years
NAV	10.0	14.5	8.3	18.1	47.8	288.7
NAV - total return	10.0	14.5	9.8	23.1	58.9	350.2
Benchmark*	8.1	12.8	3.9	21.7	22.1	145.9
Small Cap Index**	7.3	8.3	0.4	17.9	16.7	154.3
Share Price	10.5	13.8	4.5	-0.1	38.2	252.2
Share Price - total return	10.5	13.8	6.1	4.4	49.0	313.8

Source: First State Investments. As at 30 June 2016. * MSCI AC Asia (ex Japan) Index. ** MSCI Asia (ex Japan) Small Cap Index. Past performance is not necessarily a guide to future performance.

Year-to-date performance

We invest with a long-term, that is, a three-to-five year mind-set, if not longer; and we hope to be measured over a similar time period. However, we are aware that the long-term is made up of several short- and medium-terms and sometimes it can be helpful to look at what has driven recent performance.

Over the first half of 2016, Scottish Oriental's NAV rose by 14.5%. Whilst a double digit return is pleasing, it is unfortunate that most of this return resulted from sterling's near 10% fall over the period. However, discounting sterling's Brexit-induced weakness, Asian stock markets still produced positive returns during the first half of the year. This seems incredible given both the start to the year that we had (stock markets and commodity prices falling sharply) and what has happened since then (poor corporate results, downgraded earnings forecasts, faltering global growth and the Brexit referendum result).

But it is not difficult to see why stock markets have gone up. Further bursts of economic stimulus have "righted" markets again. We would argue that this is artificial and is, at best, stealing growth from the future and, at worst, exacerbating the misallocation of capital that has resulted from several years of cheap money. It is disturbing that any market shock seems to be followed by a brief pause before policymakers make reassuring noises and promise to print more money if needed.

Normally it is possible to look at Scottish Oriental's returns over a period and identify sector and country themes that have driven investment performance. This period has proven much more difficult to analyse, which can perhaps best be illustrated by the best-performing stock (Minth Group) and the worst-performing stock (Trinity) in the portfolio both being classified as Chinese Consumer Discretionary companies.

What has become apparent is that the market is reacting more strongly to both good and bad news and we have had our fair share of both over the period.

We benefited from six of the Trust's top ten holdings (Minth, AmorePacific Group, Marico, Raffles Medical, Kansai Nerolac Paints and Delfi) performing well over the period with results broadly confirming their investment cases with the other four top ten holdings performing acceptably i.e. they still made money. Minth was particularly strong and was the Trust's best performing stock over the period. It announced results in March that showed continued growth and an end to the falling margins that had accompanied its expansion and the share price reacted accordingly. We took profits from all six of these companies over the period but only the Marico sale was significant enough to comment on individually.

Other notable performers were Sunny Optical, Chroma ATE and Haw Par (Singapore, Consumer Staples). Sunny Optical's results showed rising revenues and profits as its camera lenses and modules continued to gain acceptance. The outlook for Chroma ATE's testing equipment is improving, and Haw Par's results showed strong profit growth in its Tiger Balm business.

We expressed some doubts about traditional Chinese medicine retailer Eu Yan Sang's (Singapore, Health Care) strategy last time and so were happy when the management made an offer to privatise the company at a reasonable premium to the prevailing share price - which we have given an undertaking to accept. One other holding, crane supplier Tat Hong, announced an approach during the period; but the company is yet to provide further details so we have not acted. Both contributed positively to performance.

The Trust's worst-performing stock this period was Trinity. It has faced near-impossible operating conditions given the slowdown in luxury retail in China and Hong Kong. The company has replaced its CEO and issued a profit warning stating that 2016 will likely see higher losses than 2015. Our original investment case is gone. What is keeping us holding on is a belief in the Fungs, Trinity's controlling shareholders, and their ability to extract some value out of the company. We will see, but this is one of the poorest and most chastening investments we have made for some time. The lesson, which we should have already known, is that fashion businesses can be inherently unpredictable and make difficult long-term investments.

Pacific Basin was the Trust's second worst-performing stock, continuing to find conditions difficult but it is at least on a more solid footing after its rights issue. Liftboat operator Ezion Holdings was also poor again. It announced a rights issue towards the end of the period to expand into the offshore wind market in China which should reduce its dependency on oil production. We continue to watch its cash flows. Nitrogenous fertiliser producer China Bluechemical (Materials) suffered a production shutdown during the period which will impact on its results.

Hana Tour Service's core travel business performed reasonably well but losses at its duty free start-up impacted sentiment. Blue Dart Express and Vitasoy (Hong Kong, Consumer Staples) performed adequately on an operational basis but both stocks fell back from expensive valuations. Indoco Remedies and Somboon Advance Technologies (Thailand, Consumer Discretionary) produced slightly dull results but these have not changed our investment cases. Tata Global Beverages disappointed because of its international operations and this has reduced our enthusiasm for the company. Yashili (China, Consumer Staples) struggled as it is investing in its production and branding.

Finally both of Scottish Oriental's industrial barcode printer companies disappointed. TSC Auto ID (Taiwan, Information Technology) suffered a drop in profits as it invested in new technologies, while Godex (Taiwan, Information Technology) saw falling revenues and profits as some of its key customers had been acquired and it has not managed to replace these customers. We think TSC Auto ID is the better company but it is valued accordingly.

Outlook and conclusion

Little has changed in our outlook for Asian markets, which remains uncertain. Despite the increasing prevalence of negative interest rates in developed markets, global growth remains muted. This lack of growth has resulted in challenging export conditions for Asian corporates. Low, and particularly negative, interest rates are likely to have many unforeseen consequences, but for now there are few inflationary pressures. If anything, the build-up of debt may become deflationary as cash flows are directed towards debt repayment. While inflation remains muted, interest rate cuts are more likely than increases in Asia as central banks look to stimulate domestic economies and avoid currency strength.

The banking sector is struggling, as interest rate spreads remain under pressure and the risk of default increases, especially from borrowers in industries where easy money has led to overcapacity and thus poor pricing power. Low interest rates made borrowing, particularly in US dollars, an apparently attractive proposition and there is a sizeable segment of Asian companies that are vulnerable to interest rate rises. Therefore, it is difficult to see a normalisation of the interest rate environment without triggering economic distress.

We are not macro-economic commentators, preferring to be informed about the economic climate by company management teams rather than by economists. What these management teams are telling us now is that growth is scarce. We are finding that where growth exists, this is well-recognised and, accordingly, valuations are relatively full. Therefore, we are sticking to tried and tested companies, particularly for larger positions in the Trust, and are maintaining a modest net cash position to give us the flexibility to add should some of our favourite companies become less fully valued. We also have ?20m of unutilised debt which we will be able to deploy should our favourite companies become cheaply valued.

We are not positive about the remainder of 2016 but we hope we are wrong. If we are wrong, Scottish Oriental should produce positive returns for its shareholders. If we are right and 2016 is a poor year for Asian economies and companies, then we hope, by investing in high quality businesses, to do a reasonable job of preserving the Trust's capital as best as we can.

We trust this update has given you a better understanding of the companies that Scottish Oriental invests in. We would welcome feedback on whether it has been helpful as well as what you would be interested in reading about in the future.