abrdn Asian Income Fund — A reappraisal of the opportunities for AAIF

While AAIF is not currently (and as we show in Exhibit 1, has not historically been) heavily invested in China (7.7% of the portfolio at July 2022), the country is a significant constituent of the benchmark making up 29.9% for the MSCI AC Asia Pacific ex Japan Index and 23.6% for the MSCI AC Asia Pacific ex Japan High Dividend Yield Index (end of July 2022). This makes the outlook and sentiment towards Chinese equities important for the region’s equity markets as a whole and for AAIF’s relative performance. The largest Chinese benchmark positions are the internet stocks such as Tencent and Alibaba, which are not dividend payers and so do not form part of AAIF’s opportunity set. Chinese banks such as China Construction Bank are high dividend payers, although the managers favour more transparent Singapore-based banks such as DBS Group Holdings and Overseas Chinese Banking Corporation, which have extensive operations in China.

This means that AAIF has a low historical correlation to Chinese equities relative to peers (Morningstar Asia Pacific ex Japan Equity Income category), and the two reference indices (Exhibit 3). There are also less domestically derived Chinese earnings compared with comparators according to Morningstar (Exhibit 2).

China’s zero-COVID policy has been a source of concern for global economists as it has contributed to a slump in consumption and exacerbated supply chain problems (such as delays in shipping), while increasing costs and fuelling inflation. The government’s policy has not changed – lockdowns are still occurring but are becoming more targeted in conjunction with mass testing on a localised basis rather than being applied wholesale. This development could help to mitigate the effects of lockdowns on both the Chinese and global economy. However, if restrictions are lifted and there is a rapid reopening of parts of the Chinese economy currently in lockdown then pent-up consumer demand could have a significant impact on regional inflation.

While Asian companies have not been immune to the challenges presented by supply constrictions and rising input costs, they are (in general) in relatively robust condition with less debt at both the corporate and government level. As a result, Asian companies are better equipped to deal with a slowing economic environment, while the region as a whole is not facing the headwinds of rising interest rates. Given the economic slowdown and rise in input costs, it is more important than ever to focus on the corporate balance sheet to ensure that lower sales or squeezed margins can be absorbed without hindering the operational viability of a company or reinvesting for future growth.

AAIF’s investment strategy is active, with sector and country positioning historically changing incrementally over time. Over the last 12 months the team has been rotating at the margin out of technology holdings such as Infosys and Hana Microelectronics and increasing its holdings in financials via names such as DBS Group Holdings and United Overseas Bank (see Exhibits 5 and 6).

AAIF’s earnings per share increased by 21% from 4.32p in H121 to 5.23p for H122, with the fund’s last reported yield equating to 4.6% versus the MSCI AC Asia Pacific ex Japan Index’s yield of 3.1% and the MSCI AC Asia Pacific ex Japan High Dividend Yield Index’s 6.6% (July 2022). Over the past year (to Q122) Asian companies as a group have increased dividends by 21% year-on-year, which is above the level of growth seen in Europe for example. In addition, the low level of relative net debt to equity in the region gives companies more flexibility to utilise their balance sheets.

The Association of Investment Companies (AIC) Asia Pacific Equity Income peer group comprises five funds, with Henderson Far East Income (HFEL), which currently offers an 8.5% yield, being by far the highest yielding fund. If this fund is excluded, then AAIF is yielding a similar amount to the other three funds in the category. AAIF has grown its dividend by an annualised compound rate of 3.4% over the last 10 years. It has 13 years of consecutive increasing dividends and is in the AIC’s ‘next generation of dividend heroes’ cohort. The board has guided for a dividend of at least 9.75p for FY22 (FY21:9.5p), although this is not guaranteed.

It is in the nature of financial markets that there is uncertainty but at the moment, with the various geopolitical events and global economic slowdown, AAIF’s portfolio managers are focusing on the stock specific merits of portfolio as the best way to counter macroeconomic-generated turbulence. The investment process focuses on finding the best quality companies (most capable management, best business models, highest barriers to entry, most robust end markets and most appropriately structured debt profile) that they can at the most attractive valuation available. The relative valuation discipline is evident via various metrics such as price to earnings and price to book, but the portfolio also has quality, as is evidenced by the better return on capital invested and net margin trends over the past three years (Exhibits 9 and10). The portfolio managers’ objective is to have a diversified portfolio, which is not over-exposed to any one sector or country, and to hold the best quality growth and value stocks, which gives the strategy a core buy and hold approach able to perform in varying market conditions.

abrdn’s investment process puts ESG at the very heart of the stock analysis. Aside from the wider societal benefits of using its ownership to address areas of concern, this focus adds additional layers to the identification of ‘quality’ within the portfolio. Arguably, businesses that take action to mitigate ESG risks and that have a culture that puts these factors at the front and centre of their activities should be afforded a premium valuation over time versus those companies that pay little or no heed to such considerations. According to work done by Morningstar, the AAIF portfolio historically scores appreciably better than its AIC category peers on these considerations overall (Exhibit 11).

With five Morningstar sustainability globes, AAIF also has the highest sustainability rating given by Morningstar, with a better profile in terms of a carbon risk and fossil fuel involvement than its Morningstar category peers. This is despite the fund having above-average exposure to basic materials via positions in five companies including BHP and Rio Tinto. It is an important facet of fund management (either active or passive) that managers leverage their shareholdings on behalf of their investors to engage in an informed and constructive manner with company management to extract the maximum value out of the position, and this includes on ESG matters. As an example, AIA is a top 20 position in the portfolio with an excellent market share and established footprint in the Asia region. The team at abrdn engaged with the company in a number of areas such as its views around net zero emissions and the impact of climate change on its liabilities. After this engagement, AIA announced that it had divested its coal mining and coal-fired power business and was committed to achieving net zero greenhouse gas emissions by 2050. Subsequently AIA’s MSCI ESG rating was upgraded from A to AA in October 2021, its second upgrade in two years.

The portfolio is built from the bottom up, but there are a number of themes such as aspiration, building Asia, digital future, going green and tech enablers. We covered some of these themes in our last note in May 2022, A core option for Asian income and capital growth.

The portfolio is more heavily invested in the higher-yielding markets such as Singapore, Taiwan and Australia (Exhibit 12), while being underweight the more expensive Indian and the volatile Chinese markets.

At a market level, there have been substantial regional disparities in performance in CY22 to date, with Korea and Taiwan returning negative double-digit returns, while India and Australia were the strongest regional performers (Exhibit 13). The five largest country positions within the MSCI AC Asia Pacific ex Japan Index are China (29.9%), Australia (16.4%), Taiwan (13.8%), India (13%) and South Korea (11.2%). This compares with the high-dividend index country weightings of China (23.6%), Taiwan (23%), Australia (17.4%), Hong Kong (9%) and Singapore (6.7%).

From a sector perspective, energy, utilities and financials were the strongest returning, while technology, telecoms and healthcare saw the largest sell-offs in the region (Exhibit 14). The largest sector weightings in the MSCI AC Asia Pacific ex Japan Index are financials (22.4%) and information technology (19.1%), while in the high-dividend index financials account for 28.6% and information technology 15.8%. The managers seek to have a variety of sources of income within the portfolio rather than being reliant on what may be considered the traditional sources of dividends, such as utilities or banks. Thus, there are decent-sized weightings to technology, industrials and materials in the portfolio, as illustrated by Exhibit 15.

The portfolio has exposure to a broad variety of sectors. Key overweights include technology via holdings such as Taiwan Semiconductor Manufacturing, real estate with China Resources Land and basic materials with BHP Group. Sector underweights include financial services, telecoms and industrials.

From a country perspective, the fund is overweight Singapore (DBS Group) and Thailand (TISCO Financial), and underweight China and India. Compared with some regional equity income strategies, the managers believe that there is less quality available to them in general in some equity income stalwarts such as healthcare, but this is more than compensated for by global leaders in the technology space, such as Taiwan Semiconductor Manufacturing Company (TSMC).

The top 10 positions at July 2022 share a fair amount of commonality with a year ago (Exhibit 16). The headline level reduction in technology is evident by the lower weightings in TSMC and Samsung, while the increase in financials is illustrated by the higher weighting in DBS Group and a new top 10 position in United Overseas Bank.

For CY22 to end July, the fund returned -4.3% in NAV (cum income with debt at fair value) versus -6.1% for the MSCI AC Asia Pacific ex Japan Index, 1.3% for the high-dividend Asia index and -2.9% for the Morningstar Asian equity income peer group (all total returns in sterling).The fund’s performance over one, three and five years is ahead of the MSCI AC Asia Pacific ex Japan Index and peers.

So far in 2022 AAIF’s performance has benefited from its geographic allocation, with overweight positions to Singapore in particular being accretive, while the overweight Taiwan position has detracted. The sector positioning overall hurt the performance during the period, with the overweight technology position a negative, while the overweight financial weighting proved helpful. The strongest performers in absolute terms include top 10 positions in BHP Group, Overseas Chinese Banking Corp and United Overseas Bank. Some of the large technology positions, such as TSMC and Samsung, have been weak in CY22 and held back the fund’s overall performance over this relatively short period of time.

While the fund’s performance has historically been competitive over the last 10 years, its standard deviation of returns has been modestly higher than its Morningstar peer group or either of the two reference benchmarks. This additional ‘risk’ has, however, been generally used to good effect, with varying but in general higher-risk adjusted returns than comparators, as evidenced by its historical Sharpe ratio (Exhibit 18).

The fund’s sensitivity to market movements (beta) has tended to be marginally above one over the past 10 years, with a good record in capturing movements in markets while offering some protection on the downside. This can be largely attributed to the balanced and diversified nature of the portfolio and the managers’ focus on investing in quality at the right price.

AAIF trades on a historical price to earnings multiple of 12.6x, which is in line with the index but slightly more expensive than peers. Historically the portfolio has delivered superior earnings and book value growth. Its process seeks to identify quality at the right price and historically the fund has had a better return on invested capital than the benchmark and peers, while debt to capital is in aggregate lower than comparators. From a positioning perspective, the fund is higher weighted in basic materials and real estate versus peers by around 3.5pp and 4.6pp, respectively, with prominent relative positions in the likes of BHP and China Resources Land. Singapore is the largest country overweight relative to the peer average of 9.2pp, with notable weightings in DBS Group and Overseas Chinese Banking Corporation, while as discussed above, China is a notable (8.4pp) underweight relative to peers.

Despite its solid performance, growing dividend and share buy-backs, AAIF’s rating has moved from a premium to one of the wider discounts in the sector over the past 10 years. There was a period of underperformance in 2020 when the focus on quality growth companies was out of favour and the fund lagged the recovery late in the year. abrdn as a house has seen outflows, which could account for the share price derating seen versus NAV. abrdn has an established and successful franchise in Asian equities with a well-resourced investment capability and a pragmatic and efficacious process. Arguably the current discount of 12.6% presents a good opportunity to buy a quality and diversified basket of Asian equites on an attractive discount to cum income NAV.