Historically cheap valuations will support Asian equities

RBS argues that while the upside will be capped by the debt overhang in Europe, the potential rewards for buying Asian equities now outweigh the risks.

Given the lacklustre US recovery and the debt overhang in Europe, the payoff structure for Asian markets this year is similar to writing a put option — one in which the upside is capped and the downside could be substantial, Royal Bank of Scotland says in a report published yesterday.

“The eurozone crisis will likely take years to resolve and the mere presence of this overhand should cap any major moves higher in Asian markets. Simply put, the propensity for investors to overpay for risky assets seems low when the chances that things will go wrong somewhere down the road are high,” Asian equities strategist Dylan Cheang noted in the report.

Arguably this sounds pretty pessimistic, but Cheang also argues that Asian valuations are cheap compared to historical levels and, while the upside is capped, he does see a rise from current levels for the MSCI Asia Pacific ex-Japan index — a 26% rise to be specific.

Using a composite valuation indicator (CVI), Cheang notes that the index is currently one standard deviation below its historical mean, a situation that has occurred five times during the past 20 years, including during the 2008 financial crisis when the index fell through two standard deviations. Aside from this most recent collapse, further share price declines after the first standard deviation level was breeched have been minimal. During the Asian financial crisis in 1998, the additional decline was only 16%, while during the TMT bubble in 2001 and during Sars in 2003 there were no further declines after the index fell through one standard deviation.

But the upside after these breeches has been significant, with an average gain of 114% from the standard deviation level to the next peak. Although Cheang prefers to exclude the period after Sars in his models since the 296% rally that occurred then was influenced by many other factors, such as strong global liquidity and the emergence of China. Excluding that gain, the average is  69%. After the subprime crisis, Asian markets rallied 57% to their peak.

“On the other hand, the additional downside one has to pay for entering ‘too early’ has averaged only 21%. From this angle, the risk/reward looks fair in our view,” Cheang said.

In a worst-case scenario, in which the European debt crisis deteriorates further, regional markets could fall another 15% to become two standard deviations cheap. However, it is worth noting that the last time this occurred, in 2008, the rebound was swift and decisive.

“Catching market troughs is more art than science and from a rational standpoint we believe that it pays to turn constructive on the region again. In any case, investors who entered the market at the one standard deviation cheap level back in 2008 still managed to garner 57% returns in the end,” he said.

That is, of course, if they sold before the markets started to head lower again.

Cheang acknowledges that there are still substantial uncertainties, however, and notes that Asian markets are likely to experience the same challenging macro conditions in 2012 as the deleveraging in the advanced economies continues to be a major drag on both growth and sentiment. Because of this, it will pay to stay prepared by balancing the downside risks with adequate defensive exposure.

RBS does this by adopting a barbell approach to its asset allocation, meaning that it balances an overweight position in one market or sector with an underweight position in a similar market or sector. For example, for its growth/consumption theme, it is overweight China and underweight India.

The good news for Asia in all this is that the economic downturn has helped reduce the inflation pressure, which allows more room to ease monetary policy. Another positive, Cheang notes, is that the US economic recovery, while insipid, continues to muddle through — “a very positive outcome given widespread expectations that the world’s largest economy was heading towards a recession”.

Cheang also argues that for long-term investors, focusing on certain investment styles that have worked through the cycles in the past two decades should help to maximise the returns. His conclusion is that value stocks have outperformed growth stocks during this period and stocks that pay high dividend yields and have a low gearing have returned more than those that pay little or no dividend and are highly geared. The difference in performance between cyclicals and non-cyclicals during the period as a whole is small, but since non-cyclicals tend to substantially underperform cyclicals after a crisis, investors will do well to focus on cyclicals right now.

In other words, RBS says that the stocks to buy right now are high-yielding cyclicals with attractive valuations and low gearing. Cheang singles out three Hong Kong-listed stocks that fit these criteria and which are part of the bank’s thematic stock basket: Shougang Fushan, Sinotrans and Pacific Basin Shipping.

Overall, RBS is overweight on China, Malaysia, Taiwan and Thailand, while it is underweight on India, Korea, Australia, the Philippines and Singapore. The latter has been downgraded from overweight as the recent slew of policy tightening measures, new supply and rising unemployment should trigger a pullback in property stocks, which, according to RBS, will be negative for the associated banking sector. The bank has a neutral weighting on Hong Kong, Indonesia and New Zealand.

From a sector perspective, it is overweight telecoms, financials, utilities and industrials and underweight consumer discretionary and materials. It is neutral on consumer staples, energy, technology and healthcare.

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