Commentary

The fund performed slightly better than the benchmark during the period and remains broadly in-line with the MSCI EAFE Value benchmark year-to-date. The largest positive contributors to relative return in order of their impact were Mitsubishi Heavy Industries (+23%, total return in local currency), LG H&H (+9%), Fresenius (+4%), Korea Tobacco & Ginseng (+5%) and Eni (+3%).

LG H&H is a Korean consumer goods company with three core businesses: Home Care & Daily Beauty (HDB), Refreshments (primarily Coca-Cola bottling) and Beauty (skin care). Since its IPO in 2001, LG H&H has grown revenues per share by nine times, improved its balance sheet from net debt to net cash and provided a total shareholder return of 20% per year. HDB and Refreshments account for around 50% of operating profit and are historically stable businesses which have grown at mid-single digit rates per year over the last decade. Beauty makes up the other half and has grown at 19% per year in the five years preceding COVID, driven primarily by its luxury skin care brand Whoo in China.

A large part of Whoo sales are to Chinese consumers through duty-free stores in Korea. This channel has been hit by COVID related travel restrictions as well as recent rebate negotiations between Korean duty-free stores and resellers, which has also impacted peers such as Estée Lauder and Amorepacific. These effects led to a decline in Beauty sales of over 30% between 2019 and 2022. As travel between Korea and China returns to normal, we expect to see sales recover.

The current valuation of 15 times forward earnings is near the lowest levels in the company’s history. Its long-term average is at 23 times and its peers currently trade on around 30 times earnings.

At the stock level, the largest negative contributors to relative return in order of their impact were Siemens (-10%), CK Hutchison (-11%), Alibaba (-7%), easyJet (-6%) and Bayer (-5%).

The weak performance of Siemens, Alibaba and CK Hutchison was driven by a darkening outlook for the Chinese economy. Siemens, the German industrial group, derives around 13% of its revenues from China. Exposure to China is most significant in its factory automation division, Digital Industries. This division provides industrial software and hardware, of which 25% of its revenues comes from China. For the quarter ending June, Siemens reported a 61% decline in factory automation orders from China, taking Chinese orders to below 2019 levels. While the headline sounds dramatic, we do not find it surprising given the exceptionally

Commentary

strong order environment during COVID. Digital Industries is not normally a business that builds up orders years in advance, with the backlog before COVID at around one third of annual revenues. During COVID this rose to over two thirds of revenues – an unprecedented level that reflected customers’ concern around supply chain constraints. We are now seeing a return to normal, with customers destocking as component availability improves. Importantly, Siemens has seen very few order cancellations. This is because it increasingly asks for prepayments, helping to avoid double ordering in times of component shortage.

We do not attempt to forecast orders or revenues on a quarterly basis, but we remain positive about the long-term outlook for Digital Industries. The need for energy efficiency, labour efficiency, and increasing localisation of supply chains means that corporates will continue to invest in automating their factories. Siemens is well positioned to address those needs and they have continually gained market share.

Beyond Digital Industries, Siemens also owns leading businesses in building and grid automation, hospital equipment, and rail infrastructure. The long-term outlook for all of these remains good, and the company should be able to achieve its goals of growing group revenues by 5-7% through the economic cycle and growing earnings per share at high single digit rates.

Over recent years Siemens has divested its gas, power and wind assets, and it has floated the healthcare business. In the process Siemens has become more profitable and cash generative. However, the valuation remains undemanding at a price-to-earnings ratio (P/E) of just 14 times. Excluding the listed healthcare business (Siemens continues to own 75%), the core business is valued at around 11 times P/E when industrial automation peers are valued at double this.

Alibaba reported a solid set of results for its first fiscal quarter of its 2024 financial year. Revenue growth was 14% with the core Taobao and Tmall division growing 12%. Adjusted profit growth (including a one-off re-basing of share-based payments at Ant Group) was 43% (70% excluding this one-off adjustment). Alibaba is working on the finer detail of delineation and separation of the six business units that can be listed separately. The business is extremely lowly valued at just 10 times net profits. Adjusting this for the year-end net cash of US$48bn (market capitalisation is US$235bn), the valuation drops to just eight times net profits. The group is generating free cash flow of c.$24bn a year, a free cash flow yield of 10%. The company continues to repurchase shares, US$3bn worth last quarter with an outstanding buyback authorisation of US$16bn. With an expected return on equity this year of 13%, these buybacks are very accretive. Ant Group, the firm’s 30% associate, is offering to buy back its own stock at a valuation that is 22% above the value we assume for Ant Group in our sum-of-the-parts valuation. With the core business generating more than 100% of group operating profit, any value ascribed to the spin-offs of stakes in the other five divisions is going to make the valuation of the core group look even more compelling.

The fund offers authentic contrarian value with a highly attractive weighted average upside on a two-year view of 54%. This is on estimates and valuations for the individual holdings that we think are conservative, providing a good margin of safety. The strategy has a forward price to earnings ratio of nine times and a price to book multiple of one.

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