While much of Asia’s rise in the past few decades was built on capital-intensive industries producing cheap, low-margin products that were exported across the world, there has been a marked shift in recent years. 
Across the region, we have seen a real emergence of what we define as quality; businesses that have unlevered balance sheets, are highly cash generative and have exposure to structural (not cyclical) growth. China has made significant investment in R&D, even outspending America, enabling it to manufacture products of far higher quality which it is now able to sell at a much higher margin. From an investment perspective, the universe of potential sources of alpha is therefore expanding by the day.
Critical to us is for these businesses to maintain high returns on capital. Naturally, competition will increase as new entrants seek exposure to these high returns, but our proprietary empirical research demonstrates that stocks that can maintain high levels of return on invested capital (ROIC) persistently generate outperformance.
Conversely, those that suffer deteriorating ROIC profiles tend to be the worst performers. A systematic approach may be adept at identifying high ROIC businesses but will be less able to weed out the companies that are likely to fall from grace.
Where are these opportunities?
While not exclusively, a large portion of the quality universe in Asia Pacific is found in the healthcare, information technology and consumer sectors. They tend to exhibit the strongest intangible assets that underpin sustainably high returns on capital, precisely the characteristics that we seek.
The likes of Shenzhen Mindray and Hangzhou Tigermed epitomise this, with their ability to service parts of the Chinese healthcare industry but also become globally competitive, as highlighted by their international client bases.
It’s not exclusively about China, however. Although its growth story is well known and still dominates the headlines, it is important to recognise there are other opportunities across the region which may be lesser known and have even greater room for growth.
India has got extraordinary growth prospects going forward and, in many ways, we believe the country will follow the trajectory that China has exhibited. There are also some specialty areas where the Chinese are not yet competitive, such as the semiconductor sector.
Taiwanese and Korean companies dominate the most advanced parts of this space, with the Chinese struggling to catch up. It’s therefore important to consider the wider region, as there are countries benefitting from the same growth paradigms as China, while also dominating in areas where China is struggling to compete.
Seeking niche leaders
Our Asia Pacific Franchise strategy seeks to find stocks that play key roles in these industries – companies like ASML, which has carved a niche within the semiconductor equipment sector.
The company’s market leadership in EUV technology has transformed it from being a lithography market leader to a genuine monopoly. Lithography has arguably become the most critical part of the semiconductor manufacturing process, and ASML’s EUV machines – about the size of a single-decker bus, at a cost of more than 100 million euros – have become precisely what chip makers need to print smaller circuits while increasing capacity and speed.
While the likes of Samsung and TSMC – ASML’s largest clients – strive to maintain technology leadership in semiconductor manufacturing, the Chinese producers are endeavouring to play catch up. The result is that ASML’s importance in the supply chain has become further entrenched, evidenced by its order book stretching out to 2026.
Will the cyclical rotation continue?
This year has seen the continuation of the ‘cyclical’ trade, with investors buying up those companies hardest hit by the pandemic, in addition to those set to benefit from higher yields. Effectively, we’re seeing a valuation catch-up in these areas, but it doesn’t mean they have experienced an improvement in quality, and their returns on capital over a full cycle are likely to be sub-optimal.
At Ninety One, our Quality team tries to cut out noise and purely focus on the long term. We believe those high-quality businesses which are able to earn very high returns on invested capital, reinvest at those very high levels and, therefore, secure future growth, will continue to outperform.
What short-term weakness does present is the opportunity to upgrade a portfolio from a quality and growth perspective, and we have sought to do this during the recent periods of dislocation. We firmly believe that Asia’s transition to quality, fuelled by investment in innovation and productivity gains, is one of the strongest drivers of growth across the region.
Therefore, for investors with long duration such as ourselves, we believe this focus on quality stocks will continue to deliver outperformance over entire cycles, fully accounting for periods when market conditions favour more cyclically orientated stocks. Over time, we expect this nascent universe will become an even deeper pool of potential alpha, full of companies that focus on sustainable returns that compound over time, with significant visibility of cash flows and profits.
Charlie Dutton is portfolio manager of Ninety One Asia Pacific Franchise fund. The views expressed above are his own and should not be taken as investment advice.