Successfully investing in Asian equities requires specialist regional expertise. Each market has its own unique characteristics which affect the optimal way to calibrate investment methodologies.
This research note only covers the key markets in our stock universe. We’ve also excluded Australia because, other than a dividend imputation system and retail investors’ love for franked dividends, Australian equities don’t have any interesting idiosyncrasies which affect how we run our investment process.
We focus on the lesser-known characteristics of each market which, in our opinion, don’t receive as much attention as they should.
Korea
Preference shares which offer higher dividends trade at a large discount to ordinary shares
Over 100 listed Korean companies have both ordinary and preference shares. The preference shares typically trade at a large discount.
Consider LG Household and Healthcare, a large manufacturer and distributor of cosmetics, cleaning products, and personal care products. It has both ordinary shares (051900 KS) and preference shares (051905 KS). The ordinary share price is KRW345,000, whereas the preference share price is KRW152,000, a 56% discount (15 March 2024).
The preference shares have the same legal claim on assets. They get their “preferred” status as they are legally required to pay a higher dividend than the ordinary shares.
So why do they trade at a large discount? There is a big reason and a smaller reason.
First, the big reason. Korean preference shares have limited or no voting rights. They were created so that controlling shareholders could raise money without losing control.
The second reason is preference shares are typically illiquid. LG Household and Healthcare’s median daily turnover for the ordinary shares is $US16.9m, whereas the corresponding figure for the preference shares is $US0.6m. In many cases, the liquidity of Korean preference shares is so low, we exclude them from our stock universe.
Stocks go ex-dividend before the dividend amount is known
To some extent, this is also an issue in Japan where it is common practice to announce an estimate of the amount to be paid, with the understanding that this could vary. However, the difference is typically small.
In Korea, there is often little or no indication of the amount to be paid.
This is annoying as it’s necessary to estimate the likely dividend payment when Korean stocks go ex dividend to determine stock returns (until the dividend is actually paid a few months later).
However, it also generates attractive investment opportunities as some dividend ex-date moves for Korean stocks differ significantly from the forecast dividend payment. We screen for these opportunities when Korean stocks go ex-dividend.
Retail investors have a lot of clout
Korean retail investors like to share their views on stock forums. They are known colloquially as “ants” because of their willingness to band together as a collective. This gives them significant political clout which they used to their advantage to persuade the government to implement a short selling ban in November 2023.
Strong retail flows also mean that the Korean market is more prone to meme stock mania than other markets in the region. For most of 2023, this was an issue for battery stocks, particularly cathode stocks.
The government says it’s getting serious about addressing the “Korea discount”
The “Korea discount” refers to a tendency for South Korean companies to trade on lower valuations than regional peers due to factors such as controlling shareholders potentially disadvantaging minority holders, and the large number of conglomerates (or chaebols) which typically trade at a deep discount to net asset value due to the absence of potential catalysts to close the gap.
Korea’s Financial Services Commission recently launched its “Corporate Value-up Program” to reduce the valuation discount.
The program is aimed at companies like LG Corp (003550 KS) which has historically traded at a very large discount to net asset value. Recently, this discount has decreased to around 70% and could potentially decline further if more concrete measures are introduced that result in the rerating of Korean conglomerates.
Japan
Shareholder perks affect stock valuations
In Japan, shareholder perks are highly sought after – more so than in any other stock market - and companies that offer attractive perks often look expensive based on standard valuation measures.
Based on finance theory, companies should be valued based on the present value of future dividend payments. In Japan, it’s also necessary to include the value of shareholder perks.
Consider Aeon (8267 JP), one of the largest retail companies in Japan which operates a well-known supermarket chain. It has a reasonably impressive revenue yield, comfortably exceeding 250%. However, it’s gross profit margin is miniscule, and it trades on an earnings yield just over 1%.
It looks grossly overvalued - until you consider the shareholder perks.
Japanese retail investors purchase shares in the company for the shareholder discount, ranging from 3% to 7% for purchases, depending on the number of shares owned. This explains why the gross profit margin is so small – and why traditional valuation models aren’t appropriate for valuing the company.
The BOJ is a major shareholder in many companies (and for many years it distorted the market)
Recently, the Chinese government directed state funds to purchase shares to support the market. This received a lot of publicity, some of it negative as pundits questioned whether it was the government’s role to prop up share prices.
What has received much less publicity, largely because it has taken place behind the scenes over many years, is the Bank of Japan (BOJ) has bought so many Japanese shares, it is a major shareholder in many Japanese companies.
Consider Fast Retailing (9983 JP), the owner of the retailing chain Uniqlo. The BOJ owns around 20% of the outstanding shares. One reason why the BOJ’s holding is so high is Fast Retailing is the largest component of the Nikkei 225 Index, and the BOJ has purchased shares using ETFs tracking this index.
The Nikkei 225 does a poor job of representing the overall market given it has a price – rather than a market cap – weighting methodology.
An even less representative index is the Nikkei 400 which uses a convoluted methodology based on returns on equity and operating profits. Up until recently, the BOJ also bought ETFs based on this index.
These ETF purchases distorted the Japanese equity market, inhibiting efficient price discovery. Fortunately, in 2021 the BOJ switched to only purchasing Topix ETFs, and recently it has not been an active market participant. And on March 13, Bloomberg reported that the BOJ is considering axing ETF purchases all together (and this was confirmed on March 19 during the BOJ’s monetary policy announcement).
Transaction costs are extremely low
When we assess the cost of transacting in each market, there are three things we focus on: stamp duty costs, bid-ask spreads, and turnover.
Stamp duty is an obvious – and easy to measure – component of transaction costs. Japan doesn’t have stamp duty costs. The only other market in our stocks universe without stamp duty costs is Australia.
Bid-ask spreads are an important driver of slippage costs. Invariably it’s necessary to cross the spread when executing trades and, if the spread is large, this adds to the cost of trading. The following chart shows the average bid-ask spread (based on Bloomberg’s calculation methodology) for the markets in our stock universe for stocks with a median daily turnover greater than $US1m.
Chart 1: Bid-ask spread for Asian stocks >US$1m turnover Source: OFAM, Bloomberg
Japan has the lowest bid-ask spread and it’s considerably lower than the other markets with the sole exception of China (where we have minimal gross exposure due to the difficulty shorting stocks).
High turnover is important to minimise market impact costs. Although market impact costs are notoriously difficult to estimate, one thing is known for certain: the lower the trade size relative to market volumes, the lower the market impact. The following chart shows the average turnover for the markets in our universe for stocks which have at least two analysts providing coverage.
Chart 2: Average turnover for Asian stocks with at least 2 analyst coverage Source: OFAM, Bloomberg
China is number one on the list, largely due to extremely strong retail flows. Taiwan is number two, again driven by retail flows and numerous stocks which are impacted by extreme day trading. We cover both these issues later in this research note. Japan comes in a close third.
The combination of no stamp duty, low bid-ask spreads, and high turnover, make Japan an attractive market for executing high turnover investment strategies.
There isn’t a closing auction but there are huge volumes just before market close
Unlike most major exchanges, Japan does not have a closing auction. This will change in November when there will be a separate pre-closing auction period from 3:25pm to 3:30pm (trading hours will also be extended by 30 minutes).
Despite the absence of a closing option, almost 16 percent of daily trading volumes (on average) is executed in the last minute of trading. It’s the only exchange we’re aware of where there is a huge surge in trading activity just before the close of normal trading hours.
Big lot values inhibit trading for some stocks
There are numerous Japanese stocks in our portfolio with lot values exceeding US$25,000. For two stocks, the lot size is around US$50,000: SMC Corporation (6273 JP) and Keyence (6861 JP).
Breadth is a key tenet of our investment process. We have numerous stocks in our portfolio
(>1,200) and we execute a large number of daily trades (>200).
When the fund was launched in June 2020, stocks with large lot values had to be excluded from the stock universe. Now that the fund’s AUM has increased substantially, we can take positions in all stocks with large lot values, but trading is still an issue for these stocks given our typical trades sizes are small.
Hong Kong
H-shares offer an attractive positive “carry” relative to A-shares
There are numerous Chinese stocks listed in Hong Kong (H-shares) and in China (A-shares). Both A-shares and H-shares have the same dividend (and voting) rights.
Numerous H-shares trade at a substantial discount to their A-share counterparts.
Consider China Life Insurance (2628 HK and 601628 CH), the largest life insurance company in China by market share. The company’s H-share is currently trading at almost a 70% discount to its H-share.
Given the same DPS but a much lower price, holding the H-share generates a much higher dividend yield than holding the A-share. More specifically, the forward dividend yield for the H-share is almost 8%, whereas the corresponding dividend yield for the A-share is less than 2.5%.
Interestingly, China Life Insurance is far from having the most discounted H-share. For example, two large financial companies (CSC Financial and China International Capital Corporation) have liquid H-shares trading at an even larger discount.
The positive “carry” from these discounted H-shares effectively means the A-share premium would have to increase even further from the current extreme levels to justify owning the A-share. We believe it’s hard to rationalise the A-share investment case, but markets don’t always behave rationally, particularly over the short term.
State-Owned Enterprises (SOEs) trade at a substantial valuation discount
China has many listed SOEs which are partially owned and controlled by the government.
SOEs trade at a substantial valuation discount to the market. The Hang Seng China Central SOEs Index (HSCSOE Index) trades on a PE ratio of 6.2 and forward Dividend Yield of 6.6% (17 March 2024). The corresponding numbers for the Hang Seng Index (HSI Index) are 9.1 and 4.1%.
Also, a large percentage of SOEs in our H-share stock universe currently trade at a significant discount to book value.
This is an issue because China has set the floor price for the issue of new SOE shares at book value. This means capital raisings are more likely to occur for A-shares (given they trade at a higher price which is more likely to exceed book value). It also means that capital raisings for SOEs can be EPS accretive for H-share shareholders. This is another underappreciated advantage of owning H-shares.
The low valuations for SOEs have attracted the attention of China’s security regulator (China Securities Regulatory Commission). It has proposed creating a “valuation system with Chinese characteristics.” We’ve researched this but still aren’t entirely sure what it really means. Similarly, the SOE reform proposals include lots of grandiose goals but are light on detail.
What we do know is SOEs currently trade at a valuation discount to the market, and this is likely to continue.
China
Shorting stocks is difficult
This is a big impediment to implementing a market neutral investment process in China. Unfortunately, the cost of borrow for A-shares has recently increased and the available inventory of stocks that can be shorted has declined.
Given this, many China quants get short exposure via index futures. This reduces costs but at the detriment of introducing unwanted risk bets, particularly a large size bias. We discussed this issue in depth in the following research note: https://www.oqfundsmanagement.com/post/lessons-from-china-quant-quake
Day trading is prohibited
China has a “T+1 trading rule” which prohibits investors from selling the shares they bought on the same day (but investors are allowed to buy shares they sold earlier in the day).
Retail participation drives high liquidity and unusual share price moves
Retail investors are responsible up to 80% of Chinese equity turnover (this number varies depending on the source, but it’s widely agreed to be in the 70% to 80% range).
This generates short-term mispricing opportunities, but they are hard to exploit in a market neutral fund given the difficulty of hedging long exposures.
Taiwan
Day traders distort trading volumes and stock volatility for numerous stocks
Consider Jarllytec (3548 TT), a relatively non-descript company that is a manufacturer and distributor of hinges primarily used in the production of phones, notebooks, and LCD monitors.
What stands out most is the stock’s extremely high turnover relative to its market capitalisation. Median daily turnover is US$51.3m and the market cap is US$569m (17 March 2024). Put differently, the daily turnover is around 9% of the stock’s market cap.
There are numerous stocks in Taiwan with extreme turnover to market cap ratios. They are all extremely volatile and dangerous shorts. More broadly, they need to be treated differently to other stocks which aren’t impacted by extreme retail trading flows.
There is a large change in bid-ask spread around NT$100
There are lots of stocks in Taiwan which trade around the NT$100 mark.
Consider Taiwan Mobile and Chunghwa Telecom, two large cap and liquid Taiwanese telecommunications stocks. The March 15 closing prices were NT$99.30 and NT$122.50 respectively. In Taiwan, stocks which trade between NT$50 and NT$100 move in NT$0.10 increments, whereas stocks which trade between NT$100 and NT$200 move in NT$0.50 increments.
The relative differences in the bid-ask spreads impacts how we trade the stocks. When the bid-ask spread is high (such as for Chunghwa Telecom) we avoid short-term trades, even when market volumes are high enough to easily absorb the trade. Often, we will put the trade on the bid or offer to avoid having to cross the spread, particularly if the trade urgency is low. When the spread is relatively low, such as for Chunghwa Telecom we don’t have the same trading constraints.
It’s unfortunate we need to change our trading behaviour based solely on the price level, but such are the idiosyncrasies of investing in Asia.
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