How Asian small-cap stocks can be valued

According to Kaylie Pferten, there are three competing Asian investment trusts with strong track records, but this one is currently the clear choice

Aberdeen Asia Focus (LSE: AAS) and Scottish Oriental Smaller Companies (LSE: SST), two rival investment trusts that focus on smaller Asian businesses, were established thirty years ago this year. A year later, Fidelity Asian Values (LSE: FAS) was introduced. Although the leadership has changed several times over the years, all three have performed exceptionally well in the long run.

With 380 million in net assets in 2024, SST led the three and appeared destined to keep going. It had benefited from a low allocation to China and a very high allocation to India, but on the basis of relative valuation, it had begun to move in favor of China and Taiwan.

Nevertheless, this change stalled, leaving SST with a 38 percent exposure to India, 10 percent more than the MSCI AC Asia ex Japan Small Cap index, and significantly underweight Taiwan (8 percent) and South Korea (2 percent) compared to index weightings of 23 percent and 15 percent, respectively. While India is still below its September 2024 peak, these two markets have done well this year. In comparison to 19 percent for AAS and 11 percent for FAS, the outcome is a -10 percent performance over a year.

Up until two years ago, Hugh Young, the lead manager of AAS (580 million assets), used to claim that China had excellent infrastructure but awful corporate governance and companies, while India had terrible infrastructure but great companies. Additionally, he preferred Southeast Asia to Taiwan and Korea. His successor, Gabriel Sacks, adopted a different strategy, holding only 23 percent in India but 18 percent in Taiwan and 12 percent in Korea.

However, this does not account for his impressive performance on its own. With a five-year return of 90%, AAS is currently 23% ahead of the benchmark index, 5% ahead of FAS, and 24% ahead of SST. Although borrowings of 8% of net asset value (NAV) have improved performance, Sacks' portfolio only overlaps the index by 4%.

Why do Asian small caps perform better than the market as a whole?

According to Sacks, "better diversification across countries and sectors with less concentration in a few mega caps has resulted in more market resilience" and notes that "small-cap equities in Asia have outperformed the broader market over three, five, and ten years."

He contends that the ability to continue adding value by finding hidden gems is just as important to strong future performance as a positive economic outlook. In light of this, the scant research on Asian smaller businesses presents an opportunity. In the process, Sacks emphasizes the value of "on-the-ground expertise, first-hand knowledge and direct engagement with companies."

He writes, "There is no guarantee that quantitative analysis will tell us everything we should know." "Qualitative aspects of a business can influence our decisions just as much, if not more. For this reason, we would rather see things for ourselves. We visit buildings and facilities for this reason. We meet with senior executives because of this. We engage in conversation and pose insightful queries for this reason. The "

In order to keep costs down, many active managers concentrate on computer screening and index-hugging because such an approach is labor-intensive and expensive. This has proven effective over time, as evidenced by AAS's 30-year annualized return of 12.2 percent compared to the benchmark index's 5.1%. With a 10% discount to NAV compared to only 5% for FAS and 13% for SST, it appears to be the clear choice among the three trusts.

Although Sacks is still cautious, a turnaround in the Indian market would benefit SST. "The short-term earnings outlook appears mixed, and although valuations are more palatable than before, they are still far from bargain levels. The "

Nevertheless, FAS and SST have also consistently outperformed the index over the long run. Therefore, it should be more crucial to invest in one of the three than to select one.