Tips for Choosing a Quality Company

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Although each investor may have a different definition of a quality company, research has shown that several quality factors have a greater impact on stock performance. These quality factors can mostly be found in a company’s annual report, such as return on invested capital, return on equity, debt to equity ratio, accounting quality, gross profitability, and EPS growth. In summary, companies with high barriers to entry (reflected in higher return on invested capital and return on equity) and the ability to generate cash flow (reflected in good accounting quality, lower debt to equity ratios, higher gross profitability and EPS growth) typically have better stock performance.

Of course, the above research is based on statistical correlations and is not a definite or unchanging rule. During times of quantitative easing by central banks, even poor-quality companies may have the best stock performance, as seen with the surge of meme stocks in 2021 and early 2022. Additionally, investors may be willing to tolerate negative cash flow for a relatively longer period of time when emerging technology companies are building their own competitive strengths in new industries, such as with Amazon.

Currently, global central banks are tightening liquidity, and investors exhibit lower tolerance for risk. As a result, companies that do not conform to the abovementioned quality factors may experience significant price pressure.

This was evident in the recent targeting of an Indian conglomerate by short-sellers in early February. Despite its highly diversified portfolio, which includes a range of businesses from airports and data centers to mining and national defense, the company’s primary focus is on traditional industries. Nevertheless, over the past five years, the company’s stock price has skyrocketed from just over 100 rupees to more than 4,000 rupees, making its founder one of the richest men in the world.

The short-sellers accuse the company of manipulating its stock price through complex structures. The veracity of these allegations is difficult to confirm, but we can try to analyze the company’s annual reports with the abovementioned quality factor framework to get more informed on the issue.

While profit inflation is common in annual reports, manipulating cash flows is more challenging. Therefore, we can start with looking into the company’s cash flows. Over the past two years, the company’s operating cash flow was only 54 billion rupees, far below its investment cash requirements of 250 billion rupees. Most of the required funds came from bank loans, resulting in the company’s borrowing amount soaring to over 400 billion rupees, approximately 1.5 times its capital, which is relatively high. However, the company’s shareholder return rate is only 2.9%, which is exceptionally low, and the annual return rate is insufficient to support the company’s rapid expansion.

From a valuation perspective, the company’s stock price has skyrocketed over the past five years. Unless there are significant changes in its business, it is generally difficult to support such rapid growth in stock prices. Despite a decline of more than 50% in its stock since the beginning of January, the company’s price-to-earnings ratio (based on its earnings in 2022) remained over 200 times by mid-February, far higher than other traditional industry companies. At the same time, the company’s price-to-book ratio was 9.3 times, while the Hang Seng Index’s price-to-book ratio was only 1.2 times by then.

We primarily invest in Chinese stocks and are not experts on India. Our research on Indian companies is limited to analyzing their annual reports. Relying solely on annual report data has its drawbacks, as other competitive advantages of the company may not necessarily be reflected in the numbers over one or two years, such as their execution capabilities and political-business relationships. However, analyzing these quality factors along with the current performance should also provide insights for investment.

Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.

Why Emerging Markets May Outperform the U.S. Stock Market This Year

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Over the past 12 years, the U.S. stock market has outperformed emerging markets by a large margin for many reasons, including a strong dollar and the country’s shift from reliance on imported energy to self-sufficiency. The U.S. economy also benefited from technological innovation, especially in terms of the first-mover advantage enjoyed by internet companies that have scaled and expanded their global market share. 

But there’s a good chance that emerging markets will redeem themselves and outperform the U.S. this year. Long-term and short-term factors driving stock market performance are different, in this article, we will focus on the short-term factors why emerging market may come to shine.

In the MSCI Emerging Markets Index, China has the largest weighting of roughly 33%, followed by Taiwan at 14% (nearly half of which comprises of TSMC), India at 13%, and South Korea and Brazil collectively accounting for 17% of the index’s composition. The rest of the component countries are mostly raw-material or energy exporters. Excluding TSMC, China and India play the biggest roles among emerging markets. If economic conditions improve in these two countries, boosting demand for raw materials and energy, other emerging economies will benefit as well.

From a macro point of view, the possibility of a recession in the U.S. economy is fairly high this year, with many leading indicators already pointing to potential economic contraction in the States. The U.S. stock market’s decline last year was mainly due to compressed valuation. That is, the market has yet priced in the impact an economic downturn can have on corporate profits. That said, a sudden pivot where the Fed shifts to a dovish stance and begins cutting rates mid-year may help offset the impact U.S. stocks would suffer in a recession, but such a policy shift seems unlikely at this point. 

Turning to China, economic recovery can be expected as the pandemic has likely peaked and the government’s grip on the real estate sector and internet platform companies seems to be loosening. The resolution to the China-U.S. ADR audit dispute also helps.

The other major emerging market, India, is also showing brighter economic outlook. During the 2008 global financial crisis, the Indian government resorted to excessive borrowing to revive the economy, which led to persistently high bankruptcy rates among Indian companies after 2008. The situation has been improving over the past few years, as companies have slowly recovered from insolvency troubles. Banks have seen growth in lending and improvement with the problem of non-performing loans. The corporate debt-to-GDP ratio is also falling. Although valuation of the Indian stock market is slightly elevated, overall India is expected to enjoy more bullish factors than the U.S. this year. 

While economic recovery will provide upside potential for earnings, capital inflow is also necessary to drive the stock market upward. On this front, China’s credit impulse shows that domestic funding conditions have improved from tight to neutral over the past year. In contrast, the federal funds rate continued to rise in the U.S. The U.S. futures market currently projects the federal funds rate to reach around 5% by mid-year and estimates that there won’t be room for a rate cut until the end of the year. Given different capital conditions, the Chinese stock market is likely to perform better than the U.S. stock market. Foreign capital flows can also improve for China as the dollar peaks. Historically, economies and stock markets of emerging markets would stand to benefit from a depreciating dollar. 

To sum up, there’s a good chance that emerging markets will turn the tables this year and beat the U.S. stock market. 

Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.