Should one invest in Asia?

This may seem to be an odd title for an article, for the whole world is currently going ga-ga over the long-term prospects of the region.

Report after report and long-range forecast after long-range forecast talk about the great growth prospects for the Asian region.

Asia today accounts for 55 per cent of the world's population and an even greater share of the working-age population, and seems poised to become the growth engine for the world over the coming decades.

The region is home to the best-performing economies of the post-war era and its companies have now acquired global scale and are steadily populating the list of the world's largest and most profitable corporations.

Strange as this query may seem but an interesting article written by Joe Studwell (of China Economic Quarterly fame) in the latest edition of the Far Eastern Economic Review asks exactly this question.

His article lays bare the dirty little secret known to old Asian hands, but not obvious to new entrants into the region.

The Asian markets have actually performed very poorly over the last 20 years despite all the economic progress and development.

The strong world-beating economic performance has not translated into equivalent financial market returns.

Studwell's article points out that if you had invested in Asia (market cap weighted index) in 1985 (when most markets were first opened up to foreigners), then over the 20 years ending 2005, you would have seen a near five-fold return on your initial outlay.

Not bad, one would think, though a similar investment in US or European equities over the same 20-year period would have seen a near seven-fold return (in dollars).

The problem with the Asian markets, more than the underperformance, is that the entire return in Asia was achieved from 1985 to 1990.

Since 1990, the Asian markets have actually fallen in dollar terms, a sobering fact. In US dollar terms, using 1985 as a base of 100, the average index of Asia stood at 585 in January 1990 and 504 in January 2005 (UBS Asian weekly).

Over the last 15 years, investors have found it extraordinarily difficult to make money on a consistent basis in Asia, and this cuts across markets.

Two questions arise from the above data: first, why has Asia done so poorly, and secondly, given the atrocious track record, why are investors continuing to pour money into the region? Do they know something that we do not?

As for the poor performance, the reasons are actually quite well documented. After going up five-fold in five years (1985-1990), the Asian markets went to a significant premium on most valuation measures (compared to the US), despite having no free cash flow and significantly inferior capital efficiency ratios.

There was too much hype and hoopla around Asia with many UK fund managers at this point having more money in Asia than they had in US equities.

Being so overvalued at this point (1990), they were bound to deliver mediocre performance. This was only compounded by the Asian crisis of 1998, which totally destroyed returns in US dollar terms due to sharp currency depreciations across the region.

Also during 1982-2000, the US went through the biggest bull market/bubble in its history, and thus the comparison for Asia was also against a period of very strong financial market returns in the developed world.

The period 1990-2000 was a period also of extraordinary economic volatility for emerging markets as an entire asset class, with the asset class being hit by the Russian debt default, Brazil default, LTCM meltdown, and the whole Asian contagion.

As one economic crisis after another hit these markets, the whole asset class got derated and acquired a reputation for being too risky for institutional investors to seriously participate in.

There were also serious abuses of corporate governance across Asia, and minority shareholders were often given a very raw deal.

This only compounded the feeling that Asia should trade at a discount given all the economic volatility and wealth destruction.

The fact is that most of the Asian markets (especially North Asia) went through their own financial market bubble between 1985 and 1990, because they were discovered.

They went through the inevitable debubbling process after 1990, which was compounded by the economic volatility and contagion experienced by emerging markets between 1990 and 2000.

As the region worked off the excesses of its bubble, relative underperformance was to be expected.

As for why the region is attracting so much cash today, there are various reasons.

• The world is awash in liquidity and expected returns across most developed markets are very modest, a perfect environment for heightened risk taking.
• The Asian markets are cheap, trading at significant discounts to the developed markets, but with vastly improved free cash flows and capital efficiency ratios. Asian markets today actually have a higher RoE than the US.
• Emerging markets have consistently outperformed the developed markets since 2000 and inevitably there is a lot of momentum money chasing returns in these markets currently.
• Macro risks in Asia have reduced significantly; these countries have much better financial discipline (across indicators) than the developed countries.
• There has been significant improvement in corporate governance across companies and sectors. Some of the discount due to this has inevitably narrowed.

As for what will happen over the coming decade, only time will tell, but we can at least try to hazard some guesses. I believe that this time Asia will not disappoint, and strong economic performance will translate into strong financial returns as well.

The representative nature of the Asian benchmarks is much better today in capturing economic growth and quality of companies vastly superior.

Having been decimated by the Asian crisis, it is time Asian corporate profit growth recoupled with economic growth, for the profit share of GDP cannot keep declining beyond a point.

I also feel that the US market in particular, and developed markets more generally, are in a similar position to Asia in 1990.

These markets are expensive (by any historical parameter), have to work off their own financial market bubbles, and are very over owned and over represented in the global indices.

While one does not expect an Asian-style crisis to grip these economies, I think it is a fair bet to assume that the dollar will be significantly lower in value over the coming years than it is today.

This currency depreciation will have its inevitable consequence on relative financial returns.

While a lot of momentum money is hiding in Asia currently, and will be pulled out at the first signs of trouble, the case for continued long-term Asian outperformance is strong.

Given their own return compulsions, most large global investment institutions will have no option but to increase their weightings in Asia.

There is a reason why so many large marque hedge funds are setting up shop in Asia--their clients are demanding it.