EPIC Oriental Focus Fund: A highly profitable and fast-growing portfolio
EPIC Oriental Focus Fund
October 2023
A highly profitable and fast-growing portfolio
This article updates the article published in February 2023 which highlighted the underlying profitability of the holdings in the EPIC Oriental Focus Fund. The data are sourced from Bloomberg, AlphaDesk, and MSCI.
The chart above reiterates the superior profitability of the EPIC Oriental Focus Fund portfolio. The weighted average return on equity of the portfolio stood at 21.1% on 1 September 2023. This compares to the 8.8% return on equity of the MSCI Asia ex Japan Index. The portfolio is more than twice as profitable on this measure. The portfolio’s weighted return on capital, at 15.9%, is more than three and a half times higher than the 4.3% of the index. We also note that the weighted net debt to equity of the portfolio (excluding banks which represent 15%) is -9.5%. In other words, net cash. These exceptional profitability measures have been achieved without leverage.
In addition to profitability, we remain very focussed on the growth potential of the portfolio. What follows us a review of the top ten holdings, paying attention to both profitability and growth. The top ten holdings accounted for 53.6% of the portfolio as at 1 September 2023
TSMC (8.6% weight)
Taiwan Semiconductor Manufacturing Company needs no introduction. It is the largest company in our investment universe (market cap $440bn) with a 7.4% weighting in the MSCI Asia ex Japan Index. The chart below shows TSMC’s net profit margin and return on invested capital over the past 20 quarters. The numbers have tailed off in the last couple of quarters, reflecting the industry wide slowdown, but remain nothing short of outstanding. The compound growth rate of revenues, operating profit and earnings per share over the company’s past five financial years (to December 2022) stand at 18.3%, 23.8% and 24.3% respectively. Are these historic numbers a good indicator of future growth? Probably. Thanks to the COVID related supply chain crisis, the consequent ‘reshoring’ agenda of the West and growing geopolitical tensions, TSMC is constructing new foundries in the United States, Japan and Europe over the next few years funded to a significant extent by Government grants. Revenue growth is, therefore, more or less assured although one would assume that higher labour and other operating costs are likely to impact operating margins somewhat. TSMC has guided to a long-term return on equity of 25% (3.5% lower than the average of the last 20 quarters). They rarely disappoint. Net debt to equity is -22.6%.
Samsung Electronics (7.2% weight)
Samsung Electronics (SEC) also needs no introduction. The company operates globally but is headquartered in Korea – one of the world’s most cyclical economies, where profitability rates have long been among the lowest and most volatile across Asia (see our July 2023 article, ‘A top down view into Asia ex Japan’s profitability’). Corporate governance standards remain well below global standards. The compound growth rate of revenues, operating profit and earnings per share over the company’s past five financial years (to December 2022) stand at a lacklustre 4.8%, -4.2% and 6.1% respectively. We are long term investors and note that SEC is at the vanguard of better corporate governance standards in Korea. The recent order from Nvidia for HBM3, and the improving inventory situation in both DRAM and NAND, suggest better days lie ahead. Net debt to equity is -29.6%.
JNBY (6.2% weight)
JNBY is a leading Chinese apparel design house. The company listed in late 2016 and we have been holders since October 2017. With a market cap of just US$630m, it is our smallest market cap holding (and the only sub $1bn market cap holding). The compound growth rate of revenues, operating profit and earnings per share over the company’s past five financial years (to June 2023) stand at a respectable 9.3%, 9.6% and 9.2% respectively. Not bad for a largely offline retailer which faced repeated COVID lockdown measures during large parts of the period. The chart below tracks gross profit margins and return on equity. The average ROE of nearly 34% is impressive. The company posted knockout second half (June year-end) results earlier this month. Net profit grew 117% y-o-y, beating consensus forecasts by 45%. For the full year, earnings exceeded consensus estimates by 22%, driven in large part by the 9% growth in same store sales. Online sales (+24.5% y-o-y) now account for circa 20% of total revenues while digital and smart retail channels revenues rose 70.4% y-o-y and now account for 25% of offline revenues. Equally important is the continued success of JNBY’s membership program which accounts for 80% of offline retail sales. Membership grew 17% to 5.9m y-o-y. A dividend payout ratio of 75% is an added bonus. A little gem in every sense of the word. Net debt to equity is -28.8%.
eMemory (5.9% weight)
Taiwan’s eMemory was first purchased in November 2017. Over the past five financial years (to December 2022) revenues, operating profit and earnings per share have compounded at 18.5%, 25.2% and 22.3% respectively. eMemory specialises in embedded non-volatile memory. OTPs (one time programable ICs) such as NeoBit and Neofuse dominate revenues currently but the excitement lies in MTP (multiple times programable ICs) and PUF (physically unclonable function ICs). PUFs are implemented in integrated circuits and are used in applications with high-security requirements. They are unclonable, robust and relatively low cost and also referred to as Root of Trust. eMemory’s traditional clients are foundries, the likes of TSMC and UMC, but the excitement lies in the broader need for high security ICs or confidential computing. The chart below shows the OPM and ROE for eMemory over the past 20 quarters. Net debt to equity is -99.0%.
Minth Group (4.9% weight)
Minth Group manufactures automobile body parts and more recently has moved into aluminium battery housing units for electric vehicles. We first purchased the stock in December 2006. Since listing in late 2005, the stock has delivered a compound total return to shareholders of 15% annually – three times the return of the Hang Seng Index and the MSCI Asia ex Japan Index. Over the past five financial years (to December 2022) revenues, operating profit and earnings per share have compounded at 8.7%, -4.7% and -5.8% respectively. As a manufacturing concern, COVID related lockdowns and supply chain issues impacted both growth and profitability, but this is now behind us. 2023 first half revenues rose 34.4% and net profit increased a similar 34.9%. The battery housing division posted revenue growth of 262% y-o-y and already accounts for almost 20% of group revenues. Importantly the ASP (average selling price) of these battery housing units is some ten times that of their other products. Profitability should improve as capacity utilisation in this division continues to climb. Net debt to equity is 22.1%.
Larsen & Toubro (4.7% weight)
Larsen & Toubro (LT) is India’s largest Engineering and Construction company by a huge margin. Unusually, and something we like, there is no promotor behind the company. The two largest shareholders are the L&T Employees Trust (13.7%) and the Life Insurance Trust of India (11.1%). Historically the company has been criticised for poor working capital management and subpar profitability. The company recently announced a special dividend and a share buyback (2.4% shares outstanding) which was well received by the market. The company holds majority positions in two listed subsidiaries, L&T Finance and L&T Technology. These stakes are worth some $7bn, or one seventh of LT’s market capitalisation, but we believe it unlikely that LT will monetise these (successful) investments. Over the past five financial years (to March 2023) revenues, operating profit and earnings per share have compounded at 9.3%, 8.2% and 7.2% respectively. The order book is huge at US$38bn (March 2023) and the company recently won a US$3.9bn contract from Saudi Aramco. Broadly speaking infrastructure (mainly domestic) is 80% of the order book and hydrocarbons the balance. Management efforts to control working capital have shown promise in recent years, declining from over 25% of sales in 2021 to 17% in the first quarter of the current financial year. Gross Fixed Capital Formation, at almost 30% of GDP, is booming in India and LT will continue to benefit from this. While the company does not match the profitability of many of our other holdings, growth is expected to remain robust and the recent positive moves by management (special dividend and share repurchase) suggest they are serious about improving shareholder returns. Net debt to equity is 60.4%.
Tencent (4.6% weight)
Tencent is principally engaged in the provision of internet value-added services (games), mobile and telecommunications value-added services (WeChat) and online advertising services in China. Over the past five years (to December 2022) revenues, operating profit and earnings per share have compounded at 18.5%, 12.1% and 21.1% respectively. An impressive track record – but the crack down by the Chinese authorities on the sector has seen revenues and earnings stall with valuations declining almost non-stop over the past two and a half years, a situation not helped by the gradual sell down by major shareholder, Naspers. With hindsight we should have been more proactive but with the underlying profitability remaining strong and growth in the business returning we expect better shareholder returns over the next few years. Net debt to equity is 8.7%.
Century Iron & Steel (4.2% weight)
We purchased Century Iron and Steel in June 2021. The company is a direct play on Taiwan’s booming offshore wind sector. For Taiwan to reach its 2050 carbon neutrality target it will need to generate up to 55 gigawatts of offshore wind power. The company has a very long lease over a huge waterside site in the Port of Taipei and this in itself is a huge competitive advantage when one thinks of the weight, size and length of the pins and jackets it fabricates, assembles and ships. The order book has visibility into 2027. Furthermore, the second generation of wind farms are likely to upgrade from 9.5MW to 14-16MW turbines which implies significantly higher steel content per submarine infrastructure. COVID travel restrictions significantly impacted performance in 2022 with the inability to recruit specialist engineers from Europe leading to limited production and, in consequence, financial provisions due to contact obligations. One can observe this in the chart below which tracks the return on equity and the operating profit margin over the past 20 quarters. Despite this recent issue, over the past five years (to December 2022) revenues, operating profit and earnings per share have compounded at 35.1%, 32.1% and 37.6% respectively. Net debt to equity is a significant 120.5%.
Alibaba (3.7% weight)
Alibaba again needs no introduction as one of the world’s largest e-commence players with a dominant position in the Chinese market. Over the past five years (to March 2023) revenues, operating profit and earnings per share have compounded at 28.3%, 10.9% and 2.0% respectively. Clients will remember the failed floatation of subsidiary Ant Financial in late 2021 and the subsequent crack down by the Chinese authorities on the sector. Earlier this year, Alibaba announced plans to spin off various divisions and senior management changes. Chairman and CEO Daniel Zhang stepped down with Joseph Tsai and Eddie Wu assuming the Chairman and CEO positions. While this was consistent with the recent strategic review, earlier this month the company announced that Mr Zhang will no longer oversee AliCloud which is increasingly important given AI opportunities. Not ideal but this is reflected in the current extreme low valuations, i.e. a single digit price earnings ratio.
AIA Group (3.6% weight)
AIA Group is a leading life insurer across Asia ex-Japan. The company has strong positions in Hong Kong, Singapore and Thailand and is growing fast in China. Agency is the name of the game in Asia’s life insurance market and AIA continues to strengthen its market-leading position in the agency distribution channel. This is evidenced by the MDRT (million dollar roundtable) statistics. MDRT represents high-quality agents, and this statistic is more meaningful than just the agent headcount. AIA’s MDRT members compounded at 22% per annum in the decade to 2022 to circa 15,000 – more than twice that of their nearest competitor – with around half of those in Greater China where the growth potential remains high. That said, AIA was hit hard during the pandemic. For the five years to December 2022, revenues, net premiums, operating profit and earnings per share compounded at -15.1%, -8.5%, 0.1% and -11.3% respectively. New business value grew 32% y-o-y in the first half of the current year and the share buyback program has resumed.
Conclusions
The EPIC Oriental Focus Fund trades on 24.4x current year earnings and 16.7x forward earnings as per our internal calculations as at 5 September 2023. This is not a “cheap” portfolio by comparison with the MSCI Asia ex Japan Index, which trades on 16.6x current year earnings and 12.6x forward earnings. The difference is that our portfolio is compounding at a rate far above that of the MSCI AC Asia ex Japan Index and is likely to continue to do so.
To quote Albert Einstein again “compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn't… pays it.”
Henry Thornton
Fund Manager, EPIC Oriental Focus Fund