China in transition

There was a need for China to engineer this economic transformation, says Graham. China's exports have been a strong driver of the economy in the past. These exports now represent some 23% to 25% of the imports of its major global trading partners and, at that level, "the growth prospects start to dim."

Also, he notes, China's rapid industrialization has resulted in excess capacity and inefficiencies in its industrial base. There are also considerable challenges with air and water pollution, he says. There is now a necessary rationalization under way in China's industries, an emphasis on more added-value manufacturing and "a strong political commitment to the environment," he says. As well, "the boom in government infrastructure spending with the accompanying demand for steel and cement is over."

These developments have negative implications for commodity-producing countries such as Canada, Australia and Brazil, says Graham. "China's demand for key commodities is going to be structurally lower."

Of the turmoil on mainland China's stock market, Graham says: "There was a bubble, which has burst." The China Securities Regulatory Commission's intervention in this stock market was less than successful, he notes.

"The good news is that the crash in mainland China's stock market has not spilled over to the underlying economy."

Another aspect of China's economy that Graham and his team are watching closely is the relationship of China's currency, the renminbi, to other key global currencies, particularly the U.S. dollar. The Chinese currency depreciated a little in the summer of 2015, but there is still further to go, says Graham. "It remains to be seen if China's government can manage the depreciation so that it is orderly."

On the political front, there are some positive developments in China. "The government is cracking down on corruption within its ranks," says Graham, "but China remains a single-party state and the government is sensitive to criticism."

From an investor's perspective, says Graham, there are "profound" changes in China and the rest of Asia that deserve attention. These secular changes are shaping the Asia team's long-term investing themes. They include: strong Asian consumption growth, reflecting rising disposable incomes; deregulation in some countries so as to foster more competition in sectors; and growth of trade between countries in Asia, assisted by a reduction in trade barriers in the region.

At the business level, Graham says another significant theme is the role that new technology is playing in many sectors. "We are essentially bottom-up stock selectors focusing on the company's fundamentals, but we do pay close attention to changes in the macro picture."

Andrew Graham

Established in 1881, Martin Currie, with assets under management of $14.9 billion, is a sub-advisor to TD Asset Management Inc. At Martin Currie, Graham and his team are responsible for a wide range of mandates including TD Asian Growth. Graham co-manages this portfolio with Paul Danes, who is based in Singapore.

The Asia team targets companies with established franchises, preferably operating in areas where there are barriers to entry. "Sound corporate governance, which is a particularly important criterion in these developing markets, and sound financials are a prerequisite," says Graham. The companies must generate good returns on capital and have strong balance sheets. A plus, he says, is where the companies are willing to return excess funds to shareholders through dividends or share buybacks. Valuation is the key consideration, he says. "We buy businesses trading at a discount to our estimated intrinsic value. We require a significant margin of safety." The investment horizon is generally three to four years.

TD Asian Growth, which currently holds 49 names, (the range is 40 to 60), is benchmarked against the MSCI All Countries Asia Pacific Ex Japan Index. Geographically, the portfolio has some 26% in companies based in China, a modest overweight position. Eighteen percent is in Australia, a slight underweight, 13% in South Korea, which is close to market weight, and 12% is in companies based in Hong Kong, another overweight position. The team invests in companies based in mainland China through H-shares, which are listed on the Hong Kong Stock Exchange and trade in Hong Kong dollars.

The TD fund is significantly underweight in the financial sector (which includes real estate companies) at 29% versus 37% in the index. Technology at 19% is market weight. A significant overweight is in consumer-related stocks at 19%, reflecting an emphasis on consumer- discretionary stocks. "We generally find consumer-staples companies in the Asia-Pacific region to be expensive," says Graham.

A specialist in Asian financials, Graham says that the fund's underweight position in this sector largely reflects concerns about segments of China's financial sector. For example, he says, China's real estate companies tend to be highly leveraged. Also, some life insurers in China have weak balance sheets.

For the Martin Currie Asia team, China Construction Bank Corp., which has been listed on the Hong Kong Stock Exchange for more than 10 years, represents the "best run bank in China." It's a full-service retail and business bank, "with strong systems, a nationwide branch system and a solid deposit base." The stock is a top-10 holding in TD Asian Growth.

In technology, a top-10 weighting is Tencent Holdings Ltd., a dominant Internet-services company in China. Founded in 1998, the company was listed on the Hong Kong Stock Exchange in 2004. "The company has developed a good business in online games for both mobile and desktop use," says Graham.

Tencent generates large amounts of cash flow, he says, which it has been investing in other types of online services with its goal to develop an Internet eco-system. "For example, Tencent provides a prominent platform for social media." In all, "the company is focused on both growth and on increasing its profit margins."

Another major tech holding in TD Asian Growth is Taiwan Semiconductor Manufacturing Co. Ltd., which has an American Depository Receipt and trades in New York under the ticker TSM. This stock has been in the portfolio for some time. "This dominant semiconductor manufacturer has considerable economies of scale and is shareholder-friendly, returning cash to shareholders mainly in the form of dividends," says Graham.

A South Korean consumer-staples stock that meets the Asia team's criteria is LG Household and Health Care Ltd. The company produces household and personal care products for the market in Asia. "The company has successfully used the strong cash flow from its household-products division to build its high-margin cosmetic division," says Graham.

An Australian casino operator that is "well positioned to take advantage of the growing travel to Australia from China and the rest of Asia" is Star Entertainment Group Ltd. "It is a major player in its market, with casino complexes in key Australian cities." The company had previously underinvested in its properties, Graham says, but this has been remedied. The casino business is profitable, he says. "Star Entertainment has good earnings and cash flow visibility; the company has very long-term casino licenses for its complexes."

Another play on the increase in travel by Chinese nationals is Beijing Capital International Airport Co. Ltd., which manages the aeronautical and commercial businesses at the Beijing Capital Airport. "This is a secular growth story and also reflects the emerging importance of the Chinese consumer," Graham says.

When it comes to selling stocks, the Asia team's discipline reflects both its strict intrinsic value approach and its ongoing monitoring of the company, including its governance practices, says Graham.

Based on valuation, Graham and co-manager Danes have sold TD Asian Growth's holding in BGF Retail Co. Ltd., a convenience-store operator in South Korea. "It is a well-run business," says Graham. "We bought the stock about one year ago, but the market subsequently got excited about it and drove the share price into overvalued territory."