Tech is the Invesco Perpetual Asian fund’s largest sector overweight relative to the MSCI Asia Pacific ex Japan index. It’s an area of the market that has evolved significantly over the last decade, with the emergence of Chinese internet companies being the most eye-catching development. 
The four biggest companies in the sector are now the region’s ‘big four’ and the strength of their earnings in 2017 was a key driver of the Asian equity market performance in 2017, which can be seen in the chart below.
Top 4 index constituents in Asia Pac ex Japan: Samsung Electronics, Tencent, Alibaba and TSMC
Source: Thomson Datastream as at 31 December 2017, rebased to 100 from 31 December 2014
Our investment process is focused on investing in companies whose share prices are substantially below our estimate of fair value, regardless of style. It’s an approach that leads us to focus on unloved areas of the market, as we find this the best place to find undervalued companies.
The tech sector has been a good hunting ground for ideas in recent years, with those currently held in the fund being at various stages on their journey from ‘contrarian’ to ‘popular’. The key questions for us are whether the sector can sustain its recent performance and whether it is still an attractive source of opportunities?
Two of the ‘big four’ are Samsung Electronics and Taiwan Semiconductor Manufacturing. Both are long-term holdings in the fund and can no longer be described as contrarian ideas, but they remain attractive in our view.
They are global leaders in their field, having grown their profits at a compound rate of around 15 per cent per annum over the last decade. Both have strong balance sheets and higher than average dividend yields, they also spend huge amounts on investment and research & development, leading to substantial barriers to entry for potential competitors.
Samsung Electronics is famous for its smartphones, but the driver of its recent profit growth has been its dominant position as manufacturer of memory semiconductors.
It is also an innovator in screen technology, and the only available supplier of the OLED screens that are such a key feature of Apple’s latest iPhone X. In fact, we estimate that Samsung makes 30-35 percent of the iPhone X’s components (by value), at double the margin it makes on sales in its own handset division.
These companies are exposed to the smartphone cycle, which is mature – but semiconductor demand remains high. Technological innovation continues to change the world at a rapid rate and companies with a focus on new technologies such as automation, cloud computing, the ‘internet of things’ and augmented/virtual-reality stand to benefit over the longer-term.
The other two of the ‘big four’ are Chinese internet giants Tencent (social media and online gaming) and Alibaba (e-commerce). These companies benefit from strong structural trends such as consumption growth, with revenue growth of more than 50 per cent per annum, while being very cash generative and self-funding.
They enjoy a privileged position – shielded from competition by the great Chinese firewall – although their product development is in many cases ahead of that seen in the US. Chinese internet has been a long-standing theme in the fund, but we do not hold Alibaba and only have an underweight position in Tencent. We recognise the strength of these businesses, but have found better opportunities elsewhere.
Five years ago Tencent was the only Chinese internet company included in regional benchmark indices, others being excluded due to being listed in the US and not Hong Kong.
Scandals such as that uncovered by short-seller Muddy Waters at Sino Forest tainted all US-listed companies, as did the complexities of the VIE (variable interest entity) corporate structure that they used.
However, US-listed companies such as online game developer NetEase and internet search provider Baidu (both held in the fund since 2012) had strong fundamentals and were professionally run, in our view, with earnings growth that had proven to be resilient to the slowdown in the Chinese economy.
Perceptions have changed. Alibaba’s market debut in 2014 was a catalyst for the MSCI’s decision to include US-listed companies in their China index – increasing awareness of the sector. This has helped improve investor sentiment towards these companies, but the key driver of performance has been their impressive earnings growth.
NetEase has succeeded in transferring its PC gaming expertise to mobile platforms, and has delivered a number of new hit game titles, with earnings growth of over 30 per cent per annum from 2012-2016. NetEase has moved from being ‘contrarian’ to ‘popular’, but we have been able to take profits from winners like this and recycle them into new ideas such as JD.com (e-commerce) and Autohome.
We believe it is still early days for the internet revolution, and while valuations may be less attractive than before, we can still find companies offering services with underappreciated monetisation potential.
More recently we have had a focus on heavily cash-backed businesses with strong free cashflow and potential dividend growth. Opportunities that fall into this category are typically trading on a pretty low valuation because of some short-term weakness in an area of their business.
Our research has enabled us to build conviction that the market is undervaluing these companies' core business and underappreciating the strength of their balance sheets, which may help limit potential losses in the event of a market sell-off.
This focus has led to the introduction of holdings in Taiwanese tech companies such as Asustek and Mediatek, as well as companies in other sectors that are self-funding and which throw off a lot of cash.
The tech companies currently held in the Invesco Perpetual Asian Fund are at varying stages on their journey from being ‘contrarian’ to ‘popular’. They have different growth drivers, but share some common characteristics that we find attractive. That is, they tend to generate lots of cash, have strong balance sheets and do not need to raise capital to fund growth in their businesses. It is a bias towards companies that display these characteristics, and that trade below our estimate of fair value, that results in a bias towards the tech sector – rather than a bias towards the sector itself.
William Lam is manager of the Invesco Perpetual Asian fund. All views are his own and should not be taken as investment advice.