Pacific Horizon

PHI is a long-term outperformer looking cheap after big NAV falls…

Disclosure – Non-substantive Research

This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. With this commentary, Kepler Partners LLP does not intend to influence your investment firm's behaviour. 

Pacific Horizon
2021 Kepler Growth Rated Fund

This trust has been awarded a rating by Kepler for growth... Find out more

Summary

Pacific Horizon Investment Trust (PHI) aims to generate long-term growth by identifying the companies developing and benefitting from our future ways of living and transacting. Managers Ewan Markson-Brown and Roddy Snell at Baillie Gifford have built a portfolio concentrated in internet-related and technology companies, as well as those benefitting from the shift to online consumption, the development of electric cars and the expansion of middle-class consumption into Asia – where 50% of the world’s population lives.

The managers have a bias to small and mid-caps relative to their peers and the index, and own one unlisted stock. The approach is highly active, with an active share of 83%; individual companies are allowed to grow to a high weighting as long as the managers think the growth can continue. Ewan and Roddy believe that we are nearer the beginning of the technological revolution than the end, and so there are small companies which could revolutionise the world ready to be found. The relatively diversified portfolio of 78 stocks means the managers can accept that some of their stock ideas won’t pay off.

PHI has one of the best long-term track records in the AIC Asia Pacific sector. As we discuss in the Performance section, the trust has performed strongly relative to peers over the past five years. During a particularly strong run in 2016 and 2017, it was trading on a significant premium to par and regularly issuing shares. As markets have become more choppy – particularly since the outbreak of the coronavirus pandemic – the shares have fallen onto a 12% discount. PHI does not pay a dividend.

Kepler View

PHI offers a way to invest in the exciting secular changes happening in Asia. Many of these involve new technology or online ways of doing business which are in line with, or in advance of, the current state of development in the UK, despite the fact that the region is supposedly ‘emerging’ rather than ‘developed’. There are of course dangers in investing in high-growth online businesses. One of these is that a competitor will come along and steal your lunch. New entrants can seem to come from nowhere – does anyone remember Myspace? We think Ewan and Roddy’s move into SEA and away from Tencent illustrates they are well able to cope with this element of the technology sector. Moreover, the relatively diversified portfolio of stocks allows them to take more shots without having to pick a handful of winners and hope for a 100% strike rate.

In particular we think that the coronavirus pandemic illustrates how the process of digitalisation could go much further than it has – how many of the new online shopping customers will go back to physical visits after the crisis ends, for example? In this light, the managers’ saying “everything can be replaced by software” makes more sense. For those who want to take a long-term position in a trust aiming to invest in the future, the current 12% discount could be an appealing entry point, although we note that discount volatility has been high.

Bull bear
A highly active approach maximises the potential for outperformance A highly active approach can lead to underperformance if active decisions don't work
High revenue-growth potential in Asia and new technologies Gearing can exacerbate losses in down markets
Commonality of approach at Baillie Gifford means there is a lot of expertise to draw on Discount volatility is high

Portfolio

Managers Ewan Markson-Brown and Roddy Snell describe themselves as growth investors looking for high-growth companies who are excited by the future. As such, PHI’s portfolio is concentrated in companies using new technologies to open up new markets or new ways of doing things. The approach is highly active, with only 17% crossover with the regional benchmark (the MSCI AC Asia ex Japan Index), corresponding to an 83% active share.

Ewan and Roddy aim to find companies with strong competitive positions at a relatively early stage of their development and hold for the long term, until their competitive advantages erode. They view the technological revolution as closer to its beginning than its end, and aim to find companies which are benefitting from this multi-decade theme. As well as understanding technology itself, this requires analysing the tastes and lifestyles of the younger generation in their region, which currently contains 50% of the world’s population.

The top holding, SEA Limited, illustrates many of these points. SEA is a Singapore-listed business which operates in the e-commerce and online gaming worlds. Its portfolio of businesses includes Shopee, an online delivery and distribution platform which dominates in Singapore, Taiwan and the ASEAN region and is expanding into Brazil. It also owns Garena, an online gaming platform, and Sea Money, a digital financial-services company which provides mobile payment services, microloans and other financial products. PHI has owned SEA since the latter’s October 2017 IPO. At the time, Ewan and Roddy believed that the markets for its two main gaming and e-commerce lines of business could compound by 20% a year for a decade, with the ASEAN region it serves around five to ten years behind China in these areas. From $17 at launch the shares have risen to $45 (after the March sell-off). SEA makes up 8.1% of PHI’s portfolio.

top ten holdings

holding
weight (%)
SEA
8.1
Alibaba
6.0
JD.com
3.9
Samsung
3.5
Li-Ning
3.4
Accton Technology
3.0
Tencent
2.7
Kingdee International Software
2.6
Ping An
2.6
Koh Young Technology
2.3
TOTAL
38.1

Source: Baillie Gifford, as at 29/02/2020

As the above table shows, the second- and third-largest holdings are also e-commerce companies, but both focussed on China: Alibaba and JD.com. That said, the managers have been selling down their Chinese technology holdings since early 2018, and the weighting to Tencent in particular has fallen (it was at one time the largest position in the portfolio). Ewan and Roddy believe that in China the competitive advantage of the leading companies such as Tencent has fallen and there is greater competition. For example, ByteDance’s TikTok came from out of nowhere to become one of the world’s leading messaging apps, leaving Tencent’s offerings looking old. This illustrates how quickly tastes and technologies can change, and being alert to this is a key task for the managers, while their desire to be long-term holders has to be balanced against this. In Ewan and Roddy’s view, SEA’s dominant market position in relatively immature markets means its growth potential is more secure than some platforms in more mature markets like China.

Internet retail and online services are not the only focus of the trust by any means. These stocks now tend to sit in the consumer-discretionary sectors after classification changes – in fact, we wonder whether in the post-coronavirus world, some such as Amazon will be considered staples. In technology proper, PHI has holdings across software and hardware. Software is a relatively small part of the portfolio at just over 6%. Holdings here include Kingdee, China’s leading online enterprise resource-planning developer. The managers are actively looking for more investment opportunities, particularly in those software companies moving their services online, where they think economies of scale can really take effect and dominant market positions can be created.

Hardware includes stocks like Taiwan’s Accton Technology, which designs and manufactures network switches for large data centres. Data centres are what make the cloud services and networks which are central to so much of modern business practices possible – particularly in the states of quarantine so many countries are enduring. Ewan and Roddy compare them to picks and shovels in the 19th-century gold rush: essential tools which allow the better-known companies like Facebook (a customer of Accton) to mine gold. In the managers’ opinion, the market-leading technology Accton owns puts it in prime position to benefit from trends such as online gaming. Other hardware holdings include companies creating 3D inspection technology and electrical components as well as circuit boards.

Although there is a strong bias to these technology- and consumer-related areas, the managers also take positions in basic-materials companies which they think are benefitting from the same trends. For example, as of the last semi-annual report (dated the end of January), PHI also owns oil & gas company CNOOC, as well as a zinc miner and two nickel miners (demand for nickel is expected to rise as electric vehicles become more prevalent). This part of the portfolio has been increased over the past two years with the proceeds from selling down Chinese internet companies. In fact, at the end of 2019, materials were the fourth-largest overweight after healthcare, information technology and communication services. Many basic-materials companies produce the raw materials necessary for technological innovations. The largest underweights were to financials, real estate and consumer staples. That said, sector weights are derivative of stock selection rather than expressing a top-down view, and Chinese insurer Ping An is a key top-ten holding.

Even though PHI has some large single-stock positions, it is otherwise quite diversified. The 38% in the top ten holdings is marginally below the peer-group average of 40%, while its 76 stocks are close to the peer-group average of 78. This is due to the managers’ aim to find high-growth stocks to take them further down the cap spectrum. PHI has numerous smaller positions in small and mid-caps with extremely high growth potential. Ewan and Roddy buy these companies knowing that not all of them will succeed, but the ones that do will likely make shareholders enough money to more than make up for any disappointments. As a result, the trust’s portfolio has the highest weighting to small and mid-caps in the AIC Asia Pacific sector (38%, compared to a 22% sector average), and one of the lowest weightings to what Morningstar calls ‘giant caps’ (28%, compared to a sector average of 53%). Many of these small caps operate in the biotechnology industry and can be highly volatile, with the potential for huge gains in short periods of time (or indeed losses).

Even more so than sector, the geographical breakdown of the portfolio is a by-product of stock selection. SEA, the largest position, generates most of its revenues away from Singapore, its market of listing. SEA is a major player in the Indian and Latin American online gaming markets, for example, and Shopee is one of the market leaders in Indonesia and the ASEAN region as a whole. Shopee also derives revenues from Brazil. Businesses operating online and selling online services have the potential to be extremely international in terms of revenue streams. That said, the chart below shows that the trust is concentrated in the more technologically advanced companies of North Asia. South Korea is home to many of the trust’s biotechnology holdings.

geographical Allocation

Source: Baillie Gifford

Gearing

The board sets gearing parameters within which the managers are permitted to operate, which are currently 10% to minus-15% (i.e. holding cash) geared. The gearing level is currently 8%, and has been at a similar level for the past two years. The managers have access to a £30m revolving credit facility which can be drawn down or paid back at short notice, and which would amount to roughly 13% if fully drawn down.

Returns

PHI has performed strongly over the long term. Even after the vicious market falls in March after the coronavirus pandemic hit, it is up 16.5% in NAV total-return terms over five years. A passive investment in its benchmark (represented by the iShares ETF in the graph below) has returned just 2.2%. The below chart shows cumulative relative performance versus the passive, with an upwards-sloping line indicating a period of outperformance.

relative performance over five years

Source: Morningstar

The period of the most outperformance came in 2017 and the first half of 2018. In this period, information technology, consumer-discretionary stocks and Chinese internet-related companies strongly outperformed. PHI also had almost half its portfolio in information technology during this period, which helped it to outperform, while it had a high weighting to consumer discretionary as well. Positions in the largest technology companies in the region helped performance – Alibaba, Tencent and Samsung, for example. However, PHI also benefitted from owning smaller, less widely held companies which also did very well. These included Sunny Optical, a Chinese lens manufacturer, and Koh Young Technology, a Korean company which develops 3D optical inspection technology and benefits from the global trend to factory automation.

Relative returns have been volatile since then. The biggest gainers in the 2017 rally (i.e. technology- and internet-related names) sold off at the end of 2018, which means that PHI posted a bigger loss for the year than the ETF. However, renewed risk appetite in 2019 saw the trust outperform once more. In that year, the trust also benefitted from a number of buy and sell decisions. The weighting to technology was reduced during 2018 as the mangers became convinced that competition was increasing in the Chinese internet space, and that the ‘moats’ of some of the incumbents they had backed were not as wide as they once were. They sold Baidu and Sunny Optical and reduced Tencent, for example, and bought into stocks which they thought had even greater competitive advantages. One such is the top holding, SEA Limited, discussed in the Portfolio section.

annual returns

Source: Morningstar

Looking back on a 12-month basis, PHI has outperformed. NAV is down 6.7% on a total-return basis compared to the ETF, which is down 10%. In the six months to the end of January, the technology weighting was again a positive relative to the ETF. Not holding much in the ASEAN region also helped, as did some of the major holdings, including top-ten holdings SEA and Li-Ning. The trust lost a little more than the ETF in the initial crash, but has rebounded more strongly as of the time of writing (30/03/2020), although the situation is highly fluid.

one-year performance

Source: Morningstar

Dividend

The objective is to generate long-term capital growth, and the directors recommend investors do not consider PHI if they require income. Expenses are charged to the revenue account, so the trust generates little or no distributable income. As a result, no dividend has been paid since 2016.

Management

PHI is managed by Ewan Markson-Brown and his deputy manager Roderick Snell. Ewan has managed the trust since March 2014, having joined Baillie Gifford the previous year from PIMCO, where he also worked on emerging markets. Prior to his time at PIMCO, Ewan ran Asia Pacific portfolios at Newton and Merrill Lynch. Roddy joined Baillie Gifford from university in 2006 and worked in the UK and European teams before joining the emerging-markets equity team. Ewan and Roddy are co-managers of the open-ended Baillie Gifford Pacific Fund.

Baillie Gifford takes pride in having a distinctive, collegiate approach and in having a low turnover of investment staff, in keeping with its long-term approach as investors. Over the past 20 years, annual turnover has averaged just 5%. The performance-bonus part of the managers’ compensation is based on rolling five-year performance, incentivising them to invest for the longer term.

Discount

PHI’s discount has tended to be volatile, and over the past five years it has risen and fallen in line with NAV outperformance and underperformance. After the 2016/2017 rally in high-growth consumer-discretionary and technology stocks which favoured PHI, the trust traded on a premium for much of 2018 and 2019. After those markets proved to be less favourable to PHI’s style, it fell back onto a discount. In the coronavirus-inspired sell-off in February and March, the share price has fallen faster than NAV, and the trust now trades on a 12% discount – although we note this is not the widest it has traded, even in recent months, and the figure has been highly volatile in recent weeks.

discount

Source: Morningstar

The board has the authority to buy back or issue shares to control the discount. It last issued shares in April 2019, and last bought back shares in October 2019 when the discount widened beyond 10%. Shareholders have the right to vote on the continuation of the company every five years, and the next vote will be held at the 2021 AGM.

Charges

The ongoing charges figure (OCF) is 0.99%, which compares to an Asia Pacific-sector weighted average of 0.95%. This includes a management fee of 0.75% on the first £50m of net assets, 0.65% on the next £200m and 0.55% on the remainder. This amounts to roughly 0.67% at the current level of net assets (£225.8m). There is no performance fee. The KID RIY is 1.62%, compared to a weighted sector average of 1.43%.

ESG

Baillie Gifford considers ESG issues as part of its investment processes. The company believes that companies need to be alert to changes in the attitudes and values of the societies they sell to in order to continue to be successful. The company believes that those companies which fail to do this tend to be unsuccessful, either because of falling consumer demand for their products or regulatory and government interference. The managers of PHI, Ewan and Roddy, therefore consider the positive and negative impacts of candidate companies on society, and aim to find those which add value. They also ensure that these companies uphold the interests of minority shareholders, and so there is a good alignment of interests between shareholders and management. There is no negative screening out of companies, and Ewan and Roddy take a positive engagement approach, encouraging companies to improve policies and management systems and view ESG factors as important to long-term return potential.

Fund History

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