A positive relative performance of 0.4% in March has led us to finish the first quarter of 2024 with an outperformance of 2.3% against the MSCI Emerging Markets index.
The largest contribution to performance during the quarter came from South Korea, driven by our value-oriented positioning in the market. This was followed by Taiwan, in particular technology-oriented names. We also saw a positive contribution through stock selection from China despite still being somewhat underweight the market.
A pullback in some of our Brazilian mid-cap stocks, some weakness in our Polish positions and our underweight in India offset some of that outperformance during the quarter.
We have been taking profits in Taiwan and reduced our overweight to the market since the start of the year. At the same time we have added to Korean exposure even as we have been shifting out of some stocks such as banks that have had very strong moves on the current value-up theme.
A core concept of the North of South investment philosophy is the idea that investors in a given country have choices when deploying their liquid savings. They can keep their money in the bank or purchase domestic bonds, earning a fixed rate of interest. Alternatively, they can invest in equity markets. In countries with high interest rates like Brazil there is a real tension between returns available from fixed income and the equity market.
In Taiwan, domestic interest rates have been extremely low for decades. We have always been bemused how inefficiently the Taiwanese equity market was priced relative to the paltry returns of 1-2% available on domestic deposits and bonds. For many years, the equity market offered a much higher dividend yield of around 4%. This was not due to lack of growth – even prior to the post-Covid boom, dividends paid out from the MSCI Taiwan index nearly doubled between 2014 and 2019 thanks to expanding earnings. These figures understate the true opportunity available to investors willing to go beyond mega-cap stalwarts like TSMC that benefit from a US ADR listing. Many of our mid- and smaller- capitalization stocks offered high single digit dividend yields and have unsurprisingly formed the backbone of North of South’s income strategy.
Over the past year, this has begun to change. Domestic financial institutions found traction among retail investors by launching specialized ETFs that targeted dividend paying companies, in particular in the technology sector. These funds pay out progressively higher monthly dividends often in excess of actual dividends received on their portfolios, offering clients a super-charged income profile relative to bank savings. Paying investors “income” out of their capital has elicited grumblings from the regulator but is an effective marketing strategy. This is particularly effective as strong inflows have helped drive up the shares held in these funds, providing capital growth to investors on top of the income.
Taiwanese domestic ETF assets have mushroomed from around US$4bn at the end of 2019 to more than US$45bn, with most of the growth coming in the last two years. Last month saw two additional ETF launches which attracted an additional US$4bn of new money into this space. Much of the new money has been focussed on smaller and mid capitalization stocks and in many cases the ETFs have ended up owning significant stakes in these companies. We have watched as many of our holdings have moved from significantly discounted levels towards fair value and in some cases beyond. The Taiwan FTSE Mid-Cap index now trades on a forward P/E of 19x against a historic range of 10-14x. Its dividend yield has dropped to a record low 3%. The yields offered to investors on these ETFs remain in the high single digits as they are partly funded by returning capital. This is not a sustainable form of income and will one day lead to problems but for now remains attractive to retail investors.
Our valuation discipline has required us to reduce and exit some of these positions. At the same time, we acknowledge that some Taiwanese companies are also seeing a real tailwind from AI driven demand. This means near term growth rates and profitability can be higher and justify higher valuations. Disaggregating flow driven performance from fundamental changes in the business is both a challenge and an opportunity. We will continue to adjust our positioning to take advantage of these type of developments.
