It is not all about earnings

The Asian equity team use all three key financial statements when making investment decisions.

We rather take the risk of buying what we believe are undervalued stocks with limited downside, rather than buy stocks where there is a material risk of a de-rating, leading potentially to an investment declining in absolute terms.

Our investment process is to buy stocks trading at a significant discount to our estimate of fair value. Typically that estimate is derived by applying what we think is a fair multiple to our expected earnings for a company in three years' time. Often, however, we use free cash flow (FCF) instead of earnings, and apply a fair free cash flow yield to derive our fair value.

Earnings do not tell the full story

As investors, we broadly accept that earnings are a good starting point but they do not tell the full story. It can be helpful when analysing certain types of companies to also examine FCF and balance sheet strength, particularly in the case of capital intensive businesses where the equity owners can be asked at various stages to help fund new asset purchases.

FCF analysis led to the purchase of holdings: JD.com, Mediatek, Asustek and Samsung Electronics

As investors, we broadly accept that earnings are a good starting point but they do not tell the full story. It can be helpful when analysing certain types of companies to also examine FCF and balance sheet strength, particularly in the case of capital intensive businesses where the equity owners can be asked at various stages to help fund new asset purchases.

A great example of a stock where we used FCF to drive our valuation estimate is JD.com, one of our top five holdings in the Invesco Perpetual Asian Fund. JD.com is the 'Amazon of China' and competes with Alibaba. FCF is materially higher than earnings for JD.com as their customers pay them sooner than they pay their suppliers. Despite a net loss in accounting terms over the last reported 12 month period, the company's free cash flow has been significantly positive to the tune of US$4.3bn which puts the stock on a FCF yield of 7%. In our opinion, this is a reasonable FCF yield for a company with little or no growth prospects, but for a company like JD.com which is growing revenue at 40% per annum, it is very attractive.

Another tool we use in addition to the straight FCF yield is the "FCF to enterprise value". This is in many ways a superior metric to the straight FCF yield because it highlights those companies with substantial cash on their balance sheets which a simple P/E ratio or even a FCF yield would fail to capture. For example, we invested in a leading Taiwanese semiconductor design company, Mediatek, which had approximately 40% of its market value in cash. This placed it on a FCF/ EV of over 10% which led us to conclude that this company was undervalued given its strong growth outlook in 2018 and 2019. In some cases, the fair value multiple we apply to derive our fair valuation estimate is adjusted depending on the strength of the balance sheet. A good example of a stock where we made such an adjustment is when we decided to invest in Asustek, a Taiwanese motherboard manufacturer, which has a substantial amount of cash on its balance sheet (approximately equal to 80% of its market capitalisation).

Large cash balances can be returned to shareholders in the form of dividends or share buybacks. Companies such as Microsoft and Apple have over recent years been under pressure from investors to return cash to shareholders and, as a result, have made commitments to do so which have help their share price performances. Samsung Electronics is a good example of a stock where FCF/EV analysis highlighted the stock as being undervalued, given the amount of cash on its balance sheet, and now some of this cashflow is being returned to shareholders. Recently, Samsung announced their updated shareholder return policy whereby 50% of its free cash flow would be returned to shareholders each year in the form of dividends and share buybacks. This has helped to support Samsung Electronics' share price performance and, importantly, our holding has been a key positive contributor to the Invesco Perpetual Asian Fund's absolute and relative returns (MSCI AC Asia Pacific ex. Japan Index) over the last 10 years.

Finally, while large cash balances provide a margin of safety, a catalyst is required for the full value of this cash to be factored into the share price, such as higher dividends, share buybacks or an acquisition. As a team, however, we do not have to identify a specific catalyst before we invest as we believe that typically as soon as a catalyst is apparent then the share price reacts very quickly. We trust that our investment horizon is long enough to give time for a catalyst to emerge. However, we acknowledge the risk that in some cases a catalyst may not appear and the investment does not render value for shareholders. We rather take the risk of buying what we believe are undervalued stocks with limited downside, rather than buy stocks where there is a material risk of a de-rating, leading potentially to an investment declining in absolute terms.

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Past performance is not a guide to future returns.

This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.

The Invesco Perpetual Asian Fund invests in emerging markets, where there is potential for a decrease in market liquidity, which may mean that it is not easy to buy or sell securities. There may also be difficulties in dealing and settlement, and custody problems could arise.

The fund may use derivatives (complex instruments) in an attempt to reduce the overall risk of its investments, reduce the costs of investing and/or generate additional capital or income, although this may not be achieved. The use of such complex instruments may result in greater fluctuations of the value of the fund. The Manager, however, will ensure that the use of derivatives within the fund does not materially alter the overall risk profile of the fund.

For the most up to date information on our funds, please refer to the relevant fund and share class-specific Key Investor Information Documents, the Supplementary Information Document, the Annual or Interim Short Reports and the Prospectus.

Important information

This document is for Professional Clients only and is not for consumer use.

Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.

Invesco Perpetual is a business name of Invesco Fund Managers Limited, Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire RG9 1HH, UK. Authorised and regulated by the Financial Conduct Authority.