TDF: Neutral On This China Fund Ahead Of A Tender Offer Catalyst

It’s been a terrible year to be a China optimist, and since my last writeup on the Templeton Dragon Fund (NYSE:TDF), the fund has underwhelmed along with the broader Chinese markets. Yet, last month’s policy meeting offered some light at the end of the tunnel. In a new first, Beijing has introduced considerable fiscal flexibility, adding ~80bps to its deficit ‘red line’ (~3%) to be funded via ~RMB1trn of additional sovereign bond issuance in Q4. To be clear, any near-term economic impact will likely be limited, given most of this funding will be allocated to low multiplier projects like reconstruction rather than direct property stimulus. But this is still a step in the right direction and suggests Beijing could now be more open to levering up at the central government level to compensate for local governments constrained by their massive off-balance sheet liabilities.

Against an uncertain China backdrop, though, underwriting a pricey ~16x earnings multiple for the TDF portfolio leaves little downside protection should earnings disappoint. While there is an interesting fund-specific tactical setup, as TDF’s upcoming tender offer (up to 25% of issued and outstanding common shares) could take a few percentage points off the current low teens % NAV discount, I would probably be on the sidelines here.

Fund Overview – Puts And Takes From This Year’s Reshuffling

The Franklin Templeton-managed Dragon Fund emphasizes long-term capital appreciation relative to its benchmark MSCI China All Shares Index by investing in large and mid-cap Chinese equities across mainland and Hong Kong share classes. In line with the rest of the Chinese active fund universe, TDF has seen its net asset base decline to ~$330m (down from $410m in Q1) despite reducing its fee rate by ~15bps in April. Per the updated fee schedule, this implies a ~1.1% expense ratio – very competitive relative to comparable active funds like Matthews International’s China Fund (CHN), which charges ~1.7%.

The other key change this year has been at the portfolio management level, with Nicholas Chui (ex-Blackrock and abrdn) taking over from lead manager Michael Lai, effective Q2 2023. As a result, the fund has seen some notable shifts in its sector allocation – most notably, TDF now holds a significant overweight position in the Media & Entertainment sector at 21.1% (~9% delta vs its benchmark). Retailing, the previous sector overweight is now an underweight position (8.3% vs. 9.3% benchmark), while Consumer Durables & Apparel has been kept as a major portfolio overweight (6.4% vs 1.9% benchmark). Other notable components of the top five include Capital Goods (another big overweight at 11.6%) and Food, Beverage & Tobacco (10.9%).

The fund’s largest single-stock holding remains tech/media conglomerate Tencent Holdings (OTCPK:TCEHY) at 9.3%, followed by e-commerce leader Alibaba Group (BABA) at 6.7%. Outside of the top two, TDF has reshuffled its single-stock portfolio composition a fair bit, with Kweichow Moutai (4.7%), Ping An (OTCPK:PNGAY) (4.2%), and Baidu (BIDU) (3.9%) gaining share at the expense of banks and consumer goods companies like China Merchants Bank (OTCPK:CIHKY) and ANTA Sports (OTCPK:ANPDY), respectively. The portfolio has also been narrowed to 44 holdings (vs. 67 prior and 791 for the benchmark index), mostly H/A shares. TDF’s higher concentration allows for more upside from the manager’s higher-conviction bets, though it also skews portfolio valuations significantly higher at 16.1x trailing earnings (around four turns higher than the more diversified benchmark).

Fund Performance – Relative Near-Term Underperformance Continues

On a YTD basis, the fund has declined by -18.3% in NAV terms, but due to a wider discount, TDF’s market return is closer to -22.2%. With the fund headed for another poor year (note TDF was down by a steeper -33.0% in 2022), its annualized rate of compounding is down, albeit to a still respectable +6.7% (+7.2% market price), since its 1994 inception. Much of the returns were back-end loaded, though, with absolute and relative performance faltering over the last decade. On a three, five, and ten-year basis, the fund’s market price returns are -21.6%, -3.4%, and +0.5%, respectively, consistently below its benchmark.

Despite the various policy changes this year, TDF’s semi-annual distribution policy remains intact. While the fund distributed $1.30/share last year, much of this came from capital gains, a luxury TDF won’t have this year. With limited income from its newly rebalanced portfolio (1.1% dividend yield) to compensate, I wouldn’t get my hopes up for a payout this year. If the new manager’s preference for tech/consumer growth names is anything to go by, distributions will likely remain low through the coming years as well.

In place of distributions, the fund’s Board has authorized a tender offer commencing this week for up to 25% of issued and outstanding common shares. As purchases will be conducted at a 2% discount (to cover processing and payment costs), expect the NAV discount to narrow somewhat. Don’t get your hopes up too high, though, as the market has already shaved off a few % points (currently low-teens % vs high-teens % last month) in anticipation of the tender offer.

Neutral Ahead Of A Tender Offer Catalyst

TDF presents an interesting near-term setup as it follows through with its tender offer (up to 25% of shares) over the coming week. Tactical investors may reap some short-term gains in the likely event that the NAV discount narrows, though any benefits are unlikely to outweigh China’s broader economic woes.

To be clear, it’s not all doom and gloom, as evidenced by Beijing’s newfound willingness to raise its fiscal deficits and fill any spending gaps left by constrained local governments. RMB1trn of additional central government debt is a big deal, but it remains too soon to underwrite a turnaround for equity markets, particularly with the spending going toward infrastructure reconstruction rather than high-multiplier stimulus measures. TDF’s portfolio doesn’t leave a lot of margin for error either at the current mid to high-teens earnings multiple; net, I am on the sidelines at these levels.