Innovation in Action

What impact are innovative companies having on the composition of equity benchmarks?

When I look at today's benchmarks tracking international markets, they seem to be trapped in this old EAFE (Europe, Australasia and the Far East) or developed market framework. Most benchmarks reflect where the world has been, not necessarily where the world is going. In my view, two important economies are essential for investors right now. The first, of course, is the U.S. The second is China and, more broadly speaking, the Asia ex-Japan region. An investor's U.S. portfolio will naturally cover the U.S. market. Investors then need to consider their international portfolio, which I believe needs to include a healthy allocation to China to give you the right picture of today's world. When I look at the benchmarks tracking international markets, China is not at the center. Many investors seem to have a big hole in their asset allocation models, which is Asia ex-Japan equities.

When investing in China and other parts of Asia ex-Japan, what is the role of active security selection?

China is a good example of how innovation is generating opportunities in Asia through creative destruction. China has fully embraced the digital age, with retailers going straight to e-commerce, skipping over brick-and-mortar in many cases. China's merchants have already embraced digital currency. You no longer need physical money in China; all you need is your smart phone. When placing orders in a restaurant, paper menus are not provided—you just order straight from your phone. China is also fully embracing financial technology and a broad range of online services as well. Against this backdrop, innovative companies still only reflect very tiny part of the MSCI China Index, which is still dominated by big banks, big offline financial institutions and industrial companies. When we look at the MSCI China Index today, I can envision that roughly a third of the current index constituents may become obsolete in the future. To capture China's digital transformation, I believe security selection is key.

Is China approaching developed market status?

Within China today, we see at least three different development stages. Looking at China's coastal and largest metropolitan cities, these areas function similar to developed economies. Residents in cities such as Shanghai, Beijing and Shenzhen often have incomes much higher than US$10,000 per capita, a global milestone for middle-class status. The middle part of China, what we might think of China's heartland, is still emerging. As you go west into China's interior, it's much more similar to a frontier country. We cannot simply label China as either developed, emerging or frontier because the picture on the ground is much more complicated. Furthermore, not all emerging market economies will deliver superior growth just because they're in the emerging markets category. The best way to think about each market is with a bottom-up stock-picking mindset, focusing on structural growth industries within those markets.

How do you see valuations for growth companies in Asia today? Is there a disconnect between valuations and economic activity?

Valuations for Asia ex-Japan equities are slightly above their historic averages. The market is forward-looking, with investors often thinking 6 to 12 months ahead. During the first half of the year, investors seemed to be expecting a V-shaped recovery. There could be some volatility ahead if expectations for a fast economic recovery dampen. At the same time, there is also another dynamic at play in today's markets, where the major market players are changing. Companies with significant future growth potential are often trading at a premium because growth may be harder to come by in a low-rate environment. Intangible assets, such as intellectual property, network and data, are also playing a key role in driving valuations higher for some growth companies.

What about earnings? Have investors correctly priced in future earnings, or are investors being overly optimistic?

Depending on the pace of economic recovery from COVID disruptions, we could see some delay in earnings recoveries. I don't think we really have a clear view of what will be happening for earnings in the next year or two, so I believe it's important for equity investors to maintain a longer-term time horizon, at least three to five years or longer. Many things remain unknown in the near term. Taking a longer-term view, I continue to believe that companies with strong organic structural growth have the potential to perform better. Sectors such as health care, Internet services, software and online education may provide attractive opportunities for long-term investors.

Michael Oh, CFA
Portfolio Manager
Matthews Asia