Investment Manager Report
Dear Valued Investors,
In the current environment, it is understandable that macroeconomic news dominates the headlines: a jobless recovery in the U.S.; the potential of a break-up in the European Union; and central bankers as heroes and villains. However, I think that, while investors are right to talk about them to provide context for investment decisions, they may be placing too much emphasis on these events when it comes to decision-making. Recently, I shared a coffee below the skyscrapers of Hong Kong with some former colleagues and investors who have considerable experience investing in Asia. We chatted about the macroeconomic topics of the day: U.S. unemployment; the upcoming U.S. presidential election and the country’s fiscal cliff; problems in Greece and Europe; and China’s banking system and property markets. However, after much circular discussion, one of them said: “Stick to the micro! It’s best just sticking to the micro.” It’s tempting to see this as a sort of resignation—macroeconomics is too complex! But it is more than that. Sticking to the micro does not mean ignoring the macro.
What it means is that ultimately, even if you have a macro view, the “unit of investment” that you deal with is the security that you buy. If you are an equity investor with a short-term view, you might say it’s about “trading equities.” In that case, the business fundamentals probably interest you the least. Rather you focus on trading those equities that are most exposed to changes in monetary policy. However, I think some investors may get themselves into deep water by taking such an approach. For the effects of macroeconomic policy—whilst sometimes predictable—are often imprecise. Consider the U.S. Federal Reserve’s third round of quantitative easing, or QE3, for example, and Milton Friedman’s famous comment that monetary policy works with long and variable lags. In more detail, he believed: “Changes in money tend to affect output after something like about six to nine months, and inflation only after another 18 months, by which time the effect on output is negative rather than positive.” I am not an economist, let alone a monetary wonk, so what I take from this is that, if I try to base my views on monetary policy, I am implicitly taking no more than a nine-month view on real economic activity and perhaps a two-year view on inflation. That is before I have to take into account how much has been factored in by other market participants.
To make matters even more complex—those initial positive effects may turn out to be negative over the course of the next 24 months and so, if I choose to express my view on activity by buying companies for which I see no long-term investment horizon, I may end up with events going against me and holding businesses that I do not like for the long run and praying for another round of monetary stimulus.
This activity seems to be more of a game than anything else. And a difficult game to be playing at that! It is a game in the sense that there is no real way, as far as I can see, to try and assess the likely magnitude and length of the initial swell of optimism and the timing, extent or duration of the inflationary backwash. The best strategy would seem to be to “place your bets” and see where the momentum of the wave takes you. My advice to those looking for this kind of excitement would be to take up surfing.
Today, with depressed economic activity across much of the world and with tight monetary policy in China, many investors have been waiting for the next round of stimulus. What will the effects of QE3 be? What will be the impact of European Central Bank loosening? When will the Chinese loosen monetary policy and how will markets respond? I think these are inherently short-term questions from an investment point of view. They may have big implications for some groups of stocks over the short run—cyclical businesses, highly indebted companies, and distressed equities are probably best placed to rally strongly on positive announcements and positive impacts from these government policies. But are they the companies you want to hold for the long run?
Even the question about how the European Union will evolve—will Greece leave?—seems to be inherently short term, too. For, despite the fact that there may be big long-term consequences for the political union itself, nevertheless, businesses that have strong market positions and are able to change and adapt to new situations will ultimately still have good long-term prospects. So, it seems far more worthwhile to focus on businesses for two reasons. First, they are ultimately the units of investment that count, and second, in an uncertain future, it is prudent to invest in those entities that can change and adapt and have the best chance of growing through different environments.
But there is a third reason, too: many investors seem to talk as if macroeconomic concepts such as money supply, government spending and exchange rates impact an individual’s behaviour without recognising that these great magnitudes are also created by the actions of those same individuals. Even in our fixed income deliberations, where Portfolio Managers take a greater account of macroeconomic policy because they are buying the debt of governments as well as of companies, seeing the macro picture through the eyes of businesses is often instructive. Therefore, for us, a focus on the entrepreneur, and their decisions, is a way of better understanding the macroeconomic context of our decisions. How does the macro impinge on decision-making for us? At Matthews, both our Lead and Co-Portfolio Managers meet regularly to discuss portfolios and the macro environment. What we are not doing is taking a view on "India vs. China" or "consumer vs. industrials vs commodities." Rather, we are asking ourselves questions about the risk environment—what keeps us awake at night? What industries are struggling? Why? How will this impact the competitive environment and the survivability or sustainability of these businesses? And about opportunities—how do we think these markets and households are evolving over the next decade? Should a market decline precipitously or should a currency devalue, we will look at those markets very seriously as a source of new ideas. Ultimately, however, investment decisions still depend above all on the sustainability and value of the businesses that we buy. This is why we take the long-term view and, in so doing, believe we can ride out these short-term waves of changing macroeconomic policy.
We feel privileged to be your investment advisor for Asia and thank you for your support.
Robert Horrocks, PhD
Chief Investment Officer
Matthews International Capital Management, LLC