Investment Manager Report
Dear Fellow Shareholders,
2011 was a difficult year for Asia's markets. It began, if not with euphoria then, at least on a high note as investment inflows into the region were strong, and stocks in cyclical and commodity-related segments had been riding high at the end of 2010. Markets had appeared to be putting behind them the shock of the financial crisis and were once again looking forward more confidently to years of uninterrupted growth. Valuations reflected this and, though they were not as egregiously expensive as they were in 2007, they certainly afforded much less room for markets to shrug off any shocks.
The shocks were aplenty. Some of the largest shocks resulted perhaps from the complacency of U.S. and European policymakers that saw both fiscal and monetary policy withdrawn. Authorities seemed to feel they had done enough to support growth and were wary of creating inflation. But gradually, inflation expectations and bond yields began to decline as investors fretted over growth prospects. The approximately 30% return on U.S. Treasuries from already low yields at the start of the year made a mockery not only of these policy actions but also of those who worried that the economic recovery of 2009 to 2010 was about to ignite inflation. Faltering growth began to create pressure on European bond yields as investors doubted the ability of previously “safer” governments (like Spain or Italy) to pay off their debt. In Asia, inflationary pressure was much more of a reality. The region—not for the first time in the recent past—found its rates of growth in domestic demand at odds with what was happening in the West, and started to tighten monetary policy by raising interest rates and reserve requirements, and implementing administrative and price controls on certain industries and markets. The steady drumbeat of commentary questioning the health of China's financial system and property markets only intensified as monetary conditions put stress on funding property developers.
Tighter lending conditions across the region make life difficult for Asia's smaller companies. State-controlled businesses in China, India's public sector or Korea's industrial giants, for example, all tend to soak up more than their fair share of capital, leaving small-scale entrepreneurs to rely on internally generated cash flow or less formal financial markets. Even worse for small companies was a string of corporate governance issues, centered among U.S. and Canadian-listed Chinese small-capitalisation stocks that shook confidence further. Many of these firms had listed via reverse mergers or takeovers: that is they bought into listed shell companies in order to avoid more strenuous public listing requirements set by exchanges. Nevertheless, in the environment of nervousness, and given the stresses on business performance caused by rising costs and limited access to funds, investors were understandably inclined to sell first and ask questions later.
Throughout all this turmoil, however, few investors seemed to question the long-term potential of the Asian region. Nor do we believe most investors would disagree that Asia's growth is likely to outpace that of the West over the next decade. This did not, however, prevent some capital from leaving the region and being sucked into the U.S. For however fragile the U.S. may seem, it enjoys a safe haven status. By the end of 2011, stocks with stable earnings that were able to profit from Asia's long-term growth held up very well compared to the rest of the market. Materials, exporters and domestic industrials all did poorly. Small companies were hit hard and companies with more distressed financial profiles or less-seasoned management teams were also aggressively sold down.
Throughout the year, this caused volatility in fund performance, particularly relative to benchmarks. The Funds generally outperformed during periods when the market fell and often underperformed during rallies as the cyclical sectors bounced back. For the year, Fund performance in absolute terms, as well as relative to the benchmarks, was driven by three main factors: their focus on buying businesses with more stable revenue or cash flow growth; a focus on domestic demand as the driving force for that growth over long periods; and in the case of the Asia Dividend Fund, an emphasis on dividend-paying equities. These factors tend to cushion the Funds in difficult markets.
As the dust settled on the markets at the end of the year, what was immediately apparent was that a wide dispersion in valuations had grown between different sectors and styles. This poses some challenges for stock selection and portfolio management. It is undeniable that markets as a whole appear cheap relative to their history and to the U.S. However, many of the sectors we have favoured over the last few years, and the kinds of growth that we prefer to focus on, are now noticeably more expensive than much of the rest of the market.
We do not attempt to trade in and out of the market cycles because rather than correctly "playing" sector rotations, we would likely get whipsawed by the markets, buying near the top and selling near the bottom. Nevertheless, we are cognisant of valuation differentials, and are deploying more research efforts in these areas to uncover what we consider to be long-term value—that is, businesses we would be happy to hold for the long run.
Other areas of investigation present themselves to us in the form of smaller companies, particularly in China, which bore the brunt of a credit squeeze and corporate governance scandals during the year. India, too, offers opportunities. For most of the past few years, it has been among the region's more expensive markets but has become, after a nearly 40% decline, one of the more attractively priced markets. Again, the challenge will be to stick to our knitting, and make use of opportunities that make long-term sense for the Funds.
It is always a privilege to act as your investment advisor.
I wish you all a prosperous 2012.
Robert Horrocks, PhD
Chief Investment Officer
Matthews International Capital Management, LLC