Investment Manager Report

January 2015

Dear Valued Investors,

A couple years ago, I expressed a concern for the chase for yield in markets and remarked, “There are times when there is actually safety in growth!” Such has been the story this year. Higher-yielding equities have struggled somewhat. Companies with faster growth profiles have done well. “Developing Asia” has outperformed “Developed Asia” and small-capitalisation stocks have outperformed large-caps. In our dividend-focused portfolios, these have largely concentrated in growth in dividends, rather than yield and that has helped deal with the headwinds for such strategies. Elsewhere, our focus on high return-on-capital businesses with secular (if not always remarkable) growth has done well. Of course, we are not trying to rotate across different styles—we are convinced that both ways of looking at the region can provide good long-term, risk-adjusted returns. But the volatilities inherent in the portfolios are different, and they can suit different periods in the markets. But what is common across all our portfolios is a belief that Asia’s long-term growth prospects remain strong, and investing in businesses that grow with the development of the region’s middle-class lifestyles provides a good backdrop for returns. This year, despite all the concerns over slowing headline growth rates in China and a strengthening U.S. dollar, our conviction that Asia will continue to press for growth-oriented reforms has been further buttressed.

This has certainly been India’s year— at least according to the short-term verdict of the markets. There has been plenty of excitement generated by, first, the appointment in September of 2013, of Raghuram Rajan to be the Governor of India’s central bank. Part of India’s Achilles heel, in the eyes of foreign investors at least, has been fiscal and monetary irresponsibility. Governor Rajan, as a Chicago Booth School of Business economist, exudes the kind of sensible, apolitical expertise that reassures foreign investors. In addition, India’s politics have often appeared hopelessly divided and a clear political “win” for a single candidate has given investors further reassurance. The fact that the winner was the reform candidate has added further spice to the story. And if that wasn’t enough, India began the year at what appeared to be the turning point, i.e., the trough of a credit and earnings cycle.

All of this means that the main India market benchmarks are up about 30% year-to-date. There has surely been some earnings growth, but valuations have risen quickly. None of which is to say that the rise in India is unjustified. If we are going to be able to look back on Prime Minister Narendra Modi’s reforms as a success in about a decade’s time, the markets have not yet fully reflected this. Current valuations are surely not discounting much more than a strong rebound in short-term earnings and at least a successful start to the reform process. India remains a country where much can be achieved over the next decade to improve people’s standards of living, their spending power and their productivity. If it can achieve better rates of savings and more efficient mobilisation of those savings into much-needed infrastructure projects, why can’t it mimic the growth of its giant neighbour China? 

But it is still an open question. Now more than ever, investors interested in India should decide if they are in it for the long haul. There may be plenty of opportunities for disappointment either on the political front or in terms of short-run earnings momentum. 

These days, the media would have us believe China is not for the faint of heart. Yet, China has initiated its own reform process. Its leaders have also become comfortable with the slower rates of real GDP growth demanded by the markets as a sign of responsible economic management. Have earnings in China not compounded at 12% in U.S. dollar terms since December 2010 as the markets have derated? All of this leaves China trading at the lows last seen during crises past.

Japan has also impressed with its aggressive monetary easing. There are plenty of Abenomics critics in financial circles, but for those that believe economies “can get stuck in a rut” when policy rates are at or near zero, aggressive central banking is what is needed to set the economy back on course. Neither has Abenomics always achieved great popularity in Japan, but the recent snap election seems to have boosted Abe’s mandate and at least been a vote of confidence in the monetary and other reforms that appear to be starting to show results in an improved labour market and strong profitability in corporate Japan.

The one cloud this year has been the strengthening U.S. dollar. But, as we wrote earlier this year, this does seem to have been a case of dollar strength, not Asian weakness. So, we reach the end of the year with the momentum still behind the U.S. markets in terms of rising prices and rising valuations, whereas Asia has been more listless, but has started to see better operational results as margins have stabilised and sales growth remains robust. Who knows what will happen next year, but the momentum still seems to be behind the “growthier” elements of the markets in Asia. But there is real relative value emerging in Asia, where portfolios with growth far in excess of the broad market indices in the U.S. and Europe can be had for the same valuations or even discounts of 20% or 30%. Periods of tighter money (a strong U.S. dollar) and weaker growth (e.g. China, Europe) have typically been harder times for Asia’s stock markets—and this is what we have been facing for the past year or more. But Asia’s markets have been resilient and, furthermore, continue to lay the groundwork for future growth in its reform plans. I remain optimistic based on the region’s long-term growth that can still be accessed at reasonable valuations.

It is a privilege to serve as your advisor for Asia investments.

Robert Horrocks, PhD
Chief Investment Officer
Matthews International Capital Management, LLC