Investment Manager Report


July 2011

Dear Fellow Shareholders,

Sustainability has been the watchword for global economic markets so far as countries, businesses and stock prices all struggle to maintain the momentum in growth that has been built up since the financial crisis began. In addition, markets have been hit by the question: How long can this go on? These concerns have been leveled at U.S. unemployment, Chinese property markets, Asia's inflation and European debt. The question is well put. And given the context in which we are all seeing things these days—the aftermath of the greatest global financial crisis since the Great Depression—people seem naturally disposed toward extreme answers to that question. That is, people want to hear that either everything is all right or that the next crisis is imminent. I suspect that the best answer to such questions is rather ambiguous, for it is not at all clear that we have either emerged from the last crisis or already sown the seeds of the next crisis. We are likely living in a world of greater uncertainty and volatility than in the past. However, this does not necessarily mean that strategies to deal with that uncertainty are unclear.

Why is the world likely to be more volatile? One of the most powerful balancing forces in the economy is broken. Interest rates in the U.S., Japan and Europe have fallen about as far as they can go. Demand shocks will not be so easily absorbed by central bank monetary policies and low rates of nominal GDP growth, which is real growth plus inflation, are comparatively low. So smaller shocks are needed to push economies back into recession. Household debt is high in many of the large consumer-driven economies, and each shock to demand is greeted by renewed attempts to pay down debt. But one’s savings are another’s “spendings.” This means one person’s attempt to shore up his own finances may worsen another’s income. In addition, each shock puts more people on the unemployed registers, hurting the development of experience and skills in the economy. Each time the economy recovers, it does so incompletely, leaving scars of idle capacity and missed opportunities. How sustainable can growth be in a world in which small random shocks to growth will lead to large policy responses that may themselves be quickly withdrawn?

This has implications for our markets in Asia, too. Given fixed exchange rates, money supply may be more volatile and cycles in prices for goods and assets could be more abrupt. Regional policymakers will need to deal with this, and we have said before that this may mean capital controls or currency appreciation. Within markets, too, however, there will be effects as sectors that are more cyclical in nature, more sensitive to money supply or more directly affected by U.S. and European demand could see shorter, more abrupt cycles. These would include the materials and export sectors. This has been the story of the past few months, and particularly of the year to date. At the start of the year, commodity stocks were rallying sharply. Our Funds thus underperformed during this period as this is a sector that we have tended to invest in very lightly. The sector’s inherent cyclicality coupled with the difficulty for management and businesses to add value through the cycle means that success is more about timing the commodity cycle correctly rather than identifying the best businesses to own. However, as monetary policy in Western economies tightened and governments turned their attention to cutting deficits and debt burdens, the sector promptly fell back. Our Funds, on the whole, enjoyed far better relative performance during the second quarter than they did the first.

If I am correct in my analysis of the macroeconomic environment, then these abrupt cycles are likely to continue. In the face of this, how will we implement our investment philosophy? By staying true to our beliefs. I think that many people will either be sucked into trying to time these cycles or tricked into mistaking short-term volatility for the start of a long-term trend. Our technique has been to focus on the sustainability of businesses. Sustainability can be due to a company’s ability to raise prices; however, such ability often stems from the nature of a firm’s products or services. We prefer to see products and services bought or used repeatedly by households on a regular basis, rather than during short-term fads. We also look to management teams that are trying to steer their companies on a course of steady growth funded from cash flow, in preference over businesses that rely on external financing. These companies are likely to be able to prosper even if “normal” rates of inflation rise in the future. But they are less likely to enjoy (or suffer from) the kinds of price cycles that we have witnessed in some commodities. This means that our portfolios, whilst being less volatile in absolute terms, may exhibit more volatility in performance relative to benchmarks. We have never been overly concerned with managing short-term volatility relative to an index and we are not inclined to change now.

The companies that are likely to weather inflationary cycles are those that can better manage input costs and more easily raise output prices. There are industries that find this relatively easy to do—consumer-facing businesses with brand power; monopolistic business; those with less exposure to regulators and policymakers’ price controls; and those businesses that dominate hiring in any sector of the labour market. Businesses that can manage their capital commitments and are able to drive production-related efficiencies, which raise margins and competitiveness, are far better-placed to thrive. These are just some of the things we look for in identifying businesses that can achieve through-the-cycle growth, withstand acute periods of inflation and weather the downturns. It is a strategic approach to managing the cycle using stock selection rather than a tactical approach using sector allocation.

This being our approach, one should not expect an increase in cyclical volatility or a shortening of cycles to drive higher levels of turnover in our portfolios. We are neither inclined to trade the commodity cycle, nor to change the kinds of businesses we seek. It can be frustrating at times, during such cycles, and one may be tempted to try to follow the momentum of prices. However, for us to do so would be to turn our backs on our strategy. We are not expert in second guessing policymakers (known as “Fed-watching”) or forecasting market sentiment. What we do enjoy doing and where we think we have a greater chance of success is in deciding which businesses and management teams are best-suited to preserve and grow clients’ capital over the long run.

It is a pleasure to continue to serve as your investment advisor.

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