Investment Manager Report
Dear Valued Shareholder,
At the end of last year, investors were treating Asia as simply another emerging region at the mercy of the twists and turns of U.S. economic performance and monetary policy. But things seemed to have changed over the last six months—at least that is the impression that I have received from investors across the world. There is more willingness to think of Asia as a distinct region, like Europe—although it is still a radical change for some investment frameworks—and there is a growing understanding that all emerging markets are not created equal.
This change of heart toward Asia has no doubt been helped by several factors. But I would emphasize two elements in particular: growth prospects and valuations. First, taking growth, I quote a fellow panelist in Hong Kong, a few months ago, who had been asked about potential catalysts for the markets. He replied with, “You know, one day, we are just going to get bored of being negative.” And this finally appears to be the case. Asia has a lot going for it in the long term—fast rates of productivity growth, driven by better education and increased investment in capital, made possible by high savings rates. Countries seen as most vulnerable last year—India and Indonesia—appear to have taken some steps toward reform. Indeed, the difference between the political climate in Asia and in the Western economies is quite stark. The U.S. and Europe, though recovering, still seem to be underperforming and the political rhetoric is mainly focused on demand management—fiscal and monetary stimulus. Closely related is the question of wealth and income inequality. Policy is focused on trying to get people to spend more.
In Asia, over the last 18 months, we have seen the three giant economies put in place reformist governments: Xi Jinping in China, Shinzo Abe in Japan, and most recently Narendra Modi in India. Yes, there is a vast element of demand stimulus in Abenomics, but there is also much more emphasis on the supply side—labor force reform, corporate governance and financial reform. In China, financial reform, too, seems to be at the heart of policy as China tries to improve the pricing of risk and the allocation of capital across its private economy. Modi’s ascent to power in India has been greeted with comparisons to Ronald Reagan and Margaret Thatcher. And if he is successful in achieving, on a national scale, what he did in his home state of Gujarat, then India should see a wave of productivity growth. So as one half of the world tries to get the filling back into the pie, the other half is busy trying to grow the pie.
The second element that is in Asia’s favor is valuations. Valuations remain at a discount to long-term averages on a variety of measures, including price-to-earnings ratios, price-to-book and dividend yield. In Asia, equities look unequivocally cheap, relative to the rest of the world. Based on Factset aggregates, and using a composite analysis by any of the most commonly used measures of valuation, Asia is trading at a significant discount to the U.S. or anywhere else in the world, for that matter, save Eastern Europe. And this remains the same whether one looks at the Far East, Asia, Asia Pacific, Asia ex Japan or Asia Pacific ex Japan.
Despite all this, we often hear concerns that the sectors Matthews likes to invest in trade at a premium to the markets. This is generally, true. So we must believe we are getting something in return for that premium. First, we would argue that a significant portion of that premium is accounted for by the fact that we invest relatively little in China’s banks, or in any regional banks whose primary role is to funnel savings into the less efficiently run state-sponsored industries. This segment is trading at a well-deserved discount. Second, because benchmarks tend to be biased toward old-industry (heavy industrials, materials, energy) in Asia, we feel they are backward-looking. Third, we focus on long-term returns, which mean favoring cash-generative businesses with good capital allocation, high rates of marginal return on capital and management with good track records of either sharing corporate cash flows with minority investors or reinvesting sensibly in the business. We believe we are getting ample compensation in return for the premium we pay. And even then, when we look at the portfolio valuations in a global context, they are often trading either in-line or at a discount to U.S. and European equities with, we believe, better growth prospects.
Indeed, it is the growth strategies that have performed best in the past year or so. Small company strategies, too. This is not unusual in a period of recovering growth and rising interest rates, as the markets become more willing to value the long-term prospects of a business rather than focusing on immediately extracting cash. I would expect the markets to continue to hold a bias toward growth companies, if the current environment persists.
So, sentiment has improved markedly. But it is still wise to inject a note or two of caution. The conditions that caused market jitters have not gone away—a stronger U.S. dollar, some current account deficits and high rates of inflation. Indonesia, which had started to address these issues, has not given politicians as clear cut a reformist mandate as we hoped. Thailand is still sorting through its own political face-off. And the markets are starting to price in expectations for reform in India and Japan. But I really don’t feel that we are in a situation where markets are oblivious to bad news. After all, Asia has gone through more than three years of de-rating based on concerns over slowing growth and financial vulnerability. I am comforted by the fact that corporate earnings growth in the portfolios appears to have held up fairly well and the politicians are trying to deal with the region’s weaknesses. So I remain optimistic in the light of Asia’s growth prospects and a reasonable cushion from valuations.
It is a privilege to serve as your investment advisor.
Robert Horrocks, PhD
Chief Investment Officer
Matthews International Capital Management, LLC