Shareholder Letter and Commentaries
By Robert Horrocks
April 25, 2012
It was a strong first quarter for both Asia’s equity and fixed income markets, though many might be surprised to hear this given the continued media coverage about the sluggish U.S. recovery, debt problems in the Eurozone and slowing growth in China. Indeed, macroeconomic news seemed to overwhelm sentiment in the markets and dominated many discussions among the punditry for much of the quarter. Even though stock prices rose, valuations in Asia at the end of the first quarter remain below long-run historical averages. Perhaps this reflects continued nervousness over these big macroeconomic issues; the most common phrase I heard from investors at home and abroad over the first few months of this year was: “I’m waiting for the pullback.”
Despite the good absolute returns, and after the strong relative returns of the last four years, some of the Funds got off to a slower start this year versus the markets. In the early part of the rally, as commodity companies and more cyclical business rallied, our Funds, which own comparatively less in such businesses, did not keep pace. As the performance of smaller-capitalization stocks improved, we started to catch up. Our reaction to this is to ask questions of ourselves and to test our assumptions and beliefs. More than anything, it means "getting on the road" to speak with managers in Asia and to hear what they have to say and to see what they are doing.
The investment team has been very active in its research. Three areas of interest have received particular attention: Japan, India and small Chinese companies. Why Japan? Well, valuations are very low—shares on average trade at book value. That observation seems simplistic and naive, but it is true nonetheless. In addition, new markets are opening up for some Japanese companies such as the capital goods sector, where producers of automation equipment are helping China’s companies to increase productivity despite higher labor costs. There are also opportunities in the health care and consumer goods areas, as Asian consumers begin to focus more on buying top quality products and developing brand loyalty, rather than just seeking out what is cheapest. Both of these developments are tied to rising wages in the region—a trend that we believe will continue and can only bring prosperity to Asia’s households. We believe it cannot be coincidence that over the past few months Chinese companies have been investing in or buying Japanese electronics and household goods businesses.
India and smaller companies in China offer slightly different sorts of opportunities. Both suffered severe dislocations last year that made them attractive areas for investigation. Not only did India's stock market suffer last year but its currency weakened: despite a rally in both, the market capitalizations of many Indian businesses in U.S. dollar terms are still well below levels attained in the last five years and valuation multiples have also contracted. This makes India, long one of the region’s most expensive markets, appear unremarkable in terms of valuation. With that in mind, several members of our investment team, from different Funds, spent some 50 person-days in India during the first quarter of the year researching potential ideas. China’s smaller companies were hit hard by at least two events in 2011—corporate governance scandals among some Chinese companies listed in the U.S. and Canada and a credit squeeze in China as bank lending dried up and informal capital raising became a high-profile legal issue. The current fetish of "risk on, risk off" talk also encourages investors to treat entire asset classes as easily manageable chunks. Thus, it seemed to many of us on the investment team that among China’s small companies, the good, the bad and the ugly, had all been sold down together with perhaps insufficient discrimination of the future prospects of the underlying businesses.
It was with this opportunity in mind, and because we wanted to monitor the macroeconomic situation, that several lead portfolio managers visited and talked extensively with entrepreneurs from China’s city of Wenzhou, seen as the heartland of Chinese entrepreneurialism and informal financing. What we heard was that labor and raw material costs were more of a challenge than funding, but that business was good. Entrepreneurs candidly admitted mistakes of over-diversification and unrelated property investments, noting that they had lost money as a result. But these losses, they said, just made them more determined than ever to focus on their core business. Their comments from our visit made us generally less concerned about the macro situation. Furthermore, the government is taking much-needed steps to support informal lending channels and bring them out into the open to offer the kind of efficient capital allocation that China’s growing economy needs.
Another motivation behind our recent research efforts in China was to assess the extent of property and stock speculation for the potential dangers they may pose to the economy. For those worried about what wealth destruction might mean for China’s growth and for Asia, it appears to be stale news. Market participants told us that the majority of sales were to first-time buyers or people upgrading their homes; speculators made up a relatively small percentage of the market. Any hit to wealth and short-term sentiment from falling prices, therefore, is likely to be limited and has probably already happened. The domestic stock market is currently down nearly 60% from its peak in 2008 and prices of luxury properties that were the subject of speculative buying have fallen in some cases by as much as one-quarter. These declines in the values of assets that were the “playthings” of the relatively few have already wiped out a fair portion of some rich people’s wealth. Yet overall retail sales, though a little slower, continue to be strong and income growth is robust. That China’s GDP growth will slow over time as consumption increases must surely surprise no one. Nevertheless, rising wages in China and changing patterns of consumption across Asia as the middle class grows will offer profitable opportunities for companies from Colombo to Tokyo. Finding these opportunities remains the key focus of our research efforts.
How the markets behave in the near future, including the size and duration of any pullback, is unknowable. However, we remain confident in the long-term growth and prosperity of Asia. Therefore, our approach, in the midst of what are admittedly absorbing macro discussions, has been to focus on finding good businesses, rather than try to speculate on events. As much as we all like to discuss the big issues of the day, for members of the Matthews investment team, the real excitement and challenge comes in discovering businesses whose future prospects are underappreciated by the average view of the investment community.
It is a privilege to act as your investment advisor in Asia's fixed income and equity markets.
(c) Matthews Asia