Signs of Life for Dividend Growth
Matthews Asia Portfolio Manager Yu Zhang provides an update on the Fund.
The first half of 2021 was positive for Asian equities. A semi-synchronized global economic recovery gained momentum throughout this period and led to a market rotation from growth to value-orientated companies in the first quarter of 2021.
Last quarter, however, proved to be a story of two very distinct phases. A slowdown in Chinese growth, a COVID-related market sell-off and a shift in inflation expectations proved detrimental for the more interest-rate sensitive, cyclical value names in Asia. Toward the end of the second quarter, markets rotated back toward growth stocks. In times like these, a flexible approach that can balance exposure to quality growth and more cyclically sensitive stocks can help investors navigate markets driven by different styles.
The Matthews Asia ex Japan Dividend Fund offers such an approach. It blends dividend-growth stocks and dividend payers depending on market conditions, offering investors participation in both growth and value markets. The Fund ended 2020 with an approximately 60/40 weighting in favor of dividend growth. By the end of the first quarter this split reduced to approximately 50/50, whereas in the second quarter, the overall balance moved back to favor dividend growers as we took advantage of the volatility to add growth names that were indiscriminately sold off during the correction.
Fund performance reflected the potential benefits of a flexible approach: For the first half of 2021, the Matthews Asia ex Japan Dividend Fund returned 9.48%, while its benchmark, the MSCI All Country Asia ex-Japan Index, returned 6.51% over the same period. For the quarter ending 30 June, the Fund returned 8.11%, while the benchmark returned 3.66%.
China and Vietnam
The largest contributors to relative performance during the quarter came from holdings in China and Vietnam. While Chinese equities did not perform well over this period, dragged down by a combination of macroeconomic concerns and increased regulatory oversight, stock selection and a large underweight mitigated much of these losses.
At the same time, some sectors rose above the overall lacklustre broader market performance due to fundamental drivers. One such sector is industrials where we see opportunities in industrial automation solutions providers and manufacturing equipment companies for electric vehicles or lithium battery products.
While we are still waiting to see a meaningful recovery from the Chinese consumer, we believe that Chinese consumer stocks can potentially offer some opportunity if inflation starts to peak in the latter part of the year. For now, the portfolio has taken a light positioning on consumer businesses, given their multiple expansion in 2020. In addition, consumer sentiment was hit by inflation and bouts of COVID resurgence across Asia, and that’s one reason why many consumer names have been struggling year to date.
Meanwhile, we more than doubled our exposure to Vietnam by taking advantage of COVID-related sell-offs to add to existing holdings and introduce new names during the second quarter. Having begun 2021 with a 3% weighting, by the end of the second quarter close to 7% of the Fund was invested in Vietnamese securities. Despite the recent setback from the COVID pandemic, the structural growth story offered by the Vietnamese economy and many of its listed companies still attracts investors, and Vietnamese shares rallied year to date after significant underperformance in 2020.
In our view the increase in outsourcing of manufacturing activity from China is likely to benefit companies in Vietnam more than any other country in Asia. Furthermore the Vietnamese government continues to pursue a market friendly reform agenda. While valuations have largely caught up with the MSCI Asia ex Japan Index, they still look reasonable in our view.
Small- and mid-caps march on
Rather than country or sector allocation, the biggest driver of the Fund’s relative return continues to be stock selection. This is particularly true for the Fund’s small-cap exposure where small caps have contributed over half of the performance in the second quarter, a story which is also repeated year-to-date.
In Asia, small-cap businesses offer an interesting overlap between delivering growth and returning this growth in the form of rising dividends. Often these can be fast growing businesses where the original founder/family is still the majority shareholder. For them, dividends are a significant source of income and cash flow, and therefore are more likely to be resilient in their dividend policy and may emerge quicker from a coronavirus lockdown. In addition, at the early stages of a cyclical rebound of both the economy and corporate earnings, small caps tend to bounce more owing to their larger operating leverage.
The Fund’s small and mid-cap exposure rose from about 39% at the end of 2020 to 59% at the end of June 2021, and we believe they are well-positioned for medium- and long-term corporate earnings growth. Some of the small-cap holdings, more for industry or company-specific reasons, posted strong positive earnings growth, and that has generated attractive performance over the second quarter.
Portfolio positioning for inflation
Inflation has been a much-debated topic throughout this year. After a rather disruptive rotation in the first half, equity markets have more or less re-adjusted to the new environment, pricing in rising inflation expectations and a potential tapering of loose monetary policy.
Having increased the portfolio’s exposure to financials during the first quarter of the year on the basis they would benefit from a rising interest rate environment, this weighting decreased towards the end of the second quarter. We also slightly cut back the portfolio’s cyclical holdings, including energy and materials, as we watch out for a potential peak in GDP numbers and normalization of monetary policy.
Despite the challenges of the last 18 months, the dividend growth story in Asia remains steadfast. Overall, we expect a meaningful rebound in both corporate earnings and dividend payments, but that is mainly due to the low base of 2020 when companies suffered widespread pandemic-related disruptions. Whether earnings growth can be sustained longer term is a different question. In our view, Asian equities are fairly priced at the moment. They are neither cheap, nor expensive at this point. So where do we see opportunities?
Heading into the second half of 2021 and beyond, cyclical businesses are likely to lead the early earnings recovery phase in our view, while structural growth drivers such as domestic consumption and industrial upgrades could return to drive further earnings growth, particularly in China. The broadening of the economic recovery beyond China continues to be another potential source of ideas for the portfolio.
As fundamental, bottom-up investors, we pay close attention to whether risks have been priced in correctly and valuations are attractive. In our view, Asia equities today provide intriguing opportunities for active investors.