Investment Manager Report
Dear Valued Shareholder,
Last year began with concerns over China, which quickly spread to worries over the entire emerging market universe. By mid-year, investors started to fret over the deleterious effects of tighter U.S. monetary policy on Asian and Latin American economies. Asia, excluding Japan, muddled through and ended with price-to-earnings ratios somewhat lower than they were at the end of 2012, and dividend yields slightly raised.
The discourse over China has been lively and sometimes illuminating. But a lot of it has been somewhat crude—with people dismissing China’s economy as “fake,” describing its property market as being in a bubble and predicting the imminent collapse of its banking system. Often, I think, this is a symptom of seeing the problems of others through one’s own lens. Indeed, it has not been uncommon to hear of China’s “subprime” issue when in fact the country really doesn’t have a subprime mortgage market at all. What the discussion has lacked, I believe, is nuance. For sure, there are issues in China’s economy. Take, for example, its property market, where there is too little low-income housing. Or credit growth, where concerns are more about an overly rapid pace of growth than the actual level of debt, which does not seem unusual for a country with such a high savings rate. Or let us consider China’s banking system, which is inefficient and in need of reform and perhaps capital injections, but nevertheless does not seem to threaten economic collapse because it is, to a certain extent, a closed system.
But if anything brought the lack of nuance in the “China debate” into sharp relief, it was the Communist Party’s own reflections on its policy meeting at year end. The new administration, obviously confident in its own power, published a comprehensive piece of reform rhetoric. Asian markets rebounded sharply, and this showed a lack of nuance too. Was it worth the sharp rebound? It was only rhetoric after all! The hard slog of legislation and implementation is yet to come. However, these developments did return to people’s consciousness the thought that China’s growth story, if it is anything, is a dynamic one. It also demonstrated that the growth story is transitioning and evolving from one economic system to another and embracing new reforms in a thoughtful, pragmatic way. By the end of the year, optimism had crept in to sweeten up the sour mood—but was it realistic optimism?
U.S. Federal Reserve tapering of quantitative easing policies was a big topic as well. And again, I think the implications for Asia were perhaps misconstrued: the correlation between Asian stock market performance and U.S. Federal interest rates is not at all clear in the short course of a year. The correlation between Asia’s stock market performance and growth is much stronger. Indeed, in the past, you would probably have had a better chance of forecasting the future direction of U.S. interest rates by using Asia’s stock market performance as a leading indicator than you would the other way around. It is nominal GDP growth (growth plus inflation) that seems to matter for Asia’s stock market performance. This point appeared to have been reinforced recently, when the Federal Reserve’s actual tapering announcement was couched in language that revealed it expected future growth to improve and was prepared to keep monetary policy loose if it did not. Instead of falling, markets rallied on the news. So, if tapering is to happen—particularly since rates are currently close to zero and developed economies are depressed—I suspect it merely signals faster future growth rates, which would actually be benign for Asian markets. In the meantime, Japan’s monetary experiment continued and by year-end there was evidence that employment, growth rates and even some wages were all rising.
Finally, we had the usual lumping together of Asia and other “emerging” markets and some people writing off emerging markets altogether as they trailed the performance of the U.S. As if they didn’t matter! Asia, for example, accounts for roughly 60% of the world’s population. If we have a framework of analysis that allows us to cavalierly dismiss over half the world’s productive labor in a single stroke, we probably need a new framework. Or, at the very least, we should be careful how we use the existing one. Asia is at least one part of the world that continues to close the income gap between rich nations and poor ones and improve the lives of its citizens. So, I would rather divide the world up into countries that have put in place the right kind of incentives and institutions to grow; and those that have not. In addition, if one looks at the longer term, the difference in equity performance between countries within Asia tends to narrow. On the one hand, this encourages people to focus on the year-to-year occurrences because the differences there are greatest and getting those right consistently would surely add value. On the other hand, we take a different view, feeling that short-term fluctuations in a country’s fortunes are hard to forecast. Over the long term, we believe that the best businesses, however, will steadily increase their advantage over competitors. So, we seek to examine a different question. What are the elements that determine the success of businesses over the long term? Here, we have a clear set of principles to follow. Over the long term, it is the growth in cash flows and book values of businesses that determine returns. These arise from a business’ competitive advantage and the competitive landscape in which it operates. These can be enhanced and nurtured by a quality management team—that is, one that allocates capital sensibly. Minority shareholders will share in this growth to the extent to which management teams are incentivized and willing to allow them. These returns tend to be earned by companies that have strong balance sheets and stable and reasonable rates of growth. The key then is to invest in such companies at a reasonable valuation.
I suspect it is this last component that will require particular attention in the year ahead. Many of the qualities that we admire in businesses tend to attract a premium. But in many instances this premium has widened over the last few years. So even when Asia’s aggregate valuations are below average—i.e., a dividend yield of about 2.5% and price-to-forward earnings ratio of about 11x (for the Asia Pacific universe as defined by FactSet)—it is still crucial to judge where companies are adequately appreciated for their future growth and where they may not be. The most compelling future returns may come from identifying those businesses with long-term prospects that have been overwhelmed by shorter-term macroeconomic concerns. That remains the job for our investment team in 2014.
Robert Horrocks, PhD
Chief Investment Officer
Matthews International Capital Management, LLC
*Forward earnings are calculated by dividing market price per share by expected earnings per share.