Amid Reopening, Quality Is Key
Following a year of disruptions caused by the global pandemic, the investment landscape has been altered by changes in consumption patterns, acceleration of existing trends and a sea of liquidity unleashed by central banks and government policy makers. We recently sat down with John Paul Lech, Lead Manager of the Matthews Emerging Markets Equity Fund to discuss the approach he is taking in the Fund’s portfolio.
Have market disruptions changed the types of companies you seek to invest in?
In the Matthews Emerging Markets Equity Fund, we are looking for companies that can adapt and thrive across a broad range of conditions, so our approach to identifying good companies has remained consistent. There are five key attributes of companies that we generally like. We call these the “Five Cs”—competitive position, capital allocation, capital structure, cash flow and character. These attributes help us determine whether the business is being run appropriately for the long term, including for shareholders like ourselves who are not in a control position. 2020 taught us that things can change in ways that aren't easily forecast or perceived and underscored the importance of the quality of companies’ business models and management teams. So our focus is really on quality companies who are capable of managing the volatility that is inherent in emerging markets economies. We also seek to maintain a portfolio construction that is diversified given the inherent difficulty of predicting the future.
How do you generate new ideas and conduct research when physical travel is limited?
Idea generation can come from multiple places. First, it can come from looking at companies who are related to our existing holdings like competitors, suppliers or customers. Colleagues who work directly on our emerging markets strategies, as well as the broader Matthews Asia investment team, are also a great source of idea generation. Finally, just reading and thinking broadly is important. We don't need one hundred good ideas at the same time; we really need four or five great ideas to pursue in any given time period.
During the pandemic, our analysis of companies transitioned to virtual meetings with companies due to travel restrictions. In my experience, investment management is often a fairly introverted activity, and so our ability to research and concentrate wasn't really effected by the virtual environment. What I think the virtual environment did do is to somewhat rearrange the research process. Previously, we might go to a country, such as South Korea, and we might meet a financial services company one day and a semiconductor company the next. In the virtual environment, it's been a little bit easier to say, "Let's focus a little bit more thematically. Let's meet five different food retailers in five different geographies and see what they do similar, what they do different." So there are certain advantages to the virtual environment. From my perspective, the year was successful in terms of adapting to the virtual environment, but we’re hoping to get back on the road again soon.
What trends did you notice that were accelerating in the pandemic?
In looking at our investment universe, we tried to determine which companies would either benefit or see their business not disproportionately impacted by the global pandemic. That led us to a few sectors where we saw natural acceleration in the businesses - e-commerce, for instance, or certain software providers. The key now is to sort those companies into the ones whose competitive advantage was changed in a catalytic, structural sense.
China is the largest part of the emerging markets investment universe. How are you thinking about this important market?
China is a market we study closely, drawing on a deep bench of China expertise across the firm. In my view, it’s more important to think about the revenue exposure of businesses rather than make top-down allocations in terms of country weights as opposed to allocation. For example, we look closely at companies whose earnings and prospects are materially impacted by what happens in China, even though they may be domiciled outside of China. These could include luxury goods companies where the majority of sales and growth are coming out of China. Alternatively, these could include a copper or iron ore mining company where the majority of what's being consumed or the delta in global growth is in China.
For companies that are domiciled in China, we are typically looking for well-run, innovative companies. There are a section of companies that are really benefitting from growing middle-class consumption in China. At the same time, there are also many companies in China that don’t meet our “Five Cs” test, so we work hard to separate the wheat from the chaff.
What’s your approach to investing in non-Asia markets?
Our basic philosophy of looking at the “Five Cs” and looking for great companies isn't really different in one geography versus another. We consider whether the business we are analyzing is a great company and what influences that company as it relates to the country where it operates, for example, in terms of GDP or currency stability? Every company is impacted a little bit differently by its macro environment.
Additionally, there's really a continuum of competition that matters for any given company. Some companies are highly impacted by what's going on more broadly globally, and the other is really disproportionately connected to the local geography. In general, this is more important than the geographic region.
Looking ahead, where do you see upside surprises or elevated risks?
My sense of optimism—and caution—is really a reflection of where we are globally. There’s been significant progress among many developed economies in terms of their vaccine rollouts, which has been counterbalanced a bit by new variants of the virus emerging and ongoing health care challenges in countries such as India. We still find great companies to invest in across the emerging markets, characterized in our view by both their quality and adaptability. One area of concern is that asset prices and valuations have risen across asset classes.
We see high valuations reflected in U.S. financial markets, as well as parts of emerging markets. What’s more, we also need to be mindful of the prospect for inflation, which can cause commodity prices to rise, and how that may impact sectors and industries. Market commentators are debating whether inflation may be transitory or stickier. While the initial market rebound back in 2020 seemed to emphasize growth at any cost, some of the priciest stocks seem to have a bit of a healthy correction in more recent months. In general, we are seeing a rotation favoring concrete growth or more quality growth. It’s healthy that market performance broadens out a bit. The market favors a flexible approach, not a dogmatic factor one, and hopefully our philosophy does that.