Three Extraordinary Years in Emerging Markets. Part 1
Portfolio manager John Paul Lech explores the defining changes of the last three years and how they have informed his approach to the years ahead. Here he looks at how the pandemic underlined the importance of quality and diversity at the holdings level.Subscribe
- The exuberance of the pandemic rally favored companies that lacked profitability, cash flow or a pathway to it. Liquidity can keep things going but it doesn’t generate a self-sustaining business model.
- The war in Ukraine altered the dialogue around energy and indelibly changed the risk profile of companies whose states are known for pursuing kinetic action. These changes are likely to be long lasting.
- Interest rates don’t matter until they do. As rates rise, companies with high leverage have to roll over or replace existing debt with higher yielding instruments, challenging margins.
On April 30, 2020, we launched the Matthews Emerging Markets Equity Fund (MEGMX). The ensuing three years saw more changes in emerging markets than the whole of the previous decade. It tested our approach and our processes. I’d like to reflect on those changes and on the market environments that dominated, how our process guided us through and on the lessons we’ve learned.
Three distinct narratives unfolded that, in our view, impacted—and in some cases upended—many approaches to investing in emerging markets and equities generally. At the outset there was COVID-19, the first pandemic in 100 years; second was the war in Ukraine, the biggest ground conflict in Europe since World War II; and third was the rise in interest rates after almost two decades of close-to-zero borrowing costs. The types of companies that succeeded or collapsed during each of these narratives were very different.
The pandemic: liquidity and exuberance
I flew home from Shanghai on January 15, 2020, and less than a month later we were in lockdown. After the initial panic, markets went on a tremendous liquidity-driven rally. Our approach is an inclusive one and that allows us to buy earlier stage companies with great narratives but this isn’t the corpus of what we do. Globally, markets seemed to favor companies that lacked profitability, cash flow or a pathway to it. Some of our positions appeared to become exuberant and the more exuberance there is the harder it is to step out of the dominant current. At one point, we calculated the percentage of the equity market that was trading at over 10 times sales and the result was frightening.
“We seek diversity in what will work, with the commonality that great companies tend to survive and thrive in the long term.”
There are companies that should trade at exceptional multiples but they are few and far between. We made the decision to sell quite a few holdings that were, at the time, the best performers. This was difficult but consistent with the sell discipline of exiting when the thesis changes or when prices become frothy. In doing so, we missed the top but we also didn’t participate in the ferocious ride down. A liquidity-powered market can keep things going but it doesn’t generate profitability or a self-sustaining business model.
The surest way to generate positive returns is to make bold predictions that turn out to be correct. But often the best-performing fund in a particular market is tightly wound around a factor and history teaches us that markets are full of surprises. Guessing the big picture of what’s next rarely works over the long term.
Our approach is to focus on great companies. We seek diversity in what will work, with the commonality that great companies tend to survive and thrive in the long term. Our aim is to perform through a variety of market environments and doing so requires tempering a desire to predict what’s next and then fitting the portfolio to that narrative. We try to provide resilience from holding a diverse set of underlying companies and we will bring to the next three years what we have learned over the last three extraordinary years.
John Paul Lech
You should carefully consider the investment objectives, risks, charges and expenses of the Matthews Asia Funds before making an investment decision. A prospectus or summary prospectus with this and other information about the Funds may be obtained by visiting matthewsasia.com. Please read the prospectus carefully before investing as it explains the risks associated with investing in international and emerging markets.
The value of an investment in the Fund can go down as well as up and possible loss of principal is a risk of investing. Investments in international, emerging and frontier markets involve risks such as economic, social and political instability, market illiquidity, currency fluctuations, high levels of volatility, and limited regulation. Additionally, investing in emerging and frontier securities involves greater risks than investing in securities of developed markets, as issuers in these countries generally disclose less financial and other information publicly or restrict access to certain information from review by non-domestic authorities. Emerging and frontier markets tend to have less stringent and less uniform accounting, auditing and financial reporting standards, limited regulatory or governmental oversight, and limited investor protection or rights to take action against issuers, resulting in potential material risks to investors. Investing in small- and mid-size companies is more risky than investing in larger companies as they may be more volatile and less liquid than large companies. In addition, single-country and sector funds may be subject to a higher degree of market risk than diversified funds because of concentration in a specific industry, sector or geographic location. Pandemics and other public health emergencies can result in market volatility and disruption.