Dear Valued Investors,
According to legend, King Midas gained the power to turn everything that he touched into gold. Delighted with this power, he touched the branch of a tree and it turned to gold. But he soon found himself unable to drink or eat as anything that touched his lips aurified instantly. His final tragedy came when, heedless of his despairing protests, his daughter embraced him and thus was transformed into a priceless, lifeless golden statue. Midas had managed to deprive his life of all value.
I see parallels in the current market environment. Cash, cash and cash—it is all that anyone seems to care about at the moment. European nations need it to pay down debt as do U.S. homeowners and China’s local governments. Central banks, meanwhile, seem disinclined to increase the rate at which new cash is supplied. That is the case even in the U.S. and Europe, but it is particularly striking in Asia where central banks have been following quite a tight policy. This has all led to a scramble for cash and, as a consequence, machines idle and rust and labor languishes unemployed. At least in my view, these investors appear to be focusing on the value of cash to the extent that they lose sight of value elsewhere. Midas eventually starved for his love of gold and it is hard not to draw the conclusion that love of cash is starving the world of economic activity and starving labor of potential productivity.
Investors have also bid up prices of the “next best thing to cash”—U.S. treasuries, for example. And they have bid down prices of what are seen as riskier assets such as Asian equities. The notion of a “risk on, risk off” narrative has also added the fuel of a short-term mentality to this investment approach. It has brought valuations in Asia’s markets down to levels that are below historic 20-year averages. At the end of the second quarter, a broad-based universe of Asia ex-Japan stocks was trading on about 10X forward 12-month earnings. This is about a 20% discount to that 20-year average, which has historically been an infrequent occurrence. The current Asia ex-Japan dividend yield of 2.7% is similarly infrequently seen. Given the slow drips of bad news out of the U.S. and Europe, the markets have had plenty of time to ruminate on risks to short-term and long-term growth. This is not a fast-moving crisis, and much analysis has been focused on the issues concerning investors. This means it is not something that the markets have had to try to digest quickly with no past knowledge, insight or experience. Consequently, the low valuations are based on relatively subdued forecasts for the near term. Margins are expected to decline year-over-year.
For us, it does mean that there is more value in the markets than there has been in a while. And as a portfolio manager, it is always enticing to see established, seasoned businesses offering good dividend or cash flow yields, particularly when convinced of the long-term demand for their services or products. The frustration of a portfolio manager is, of course, that at the very time when there are so many enticing options, you often don’t have the cash to capture that value. At Matthews, portfolio managers witness the high value many investors place on cash—one of the things that we value least. Cash levels in the Funds reflect this. We generally remain fully invested.
It is not that we don’t care about cash—indeed we focus on companies that we believe will be good stewards of capital; that allocate investments carefully, and delight in creating value for shareholders or returning cash to them. As portfolio managers, we are interested in cash only to immediately put it to work, for we see a greater value in what we believe to be the underappreciated potential of Asia’s 4 billion people. In the past, extreme demand for cash has often been transitory—which is not the assumption that markets seem to be making about today’s world. The “new normal” and similar discussions of a loss of potential output in the global economy make sense to me only if they are a surrender to the idea that this love of cash will be much longer-lasting. Whether or not that assumption is right, it seems to be less appropriate for Asia, where the proximate cause of demand for cash may be the fact that policymakers and central banks have been following relatively tight policies. Compare this policy conservatism with the rest of the world in which one can blame the accumulation of excessive debt over years, even decades. For us, it remains a view that seems to be at odds with the broad sweep of Asia’s development and also with our discussions in recent company meetings.
We are meeting companies at a faster pace this year than we did last year. This is partly because we are in the enviable position of having been able to increase our investment team’s research resources over the past year and now have “more hands on the wheel.” It is also because during these times, when everyone is focusing on cash, short-term trends and the macro picture, we think it is best to take a view which the market may view as contrarian.
As I mentioned in some of my previous communications, we spend a lot of time looking at India and China, particularly small-capitalization companies. But, in truth, the opportunities are quite broad-based across countries and industries. We have seen some effect of the slowdown in global growth. Nevertheless, many of the companies we visit are focused on domestic demand and are somewhat insulated from the weakness in Europe and the U.S.
The portfolios remain fully invested: biased toward businesses that we believe will grow profitably over the coming decades from the growth in spending of Asia’s households, the development of new products, the enjoyment of new services and the enhanced expression of individual tastes and preferences. As such we hope to avoid King Midas's fate, to focus instead on what can be valued over the long term.
As always, it is a privilege to act as your investment advisor.
Robert Horrocks, PhD
Chief Investment Officer
Matthews International Capital Management, LLC