January 20, 2011
Dear Fellow Shareholders,
2010 was the year that the global economy steadied itself, but was not revitalized. Growth rates were positive in most large economies. However, growth for the most part was not sufficient enough to lift employment rates. This situation has been described as the “new normal.” And yet, it is surely abnormal to have nearly 10% unemployment in the U.S. and Europe as a whole, as well as 20% of people out of work in large economies such as Spain. As one might expect in such an environment, overall prices were subdued, rising 1.6% in both the U.S. and Europe, despite policymakers’ attempts to “jump start” their economies through aggressive fiscal expansion, monetary stimulus, or both. Those attempts have, to general consensus, produced lackluster results—although the argument rages as to whether that was because the efforts were too little or whether they were of the kind that would fail even more disastrously if they were tried on a larger scale. The experience in Asia, of course, has been very different. Asian economies were revitalized in 2010, and reached new heights of production and income. Accordingly, policymakers in Asia are stepping on the brakes to try to rein in prices and credit growth for fear that they might be in danger of igniting the same kind of bubbles that have brought the West’s economies to a crawl.
How investors will react depends very much on what they want from the markets. If they seek fast profits, then the current environment may seem an exciting one. What is the possibility of an Asian equity bubble? Will the demand for raw materials in Asia push commodity prices to new highs in the very near future? Will the great wall of liquidity—created by the West’s policy response to stagnant growth—push asset prices to historic highs? Will it also be further accommodated by Asian government efforts to hold down currencies that should appreciate by increasing the quantity of currency in circulation? However, if an investor’s commitment to the markets is longer-term in nature, as ours is at Matthews, then these issues become distinctly less enticing—for what we are witnessing is a distortion in pricing. The degrees of relative price changes are not being determined by the underlying changes to domestic demand, and can be misleading. Put another way, if the price changes that are directing true profit opportunities are being overwhelmed by speculative trading, then the investment waters are being muddied.
This makes it a peculiar and difficult time for Matthews’ style of investing. We set out to invest “through the cycle.” That means we are looking for profit opportunities that depend on solid financials and sustainable business advantages, rather than being driven by the short-term ebbs and flows of the stream of spending in an economy. We try to train ourselves to set our sights over the kind of time horizon that would take into account a complete business cycle. We, therefore, anticipate seeing temporary fluctuations in industries and in our own performance within that timeframe. Trying to remain true to our essential philosophy and beliefs in investing has therefore been a key test for our investment team over the past year—and one in which, I believe, our portfolio managers performed admirably. Looking ahead in what we expect may be a volatile environment, it will be even more important to stay true to our principles, and to properly manage portfolios for market risks, than to accurately predict each sway and twist of the markets.
An Eye for New Trends
We have to guard against many errors, but in this context, one is more apparent than any other—that is mistaking the beginning of a new trend for just another cyclical quirk. Industries have in the past morphed from cyclical to secular growth. Being mindful of these opportunities is paramount. One example of the past is the information technology industry. Certainly overhyped in the late 1990s and very dependent on corporate capital expenditure cycles, the IT industry has become more exposed over time to consumer demand and growth. As technologies and research and development have coalesced around a core set of platforms, the industry has moderated its cycles and become more transparent. We believe there are similar opportunities across the Asian markets. In the financials sector, industries such as wealth management have in the past been very cyclical, as they have lacked a deep client base or a diverse enough pool of assets in which to invest. As financial markets deepen and savings behavior changes, these businesses could change as well. The same could be said across many other emergent industries in the services and consumer sectors, such as marketing and advertising. Properly assessing these opportunities is a task for our analysts and portfolio managers.
Foremost in our minds is the energy and materials sector. Talk of commodity supercycles is always quick to surface whenever higher liquidity or a lower U.S. dollar drives prices in these sectors—and yet the key catalyst has remained monetary, despite the underlying demand in Asia’s economies. Nevertheless, at some point there will be a structural shift in the way that Asia manages its energy needs, driven partly by costs in traditional raw commodities and partly—perhaps more sustainably—by an ongoing desire to change the quality of life.
Our investment process remains informed ultimately by our confidence in the underlying business investment. But when we do try to pierce the murky future and identify broad themes and attractive industries, we do so with the knowledge that these are driven by forces and demands that are more widespread and enduring than the actions of politicians and central bankers. In so doing, we hope that we are continuing to place emphasis on stock selection, whilst neither ignoring the macroeconomic environment, nor placing too much faith in short-term forecasts of overly broad indicators such as GDP and interest rates.
Finally, Matthews continuously monitors capacity and asset flows on each of its investment strategies. If we believe the pace of inflows and/or a Fund’s asset levels could impede the Firm’s ability to achieve its investment objectives, Matthews considers strategy closures. Recently, two Funds were closed to most new investors—the Matthews Asia Small Companies and Matthews Asian Growth and Income Funds closed on November 12, 2010 and January 7, 2011, respectively. The Funds’ closures apply to both Investor and Institutional Class shares. We believe that limiting access to these Funds is a prudent step toward maintaining the integrity of our investment process.
As always, it is an honor to serve as your investment advisor.
Robert Horrocks, PhD
Chief Investment Officer
Matthews International Capital Management, LLC