October 19, 2010
Dear Fellow Shareholders,
With the recent run-up in the markets and the return of more speculative behavior and momentum-driven sentiment by some investors and commentators, it is important to look again at the ways in which Matthews invests and some of the performance risks involved in our philosophy.
The Companies We Seek
Of prime importance in our philosophy are our long-term focus, and the concepts of survivability and sustainability of businesses. We have always considered that if we are to be long-term holders of a business, we have to be confident in its ability to survive and its ability to generate reasonable rates of growth over a long period. In part, this is based on an assessment of how relevant its business and products will remain to clients over the course of a decade; no less important, however, is its balance sheet strength. Low levels of debt, coupled with lower than average volatility in margins and returns, give a company a better chance of surviving and sustaining growth. These characteristics have been particularly well-regarded in an atmosphere in which investors are best characterized as “cautiously optimistic.”
Not too distantly related is our focus on cash flow and dividends. Shareholders of our Asia Growth and Income strategies (Asian Growth and Income, Asia Dividend and China Dividend) will know that we look at dividends closely because we believe they send several signals about an investment. First, they are an indicator of value; second, they are an indicator of corporate governance; third, over the long term, dividends have accounted for a large portion of equity investors’ total returns. As such, all of our strategies pay attention to the cash flow of businesses, though some will focus on dividend yield while others will pay more attention to cash flow yield. Both of these factors will support long-term performance of investment strategies. However, it is undeniable that these factors have been well-rewarded by the market of late, where investors have been keen to see cash paid out, and stability and growth of dividends as a more concrete anchor to expectations for growth.
Also important has been our long-standing focus on Asia’s domestic demand opportunities. These have obviously been more sought after by investors in the region because of the weakness of external demand. For us, the choice of domestic demand stocks has always been more strategic than tactical. The growth in wealth of the Asian household has been a stable secular trend and one that we expect to continue. Just as important, the types of businesses in these sectors tend to be much stronger franchises than those producing for the export market, where they have little or no control over distribution or brand.
Finally, an important part of our strategy is our bias toward mid- and small-capitalization companies. This is partly because of growth prospects for these companies—which tend to be higher—and also because such growth tends to be reasonably priced relative to large caps. It is also a reflection that smaller companies are more likely to be domestically focused. We are also aware that over time, smaller-capitalization stocks have tended to outperform in both Asia and in other markets around the world. This may make it an attractive place to invest for those who are committed to the region and who have a long-term focus.
Cyclical Companies Are Not Our Focus
Equally important is the Funds’ relatively low weighting in materials stocks. These businesses remain very cyclical—with the health of this global industry still very reliant on commodity prices and, therefore, underlying monetary conditions in the world. Added to this is the likelihood that over time, after having built up their modern infrastructure, the GDP of Asian countries is likely to become less intensive in the use of hard commodities. These businesses have to show an ability to add value through the cycle, rather than just ride the cycle, for us to be interested in them as long-term investment targets. Governments have also shown their willingness to tax peak-cycle profits, which often appear as windfalls. Nevertheless, these companies will go through cyclical swings and when sentiment and global macroeconomic conditions turn in their favor, our Funds may not fully participate in any acute upturns in their fortunes.
As an offshoot of this, our exposure to Australia is relatively light, given its weight in the region (on a market capitalization basis). Of course, this is partly a reflection of the high weighting to materials companies in the country and the linkage between the commodity cycle and the Australian dollar, which makes any investment in the country seem a much more cyclical proposition. In addition, the overall growth profile of Australia is much lower than that for Asia ex-Japan. To overcome this obstacle, we need to find companies with niche markets or exceptional management and corporate governance. This we can do. But most of our strategies remain very selective in Australia and, consequently, have low exposure.
Assessing The Risks
Now, what shareholders must be aware of when it comes to our Funds is that almost all of these biases have been working in our favor over the past two years: small capitalization, domestic demand, strong balance sheets, stable business versus cyclical business, Asia versus Australia, and dividend or cash yield. While we do not wish to be inflexible, these biases are a part of our long-term thinking and strategic outlook for investing in the region. Nevertheless, we can appreciate that there will be times when such a stance can seem like obstinacy in the face of a bull run in commodity stocks, or when risk aversion leads to better performance by more highly indebted companies. Or in times when momentum may take over the market and businesses with exciting near-term performance characteristics outperform those with less stellar but more solid long-term prospects.
We are aware of these risks. Yet it is very difficult to sacrifice a long-term strategic principle for a short-term tactical gain. It presumes greater foresight as to the degree and duration of any cycle than we are comfortable claiming. Nevertheless, in putting the portfolios together, portfolio managers are mindful of these various risks and always seek to incorporate investment ideas that, while staying true to our philosophy and principles, add some degree of optionality or hedge should the short-term investment climate become less conducive to our long-term philosophy.
As always, it is a privilege to serve as your investment advisor.
Robert J. Horrocks, PhD
Chief Investment Officer
Matthews International Capital Management, LLC
Investing in small- and mid-size companies is more risky and volatile than investing in large companies as they may be more volatile and less liquid than larger companies.