April 1, 2010
Dear Fellow Shareholders,
During the last quarter, investors were far more hesitant toward Asia than they were for most of last year. This is heartening. Just as sports teams are at their most vulnerable immediately after they score, many investors are most exposed when they feel most confident. However, rather than feeling complacent about the prospects for Asia, investors, journalists and bloggers have become increasingly skeptical about its prospects. Therefore, year-to-date, a broad universe of stocks in the Asia ex-Japan region, has underperformed Latin America, North America and Eastern Europe. Only the Western European region, weighed down by worries over the cost of a bailout of Greece’s sovereign debt problems, has lagged Asia. This skepticism has meant that markets, instead of racing ahead at an unrealistic pace, have climbed more modestly.
Investor skepticism has focused largely on China. Headline economic growth has been impressive at 11.9% in the first quarter of 2010. Indeed, China’s rapid growth in an otherwise sluggish world created a trade deficit in March of US$7.2 billion—China’s first deficit in six years, though it was not entirely unexpected in light of the still-weak demand in Europe and the U.S. Behind the headline numbers, investors focused on the quality of China’s growth—particularly the role of infrastructure and property investment—and decided that the growth was of poor quality. Accordingly, the future 12-month earnings of a broad universe of equities in China and Hong Kong have nearly the same valuation as those in the U.S. (14.5X earnings for China/Hong Kong compared to 15X for the U.S.), despite the generally better growth prospects for China over the long term. In addition, the China and Hong Kong markets have shown some of the weakest performance in Asia ex-Japan over the last year, and have lagged far behind India, Indonesia, Singapore and Thailand.
The critics are right to be concerned about overly optimistic growth expectations for Asia. After all, we have just come through a debilitating crisis and will be dealing with the overhang of debt for some time. Taxes are likely to rise in the western economies, and the resulting impact will weigh against any recovery in the productivity of these economies. Where the critics have perhaps stretched their argument too far is when they claim that China’s recent growth was merely a debt-fueled bubble. We do not see compelling evidence that debt levels are excessive in China. Indeed, the ratio of total credit to GDP fell in the five years through 2008. Nor is there any strong evidence that capital was badly deployed, on average, during the recent boom. Our observations suggest that Asia’s growth has been real and support the data-driven conclusions, that we and others have drawn, that Asia’s growth has been the product of efficiencies wrought by the modernization and commercialization of its economies, and not through greater quantities of investment.
Nevertheless, stresses and strains from last year’s stimulus spending are evident as inflation in China is expected to rise throughout the year. The central authorities have already taken steps to curb lending. Interest rate increases or a renewed strengthening of the renminbi are further possible policy initiatives. Elsewhere in Asia, too, inflation has emerged as a serious concern and a far more realistic threat than it is in the West. In India, urban inflation is already in the double digits; India’s central bank raised interest rates in March. In Australia, the central bank has already hiked interest rates three times recently. These policy responses are undoubtedly a risk to near-term growth and valuations in equity markets, and ironically the medium- to long-term risks grow larger if these policy initiatives are not proactive enough to prevent a surge in prices. Nevertheless, the desire of Asian governments to step on the brakes suggests that their underlying economic problems are of a far lesser order of magnitude than those in the West, where not only is the economy’s engine not overheating, it is still laboring in first gear.
In negotiating the risks of higher inflation and valuations that are no longer cheap, some of our portfolio managers have been adding to investments in areas of the region where equity valuations are still low and where inflationary pressures are perhaps less likely to spur aggressive policy responses. An example is Thailand. Concerns over politics have been weighing on market sentiment for some time, as evidenced by the fact that the market is cheaper than any other major market in the region, except the perennially cheap Korea. Thailand remains risky for its politics, which have been divisive but, until recently, not too bloody. It also has a somewhat checkered history with capital controls (the latest being a brief flirtation in 2006). Nevertheless, there are good businesses in which to invest and the politics, while worrisome, are well-known and play a significant role in causing Thailand’s low valuations. Japan, too, has been a focus of our stock picking recently. Of all the region’s economies, it remains the one that should, in theory, benefit most from higher inflation. Rising prices in Japan would be unlikely to elicit a strong countervailing policy response and would relieve companies of the pressure on margins and returns that come from operating in an environment of deflation. Whether inflation will in fact return to Japan is debatable—but regardless of the macro environment, there are simply too many good companies trading at inexpensive valuations for us to ignore.
Valuation Risks: A Long-term View
The divergent performance we see between the economies of the West and the East has not gone unnoticed by others. And hence some sectors of the region’s stock markets have been bid up to expensive valuations. These areas are predominantly in the consumer sector: including areas like the Internet, autos, entertainment and leisure, broadcasting and retailing. Due to our domestic demand focus, we hold many such stocks in these sectors. Our reaction to higher valuations has not been simply to exit from such positions all together. Where we believe valuations are high, we may trim our exposure. However, it seems to us that trading too actively between positions that we like for the long term and those that are tactically superior only because they are cheap is akin to trying to time the market; which has never been part of our strategy. Nor do we think price targets are a particularly helpful tool for portfolio management as they presuppose that one can value a company with a high degree of certainty and accuracy. Often, companies that look expensive based on forward one-year price-to-earnings ratios may still look cheap when you consider the value of the company “as a whole” and how large it may reasonably grow. We think long and hard about removing a holding that we have chosen precisely because of the survivability of its business model and the sustainability of its growth over the long term. Yes, we risk “falling in love” with some stocks—and that is why we hold frequent “bull and bear” sessions to challenge our thesis for our higher conviction holdings. We will continue to seek out companies whose market capitalizations are still low relative to their growth prospects. We believe that many investors in the region are still guided by the indices and benchmarks. These benchmarks seem to us to be a poor reflection of the Asia that will emerge from the wreckage of the old economic relationship between East and West. They focus too much on manufacturing and too little on services. Areas like non-pharmaceuticals health care firms, that are likely to benefit from the changes in government spending priorities, make up less than 0.5% of the market capitalization of Asia ex-Japan; software less than 1%. As a consequence, we can still, and will endeavor to, find companies that are likely to benefit from Asia’s coming transformation and whose stocks are overlooked.
As always, it is a pleasure to serve as your investment advisor and we thank you for your continuing support.
Robert J. Horrocks, PhD
Chief Investment Officer
Matthews International Capital Management, LLC