January 1, 2010
Dear Fellow Shareholders,
Many commentators are describing 2009 as a watershed year—one in which global economic leadership shifted decisively from the West to the East. Indeed, the U.S. and European economies appeared to bottom out in the middle of 2009 when GDP fell 3.8% and 5.0% year-on-year, respectively. Meanwhile, Asia recovered sooner than the West, and China and India grew throughout the crisis with year-on-year growth rates falling to approximately 6% in both countries. In political circles, the Group of 20 (G–20) usurped the position of the Group of 8 (G–8) as the prime decision-making body while the world’s finance ministers struggled to coordinate global stimulus. Japan had been Asia’s sole representative in the G–8, but this change brought China, India, South Korea, Indonesia and Australia into the main forum for global economic policymaking. Some of the commentary has been hyperbole, with editorial writers, book authors and even some foreign leaders announcing the “end of the American Empire.” Even now, however, the conventional wisdom is that the U.S. faces many years of slow growth because of its debt-laden consumers, while Asian consumers are just starting to open their wallets.
You could say that markets mirrored the trends in underlying fundamentals—the S&P 500 Index bottomed out in early March 2009, but the MSCI All Country Asia ex Japan Index had already seen its lowest point in late November of the previous year. Asia is now valued at 10% to 15% higher than the U.S. on popular metrics. This can only be justified by higher growth expectations. Equities have rebounded very strongly—more rapidly than many people, myself included, would have imagined. It is hard to see how any part of the world—however “decoupled” some may argue—can truly prosper if North America and Europe (more than half the global economy) are each suffering unemployment rates of about 10%. We may have started 2009 more isolated in our optimism about the strength of Asia’s corporate fundamentals and its economies; now there are many more people who agree with our belief and perhaps express it too incautiously. That sort of company is a little disconcerting.
West Coast Offense
I believe that a certain amount of isolation and distance is a good thing for investors. Sitting in San Francisco might have made us appear far removed from the maelstrom in Asia’s markets, but it gave us perspective. Local fund managers tend to get caught up in the gossip and rumor that surround their own markets. They seem constantly tempted to trade on sentiment and momentum. At Matthews, we are able—perhaps forced—to take a measured view. We try to resist the temptation of making the “big play” or to wager everything on one big call. During the depths of the recent economic crisis, our analysts and portfolio managers continued their regular research trips to Asia to meet with business leaders, and to form independent views of how events were unfolding. Even as the container ships passed in and out of San Francisco Bay—empty and high in the water—and even as trade was collapsing, the message from businesses in Asia was that their domestic sales were still growing. I know from my own contacts in Hong Kong that more than a few local fund managers were raising cash to try to prosper from the poor sentiment and avoid market falls. Our approach at Matthews has been to remain fully invested, and whenever possible, to take incremental opportunities to build positions in specific stocks at depressed prices.
This approach was not without controversy. 2009 was a year when markets seemed to diverge widely from fundamentals, as witnessed by large swings in valuations. These divergences gave rise to the criticism that, surely, we are able to see these great dislocations before they happen. Along with the panic in global equity markets, some investors also lost confidence (or perhaps patience) with the strategy of being fully invested—to “buy and hold.” Some will no doubt argue that Asia’s markets are still 25% below their highs of October 2007. Point taken. However, in my mind, “buy and hold” still has at least one thing going for it—we only have to focus on the stock decision and get that one decision right. Trading requires you to get multiple decisions right: when to buy the market, when to sell and then when to buy again. Trading also puts a premium on the liquidity of a company’s equity and raises it to a level of importance equal to, if not greater than, the underlying soundness of the company itself. During the past two years or so, the market certainly offered up big opportunities for trading. But as I have noted, the market also whipsawed investors’ emotions, and caused them to question their basic assumptions about the future. Once people have their confidence in a market so shaken as to cause them to abandon it, how many are then able to quickly reinvest when the fear of loss is greatest? How many people invested on the basis that they held a “liquid” asset only to see that liquidity dry up when its financial soundness was called into question? According to some research, many funds that took a more active trading stance were indeed caught with high cash levels or “liquidity” when the markets bounced back. It seems to me almost by definition that many traders must be caught out of the market this way, and miss the recovery.
Markets and Fundamentals—Diverging Again?
As we enter 2010, it is of some concern to me that interest rates remain exceptionally low in the developed world, and that Asia’s recovery is underway and indeed interest rates have started to rise. It has occurred three times in Australia and once in China. Sell-side analysts are talking breathlessly of a U.S. dollar-fed “carry trade,” a strategy of selling a currency with a relatively low interest rate in order to purchase a different currency yielding a higher interest rate. Analysts also talk of the potential for an emerging market bubble, as if the prime objective of investment is to read policymakers’ minds and to try to jump the gun on their decisions. There are fundamental reasons to expect Asia to perform well as its households grow wealthier; we mostly agree with that assessment. Nevertheless, the structural reforms required of Asian economies will take time and some government commitment. Markets are increasingly willing to discount a smooth transition to the “new economic order.” Are markets starting to diverge from fundamentals again? If so, what should be done with investments?
Valuations are a source of concern, and they enter into our investment process in one of two ways. For some funds, a measure of valuation—more specifically dividend yield—is a crucial first step in the idea generation process. For other funds, the focus on valuation may be relaxed when warranted by the quality of a company’s business model and management. But in neither case is valuation a primary reason to sell out of a position completely if we believe in the long-term future of the company. High valuations are, however, reason enough to proceed into the new year with caution. This caution is already starting to influence the stock decisions we are making in the funds and I hope that it tempers the ardor of those making some of the wilder predictions for markets this year. Nevertheless, we maintain our commitment to being fully invested because, despite our concerns, we have no particular insight as to where the markets may be trading a year from now.
We also remain committed to the belief that Asia will enjoy many years of good growth and that the new decade will see a further reshaping of the region’s economies. We believe that it should also offer new opportunities to invest in growing companies in both established and emerging industries—Asia’s economic landscape will surely look very different 10 years from now. Our old image of Asia—centered on infrastructure, export manufacturing and heavy industry—is gradually being replaced by one in which service industries, including finance, health care, retail and leisure play a bigger role in the economy. Finding and researching those potential opportunities remains the focus of Matthews’ investment team. We seek to identify and hold companies that make it through each cycle stronger than they were before, rather than to invest in stocks primarily on the basis of their liquidity and to try to trade in and out of each cycle.
During the past year, we celebrated the 15-year anniversary of our flagship funds, the Pacific Tiger Fund and the Asian Growth and Income Fund and the 10-year anniversary of the Asia Science and Technology Fund. Along with our China, Japan and Korea Funds, these portfolios have track records in excess of 10 years.
We also celebrated the one-year anniversary of the Asia Small Companies Fund and launched the China Dividend Fund. This new Fund enables us to execute our dividend-focused strategy in a single-country portfolio for the first time. Few people question the importance of using different strategies when investing in the U.S. market—we think this same approach should be applied in Asia.
We thank you for your continued and continuous support during this past year, particularly as it has been an unusually volatile and challenging one. It is more than usually true to say that it is a privilege and an honor to serve as your investment advisor.
Robert J. Horrocks, PhD
Chief Investment Officer
Matthews International Capital Management, LLC