Matthews Pacific Tiger Fund Fourth Quarter Commentary
The nearly flat performance of the Index masks the underlying volatility, and a sharp divergence between the equity performance in export-oriented economies like South Korea and Taiwan against economies driven more by consumption, such as India and Indonesia.
A core element of our investment philosophy is emphasizing domestic demand-led growth since we believe that to be sustainable. Starting in 2007, a combination of solid growth, which was domestically driven, and attractive valuations led us to increase our allocation to parts of the Association of Southeast Asian Nations (ASEAN) region, including Indonesia. However, the overweight hurt portfolio performance in 2013 in terms of a negative country allocation effect.
In considering India and Indonesia, both carry deficits on their fiscal and current accounts. As investors start pricing in a gradual return to improving economic conditions in the U.S., there is concern that capital flows that have helped finance the deficit may start to reverse. In spite of periodic outflows from the ASEAN region during periods of stress, the region has attracted significant inflows that continue to be of a long-term nature, such as foreign direct investments. Overseas businesses and longer-term capital continue to be attracted to the prospects of better growth in Asia, but these should be distinguished from portfolio flows that are seeking to arbitrage the differential between rates and returns. In our view, the concerns over these shorter-term sources of flow may be exaggerated, but they are already acting as a wake-up call for policymakers in some of the affected countries. The recent sharp depreciation in some currencies—such as the Indian rupee and the Indonesian rupiah—is forcing some difficult decisions like the reduction of wasteful energy subsidies. This is a start, but there is more that needs to be done, particularly in India and Indonesia, to accomplish sustained growth for the next several years.
For nearly two years, we have selectively trimmed our exposure to parts of ASEAN, believing that valuations may have been too high and that growth may moderate. While that still remains our bias, we are alert to the possibility of further broad-based sell-offs leading to attractive valuations, particularly in Thailand and the Philippines. Thailand is in the middle of a stalemate with its political parties holding public demonstrations instead of working out their differences within the Parliamentary process. The end game with the political process is unclear, but it is clear to us that Thailand’s attraction, both for tourists and strategic investors, is unlikely to be dented in the long run.
While macroeconomic factors continued to hold significant influence on stock prices during the year, there was some noticeable divergence between stocks prices, particularly in China. The domestic Shanghai and Shenzhen A-share indices revealed widely different outcomes for 2013. The Shanghai A-share Index is dominated by financials and state-owned enterprises. Meanwhile, the Shenzhen-A share index tends to be more diversified, including private sector, IT and consumer-oriented stocks. The divergence in stock prices is perhaps reflective of the government’s efforts to strive for more balanced and profitable growth. Even as overall GDP growth in China has slowed, consumer spending and areas such as the Internet and tourism have held up relatively well. While the slowdown in growth in China is increasingly being accepted by the investment community, a possible improvement in the return on capital is not. As a result, scarcity of growth was an important factor driving stock prices which helped some of our Internet-related holdings like Baidu and Tencent.
One of the biggest contributors to the portfolio’s performance during the year was a Korean Internet-related holding, Naver (previously NHN). The firm has been a long-term holding for the Fund, and is a rare example of a service-oriented business out of South Korea gaining traction with consumers outside of the country. Its recent traction in monetizing its mobile communication services is testament to the firm’s investments in R&D, and a willingness to hire talent locally in places like Japan. We believe the expectations for their LINE platform are achievable, but the recent gains in valuations leave little room for mistakes.
During the year, we exited more holdings than we added, making the portfolio more concentrated. The exits were driven by the inability of newer positions to meet our milestones. The business environment in many parts of Asia has been difficult for the past few years, reflective of tougher lending conditions, and a moderation in growth. All this has translated into lower returns on equity (ROE) for many companies, and is one of the key reasons behind Asia’s underperformance relative to many other parts of the world. Some of the decline in ROE is likely structural, as may be the case for the industrial sector in China. However, we also believe that with stabilizing sales growth and lower inputs costs, there is a possibility that margins may stabilize and start to recover over the next few years.
So as we look ahead, one of the key questions that we wrestle with is: does Asia deserve to trade at a significant discount to many other parts of the world? Without doubt overall growth has been disappointing these past few years leading to lower profitability. More importantly, growth is becoming more fragmented, and perhaps less visible in headline indices. As an example, we are more convinced about the favorable outlook for sectors like healthcare and consumer in China than about the pace of growth for the overall economy. Meanwhile, valuations particularly in China are at levels that are at historic lows relative to many parts of the world, and are not based on analyst expectations that look particularly ambitious. Liquidity and flow of capital may continue to test Asia’s capital markets and political events in India and parts of ASEAN may pose as unquantifiable risks. However, the underlying virtuous cycle of savings led investment growth in Asia has not been altered. We would view any pickup in volatility as an opportunity to invest with businesses that continue to deliver secular growth.
The views and opinions in this commentary were current as of December 31, 2013. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the Fund’s future investment intent.
Statements of fact are from sources considered reliable, but neither the Funds nor the Investment Advisor makes any representation or guarantee as to their completeness or accuracy.
As of 12/31/2013, the securities mentioned comprised the Matthews Pacific Tiger Fund (Trades, Portfolio) in the following percentages: Baidu, Inc., 2.0%, Tencent Holdings, Ltd., 1.7%, Naver Corp., 2.8%. Current and future portfolio holdings are subject to risk.
Performance and distribution figures discussed in any of the Manager Commentaries reflect that of the Investor Class Shares.