The first word that comes to mind when talking about investing in Asian equities is growth, which justifies that throughout history many fund managers have relied on macroeconomic factors when positioning themselves in the region. But the concept of macroeconomics may be subject to very different perspectives: for some, it is a question of predicting GDP growth, interest rate developments, currency fluctuations...; while for others, the focus lies on analyzing where the continent’s production is heading, what the domestic purchase and demand trends are, where middle class spending is going to... And the latter is the perspective held by Rahul Gupta, Manager of Matthews’ Pacific Tiger Fund, which, for management purposes considers the macro from that point of view, but essentially follows a bottom-up process.
As he explained recently during an interview with Funds Society, he bases his management on the thorough knowledge of the firms in which he invests; knowledge obtained by his team (with 45 members in total) by means of more than 140 research trips annually, and on-site meetings with over 2,500 businesses in Asia, even though their headquarters are in San Francisco. Because only that knowledge of the business allows him to adopt a medium- and long-term investment vision, which explains why the fund has a very low turnover, of around 20% -30%, as compared to the average, which is close to 60 %. “During periods of markets’ ups and downs, this vision allows us to take volatility as an opportunity to buy businesses that we like, because the underlying fundamentals of companies are not subject to as much volatility as the markets,” explains the manager.
Domestic Demand as the Guiding Principle
The driver of this Matthews Asia fund is domestic demand in Asia, a theme with great potential in the long term and which is distanced from other more cyclical ones, as, for example, the raw materials theme which, nevertheless, in this environment of lower prices, and with Asia being a consumer rather than a producer, is benefiting the consumption story. The manager, therefore, focuses his analysis on understanding the dynamics of demand in each country, which are very different depending on the stage of development of the market referred to within the continent.
“The issue of sustainable living and industrialization will make economies more productive and lead to an increase in wages, fundamental pillars for building a consumer society in Asia, which is more developed in markets like Taiwan, while in others it is only in its initial stages,” says the expert. For example, the potential in India for the next few years is in sectors such as automobile or insurance, while in China the growing wealth will lead to heavy spending on leisure, travel, cosmetics, mobile phones, or health.
Regarding the opportunities in the financial sector, the asset manager distinguishes between the countries of North Asia, where the banking sector is more developed but where the insurance business has less penetration and offers more opportunities, and the countries of the South, where, in some cases, such as India or Indonesia, the population does not even have current accounts, and the banking sector, therefore, has great potential. Although Gupta is aware that debt problems in China and its banks could impact on the rest of the continent, he believes that this concern is manageable and focuses on other Chinese sectors, beyond banking and with very little leverage, like consumption. “Debt is manageable and will not impact the Chinese economy in general or other sectors in Asia,” he says.
Bias Towards the Less Developed Asia
Although the Matthews Asia fund invests across the continent, the bias is clearly towards more developing countries, which offer more potential for growth, and where asset managers find “more opportunities, quality businesses and sustainable growth,” explains Gupta. Because the point in this case, with this dynamic of consumption as the backbone of the portfolio, is to find businesses (hence the bottom-up analysis) with three characteristics: that they are good and able to grow over a cycle (“they don’t necessarily have to present the fastest growth, but sustainable growth”, says the asset manager), and which have good management and an attractive valuation. However, due to the growth they offer, these names are sometimes more expensive than other parts of the market, although the asset manager says that in the end they are more profitable, and what’s involved here is the search for alpha creation opportunities.
The other bias is the underweight of more cyclical sectors, such as raw materials and energy, which do not offer that sought after sustainability in growth. And the third bias is its larger allocation than the average to businesses with a small and medium capitalization(between $ 3 billion and $ 5 billion), which usually accounts for 40% of its universe: “Historically, we find more opportunities or sustainable growth, and less linear in these firms, and that leads to the creation of greater alpha versus the large caps,” says Gupta.
In this respect, the asset management company controls the volatility derived from these investments, and also the one derived from the currency risk - which they do not hedge - through analysis, focused on names that grow in a sustainable way and with quality: "We focus on balance sheets and on the business in order to manage these risks, ensuring that companies generate cash flows and have capacity or price power, so that in times of turbulence or problems, they can continue to gain market share,” he adds.
Reasons for Optimism
In the long run, the asset manager is very optimistic about the story facing Asia. Among the, a priori, negative factors and which he rejects, are challenges such as the Trump effect (he considers that Asia is in a much better position than other markets like Mexico), the problems in China, (which nevertheless offers many opportunities on the consumption side, thanks to the savings of its population, and that it moves towards a more balanced growth thanks to this consumption) or the effect that the next decisions of the Fed could have: “In 2013, the first signs of monetary restriction led to sharp falls in the markets and in Asian currencies, but a lot of that has already been absorbed and we think the next rate hikes are already priced in and will not impact Asian markets,” he explains.
Among the positive factors, he points out the reforms that the region is experiencing in countries such as India (which will improve the financial ecosystem), but above all, the stabilization of the prospects of benefits in Asia after times of slower than expected growth: “After a few years, we can now talk about stabilization and the next few financial years will be interesting,” he says.
Regarding the factors that are helping to change the sentiment towards the region, the step before the arrival of flows: “After a few years of being underweight in Asian stocks due to macro concerns about China and the good performance of US equities, since early 2017 investors have moved their positions in China from negative to neutral, because the worst predictions have failed to materialize and have also seen an improvement in macroeconomics and corporate profits in Asia.” This stability in China and the story of the turnaround in Asian profits, coupled with political stability - even more so than in Europe and the US - have reassured investors and begun to change sentiment towards the region.
And that improvement in sentiment, coupled with the fact that US markets are beginning to be expensive, point to the idea that sooner or later the investors will rotate their capital, taking it to Europe and Asia. “The change in sentiment has not yet been noticed in the flows, but it is the first step. Investors have to think about Asia within a 5 to 10 year horizon, not only as an alternative to the current situation,” advises the asset manager. That is, Asia as a source of alpha and not just beta.