After months of favoring speculative gambits, the momentum of the Asian markets is returning once again to the hands of the long-term investor, says Robert Horrocks of Matthews International Capital Management. Citing a reduction in the valuation gaps between Asia and the rest of the world, Horrocks says investors should start focusing on fundamental earnings potential rather than on market timing.
In this shifting climate, Horrocks, the chief investment officer at Matthews, which runs 10 Asia funds, sees plenty of opportunities for investors with lengthy time horizons. In particular, he says that Asia is especially attractive for investors seeking dividends. Meanwhile, as the Asian economy continues to become more efficient, Horrocks foresees problems for the materials industry, but he remains optimistic about consumer staples, which over time will benefit from rising household incomes.
In a recent interview with U.S. News, Horrocks laid out his forecasts for the continent and talked about where investors can find long-term profits. Excerpts:
What are your thoughts on current valuations in the Asian markets?
We have a very positive message on Asia, and I do believe that there's going to be this growth differential between Asia and the developed world that probably will be sustained for a long time. And we've seen the [Asian] markets move up very rapidly, particularly since around about March. But I would stress that the valuations—certainly with the benefit of hindsight, but even at the time—looked very cheap in March, but that valuation mismatch is now gone completely. So the risk-aversion trade has disappeared, and if you invest in Asia now, what's going to drive your returns is the fundamental earnings growth of the companies that you buy, and on average you're not going to get any return through increases on valuations. Now that isn't a reason not to allocate to China, but it's a reason not to allocate to China if you think that the market is going to continue to go up at the same pace that [it has] since March.
I've seen some analysis that suggests valuations in Asia and for the MSCI indices are roughly on a par with the U.S.—I actually think that . . . if you adjust for the different sectoral structures of the markets, there's a slight premium to the U.S. and a reasonably significant premium, sort of low double digits, to Europe. But it's not enough of a difference for me that I would personally make a big allocation call on that because the premium over the U.S. is the sort of premium that could be gobbled up [quickly]. And so I would just caution people that if they're thinking about investing in Asia, the markets are no longer cheap relative to their own prospects, [and] they're not cheap relative to the rest of the world. They're not overly expensive; they're just not cheap anymore. If you're trying to take a short-term tactical view of the market, I don't see the logic in doing that. If you think you're going to be investing in Asia now, you should be looking at the long term because you're only going to get growth through earnings.
How do you find companies with strong future earnings potential? Do you have analysts on the ground in Asia to help?
We don't. The reason for that is . . . it's my experience that if you have people in a locality where the market is, then they get battered around by all the rumors and the gossip and the whispers of what's going on in the market. And if you look at the average turnover of a portfolio [managed from] Asia versus the turnover of our portfolios run from San Francisco, you'll see that theirs are much higher. . . . What tends to predominate in Asia, in my experience at least, is that fund managers try to play the momentum in sectors and the momentum in stocks—you know, "What are earnings going to be like in the next quarter, and can I get a jump on the market?" That's the sort of question that they ask in Asia. We ask the question "Where is this company going to be in 10 years' time?
What countries are looking attractive?
For our portfolios, because they're built bottom-up, the country selection kind of falls out logically from the stock selection and our biases there. And our biases are this: domestic demand. . . . The one sort of firm, relatively stable long-term growth trend that you get in Asia is the growth in the wealth of the Asian household. Even during the financial crisis in '98, there was but a blip in overall household incomes. So that's one basic theme that we have in our portfolios. The other in terms of stock selection is we tend to look for companies that have very strong balance sheets . . . and don't come to the market for cash calls. That means that we steer clear of cyclical names. If you put that all together, you'll find that our funds will tend to be overweight in those countries where domestic demand is a bigger portion of their economies. So that's China, India, Indonesia. In terms of sectors, that means that we tend not to hold a lot of materials stocks—the steelmakers or the iron ore producers or that kind of stuff, and we prefer retail, consumer staples, consumer durables, property—these kinds of areas.
Are there any stocks that come to mind that fit this model?
If you're looking at investing over the next few decades in Asia, the key is going to be not just the consumer sector, but finding those stocks that really get into the psyche of the consumer, that really become part of their everyday life. . . . Now what does that mean? An example is a company like Tencent, which is sort of an online gaming and social networking service which allows you to assume identities and chat with people that way. And you're given a "QQ" number, and people in China are as likely to give you their "QQ" number as they are to give you their E-mail address or their mobile phone number. It's become that important a part of who they are and how they relate. That's quite a powerful hold on somebody's psyche to have. It doesn't pay a dividend to speak of, and it's a high-growth company, but you'll see it in funds like our Pacific Tiger Fund.
An example that I personally like on the dividend side and that is in our Growth and Income Fund would be Café de Coral. It's, if you like, the Hong Kong version of McDonald's. It's a fast-food chain that does you a fried rice or a stir-fried noodle kind of dish. Again, very smartly run, incremental growth, good returns on capital. Part of the office work in everyday life in Hong Kong is "I've got 15 minutes for lunch; I'll pop down, get some fried rice." It's built a reputation for quality at cheap prices, and they have the opportunity to move gradually into Guangdong and expand that way. [They have] very conservative management, and although some people criticize them for that, it gives me some comfort that they're going to approach things incrementally. They're very cautious about [expanding], and so they're not going to try to hit all of China at one time, which I quite like. . . .
I do want to address this fact that we actually tend to hold quite little in materials stocks, so we're not big owners of steel companies, oil companies, what have you. And people always associate commodities with China, and I think certainly as the Chinese economy grows, yes, it's going to demand more oil, more steel. But it's going to use them at an increasingly efficient rate. That's been the case in every other economy that's developed. But there is one commodity that I know from my own personal experience that as you get wealthier, you don't use at a more efficient rate, and that's calories. You can plot a chart of my income and my waistline, and it would be a proportional relationship. And so where we do hold commodities, it tends to be the softer commodities—we have cooking oil stocks, food staples, and these kinds of things. I think that's just another illustration of how we approach these things from a longer-term perspective.
What's your outlook for dividends in Asia?
The overall dividend payout has come down a little bit, but by nowhere near as much as you've seen in the U.S. One interesting thing that I think people don't recognize is that the pool of dividends available in Asia even before this financial crisis was as large as the pool of dividends paid out in the U.S. and had been growing at a faster rate over the previous decade. So we think it's an exciting area for investment. There's a further angle on the dividend payout in Asia that I would point out, and that is we use it as a corporate governance signal. If the company is paying out cash, there's a fair chance that it had it in the first place, and that's important.