From time to time, Morningstar publishes articles from third party contributors under our "Perspectives" banner. Here, Sharat Shroff, who manages Matthews International Capital Management's Pacific Tiger and India strategies and comanages the firm's Asia Growth strategy, discusses navigating the volatile market while minimising risk potential with specific reference to the Matthews Pacific Tiger fund. If you are interested in Morningstar featuring your content, please find further details here.
1. Despite the sell-off of Chinese equities, growing uncertainties in the eurozone, and slow economic recovery in the United States, Matthews Pacific Tiger has remained relatively strong. What approach have you employed to navigate the turbulent market and steer clear of excess risk?
Following a steady start last year, Asia's capital markets continued to weaken as the year progressed. This weakening came as concerns over the growing challenges in Europe were compounded by prospects of a hard landing for China. Amid this volatility, our approach to investing has remained consistent. Our philosophy is anchored in an active, bottom-up approach to stock-picking that is benchmark-agnostic.
We try to find quality companies with businesses that can deliver above-average growth across different macroeconomic cycles. In doing so, the strategy has focused on domestically oriented businesses with steady, visible growth, accompanied by an appropriate generation of cash flows such as we often find within consumer staples. These kinds of businesses, with more recurring sources of growth, have held up relatively well in uncertain environments. What has also helped the strategy deliver at least relatively better results has been our avoidance of the risks inherent in the cyclical industries of China.
Our allocation to some of the region's smaller economies, such as Indonesia, has also increased steadily during the past few years. These economies have proved to be more resilient than some other economies as a result of structural factors such as rising per capita income and better availability of capital.
2. What is your outlook for China in 2012? Will the country be able to avoid a hard landing and negotiate a slowdown in infrastructure spending?
A certain amount of moderation is being widely anticipated, but the investment community still largely believes that the country will avoid a hard landing. Any fallout from such a potential hard landing might be disruptive to capital markets in the region and possibly for the rest of the world. The Chinese economy was able to negotiate the aftermath of the global financial crisis in 2008 through a massive infusion of government-sponsored stimulus. Consequently, there has been a surge in debt levels across many segments of its economy, and the costs of servicing the debt burden are likely to be felt for years to come.
Government efforts to rejuvenate domestic consumption mean that China might not be able to transfer household wealth to other troubled parts of the economy. So the policy options available to authorities are somewhat more limited. But a modest normalisation in the tight monetary conditions could provide some cushion to headline growth. There is also a risk that the government might panic in response to slowing growth and rising unemployment, initiating a larger reversal of the policies that seem to be reining in inflation.
Rather than fretting over China's actual rate of growth, however, we believe wages will form an increasing part of the country's gross domestic product. Data for retail sales suggest that spending patterns are holding up rather well compared with those of the rest of the world. We remain constructive on the longer-term outlook for China predicated on the belief that near- to medium-term challenges will be an opportunity for the government to address structural issues in the banking system and move gradually toward more appropriate pricing of labour and capital.
3. You often invest in smaller markets such as Thailand and Indonesia. Are you comfortable with the corporate governance practices in these countries? What steps need to be taken to improve investor and market sentiment?
We have been investing in some of these smaller markets for more than a decade and have noticed a gradual evolution and improvement in the standards of corporate governance. Monitoring this change allows us to better assess each market's risks and helps our security selection. Reaching better levels of corporate governance is still a work in progress. Corruption is still a big issue that needs to be resolved. On the other hand, the disclosure norms adopted by some of the more progressive companies in these smaller economies, particularly Thailand, are better in many respects compared with those in some of the region's larger economies. In our view, conflict of interest represents one of the key risks to investors and is a frequent cause of transgressions.
Our investment process places considerable emphasis on an understanding of corporate structures, boards of directors, and management incentives to minimise issues arising from such conflicts. We look for positive indicators such as a straightforward business model and a consistent dividend policy. Healthy corporate governance boils down to a firm's culture of respecting and understanding minority shareholders that may or may not develop, irrespective of the country. Having a bias against these markets because of a top-down view would be missing some attractive investing opportunities.
4. What do you see as the top three healthiest sectors in Asia and why?
We remain relatively sanguine over the benefits to industries that are driven by the region's rising household income, and thus, we tend to focus on areas like the consumer sector as well as health-care and financial-services firms. It is worth mentioning that stocks in these sectors, particularly in China and India, are trading at relatively higher valuations and with little cushion for disappointment.
Given the rising cost of labour in China, we also see a long-term opportunity in firms that help mitigate these labour issues, such as services-oriented companies that can improve process efficiencies. These types of companies, however, are harder to find.
We see potential in the health-care sector given the region's ageing populations and the trend of more discretionary income being spent on lifestyle ailments such as diabetes. In line with the focus on growing wealth, we also favour progressive financial-services firms that cater to those with wealth-management needs, which might include such products as insurance.
5. What impact, if any, do you think the European sovereign debt crisis will have on your financials holdings and, more broadly, on growth in the region?
The process of deleveraging in Europe is likely to affect demand growth and the flow of capital in Asia. At least 20% of Asia's exports are bound for Europe, and this could take a knock, depending on the severity of the challenges in the eurozone. More importantly, European banks are significant lenders to Asia, much larger even than their U.S. counterparts. Some of this lending is funded through local, retail deposits, which might not be affected by the deleveraging cycle. Although the contribution of European banks to overall credit in Asia is not overwhelming, it is still meaningful. A large-scale withdrawal by these institutions would pose a challenge to the region as Asian banks might not be able to fill the breach entirely, and this might temporarily affect domestic demand. The process can be unruly and would test businesses that might be overly dependent on the capital markets.
Furthermore, European financial institutions are also important from the perspective of portfolio flows into the region, be it debt or equity. If there is a withdrawal of these flows, then the impact on Asia's securities and currencies will be immediate.
Considering that overall leverage across most of Asia is still manageable, we believe that households are better-placed to withstand these kinds of shocks, and Asia will grow at faster rates than the rest of the world. The longer-term attraction of investing in these markets is also supported by some recent flows of foreign direct investments into countries such as Indonesia and India, which saw surges in FDI earlier last year.
