Spotlight on the Matthews Emerging Markets Equity Fund
Asia is the core of growth and innovation within emerging markets, and companies domiciled in Asia comprise over 80% of the benchmark universe, the MSCI Emerging Markets index.1 Drawing on active, fundamental research and bottom-up stock selection, the Matthews Emerging Markets Equity Fund aims to provide investors with a portfolio of well-managed, competitive companies across a broad range of developing economies with an eye toward quality growth.
What is the objective of the Fund?
The investment objective of the Matthews Emerging Markets Equity Fund (MEGMX, Investor / MIEFX, Institutional) is long-term capital appreciation. The Fund seeks to achieve its objective by investing its assets in companies located in emerging markets that are capable of sustainable growth based on the fundamental characteristics of those companies.
Emerging market countries generally include every country in the world except the U.S., Australia, Canada, Hong Kong, Israel, Japan, New Zealand, Singapore and most of the countries in Western Europe. Certain emerging market countries may also be classified as “frontier” market countries, which are a subset of emerging market countries with newer or even less developed economies and markets, such as Sri Lanka and Vietnam.
As an Asia specialist, what insights does Matthews Asia bring to managing an emerging markets strategy?
Our deep understanding of the diversity of the economies in Asia—ranging from small frontier to large developed, to those running account surpluses to those in deficit or where populations are growing or getting smaller—is an expertise that we can bring to broader emerging markets which have similar economic characteristics. We believe we have the resources, expertise and long-term focus to manage the increasingly complex characteristics of an Asia-focused emerging market universe—especially with regards to China which has the largest allocation in the benchmark.
We believe our proven investment process, which seeks to identify good quality companies and management teams with strong corporate governance and reasonable valuations, is broadly applicable across the investable universe. In general, quality businesses tend to exhibit similar characteristics across geographies, including being cash-generative, having strong growth prospects, low levels of leverage and strong business moats that support margin growth and profitability. The ability to work in different markets and cultures is a factor in Asia as much as it in other emerging markets.
What type of companies do you look to invest in?
We focus on where and how a company makes money, not on where a company’s shares trade or where its management sits. We seek out high-growth, high-quality companies across emerging markets and across the market capitalization spectrum. We want trends as tailwinds, but they are not the primary driver of our investment decisions. As bottom-up portfolio managers, we see ourselves as partial owners of the businesses in which we invest. We believe sound balance sheets, good capital allocation, and sustainable competitive advantage are of limited relevance to short-term traders, but critically compound value over time for long-term investors.
What is your investment approach?
The Matthews Emerging Markets Equity Fund takes a company first investment approach that emphasizes fundamental analysis over top-down country or sector allocation. The investment process centers on the fundamental analysis of a company, an assessment of the industry and competitive landscape and a determination of the valuation of the business. The Fund’s bottom-up investment approach seeks quality companies with key characteristics including:
- A focus on domestically oriented businesses or category leadership out of an emerging markets geography
- Seasoned management teams that have a proven business strategy and strong competitive positions
- Good corporate governance and alignment with minority shareholder interests
- Balance sheets appropriate to the nature of their business
- Capital structure appropriate for the business model
The Fund employs an all-cap approach and is agnostic to size. Small companies may offer attractive potential for generating alpha, or in certain circumstances the incumbent can compound advantage over time. Our investment team spends considerable time uncovering what makes good companies tick.
How do you assess the strength of a business?
Companies are evaluated holistically. We are ultimately trying to answer some very basic questions:
- Do I want to be an owner of this business?
- Is the management team working for me, as a minority shareholder with no control position?
- Is the price on offer appropriate for a long-term holder?
We often seek to answer these questions by employing our five “Cs” framework, which hones in on a company’s competitive position, its process for capital allocation, its capital structure, its cash generation potential and its character. The concept of “character” includes many attributes often referred to as ESG (Environmental, Social, Governance) which is integral to our process. Holistic analysis requires understanding both the drivers captured in the financial statements. Financial metrics may include evaluation of margins, cash flow conversion, debt metrics, etc. Attributes important to the investment decision that are not included in financial statements might include brand resonance with consumers; relationship with regulators, character of management, company culture, or other such variables. In our experience, the characteristics of a good quality company are consistent across the investment universe irrespective of the market they are in or sector they operate.
How do you construct your portfolio?
Portfolio construction for the Matthews Emerging Markets Equity Fund balances conviction and humility. A well-constructed portfolio is not a list of “best ideas.” It should contain “ballast” holdings that allows the Fund to help weather an unwritten future. With an unconstrained and benchmark agnostic approach in terms of country, sector and company allocations, exposures are a by-product of bottom-up security selection.
New positions will tend to be modestly sized, in the range of approximately 0.5% to 1% of the total portfolio, and the largest positions will with few exceptions not exceed 5-6%. The team will use a milestone-based approach to increasing conviction and position weight. These milestones are typically nonfinancial and focus on the execution of stages of the long-term growth strategy by the company. Over time, the team is able to assess the “intentionality” of management (e.g. did they do what they previously said they would do?). Measuring intentionality takes time as does getting to know management. As the team’s understanding and conviction in a company increases, then sizing may also increase. The Fund has a long-term investment horizon and seeks to hold positions for as long as possible. This should result in low turnover over time, however we do not numerically target this. Periods of higher volatility (e.g. 2020) may result in turnover that is higher than those with low volatility. The portfolio has historically held a position count in the low 50’s and will often have between 35 and 55 positions in most market conditions.
How do you determine country weights in the portfolio?
We focus on companies as our starting point, rather than countries. The portfolio’s exposure to individual countries is driven by bottom-up stock selection. We believe the best chances of capturing durable growth come from strategies that prioritize company selection over country allocation. Country weights are heavily influenced by the business model of where a company falls on the continuum of local to global competition. A semiconductor company may have little to do with its assigned geography whereas a food retailer is entirely driven by it. Over the course of a market cycle, the portfolio’s exposure to any individual country may fluctuate.
The Fund’s prospectus allows for concentration (defined as 25%+) in a single market. To date, China is the only market where the portfolio has been concentrated. China has a particularly large consumer market and many companies that are domiciled outside of China sell goods to Chinese businesses and consumers. If we look at the Fund’s China exposure, for example, the actual exposure may be greater than simply the sum of our portfolio holdings domiciled in China. This is among the reasons we build our portfolios from the bottom up, starting with individual companies and investing where we find the most compelling opportunities for growth.
Do you undertake on-the-ground research in all emerging markets?
Given the long-term holding periods, company visits and meetings are an essential part of the investment process. During the course of the Covid-19 pandemic these visits and meetings have become virtual. The virtual environment allows for more thematic or industry based research (e.g. meet two competitors back-to-back who are located in different geographies), but it also presents challenges. The virtual environment does not provide as much opportunity for serendipity but we’d note all advantage is relative. Company visits give us better insight into a company’s business model and growth prospects as well as management’s thoughts on business strategy and capital allocation. The meetings also provide a good opportunity for us to gain a greater understanding of the management team and their intentions for the company.
A first meeting with a new company will provide an opportunity to (1) understand the firm’s management strategy, track record and long-term business prospects, and (2) assess the company’s governance standards. It is vital the team develops a positive view of the governance practices before investing in a company. We believe that by investing in quality companies we have the potential to yield meaningful returns with a lower risk of permanent loss of capital. Once the company is in the portfolio, we continue to maintain regular meetings with the team to ensure that we continue to have confidence in both the business and its management team.
While the current COVID-19 pandemic has limited the amount of travel that our analysts and portfolio managers can do to see companies, we have colleagues in China, Hong Kong and Singapore, who are able to relay to us how people are dealing with the pandemic there and across the region. The investment team has had access to executives of portfolio holdings and non-portfolio holdings. Such access enables us to both monitor companies that are in our portfolios and search for new opportunities. The investment team is conducting 15-20 meetings a day on average across the team, starting early in the morning and continuing late into the night, to catch the working day in Asia. These meetings provide information, the salient points of which we can share at a daily investment team meeting and in innumerable emails and phone calls between team members. Traders, too, have been able to execute trades with minimal disruption to normal working life.
Why does corporate governance play an important role in your investment process?
Matthews Asia has, since its inception in 1991, always placed a significant emphasis on corporate governance in making investment decisions. The fair treatment of minority shareholders is an important consideration for us. Across all our strategies, Matthews Asia has always made a commitment to invest in companies that demonstrate sound corporate governance. Our belief is that an investor’s best interests are served through companies that exercise responsible ownership and that this can improve shareholder returns over the long term.
How does the Fund approach risk management?
The largest variable any investor is solving for is the future, which by definition is unwritten and uncertain. Humility is important and must balance out conviction. Risk and reward are two sides to the same coin. Risk features prominently in the security selection and construction process. This focus at the portfolio level includes thinking through the correlations between underlying positions and ensuring adequate diversity within the Fund.
Matthews Asia has developed a rigorous and tested approach to risk management with three levels:
- Portfolio Level—through the in-depth company due diligence process performed by our Investment professionals and their continuing focus on avoiding permanent impairment of capital
- Matthews Asia CIO Level—through oversight and review of the portfolio to help ensure consistency with the investment goals and objectives and a review of portfolio risk and liquidity
- Matthews Asia Enterprise Level—through independent risk and compliance monitoring performed by our Control Side functions (Legal, Investment Risk, Compliance, Operations/IT, Fund Admin and Finance) and our Governance process which was designed to ensure that all significant risks are escalated to and discussed with senior management
What experience does the portfolio management team have?
The Matthews Emerging Markets Equity Fund portfolio team has significant experience investing in Emerging Markets, including the Asia Region.
Lead Manager John Paul Lech spent nearly 10 years at Oppenheimer Funds Inc. as an Analyst and Portfolio Manager on a global emerging market equity strategy. John Paul was the first analyst hired by Oppenheimer in 2008 for the strategy, conducting primary research on companies across Asia, including China and India, and other emerging markets like Brazil, Russia and Mexico. He has experience analyzing and formulating investment theses in a variety of sectors.
Senior Research Analyst Alex Zarechnak serves as a dedicated analyst on the Fund with 25 years of emerging markets experience. Prior to joining the firm in 2020, he spent a total of 15 years (1998 – 2006 and 2012 – 2019) at Wellington Management as an analyst for the firm’s flagship Emerging Markets Equity fund as a generalist first covering CEEMEA, then Latin America. Alex began his emerging markets career as a Russia equity analyst with Templeton Emerging Markets, based in Moscow.
Peeyush Mittal manages the firm’s India Strategy and serves as an analyst on the Matthews Emerging Markets Equity Strategy. Prior to joining the firm in 2015, he spent over three years at Franklin Templeton Asset Management India, most recently as a Senior Research Analyst. Previously, he was with Deutsche Asset & Wealth Management New York researching U.S. and European stocks in the industrials and materials sectors.
Kathlyn Collins is an ESG Analyst at Matthews Asia. Prior to joining the firm in 2018, Kathlyn worked as an ESG & Global Strategy Analyst with Cartica Management LLC where she developed ESG integration and analyzed investments for portfolios, conducted company research and engagement, and wrote reports relating to Emerging Markets.
The team will leverage the full resources of the broader 40 person investment team and their expertise of investing across the Asia region. We believe the significant pool of resources that are focused on Asia and able to provide the global emerging market team with ideas and insights into Asian companies provides an important differentiator.
Our broader investment team includes five proprietary knowledge-sharing platforms that facilitate the sharing of research across the firm. Taking the form of cross-strategy working groups, the knowledge platforms are run by portfolio managers and analysts who share ideas and information that may be relevant to all strategies the firm manages. Key areas of focus include China, India, global innovation and global health care. Peeyush Mittal leads the firm’s India knowledge platform, while Alex Zarachnek currently serves as a standing member of the firm’s global innovation platform. The Matthews Emerging Markets Equity team also regularly engages with the firm’s robust China knowledge platform to help stay abreast of trends and opportunities within China’s vast investment universe.
1 Data as of March 31, 2021. Source: MSCI