Searching for Growth in Asia (Matthews)

Searching for Growth in Asia

by Taizo Ishida, Portfolio Manager, Matthews International Capital Management, LLC

March 2011

Date of publication: March 8, 2011. This piece was written prior to the earthquake and tsunami that took place in Japan on March 11, 2011.

There are many ways one might define “growth” and go about uncovering it. In my experience, I have found that there is an abundance of growth available if you know where to look and how to find it. There are a few key elements I look for: main drivers of growth, sustainability and scope of growth, and market expectations (in terms of valuation).

Many global investors today are seduced by the last several years of strong stock performance in China and India, fueled by robust economic growth. However, economic growth alone does not guarantee good stock performance—as evidenced in the chart below, comparing India’s stock market returns to the country’s GDP growth. In fact, many studies argue that, historically, there has been little correlation between stock market performance and economic growth.

Regardless of whether these empirical studies are still valid, my interest as an equity portfolio manager, revolves around one main concern: how does a company grow? How does it grow from US$100 million market capitalization to US$1 billion market cap, from US$1 billion to US$10 billion and so on.

Asia’s “Obvious Growth” Areas

"Growth" is often associated with something new and exciting, such as new technologies, new industries and new territories. It may seem obvious that as incomes grow, the average basic needs of households (housing, food and clothing) should also rise. With about 3 billion people in Asia waking up to the idea of increasing personal consumption, the region can certainly be considered to be growing and exciting.

Let us first consider a few examples of perhaps more apparent areas of growth in Asia. Prior to 2000, annual automobile sales in China had barely reached 2 million vehicles, while U.S. auto sales were approximately 17 million a year. In 2010, China's auto sales reached about 18 million vehicles, surpassing U.S. car sales at 11 million. Autos have certainly been a growth sector, but will this continue to be the case going forward? There are many questions one should ask before making a quick investment decision in this sector. Is this growth secular or cyclical (like many other markets in history)? Which segments of automobiles—sedans, SUVs or trucks, for example—should see the fastest growth? What about electric cars? Should more investment go toward local companies or multinational joint ventures? We believe that growth in this sector will be less obvious over the next 10 years than it was over the past decade, and that identifying primary drivers of future growth is essential.

Another example of an “obvious growth” area is the wireless telecommunications sector in Asia’s emerging markets. India's cell phone market grew from 2 million handsets sold in 2000 to about 545 million in 2010. The industry is still growing with approximately 18 million new subscribers a month. However, the stock performance of Indian telecom firms over the last five years tells a different story: Stock prices for this sector fell, most likely as a result of overvaluation just prior to this period. The sustainability and scope of growth for a business, therefore, are key elements to consider.

Emerging Growth

Growth is emerging in less obvious areas or, in what some might consider, the most unlikely of places. Much recent press on Japan has emphasized “how cheap” it is for investors, but we also see compelling growth as a reason to be interested. The trick here is to select companies on a bottom-up basis, rather than considering the sector overall. Retail industries in developed countries tend to be quite mature and, as such, investors don’t tend to get very excited about the prospects. But there are, in fact, a few Japanese retail companies doing very well domestically. One is a retail bicycle chain, and another is a retail electronics chain. Both generate revenues almost entirely from the domestic market, yet their revenues have grown each year for the last 10 years, a notable achievement for any part of the world. There is also another type of emerging Japanese retailer—the type that is seeking new territories within Asia. A few are even targeting select major U.S. and European cities. While the bulk of their operations are in Japan, in the coming years, a primary driver for this type of firm is faster overseas growth. None of these retail companies is an obvious investment candidate. However, they show attractive potential in their fundamentals.

There really is no easy slam dunk or truly “obvious growth” in the world of investing as so much changes so quickly (even as I write this). Particularly in Asia, the pace of change seems faster than in other regions simply due to the region’s rapid economic growth. As these changes continue, one of the more encouraging developments is the improvement of living standards in certain pockets of Asia—though not necessarily for a country as a whole. GDP per capita alone would not lead to good investment decisions because big cities are often completely different from the rest of the country. The needs and lifestyles of those living in some big Asian cities, such as Shanghai and Mumbai, are becoming quite similar to those in New York or Tokyo. This is good news for global companies that see the potential for an expanding customer base, but it may indeed be even better news for Japanese consumer companies due to their proximity and cultural similarities. Chinese tourists with spending power, for example, are quickly becoming a permanent fixture in Tokyo’s high fashion area of Ginza. Who knows? Perhaps my next investment idea may come from Ginza!

Also stemming from Japan, one “new” and less-hyped industry—unlike today’s social networking companies—is the robotics industry. Robotics firms are generally off the radar screen of many global investors simply because few of these companies are listed anywhere, except in Japan. It is no secret that Japan loves robots and more than 30% of the world’s robots are estimated to “live” in Japan. Most of these industrial robots can be found in factories as essential partners to human laborers, and the cost of replacing people with industrial robots has decreased dramatically over the last 20 years. As a result, factories in China are increasingly installing these robots at a faster-than-expected pace. Rising Chinese labor costs are encouraging more Japanese-led automation in China, and many robotic component companies are also benefiting. It would not be difficult to imagine the continuation of this trend as long as China maintains its status as the “factory of the world.”

Japan’s Growth Curve

The fact that Japan once dominated the mobile Internet space (prior to 2000) escapes most people. That was almost a decade before the average American began busily engaging in social media and games on mobile devices as they do now during their daily commute. “I-Mode,” launched in Japan in 1999, was a pioneering technology used to connect mobile phones with various Internet-related services, including e-mail and games. It was an instant hit and became a de-facto standard in Japan, though it was used only domestically.

The emergence of smartphones and third-generation (3G) and fourth-generation (4G) networks changed all this as standards became more universal, and began enabling many Japanese companies to participate in markets overseas. Some of Japan’s up-and-coming companies offering interactive mobile Internet game platforms are already attracting much interest from around the world, including the U.S. and China.

Why have I focused so much on growth related to Japan? As I mentioned earlier, I look for companies that possess certain elements, and many Japanese companies I am finding fit the bill very nicely. For me, they offer attractive company valuations and robust compliance levels that meet the standards of the developed world. Meanwhile, many actual operations of Japanese firms are increasingly taking place in more emerging nations in the region.

An Analogy for Japan

For those who have concerns over investing in Japanese companies, I would suggest considering Japanese stocks as if you were considering Swiss stocks. This is less farfetched than it may sound: both Japan and Switzerland are older, smaller countries with few natural resources. Moreover, both countries are established tourist destinations within their regions, with the added attraction of clean air and water. If you are beginning to see my analogy, I would pose this question: Would you think about the overall Swiss economy or demographics in considering whether or not to invest in some of Switzerland’s strong, global companies? If your answer is negative, you may see my point about investing in Japan from the bottom up.

Ultimately, the growth we encounter as investors is the growth of businesses and the value they create for shareholders. Finding these opportunities is never the result of simplistic processes—whether they be top-down, macroeconomic, theme-based or driven by historical data. It is a constantly surprising search to challenge conventional wisdom.

Taizo Ishida
Portfolio Manager
Matthews International Capital Management, LLC