Emerging Markets Via MAPIX

Summary

• Previous articles on Emerging Markets have found favorable prospective long-term returns, particularly in Asia.
• I have discussed the benefits of choosing well-run active funds in this space over ETFs, which can have oversized exposure to trade wars or overpriced tech darlings.
• This article recommends one such fund, Matthews Asia Dividend Fund, based on its exposure to domestic consumption growth and value approach.

Introduction

Based on Shiller PE, along with a hold of other short-term valuation metrics, including current PE, PS and PB ratios, many emerging markets (EM) and some developed markets are at about a 50% sale price relative to the US.

Source: PE Map & Table

While in the past, I have cautioned against jumping into emerging markets such as Greece or Turkey, where currency volatility or government finances leave much to be desired, a closer look at the full list above shows that a number of countries with sound budget and current account policies, much higher levels of expected economic growth than the US over the next 5-10 years, are significantly cheaper than US markets, even after October's correction.

While my prior articles pointed out parts of EM that were starting to look interesting, in this article, I'd like to recommend one actively managed mutual fund, Matthews Asia Dividend Fund (MUTF:MAPIX) that has met my needs for over a decade, that is a core part of my international exposure, and is well worth the management expenses.

My Criteria

In a world where I see a lot of overvaluation in many different sectors and regions, market-cap weighted index investing seems dangerous over the next 5-10 years. Additionally, I believe that in Asia in particular, long-term profit growth will accrue disproportionately to companies that meet the needs of the growing middle classes in those regions. Focusing on such companies has the added benefit that such companies will be relatively immune to whatever trade-related actions the current administrations MAGA policies take.

Therefore, I looked for an Asia-Pacific-focused fund, that took company governance, valuations and sustainability of profit margins all into account, and favored companies that were much more exposed to the domestic developing middle classes of those regions rather than exporting companies in the commodities or industrial sectors. Given that actively managed funds charge more than ETFs, another criteria has been that any management fees must be justified by long-term out-performance of ETFs that are in the same broad category.

MAPIX

Full Fund Information

The Matthews company is a group of investment managers specializing in Asia since the 1990s. It started small and has grown its list of funds and number of portfolio managers over time. The Asia Dividend fund in particular has been around since 2006, with results since inception shown below.

Since Inception

I first started investing in this fund in 2006 and while I've been out of it completely twice in the intervening time (in 2008 and for a while recently), I have been cost-averaging back into it since September. As the performance graph above shows, its 1% management fee has resulted in index out-performance of almost 50% (under 20k vs. close to 30k). Investment manager Q&A, as well as a close look at fund holdings every year or so, have confirmed that they stick to the criteria I was looking for when I set to find an appropriate ETF or active fund focused on Asia.

Firm Philosophy

Reading interviews with the CIO and portfolio managers closely over time, I have been satisfied that they pay appropriate attention to corporate governance and shady ownership structures (it is a strict part of their investment selection process), visit each company they invest in (being able to speak with management in a number of different local languages helps in this part of the evaluation) and "walk the walk" as far as adhering to the investment discipline that is described on their site.

This is the reason that since inception, I believe that this fund has beat ETFs such as the iShares MSCI Emerging Markets ETF (EEM) by over 5% a year. In addition, as the chart below shows, since 2006, when this fund began, it has even beat the S&P 500 Index by 50 bps per year.

Source: Bloomberg

In fact, this out-performance has occurred despite the currency headwind shown in the next chart.

Source: Bloomberg

While the dollar had its ups and downs between 2006 and mid-2014, overall the dollar was relatively stable. Since 2015, however, dollar index has strengthened considerably, meaning that without this currency headwind, MAPIX outperformance would have been much stronger.

More On Margins And Future Outlook

While looking at the past is interesting and important, an investment allocation to a fund like this involves looking ahead 5-10 years and thinking about some important underlying trends. The first part of this is simply the real growth that is available when one focuses on domestic demand in the fastest growing region of the world.

I reason as follows: the economy and wages within the region MAPIX covers are growing in real terms at about 5% a year. The rest of the world is growing in real terms at about 2% a year. Even if profit margins, dividends, and valuations, were identical, this would imply about a 3% real a year advantage to companies focused on selling into these markets rather than out of them (exporters).

In fact, everything else is not equal. Dividend payments are higher; Asian margins have been lower since 2009 (which largely explains why, despite having real growth 3% higher, firms did not grow their earnings 3% faster since 2009). Indeed, the picture that emerges when thinking through the chart below is actually quite optimistic for the future.

Margin Data

US and EM margins were at the same levels from 2004 to 2008 and both crashed during the financial crisis. However, post-crisis, they rapidly resumed and then exceeded prior levels in the US. This means that all income gains within the economy went to capital in the US, explaining why real wages did not rise (and even partly explaining the rise of Trump). On the other hand, all those real gains went to wages in Asia, resulting in a massive growth in the population of the global middle class.

While it kept profit margins there low, it has now produced a population that is capable of spending more and more on domestic goods and services (such as financial services, healthcare, consumer staples and discretionary). As productivity continues to rise, I expect margins to continue their recent increase. On the other hand, it is highly likely that US margins have peaked and are headed down towards a more normal level (around 10%).

The recent surge from the corporate tax cuts looks to be unsustainable in the long-run due to the deterioration in the budget picture. Finally, that budget picture and associated current account deficit, is also dollar negative in the intermediate and long-term.

This implies to me that there are four distinct tailwinds that MAPIX will enjoy:

1. Relative Valuations: EM in general and Asia-Pacific in particular is at a historically high level of cheapness relative to the S&P.

2. Margins: EM margins will be heading higher as US margins head lower.

3. Currency: The dollar correcting back to fair value should add 1-2% a year as well over the next 5-10 years.

4. Growth: Real Economic Growth will continue to be about 3% higher in Asia-Pacific over the next 5-10 years.

I will reiterate that margins and the dollar have, over the last 10 years, offset the benefit of 4, resulting in the impression that there is no point to owning EM (that it adds volatility to a portfolio without adding diversification benefit or excess return). This impression will, I believe, come to be seen as sorely mistaken, as margin and currency trends begin to revert.

I expect that the currency trends will begin to revert as soon as the Fed approaches the end of its hiking campaign (this is what has caused dollar strength in the last couple of years). Trend 2 is a longer-term process. The reason that margins have been so high in the US post-crisis has been an extremely worker-unfriendly environment. The monopsony phenomenon has been much written about. Unemployment and slack has been quite high.

However, wage growth has finally broken 3% a year and many states and local governments have begun to raise minimum wage levels. Healthcare benefits have largely swallowed wage and benefit gains, resulting in wage growth barely keeping up with inflation. The pressure on politicians to favor workers has not been this strong in decades. Over time this pressure, combined with low unemployment will result in margin contraction in the US.

Conversely, capital spending and R&D in Asia is now already larger than that in the US. In fact, as of 2015, North America had dropped to accounting for 27% of global R&D while Europe was down to 22%, meaning that just over half of all global R&D spend was occurring in other parts of the world.

R&D Spend Intensity

The rise in the capital stock and R&D means that over time, productivity growth and innovation will be high in the regions covered by MAPIX. Over time, this will result in the normalization of corporate profit margins back to pre-crisis levels. Additionally, the investment selection process outlined by fund management, wherein higher margin/larger moat businesses able to defend their margins are selected over businesses in highly competitive ecosystems where margins will continue to be competed away, has the potential to add alpha.

Concluding Thoughts

Looking at the components I outlined above quantitatively, I expect that the contributions to out-performance over US markets over the next 5-10 years will be as follows. Valuation: 2% a year. Margin reversion 0.5% a year. Currency: 1% a year. Growth advantage: 2.5% a year. Therefore, I am expecting roughly a 6% per year out-performance for MAPIX relative to SPX from current levels over the next 5-10 years. I would advise dollar cost averaging in to build positions at this point.

The rationale behind these numbers is as follows: The long-term valuation differential between the US and Asia-Pacific is about 25% out of whack. Over 10 years, this works out to roughly 2% a year. For margin, I expect that the 5% drop in margin from historical levels will similarly return to normal over 10 years. For currency, 1% a year is a relatively conservative assumption, as the USD is more than 20% overvalued. It is unlikely that currency reversion will occur steadily over time as shifts of this size tend to take place over 1-2 years and coincide with shifts in monetary cycles.

Finally, the real growth differential is also slightly conservative and assumes that the US continues to grow at 3% a year while Asia slows down to a 5.5% growth rate. Based on US population and productivity growth (these are the two elements of long-term real growth), 3% may be a stretch as population growth is declining to the 1% ballpark and productivity growth has stalled in the same ball park. If the more pessimistic scenario for US real growth realizes, the contribution from the growth differential could be as high as 3.5-4%, presenting some upside to these estimates.

Analyst’s Disclosure: I am/we are long MAPIX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.