G. Paul Matthews,
Chairman and Chief Investment Officer Matthews Asian Funds
Any investor who has dipped a toe in the region during the past decade can appreciate that sentiment. No one understands the complexities of investing in Asia better than the subject of this week's 10 Questions, G. Paul Matthews. Matthews founded Matthews International Capital Management in 1991 on the belief that Asia "will be the most dynamic growth region of the 21st century." The course of dynamic growth never does run smooth, but the firm's six no-load Asian funds have turned in a most-impressive long-term performance. For a five-year period, the Matthews Korea fund is in the top 1% of its peers (27.6% average annual return), the Growth & Income fund ranks in the top 2% (15.63%) and the Pacific Tiger fund makes the top 4% (11.25%), according to Morningstar. The three-year performance of the newer Matthews funds is stellar as well: The China fund beats all but 2% of its peers (3.95%), the Asian Technology fund is in the top 21% (-29.79%), and the Japan fund is in the top 36% (-21.6%). In the interview, the Britain-bred, San Francisco-based Matthews offers his unique insights on the multi-faceted Asian landscape. For instance, Matthews says: South Korea's economy is more immediately threatened by Iraq than North Korea; he remains bullish on the prospects for both Asia's technology sector and China; and that Japan still hasn't taken drastic enough measure to emerge from its lengthy funk. If you believe in Asia's prospects, you should believe in Matthews Funds. But rather than taking our word for it, read on. 1. What is the outlook for Asian markets in 2003 and how are you investing accordingly? In general, the outlook for 2003 is for some of the trends that took hold in 2002 to continue. The two significant ones, from our perspective, are the continued strength of the domestic economies in mainland China, South Korea, Thailand and, to a lesser extent, other non-Japan countries. That has gone a long way toward offsetting what has continued to be a difficult global environment for manufacturing exporters. We see no reason to expect that second trend to change dramatically over the next year or so.
It remains the case that the macro story in China is much better than the micro story. But the micro story in Hong Kong is much better than the macro story in Hong Kong. Perversely, we think some of the best investments related to mainland China will be through Hong Kong-listed and other Asian-listed companies. That theme is becoming increasingly important, not just for non-Japan Asian companies but also for Japan. China's growing role in the region has started to have an impact on the performance of individual companies in Japan. Can you provide an example? Thinking in broad terms, the outsourcing trend is an example -- Sony ( SNE) moving more than 50% of its manufacturing to mainland China is the kind of trend that I'm discussing. 2. How have you managed to outperform your peers in the Asian mutual fund arena? We're very much bottom-up focused. Over the last five years, we've been finding more companies with exposure to their domestic markets than some of our competitors have found. The tendency when looking at Asian is to focus on what happens externally -- the sense that Asia is merely a warrant on the rest of the world. The big change over the last five years is that Asia is increasingly looking internally and generating growth internally. We've been quite successful at finding a number of companies that are benefiting from these trends. The growth of consumption in parts of Asia has been dramatic.
Many Asia watchers have noted the region's growing middle class as a bullish investment trend. What sectors might benefit from this trend? I think it's early days, but one of the areas that we're looking at is the whole media/entertainment industry in the region. It's staggering to me that in the last two weeks, more than 3 million Koreans have seen Lord of the Rings. It's spent two weeks at the top of the box office in Seoul. That indicates there is this tremendous middle-class demand for many of the things that we take for granted in the U.S. Is there a cluster of indigenous companies that will be able to perform well against the U.S. multinationals? It's not clear yet -- not in terms of content, but in terms of distribution, maybe. The beneficiaries in Asia may be the distributors; the content producers are still going to be in Southern California, primarily. Although, the whole Bollywood thing in India is growing in importance.
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One exception to that rule is in the area of software for electronic games and wireless. Some of the South Korean game companies have come a long way in the last five years, especially in terms of attracting international software writers. The Garriot brothers, for example, are now working for NCSoft in Seoul. It's one area where they are making significant strides. How do the South Korean video-game companies stack up on valuations? Their U.S. competitors sport a high P/E multiple. The same is true in Seoul. Again, it's early days. We don't have significant exposure to this sector. But I think this is an area that will be a growing part of our and other portfolios over the next several years. In the same way that over the past five years, domestic food companies, domestic soft-drink distributors, domestic financial-service businesses have been growing. I think we'll see a similar trend during the next five years. 3. Moving on to geopolitical matters, what is your assessment of the U.S.-North Korea tensions? How will this affect Seoul and other regional markets? I'm no more of a political expert than anybody else, but I have been following the North Korean situation for the best part of 20 years. I would say that the level of tension today doesn't feel to me to be as bad as it was back in the early '90s, or even the early '80s. Having said that, the consequences of something going wrong are clearly much more severe because of the improved technology supposedly possessed by the North. To put the whole thing in perspective: I happened to be in Seoul in 1994, the last time this issue reached a hiatus. In 1994, the Korean economy was apparently in much better shape than it is today. The Korean market was trading between 900 and 1100 on the Kospi; the currency was 50% higher than today. What's been important in the ensuing periods has less to do with politics and much more to do with the economy. The economic performance in Korea drove both the very disappointing market performance between 1994 and 1998 and the dramatic recovery since 1998.
I suspect that although the world's attention is focused the geopolitical issue, the most important issue is whether the recovery that Korea has been enjoying over the last three years is soundly based. We believe that this time around it truly is. The geopolitical issues will have an impact on the short-term levels of the market, and the most vulnerable component of that is foreign ownership. Domestic investors have grown up with and lived with this threat on their immediate border their entire lives. They have become somewhat inured to this. It's very hard to convey how it feels to live in a city of 13 million people that's so close to a potential hot spot. It's only an hour away from the border and only two hours away from the capital. Here are 13 million people going about their lives in much the same way that we do. I don't think their investment decisions are going to be dramatically impacted by the political events as much as the way in which they live their lives. In a short-term sense, I don't think the economy is going to be that impacted. If it drags out for a long period with rising levels of rhetoric from the U.S. and North Korea, in particular, then it clearly could have an impact on portfolio investment from foreign investors and on capital investment on the part of domestic corporations. As far as portfolio sentiment is concerned among local investors, it's still only just started to recover from the economic crisis. The most important thing domestic investors (focus on) is how strong the economy will be in 2003 and 2004, and less so on the level of international anxiety over North Korea. The big problem, of course, is that this is a final piece in the jigsaw puzzle of Asia's geopolitics and no one has the last pieces. They seems to be missing. This involves China's position, Japan's position, South Korea's position and, of course, the U.S. position. This is our last outpost in Asia and a home for 37,000 U.S. troops -- very well-placed strategically on what would be a direct border with China, should reunification occur. It's not a problem for which there is an obvious solution in diplomatic terms, but a diplomatic solution must be the top priority of all concerned.
Two quick follow-ups: What is the percentage of foreign ownership in South Korea, and, what do you expect from the Seoul economy for the coming year? Foreign ownership in the Korean market is about 35% -- it's substantial. On the other hand, domestic investor own less of their own market than they have in years. We'd like to see domestic investors show more confidence in their local economy. I don't think they're held back by geopolitics, I think they're held back by corporate profits. Clearly, they voted in this last election to continue the current strategies as far as negotiations with the North are concerned. But they also voted to continue with economic reform and restructuring, which has been the lynchpin of the recovery so far. We'd like to see more restructuring; a resolution of some of the problems in the investment-trust sector that apparently are imminent; and we'd like to see individuals playing a greater investment-role in their domestic market. I think we can see a year where growth will be in the order of 4%-5%. Given the outlook for elsewhere in the world, that remains a pretty positive picture. 4. You've usually had broader exposure to South Korea. Does this continue to be the case? What specifically do you like? In the past, you've mentioned a preference for Korean wireless. We still have exposure to Korean telecoms. We still have significant exposure to the Korean consumer. We still have exposure to the financial sector in Korea. And we still have exposure to Samsung. How is the outlook for the banking sector? Are you concerned about rising consumer debt levels? Clearly the growth engine last year was the expansion of consumer credit; that is now slowing. The expectation going into this year is that the smaller and medium-size enterprises and larger corporations in Korea will have to step up their corporate investment and that any expansion in credit will come from the corporate side. I think this would be a healthy balance for the Korean financial system, if it occurs. This is something threatened by uncertainties posed by the global economy. It may seem odd to say this, but in many ways, the threat of military action in Iraq weighs as heavily on the Korean economy as the threat of military action in Korea itself -- something still inconceivable to most Koreans. The Iraq situation is more real, particularly as it has a continued impact on the price of oil, on which Korea is still dependent. Corporations in Korea may be reluctant to step up their capital-investment plans, given the uncertainty over oil prices.
We were concerned about the pace of growth in consumer credit in the first half of last year, and we're encourage that it has slowed significantly in the second half. In terms of Korea's overall consumer debt, it still appears to us to be manageable, particularly when compared to developed countries. 5. Samsung is one of the largest companies in the emerging market world. How have they managed to perform against developed-market rivals? The key areas for Samsung are memory chips; telecommunications, especially handsets; and white goods. I think in the global competition in DRAM, they've benefited from having a broader business than their direct competitors, which have been totally dependent on DRAM. In recent years, when DRAM has been weak, they have been able to make up for some of it with their telecom business. They have executed extremely well over the past few years. In the post-crisis environment, they have focused very clearly on their core businesses and have avoided their distractions that they were exposed to in the past. They have also been particularly successful in China. 6. Valuations in many Asian markets are lower than markets in developed nations. Would you define this region as cheap? Asian markets are at the low end of their valuation range, and that's driven as much by the aftermath of the Asian financial crisis as any other factor. There is one other particular thing affecting these markets -- the failure of Japan to recover from its prolonged recession. That has put a damper on multiples elsewhere in the region. 7. Speaking of Japan, it seems to be a perennial headline that the country is working to emerge from its recession. What do you make of the latest efforts, and is the country at all attractive as an investment opportunity from a one-, three-, five-year time horizon? I believe at the end of the day that any economic recovery in Japan will depend on monetary policy being aggressive enough to achieve it. I'm encouraged that over the last few years the Bank of Japan has become increasingly aggressive in its approach to ending deflation. However, it has still clearly not done enough.
We are also encouraged by some of the recent consolidation. The announcement between Konica and Minolta ( MNOLF) is a good step forward. But we have yet to see Japan take as radical an approach to financial restructuring as we saw, for example, in Korea three or four years ago. Without that, it would be unrealistic to expect as dramatic a recovery there. 8. Your firm has been quite bullish on China. Do you continue to be so? How do investors separate the wheat from the chaff in China? We are very optimistic about the long-term picture for China. But China faces enormous obstacles. They have been far more successful getting to where they are today than anyone gave them credit for 10 or 20 years ago. I tend to give them the benefit of the doubt going forward on the big issues they face -- bank restructurings, solving the bad debt problems in the banking system and continuing to restructure the state-owned enterprises. They are as likely as anybody to succeed. There's no doubting their achievements to date, even if statistics are unreliable as some suggest. Anecdotally, having been to China virtually every year for the past 15 years, I can tell you they have certainly achieved growth on the magnitude that's been reported, even if it hasn't been as consistent as the numbers suggest. 9. What's the outlook for Asian technology companies? U.S. investors aren't high on technology as a sector. How does the outlook differ? I think there's still very strong underlying demand for some basic technology products, particularly in mainland China. The obvious areas go without saying. But there is also increasingly a shift in manufacturing to mainland China, primarily in the outsourcing business. As we get into the next few years, we'll see more and more capital intensive technology industries relocate to China, including semiconductors. I think technology investing remains an integral part of the emergence of non-Japan Asia. 10. Your funds, by nature of the region in which they invest, have been extremely volatile during the past few years. Do you expect this volatility to continue, or has the region stabilized? I think that as these markets mature, they will become less volatile. But the granddaddy of them all, mainland China, is a long way from maturity. So I guess my answer would be to expect continued volatility. We emphasize the risks inherent in this region, but firmly believe in the long-term returns.