December 19, 2014

We discuss volatility and opportunity in three major emerging markets. Despite the recent sell off in Russia, other oil exporting countries and emerging markets in general, the standard investment view has been that three of the BRICs – China, India and Brazil – are just too big and consequential to be ignored. This week’s guests concur. Kenneth Lowe, Portfolio Manager of the Matthews Asia Focus fund and the Matthews Asian Growth and Income fund, and David Nadel, Director of International Research for Royce & Associates and Portfolio Manager of several funds, including the Royce International Smaller-Companies fund, will discuss the opportunities they are seeing in Brazil, China and India.

The opinions expressed on Consuelo Mack WEALTHTRACK are those of the guests and do not necessarily represent the views or opinions of Consuelo Mack or MackTrack, Inc.

CONSUELO MACK: This week on WEALTHTRACK, building up your portfolio with some BRICs! As in China, India and Brazil! Kenneth Lowe of Matthews Asia funds and David Nadel of Royce Funds discuss the additions they are making to their mutual funds from markets other investors are discarding, next on Consuelo Mack WEALTHTRACK.

Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. If we ever needed more proof of the volatility of emerging markets look no further than the recent financial whiplash in China. It happened even before this week’s turmoil in Russia’s stock markets.

In one day the Shanghai Composite Index experienced a nearly 5-1/2% decline, its biggest one day drop since 2009 after a regulator unexpectedly tightened credit availability.

Nonetheless the Shanghai Composite has been the year’s best performing stock market having been one of the worst for the prior five years.

And China’s recent stock advance has been rivaled by its fellow Asian BRIC, India. India’s benchmark SENSEX has been the world’s number one stock market for much of the year, boosted by the May election of Prime Minister Narendra Modi, a pro-business reform candidate who overthrew India’s ruling party of 67 years.

However the two remaining BRICs, Brazil and Russia have been losers.

Russia’s problems are profound, obvious and reflected in its plummeting stock markets. Its oil based economy is suffering mightily from crude’s dramatic decline and the country’s trade has suffered from European and U.S. reaction to its invasion of Ukraine.

Brazil’s economy has also been weighed down by its leadership. Under Workers Party, anti-business president Dilma Rousseff who recently won a second term in the closest election in Brazil’s modern electoral history, Brazil has experienced recession, inflation, rising public debt and scandals. The benchmark Bovespa Index has been one of the worst performing markets in the last five years. It only recently showed some life with the appointment of a pro-business, U.S. educated finance minister. Despite all of these problems, the standard investment view has been that three of the BRICs: China, India and Brazil are just too consequential to be completely ignored. In terms of population, consumption, economic power and potential they are significant.

This week’s guests agree wholeheartedly. They better as each is an international investor. Kenneth Lowe’s focus is on Asia. He is portfolio manager of Matthews Asia Focus fund, a concentrated fund launched in 2013 by Matthews International Capital Management, a pioneer in Asia- centric mutual funds. Lowe also co-manages the Matthews Asian Growth and Income fund, a much larger and older fund.

David Nadel is the Director of International Research for Royce & Associates, a pioneer in small company mutual funds. Nadel is Portfolio Manager of several funds including the Royce International Smaller-Companies fund.

I began the interview by asking them why Americans should look at these emerging markets now given the current hometown advantage of America’s improving economy, strong stock market and the excellent financial shape of so many American companies.

DAVID NADEL: Well, I think I would start with valuation. I think part of the answer to your question is what you’re paying for those two scenarios. So in the case of Brazil, one of the things that got us interested in this market, again, and we’ve been investing in Brazil for five or six years already, was the Buffett Indicator. The Buffett Indicator is the ratio of the aggregate market cap of the country to its GDP. And so Brazil is “trading” at about 39 percent of its GDP, versus about 100 percent at its peak in 2007.

If you compare that to the U.S., the U.S. is trading at about 130 percent of its GDP, and that’s not far from its all-time high. You’re also dealing with all-time high profit margins in the U.S., and in Brazil you have depressed profit margins. So from our perspective, we looked at that picture and said there is potential for margin expansion and multiple expansion. Brazilian small caps are trading at a five-year low, the BRIC markets have underperformed the U.S. market for five straight years. So if you’re a believer at all in some sort of reversion to the mean, and you’re looking for value, I think you’ve got a lot of upside potential in a market like Brazil, and some of the other BRICs as well.

CONSUELO MACK: Right. So is it a value proposition, Kenny, do you think? I mean, Matthews Asia has been a pioneer in investing in Asia, and I’m looking of course at China specifically, which again, U.S. is doing very well, China is slowing. Lots of negative stories coming out of China. So why should we be looking at investing in Asia and China in particular right now?

KENNETH LOWE: I think David raises a very good point. When you’re thinking on a shorter- term, more cyclical view, valuations do look fairly healthy across Asia. You’re looking at about 12 times earnings, 1.6 times price-to-book, which is a little bit lower than what we’ve seen on average through market cycles.

CONSUELO MACK: And this is Asia in general?

KENNETH LOWE: This is Asia in general, as a whole. Beyond that, though, when you’re thinking slightly longer term, you have to look at what the quantity of the population globally looks like, you have to look at the amount of global GDP that’s coming from a region like Asia-Pacific, and you have to believe in the fact that the growth that you’re getting out of a market place like that is substantial, and fairly superior to what you would find in a place like the U.S.. Now, there will be bumps along the way. That’s not to say that growth over the next one or two years is going to be as healthy or as exciting or as attractive as you might find in other geographies, but thinking out on a 10 or a 20 year viewpoint, we’re firm believers that you are going to see some fairly attractive, sustainable growth coming through. And we’re at the point in time where we’re actually seeing a lot of supply-side reform take place, across a number of different countries, places like China and India being some of the bigger economies that are seeing it, but also places like an Indonesia, and obviously in Japan as well, and those are things which are really setting up the future for more sustainable growth.

So there’s a shorter-term aspect around valuation, and potentially a recovery in margins, and the longer-term one around just the size and the quantity of absolute GDP and the growth in that.

CONSUELO MACK: So David, Brazil specifically. You’ve had seven trips to Brazil in the last 20 years.


CONSUELO MACK: And what, seven percent of your portfolio in the Royce International Smaller-Companies Fund is invested in Brazil?


CONSUELO MACK: You’ve got a very left-wing President, who has been disastrous for the Brazilian economy over the last four years. Why are you spending so much time and focus on Brazil, in particular, when in the international fund, you can invest basically in any international market you choose?

DAVID NADEL: I would again start with the point that Brazil is quite out-of-favor, so we do tend to look at markets that are less in favor. One of the things that really has attracted us to the Brazilian market is the social mobility of the market. So more than 15 percent of the population on a net basis has moved from the poorer classes to the middle class in the last 10 years.

When I first came to Brazil, in the early 90s, the Gini Coefficient, which is the measure of income disparity, was around 65. It’s about 50 now. You no longer have hyperinflation. You have an economy that is much broader and deeper, more globally integrated than it used to be. The Brazil that people know of, sort of from 20 years ago, is a very outmoded picture.

CONSUELO MACK: So this is the new Brazil?

DAVID NADEL: This is sort of the new Brazil.

CONSUELO MACK: And you wrote a white paper about it, which we’ll have on our website.

DAVID NADEL: Oh, great. It is really a place where there is, I think, a lot of pent-up consumer demand, and I think the market offers growth, to Kenny’s point, that is really in a different league than a lot of the developed markets. So it’s often more comforting to invest in these developed market. There’s a little less uncertainty. But I think to the political question, my sense is that Dilma is not going to want to leave with the legacy that she currently has. And she’s already shown signs that … the Bovespa fell 25 percent during her first term. The Real lost a third of its value in her first term. I mean, that’s not a great track record.

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CONSUELO MACK: | WEALTHTRACK Transcript 12/19/14 – Program #1126

CONSUELO MACK: Did that hit home? Because she did win the last election, the recent election.

DAVID NADEL: She squeaked by, by a hair. It was the closest margin since World War II in Brazilian presidential politics. She has nominated a very pro-market Finance Minister.

CONSUELO MACK: Right, Mr. Levy.

DAVID NADEL: They’ve raised rates twice. I mean, I think the early signs are pro-market. And I think that you get the votes by doing all of the Bolsa Familia stuff, which is their big social safety net, actually a very smartly crafted social safety net. But it is also a vote buyer, let’s face it. And you do all of that stuff leading up to the election, but they have now a whole slate of things that they can reform. And I, again, don’t think that she’s going to want to leave with the legacy that she currently has.

CONSUELO MACK: And how important is the political piece to your view of the attraction of Brazil as a place to invest? And I know you are bottom-up value investors at Royce, but is the political piece really important?

DAVID NADEL: The political piece is not unimportant. I think if you’re a domestic-only value manager, it’s a little bit of a luxury to be able to sort of ignore all of the political environment, and all of the macroeconomics. As an international value manager, you have to kind of pay attention to these things, and it does matter in terms of catalysts. Certainly, the picture in India, which I trust we’ll get to later …


DAVID NADEL: …is much more positive in terms of the catalyst of regime change. But in the case of Brazil, I think it’s a question of changing the direction of it relative to her first term.

CONSUELO MACK: Kenny, as far as China is concerned, we’re hearing all sorts of negatives about China. I mean, investors are less interested, foreign direct investment has been slowing in China as well. What are we missing as far as the China story is concerned, as an investment story?

KENNETH LOWE: I think people in the Western media always like to portray China as either a wonderful bastion of high growth, or as bust. And the truth is that there’s always a middle ground, or there’s generally a middle ground. At this point in time, yes, we do absolutely have slowing GDP growth. The question then becomes are we looking towards higher-quality GDP growth rather than just concentrating on the absolute number?

In our minds, at Matthews, we think that we are gradually edging towards that, and that’s through a number of different ways of reforming the economy. Clearly, the government wants to move a little bit away from the fixed asset investment and export led and credit led growth that we’ve had for a fairly long time period, and more towards domestic consumption. And that’s happening.

CONSUELO MACK: It is happening.

KENNETH LOWE: That is absolutely happening. And private enterprise really is the main driver of the economy in China.

CONSUELO MACK: And that sort of the myth one of the myths that we automatically assume, because it’s a communist government, and so many of the industries that we hear about that have been listed on American exchanges initially were state-owned enterprises or state-controlled enterprises, but in fact, private enterprise is the driving force in the Chinese economy. Is that right?

KENNETH LOWE: That is right. When you look at a benchmark, and this is part of the issue about benchmark investing, you will find it heavy into financial companies that are state-owned enterprises. Energy and material companies that, again, are state-owned enterprises. But as a bottom-up investor, and someone looking at the overall economy, you can see that about 80 percent of total urban employment is coming from that private sector. So it really is the primary driver, and that’s what’s helping to drive wages up, and that’s what’s providing opportunity for bottom-up stock pickers like ourselves. So we’re far more concentrated around how is China evolving and changing and reforming, in order to be that little bit more liberalized and that little bit more focused around letting markets set resource allocation, which is what the government wants to achieve.

CONSUELO MACK: And to the political question I asked David, how much does the political situation matter to you, as far as investing in China is concerned, and is it a positive political environment now?

KENNETH LOWE: I mean, I think that it’s important. I would use the exact terminology, it’s not unimportant. You know, as a bottom-up stock picker, clearly, first and foremost, what you want to do is understand that the company that you’re buying and investing in. And is the management team incentivizing the right way to provide minority shareholder wealth creation. But, with that said, clearly there’s a lot of moving parts in China, of which the politics is very important. So what we want to understand is whether they’re moving in the right direction towards that greater market liberalization.

In the financial sector, for example, we have seen some of that. We’ve seen an element of interest rate liberalization take place. We’ve seen the Hong Kong Shanghai Stock Exchange through train take place as well, which means foreign investors …

CONSUELO MACK: This market connect, tell us about that, because it is fascinating. KENNETH LOWE: This market connect. So this means that foreign investors, like ourselves, no longer just have to invest in Hong Kong listed companies, but we also have an ability to invest in Shanghai listed companies as well through Hong Kong.

So financial sector reform is taking place to some degree. What we haven’t seen it really is improvement around the rule of law and things like IP right protection. Those are areas where we haven’t seen as much movement as we would like to see.

CONSUELO MACK: David, India. You mentioned it earlier. It is another one of the BRICs. It’s one that both of you are investing in. Tell me about India. Four trips in recent years?

DAVID NADEL: So far, yes.

CONSUELO MACK: A year ago, you wrote another white paper. You wrote one on India, that we had on our website, we still will, what “Columbus Missed, Royce Rediscovers India.” It now has a business-friendly Prime Minister, so what’s your view now? This white paper was a year ago, it was a very good call. What is your view now, a year later?

DAVID NADEL: I am still very bullish on India. I think we’re in the early innings of what is a tremendous transformation. There was a quite dysfunctional political environment before Mr. Modi arrived on the scene, and he is India’s Margaret Thatcher. I mean, this is a huge moment of change for them. In speaking to Indian companies, there is just a sense of optimism that you haven’t had for years there.

India is a story of middle-class growth. I mean, I cannot think of a better growth story overall for the next ten years, than India. They have such a low base that they’re coming from. Per capita consumption in India is $800. It’s $35,000 in the US. It’s the lowest per capita consumption of the ten largest countries in the world, but you started in 2001 with a country that had no mobile phones. A decade later, they have almost a billion mobile phones. And you’ve got penetration rates for things like a laptop or air-conditioning that’s less than 5 percent. A refrigerator or a washing machine, less than 15 percent. A bank account, less than 50 percent. So were just very excited about this longer-term consumer story there.

And a lot of investors have played this with large caps. I think there are a number of small caps that will give you a very operationally leveraged play on these trends. It’s a market that has very little debt in it. I mean, there’s a very nascent credit markets, so I’m quite bullish about it. And it’s a market that most investors just completely overlook. It’s an overwhelming market. There are 5000 listed companies in India. It’s more than in any country in the world, and it’s I think staggering for people to get their arms around. And they have these associations of corruption and all this other stuff.

CONSUELO MACK: And bureaucracy.

DAVID NADEL: And bureaucracy, which is not irrelevant, but I think Modi, his main sort of mantra is less government, more governance. And he really stands for a pro-business approach.

CONSUELO MACK: Kenny, this is in your bailiwick at Matthews Asia. Your view of India?

KENNETH LOWE: We have seen some really important steps take place already, I think. Clearly, we’ve seen a bit of a reduction in the bureaucracy, within government. That’s going to take a lot of time to get particularly efficient, but it’s better than it was pre-Modi coming in. But in addition to that, we’ve seen things like diesel prices get deregulated, and so subsidies being removed at a state level. We’ve also seen restructures and proposals come into place as well, so there are number of steps that he’s taken in the early days. And that’s good.

My largest issue as a more conservative investor, and as a bottom-up stock picker, is that I can find very high quality companies, so that’s one box ticked, but finding them at the right price has been a little bit more challenging for us. You tend to find that those companies who are high return on capital generators are priced fairly aggressively by the market. And so whilst, yes, some of the things taking place are very exciting and good for the long-term sustainable growth of India, as a stock picker, it’s been a little bit more challenging to find those ideas that fit into a portfolio.

CONSUELO MACK: And when you’re saying a little bit more challenging, so for instance, what would your allocation be in the Asia Focus fund, for instance, into Indian companies?

KENNETH LOWE: Yes, it’s actually very low. Ultimately, we just don’t find as many ideas in India at that bottom-up level, despite what’s happening, as we do in some other geographies.

CONSUELO MACK: And small and mid-cap space, which is where Royce specializes. Give us a couple of examples of companies that you are investing in.

DAVID NADEL: So in India, I mentioned that the market is one that doesn’t have a very well- developed credit, large credit market. And so one of the investments that we have is a company called Shriram Transport Finance. And what Shriram Transport Finance does is they are the Indian number one in the financing of used commercial vehicles. So you’re talking about sole proprietor with a truck, and this is his main asset, and they have about 25 percent of the market locally. They’ve been producing 30 percent ROEs for the last ten years.

CONSUELO MACK: Returns on equity?

DAVID NADEL: Yeah, return on equity. And the growth profile is pretty fantastic for these types of companies, and it is a play on internal commerce, in general, so it’s a play on the consumer theme. In Brazil, one of our investments is a company called Kepler Weber. It’s very small, it’s a $500 million company. They are the Brazilian number one in grain silos. Brazil has completely transformed itself in the last 30 years. It was a net importer of food back then. It’s now a top three exporter of almost all of the 14 most traded crops. So it is a veritable breadbasket.

CONSUELO MACK: Very impressive. And Kenny, let me ask you, just to give us a sense of how Matthews Asia invests, the kinds of companies that you’re investing in. So why don’t you give us maybe an example of a Chinese company and …

KENNETH LOWE: Sure. Maybe I can give you an example of a Chinese company that is actually listed outside of China. We actually like to get away from some of the artificial boundaries that exist for a lot of fund managers, where they’re unwilling to go and buy something that’s maybe domiciled in Europe or domiciled in the US, even if the majority of their earnings base is coming from emerging markets, whether it’s China or otherwise. To me, that’s far more looking at the domestic Asian consumer then buying a Taiwanese tech company that’s really just exposed to Western consumer demand.

So for example, we own things like Yum Brands. Clearly, you have the majority of the business which is coming from China.

CONSUELO MACK: Which is a surprise for most of us here. You consider that to be a play on China, even though it’s an American company, Yum Brands.

KENNETH LOWE: Well, yes. I mean, I shy a little bit away from the word “play,” ..

CONSUELO MACK: Right, sorry…as an investment.

KENNETH LOWE: ..but I think as a quality company that has the majority of the earnings stream coming from a country that still has huge, huge potential for growth, for not just the KFC brand, but also the Pizza Hut brand there, they’ve done a phenomenal job in capital allocation. They own the stores in China predominantly, rather than the model that they have in the U.S., which is more around franchising, and that’s part of the reason why you have more of the earnings stream coming from there. So we’re very much fans of what I guess you could call Eastern style growth, with developed market style corporate governing standards.

CONSUELO MACK: Right. One investment for a long-term diversified portfolio. What would you have each of us own some of? David Nadel? To have exposure to these markets?

DAVID NADEL: Well, I think probably to have overall exposure to these markets, I’d look at something that’s very out-of-favor right now. It’s called the Ashmore Group. And it is a UK-based manager of fixed income, emerging market fixed income assets and some equities as well. It’s actually the global number one pure play in emerging market fixed income. And it’s a space that’s completely out-of-favor, the stock is on multi-year lows probably now, but it’s probably about a 5 percent dividend yield. They have mid-60s operating margins, a great culture. They pay their portfolio managers low bases. They have great retention of talent, and also of assets, in an area where you’d think there’d be a lot of turnover of assets. But from a headline perspective, it’s all kinds of headwinds that they face. The founder of the business is a 50 percent shareholder. I don’t think he’s sold a share, or very few, since the company went public. So for overall exposure, I’d probably pick that.

CONSUELO MACK: Kenny, what would you choose for us? And I’m thinking if you can have this focused approach as well.

KENNETH LOWE: Sure, sure. I would choose AIA Group, which is a Hong Kong domiciled life insurance company. They actually operate right across the Asian region. And you know when you look at penetration rates for life insurance across Asia, they’re actually fairly low. Even in developed countries like Hong Kong or Singapore, the death benefit coverage you have isn’t quite as high as it could be, and possibly should be. When you hit about $10,000 GDP per capita, as an economy, you tend to see these sorts of products really skyrocket and take off. So we think that there’s a lot of growth available in that industry. Now back to the bottom-up, why AIA versus anybody else? Well, they have on incredibly strong brands. Not only that, but they have a very strong market position in almost every single country that they operate with it. And they have management incentive structures that are very much aligned with growing the business profitably for the long-term, and not just caring about short-term, premium growth. Clearly, something that’s very important in a long-tail business like life insurance. So all of the quality metrics for us are ticked, as well as that sustainable growth, and were getting a bit of that cash and capital generation come back in the form of dividends at this point as well. So we like it from a number of different angles, of getting almost that holy grail of sustainable growth, quality management, and some cash back.

CONSUELO MACK: All right, we’ll leave it there. Thank you both very much. Some really fascinating ideas, and you also just dispelled some myths that we have about several of these countries as well. So Kenny Lowe, thank you very much for joining us from Matthews Asia.

KENNETH LOWE: No, thank you, my pleasure.

CONSUELO MACK: And David Nadel, always great to have you here from Royce.

DAVID NADEL: Thank you, Consuelo.

CONSUELO MACK: At the close of every WEALTHTRACK we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point is: Take advantage of tax deductible gifts. ‘Tis the season of giving and there are ways to be generous to others and yourself at the same time before year end. Consider giving appreciated stocks or mutual fund shares that you have owned for at least one year to your favorite charity. Your tax deduction is equal to the fair market value of the securities at the time of the donation. And you don’t have to pay a capital gains tax on it. Want to make bequests during your lifetime? You can give up to $14,000 a year to as many individuals as you like, without filing a gift-tax return. A couple can give up to $28,000 a year. Finally, don’t forget yourself. Max out your 401(k). You can direct some of your year-end paychecks or any bonus to contribute up to $17,500 to employer-based plans. 50 or older? The maximum increases up to $23,000. For next week’s edition of WEALTHTRACK, the last of 2014 we are going to look back at the best calls of the year. Who got it right on the economy and markets? We’ll find out. In the meantime please visit our website In the extra section you can hear some additional ideas from Kenneth Lowe and David Nadel, including a novel and safer way to invest in Russia. Think Finland – and I am not talking about reindeer.

Have a merry Christmas, a wonderful weekend and make the week ahead a profitable and a productive one.

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