In the first quarter, the Wasatch Emerging Markets Small Cap Fund gained 0.37% but underperformed its benchmark, the MSCI Emerging Markets Small Cap Index, which gained 3.59%. Emerging-market equity returns were mixed but generally rose as the prospect of further policy easing in China lifted Asian shares.
Comments from Central Bank Governor Zhou Xiaochuan that China’s growth had slowed “too much” raised expectations for new measures to support the Chinese economy. Shares in Shanghai advanced during the quarter on the hope of additional stimulus, and stocks throughout the region also rose. China and Korea posted gains that helped the Index. Our underweighting in those markets and the underperformance of our holdings were headwinds for the Fund. Taiwan was also positive. The Fund’s weight in Taiwan was approximately equal to that of the benchmark and our holdings outperformed those in the Index.
Several emerging-market currencies fell relative to the U.S. dollar during the quarter. In Turkey, Brazil and Colombia, currency depreciation impacted stock performance in the benchmark and the Fund. Meanwhile, the dollar’s strength helped the big exporting markets. India continued to provide positive performance and the Fund benefited relative to the Index from an overweight position.
Details of the Quarter
It is worth commenting on China and the changes in equity markets there, as well as the implications for emerging-market investors. China is a significant part of the emerging-market indices and it is likely to get much larger given the size of the domestic Chinese equity market as well as U.S.-listed Chinese names (over US$400 billion in market capitalization). While the Fund remains significantly underweighted in China, we expect to increase our Chinese holdings over time.
China is a challenging investment environment, reminding us of Japan three decades ago. Japan at that point had emerged on the world stage as an economic power with world-class companies like Sony, Toyota and Honda.†† From 1980 to 1989, the Nikkei Index††† went from roughly 7,000 to 38,000. It has never attained that upper level since (it is now close to 20,000). Export-oriented countries with high savings rates, high growth, big trade surpluses can have too much US$ capital sloshing around with not enough sensible investment opportunities domestically. In 1990, a Japanese company bought Pebble Beach golf resorts—one of many trophy properties Japanese companies bought overseas. Today, Chinese companies are following suit, buying trophy assets in New York and elsewhere. Some weakening of China’s domestic property market has encouraged the search for opportunities overseas.
Japan was a challenging investment environment for decades. The managements of too many companies did not understand returns on assets (ROAs)†††† or returns on equity (ROEs);‡ these managers were market-share oriented. Valuations‡‡ were high and so foreign investors ended up chronically underweight. We see parallels with China, where the market—especially for the equities of state-owned enterprises (SOEs)—will be undervalued.
The difficulty for equity investors in China has been to find high-quality names that are not SOE connected or controlled (the capitalization of SOEs is well over 70% of the market). That is part of the reason it is a value market, though SOE reform—which seems part of the Chinese government’s agenda—may help to improve their valuations. The performance of emerging-market SOEs has been substantially worse than the market since 2008. At the present time, China is opening up its equity market (with China’s A-shares, which are sold on the Shanghai Stock Exchange,‡‡‡ available to investors buying through the Shanghai-Hong Kong Stock Connect‡‡‡‡) and the currency is becoming liberalized. This is not a small market opening up. The market capitalization of the domestic Chinese market is over US$4 trillion. One can see pockets of overvaluation (technology, for example) as well as undervaluation (banks, for example).
The rise in the Hang Seng Index§ (especially in H-shares, which trade on the Hong Kong Stock Exchange,§§ that have China A-shares also) has been dramatic. There is both an arbitrage going on as well as a liquidity spillover into Hong Kong from China. Other factors are the rise in the SSE Composite Index§§§ and the decline in property prices. From 2008 to 2014, the SSE Composite went from around 6,000 to near 2,000 (from 2005 to 2008 it was up about 400%). Since 2014, it has regained its animal spirits and climbed to about 4100, a gain of about 50%. So, the Shanghai-Hong Kong Stock Connect has allowed the spill over into Hong Kong-listed equities. This recent change (in April) has allowed China mutual funds to invest in H-shares, allowing retail investors to gain exposure and insurance funds to invest in small- and mid-cap Hong Kong shares.
The rise of Hong Kong equities is not simply speculative (although there seems to be a speculative element)—it also has to do with the inexpensiveness of Hong Kong equities (relative to those in China) and the more secular opening-up process. For investors generally, the sudden rise in Hong Kong-listed shares has increased volatility and flows to levels not seen in years. It is also worth noting that this is coinciding with China’s gross domestic product (GDP)§§§§ and export growth slowing, so we are likely to see lower interest rates as the process of debt deleveraging continues. China has some of the highest real interest rates in the world, so there is scope for rates to decline.
For us as small-cap investors, our challenges in China have been lack of scale in companies we see (in a large-scale economy), hyper-competition, corporate governance and unclear strategy. These challenges will not go away. However, over time we believe companies and managements will improve. (How long has it taken Japanese companies to value the importance of returns on capital?) In the “new areas” of the economy (Internet, health care, technology), we see progress and the above issues seem less of a problem. When investing in China, we expect to invest in companies in addition to those based in mainland China. Companies based in Hong Kong and Taiwan have shown they can be successful in China, and we continue to look for such companies.
Elsewhere, India continued to see strength and the Fund continued to be structurally overweight in India. Natco Pharma Ltd. (India) was one of the Fund’s top contributors to performance. Natco’s pipeline is impressive. The company has 34 applications for new drugs filed with the U.S. Food and Drug Administration and 22 more pending. Natco plans to launch its generic form of the multiple-sclerosis drug Copaxone later this year. Natco’s share price rose sharply in the first quarter on news it had won approval to market a generic version of Gilead’s new Hepatitis C drug, Sovaldi, in India and 90 other countries.
In many ways, Korea is undergoing a similar transition to what we have seen in Japan. In Korea, we are seeing an increasing number of what we consider to be high-quality entrepreneurial firms, often with deep technical expertise. The government has encouraged the growth of these firms as it has weakened the chaebols# and encouraged growth through investments and low-interest loans.
Similar to Japan, Korean companies have historically generated low ROEs, underutilized balance sheets, and made capital decisions that benefit insiders over public shareholders. We are seeing the tide shifting in Korea, with increased dividends, improved government regulations, and greater labor productivity. The Fund is still underweight in Korea, but we are increasingly finding more attractive opportunities. Nevertheless, Korea was a source of underperformance in the first quarter as our companies overall did not keep pace with those in the benchmark. While Hanssem Co. Ltd. was up over 50%, i-SENS, Inc. was down over 20%. i-SENS is one of the world’s leading manufacturers of blood-glucose monitoring systems. i-SENS has one of the lowest costs of manufacturing for blood-glucose strips, and we expect to see the company increase the number of partners it has going forward. The company also has a strong research and development (R&D) pipeline, which will drive new-product sales this year and in 2016.
Overall, we see a much better tone in emerging markets. While GDP growth has been slowing and U.S. dollar-denominated debt levels (both sovereign debt## and corporate debt) remain a concern, we’re optimistic regarding the prospects for lower interest rates and SOE reforms.
The outlook is clearly improved and improving in the developed regions of Europe and Japan. Emerging markets may be lagging, but over time they may also benefit from the improvement in developed markets. During the past four years, the MSCI Emerging Markets Small Cap Index has essentially moved sideways even as the earnings of its underlying companies have increased. As a result, the broad emerging-market universe has become more attractively valued. In addition, the U.S. dollar’s recent climb to multi-year highs has made emerging-market equities less costly for dollar-based investors. Going forward, we anticipate lower oil prices may also benefit emerging markets.
We appreciate the support that shareholders have shown us.
Roger Edgley, Andrey Kutuzov and Scott Thomas
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††As of March 31, 2015, the Wasatch Emerging Markets Small Cap Fund was not invested in Sony Corp., Toyota Motor Corp. or Honda Motor Co. Ltd.
†††The Nikkei 225 Stock Index is a price-weighted index of the 225 top Japanese companies (called the First Section) that are listed on the Tokyo Stock Exchange (TSE).
††††Return on assets (ROA) measures a company’s profitability by showing how many dollars of earnings a company derives from each dollar of assets it controls.
‡Return on equity (ROE) measures a company’s efficiency at generating profits from shareholders’ equity.
‡‡Valuation is the process of determining the current worth of an asset or company.
‡‡‡The Shanghai Stock Exchange is the largest stock exchange in mainland China. It is a non-profit organization run by the China Securities Regulatory Commission (CSRC).
‡‡‡‡The Shanghai-Hong Kong Stock Connect is a mutual market access program, through which investors in Hong Kong and mainland China can trade and settle shares listed on the other market, respectively, via the exchange and clearing house in their local market.
§The Hang Seng Index is a market capitalization weighted index of 40 of the largest companies that trade on the Hong Kong Stock Exchange. The Hang Seng Index is maintained by a subsidiary of Hang Seng Bank, and has been published since 1969.
§§The Hong Kong Stock Exchange, one of the world’s largest securities markets by market capitalization, traces its origins to the founding of China’s first formal securities market, the Association of Stockbrokers in Hong Kong, in 1891. A second market opened in 1921, and in 1947 the two merged to form the Hong Kong Stock Exchange.
§§§The SSE Composite Index is a stock market index of all stocks (A shares and B shares) that trade on the Shanghai Stock Exchange.
§§§§Gross domestic product (GDP) is a basic measure of a country’s economic performance and is the market value of all final goods and services made within the borders of a country in a year.
#The word “chaebol” means “business family” or “monopoly” in Korean. The chaebol structure can encompass a single large company or several groups of companies. Each chaebol is owned, controlled or managed by the same family dynasty, generally that of the group’s founder.
##Sovereign debt is government debt. Under the doctrine of sovereign immunity, creditors cannot force the repayment of sovereign debt. It is subject to compulsory rescheduling, interest rate reduction, or even repudiation. The only recourse available to creditors is threat of the loss of credibility and lowering of the country’s sovereign debt rating, which may make future borrowing more difficult.