The Chinese small-cap universe is where the next undiscovered $1trn company is going to come from, according to Matthews Asia’s Tiffany Hsiao, but investors might be too scared to get in early. 
Hsiao, manager of the Matthews China Small Companies fund, said that if a company has already been ‘acronymed’ then its value has already been recognised.
The fund manager highlighted the example of the so-called FAANG stocks – Facebook, Amazon.com, Apple, Netflix and Google-parent Alphabet – as one such acronym group whose best growth is likely behind it.
Such groupings are not the opportunity that Hsiao’s Matthews China Small Companies fund are likely to be focused on.
“My philosophy is if somebody’s already put in an acronym then has already been discovered,” she explained. “We want to discover something that other people haven’t caught onto yet, that’s going to be very similar in size and scale in terms of business opportunity.”
The area Hsiao believes she will find the next “hidden treasure” is in semiconductors; China’s biggest annual import surpassing oil, calling it one of the “global champions of tomorrow” in her portfolio.
According to the manager, semiconductors in particular are going to continue growing in importance within China’s development as they play a fundamental role in their growing technology sector.
The sector is being buoyed by the returning pool of talent, or “sea turtles”, of Chinese nationals returning home as the rise of China’s new middle class creating previously unseen consumer demand.
“Their missile launchers need semiconductors and the president’s computer needs a semiconductor in it,” she said. “Most people in China don’t carry cash anymore, they carry mobile wallets. If you don’t have a semiconductor, you can’t even get your cash out.
“So, it’s critically important for our daily function to have semiconductors and also by that extension software as well.”
As such, small-cap Chinese semiconductor companies are likely to be among the chief beneficiaries of this domestic demand trend, according to Hsiao, and will also be protected from any fallout from the US-China trade war.
In fact the tariff war has actually benefitted them and the small-cap space in general, pushing a greater focus internally on China’s domestic companies to overcome their tariffed trade routes.
“If we met three years ago before president Trump was elected, I would say noise is noise, it has no real impact on how our companies grow over time,” Hsiao said.
However, while prior to the trade war domestic small caps were growing at a normal pace, “now they have accelerated”, said the Matthews China Small Companies manager.
“In the past, I would have thought that it may take 10 years for one-third of my portfolio to really do its job,” she added. “It’s now taking three-to-five years. Every time we have a tweet about the geopolitical tension these companies do better.”
Since the first tariffs were introduced on 22 January 2018, the Matthews China Small Companies fund has made a total return of 3.74 per cent compared with a 15.21 per cent loss for the MSCI China Small Cap benchmark.
Performance of fund vs benchmark since January 2018
Source: FE Analytics
While a focus on the top-down view is difficult to avoid with the trade war rumbling on, Hsiao’s FE Four Crown rated Matthews China Small Companies fund runs an inherently bottom up approach.
A third of its portfolio is focused on China’s “next global champions” with the remainder invested in “steady compounders” creating what she calls a “quality growth portfolio”. These companies she said comes from the consumer, lifestyle staples sector such as soya sauce and after-school tutoring, typically delivering a 10 to 20 per cent growth rate.
Focusing on a long-term outlook Hsiao looks for businesses which can generate a healthy cash flow reinvesting in themselves, enabling them to expand without a bank loan as the business develops.
But Hsiao explains that finding these types of companies in the Chinese small-cap space is inherently time-demanding as it is the largest investment universe in the world, according to Hsiao, in term of both market size and liquidity.
The resulting process to filter down that universe is rooted in a long-term outlook asking: “What’s the best type of small cap to have to really mitigate most of that top down macro risk?”
“So with that philosophy, we use quantitative screening to look for companies with three years consistent revenue growth,” she said, resulting in just 10 per cent of the universe being “worthy of our time to do that bottom up due diligence”.
The Matthews China Small Companies fund runs a portfolio of 40-50 stocks, stocks which Hsiao herself has given a full view of the business and the company management in particular.
“We’ve got to verify that these businesses are structured and sustainable, that the cash flows are really there,” she said. “So we have to go out and make sure that the management team is trustworthy.
“We go to the extent of really understanding every single member of your family. We go to the hometown to interview people. I personally interview ex-bosses and [former] co-workers. I want a 360-degree profile of this person. What are their strengths and weaknesses? Do they panic in times of stress?”
The product of this intense due diligence – a necessary element for small-cap investing in China for Hsiao – is a portfolio with very low volatility.
“Our job really is to prepare for the future as much as we can,” she explained. “Chinese small caps take a lot of work but they’re not scary stocks.
“I really encourage people to look into this universe, there’s a lot of hidden treasure. You can pick up what we call the giants of tomorrow, today, while they’re still very cheap and undiscovered.
“The sad part is that even though there’s lots of great companies in here, very few investors are focused on this market. So, valuations are very, very cheap.”
Performance of fund vs sector and index over 5yrs
Source: FE Analytics
The $56.8m Matthews China Small Companies is led by Hsiao with Lydia So acting as deputy fund manager. The fund made returns of 95.47 per cent over the past five years, an outperformance compared to the MSCI China Small Cap index’s 19.39 per cent. The fund has an ongoing charge of 1.50 per cent.