Tiffany Hsiaos focus on small Chinese companies gives her an unique view as to how Chinas domestic economy is faring as the country tries to recover from the Covid-19 pandemic. That perspective has also helped the Matthews Asia fund manager build a resilient portfolio in the face of the pandemicand before that, the trade war.

Taiwanese-born Hsiao grew up in Silicon Valley, where she watched her father help reinvent a calculator company and build the worlds first laptop computer using Intels 386 CPUan early lesson on the power of innovation. Hsiao has used that in hunting stocks for the Matthews China Small Companies fund (ticker: MCSMX). The $200 million fund has beaten 99% of its peers over her five-year tenure as lead manager. The funds 18% gain this year has trounced peers again, as well as the Chinese market and the S&P 500 index.

Barrons spoke with Hsiao to get her views on how Chinese consumers and businesses are recovering after the country eased restrictions, the risk of a second wave of outbreaks, and why the portfolio has been so resistant to a black swan development that has rattled markets. Heres a condensed version of our discussion.

Barrons: China is a couple of months ahead in dealing with this pandemic. The Chinese market had its biggest drop in early February, before the global market tanked on Feb. 20, and is still holding up. What has helped its resilience?

Tiffany Hsiao: Confidence. There are a couple layers: Within China, theres confidence the disease is controllable. They have so much in resourcesthey can make five million masks per city when they ask people to work togetherso they are confident they have the medical supplies and people working together. And because of how swift and effective the [containment] was, people are not worried about job security. We cant say that about the U.S. or Europe. Everyone at the companies we own is back at work.

Market Data Center: EMEA and Asia

And if you look at demographics, the largest cohort [of investors] is millennials. When they see a correction, they are going to participate because that is not their nest egg. They are still building it and have the ability to capture the falling knife, whereas in the U.S. and Europe, investors are depending on that money in the next 10 years.

What about Chinas lack of transparency and attempts to muffle early warnings, like from Dr. Li Wenliang, who eventually died?

When this virus first broke out, the Chinese governments response was not transparent. But in the past, you would see very draconian measures to suppress freedom of speech. This time, they let people vent their frustrations. People were creating art pieces out of that doctors picture and posting on WeChat and mourning his death. The Chinese government publicly apologized [for its treatment of Li]that in itself instilled confidence.

It was an unfortunate event, but the response from the government was so different than what we had seen before that people had a lot more confidence in the government after that, especially after they saw the virus spread outside of Chinas borders.

Barrons wants to know your thoughts on the market, the economy, and how coronavirus is impacting your investments. Results will be published along with our biannual Big Money Poll of institutional investors. Poll closes at midnight on Apr. 20. Have your say here

Are you worried about a second wave of infections?

People on the ground are not fearful. The government has put in place very cautious, but reasonable, polices around public health. Any person who returns from overseas has to self-quarantine for 14 days. They give you electronic bracelets as you enter, and track you. That type of policy broadcast to the people gives them confidence that the government is doing its job, so they can safely go do theirs.

In terms of valuation, the Chinese onshore equity markets have not corrected much since the Covid-19 outbreak. There is risk that if a second infection shuts down the economy for longer, valuations could become even more stretched in the near term.

Small businesses are hurting in the U.S. How are they doing in China?

[Chinas] stimulus has been very measured, such as a deferred social security tax and local tax rebates. On top of that, a lot of the more wealthy parts of the economythe landownersvoluntarily offered two months of free rent and no collections on debt. Here in San Francisco, a lot of restaurants are going out of business because landlords refuse to do that.

How has consumer or corporate behavior changed?

We are a heavy investor in software, including China Youzan (8083.Hong Kong), which is the equivalent of Shopify, and helps mom-and-pops sell anything. As soon as everyone shut down, their users went through the roof, as companies tried to go from bricks-and-mortar to online. China is very dynamic. Small- to medium-size-business owners are very nimble. And theres still demand: People still need to eat and have kids entertained with educational programming. Their basic needs havent changed; they just need a different way to get it.

People are also embracing the digital economy even more. The e-commerce adoption rate is already much higher than in the U.S., with about 25% of retail sales done online compared with 11% in the U.S. In the past, people just ordered clothes or electronics and now are ordering groceries. During the crisis, they are also having kids educated online. We own Koolearn Technology Holding (1797.Hong Kong), an online education company that was ready with content and had teachers trained.

Have any trends been derailed?

Travel is a very large part of consumer discretionary spending. The Chinese love to go overseasand now they cant. And as we emerge from this crisis, there is a fear of racism, so [travel] will [continue to] be impacted.

Theres also some time shifting: Real estate transactions were down a lot in the first quarter, but theyre starting to bounce back in cities like Nanjing. The line to go see [a new listing] was wrapped around the building. Theres pent-up demand.

How will a recession in the U.S. or Europe affect Chinas recovery?

We need to see a more effective response globally to provide a stronger backdrop for China to recover. This was supposed to be a great growth year: A lot of businesses were holding back their checkbooks for three years, [waiting] for a resolution to the trade war to deploy the capital.

What concerns you at this point?

Policy missteps as the Chinese government tries to gauge the severity of unemployment. The situation is fluid, since many workers are still in process of returning to their normal jobs. However, if countries outside of China continue to suffer from Covid-19, then those jobs may not be waiting for workers as they return.

Some natural Darwinism to clean the economy of inefficient businesses is not a bad thing, but we need supportive policies to redirect those displaced into other productive industries. From a stock perspective, the stronger surviving companies will gain market share faster.

How do you invest around that?

We stress-test every company through all types of scenarios. When you are investing in a country as big as China, something will always go wrong. I call them black ducks [instead of swans] because they are not as rare as you think. If its not this virus, its going to be a natural disaster or something else.

We want the highest return on capital possible. To do that, we tilt toward asset-light companies that dont have much balance-sheet risk. Our companies never depended on [debt], and their products are intellectual-property driven and can be used digitally and remotely. So weve been very insulated, especially year to date.

China was trying to become more self-sufficient as tensions with the U.S. escalated. Has that been derailed by the latest crisis?

The self-sufficiency theme is alive and well. When the government was thinking about how to stimulate the economy, that was the first area it looked atinvesting more in semiconductors, biotech, and software. The chairman of our largest position, Silergy (6415.Taiwan), the largest analog semiconductor company in China, told me the company will grow revenue 20% to 30% unhindered, because the areas they invest in are the areas the government wants to speed up5G infrastructure, health-care equipment, and data centersas more people work from home and embrace the digital economy.

Chip companies have seen disruptions during this crisis. What about Silergy?

If you need 2,000 components, then youll have disruption. But a lot of the products they are making need 200 to 300 components that they can source domestically. We are very careful and have very limited exposure to the heavy industrial supply chain, because there will be a lot of disruption.

Health care makes up 20% of your portfolio. What is the draw?

Part of it is my constant paranoia that something is going to go wrong, so half [of the allocation] pertains to basic stuff like vaccinesincluding CanSino Biologics (6185.Hong Kong), which is doing clinical trials in Seattle for a coronavirus vaccine medical waste, and companies trying to develop strong health-care infrastructure to keep 1.4 billion people healthy so it doesnt turn into a social problem.

And the other half?

Its focused on human DNA; 99.9% is similar, but that small difference results in Caucasian and Asians having very different critical-illness disease types, especially with cancer. In Asia, the more prevalent cancer types are of the liver and stomach, whereas those are designated by U.S. Food and Drug Administration as orphan diseases, with fewer than 200,000 new diagnoses in the U.S., compared with 1.2 million new diagnoses of liver and gastric cancers in China.

In the past, China relied on the Western world for medical advances and newer therapies. But as the drugs become more DNA-based, you need to come up with drugs that fit the Asian DNA better, so we focus on scientists who earned their stripes at Western companies and start their own businesses, like Innovent Biologics (IVBXF), whose management is top-notch talent from global drugmakers like Roche, Applied Genetic Technologies, and Eli Lilly. Its a top oncology biopharma company that focuses on drugs for Asias prevalent cancer indications and has a very strong pipeline of innovative, novel therapies in addition to blockbuster drugs.

The crisis has raised concerns about liquidity, as some markets have seized up. Have you encountered any problems?

Chinese small-caps comprise the worlds largest small-cap asset class. It surpassed the U.S. two years ago in terms of liquidity, number of stocks listed, and total market cap listed. If you are worried about liquidity, Chinese small-caps are much more liquid than the U.S.and have done much better year to date.

What happens if tensions between the U.S. and China escalate again?

A third of our portfolio are trade war beneficiariescompanies that help China turn self-sufficient. The other two-thirds are steady compounderscompanies that make soy sauce, education companies, and property managementand are not going to be affected if theres a trade war. If you hit [companies] with a couple of black swans and you still need to buy them, those are the kinds of companies we want to own.

Thanks, Tiffany.

Corrections & Amplifications The Matthews China Small Companies fund has gained 18% so far this year. An earlier version of the article listed the 3-year average return instead of the year-to-date figure.

Write to Reshma Kapadia at reshma.kapadia@barrons.com

See the original post here:

Chinas Small Companies Are Beating Almost Every Market. Here Are The Best Sectors. - Barron's