Matthews Pacific Tiger Fund 4th Quarter Commentary

GuruFocus.com
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- By Holly LaFon

For the year ending December 31, 2016, the Matthews Pacific Tiger Fund (Trades, Portfolio) declined -0.16% (Investor) underperforming its benchmark, the MSCI All Country Asia ex Japan Index, which returned 5.76%. For the fourth quarter, the Fund declined -9.50% (Investor) versus -6.25% for the Index.

Market Environment:


During the course of the year, factors driving Asia's capital markets changed, and some of these changes accelerated during the fourth quarter. These included a shift in market sentiment from worrying about the threat of deflation to anticipating inflation; expecting a shift from monetary to fiscal stimulus to a near certainty of this transition; and coping with an increase in political risk to somewhat more frail economic conditions in parts of the developed world.

Even though the world appears to be heading into 2017 with more uncertainty than it did at the start of 2016, there were periods when investors have sought cyclical and low valuation stocks. What all this meant for Asia was sector rotation away from quality and defensive stocks to sectors like energy and materials. As a result, energy and materials stocks in the Index provided the best returns for the year, while health care stocks were the worst performing. Large-capitalization stocks were significant outperformers primarily because of a flow-led rally during the first nine months of 2016. In our view these rotations tend to be transient.

Performance Contributors and Detractors:

Asia's markets were positive for 2016 despite challenges, including a rocky start and end to the year. Unfortunately, there were several factors that prevented the Fund from keeping pace. The depreciation of some Asian currencies, such as the renminbi and India's rupee against the U.S. dollar, hurt overall performance. This was partly offset by the strength of some North Asian currencies like the Taiwan dollar.

For the one-year period, the information technology (IT) sector provided the bulk of the returns for the Index, particularly in the third quarter. The Index return was driven primarily by a product refresh cycle in hardware stocks, an industry that we tend to be light on due to its perceived poor long-term outlook. However, we realize that this underweight versus the benchmark can sometimes, over shorter cycles, negatively impact the Fund's relative performance as it did in 2016. In addition, the inclusion of American Depositary Receipts for Chinese companies in the MSCI AC Asia ex Japan Index has made IT the largest sector. This resulted in a pronounced effect of these movements in this past year.

In recent quarters, some stock-specific issues also had a negative impact on Fund performance. Orion (001800.KS), a South Korean confectionary business, has been trying to deal with a channel slowdown while also bearing the cost of new product launches. This negatively impacted near-term earnings. Chinese hardware manufacturer Lenovo has also struggled with a slower demand environment while at the same time integrating sizable acquisitions that produced gyrations in its financial performance.

Capital inflows into Asia post-Brexit were noticeably higher, and perhaps put Asia's challenges into some context, compared to the more dire outlook for Asia's economy in 2015. However, these flows went into largely passively managed investments, causing large-capitalization stocks to outperform smaller stocks. This shift meaningfully hurt our relative performance as we tend to gravitate toward smaller to mid-size businesses that we believe have higher growth potential.

In the fourth quarter of the year, there were slippages in the South Korean market, due to a confluence of domestic and geopolitical issues, which hurt some consumer businesses and our related holdings. In addition, a pullback in expectations over some Korean health care businesses affected the entire sector and our exposure to it.

Notable Portfolio Changes:

During the year, some pullback in the markets presented us with the opportunity to add to our positions, and in a number of cases, we were able to rotate capital away from positions that performed well and into positions that have struggled due to what we believe are temporary issues.

During the third quarter, we exited China Vanke (000002.SZ), one of our portfolio's long-standing property holdings as we believed its boardroom battle for ownership created potential for risk. We also added a new position in an Indian software business that we have researched for many years. Its stock price had come down significantly due to certain challenges that we believe can be corrected. The business holds attractive potential over the medium term. In addition, we bought into an attractive advertising business in China as local companies invest more in building their brands--a trend that should continue to develop going forward. We also added a Chinese health care business to our pool of health care holdings. This is a vertical we are excited about, given Asia's currently low GDP spending on health care versus that of Western markets, as well as the increasing skill sets of Asian companies.

Outlook:

During periods of politically induced macroeconomic uncertainty, we find it helpful to gauge our outlook based on trends observed from companies and businesses. We have seen the most decisive shift from sluggish growth to improving trends in our portfolio's China holdings. A wide variety of stocks from sectors such as information technology, financials and health care continued to meet or exceed investor expectations, helped by structural factors like the continued strengths of the Chinese consumer sector and stabilization in the real estate sector. Likewise in India, economic activity began showing signs of recovery, aided by a favorable monetary cycle. However, the government's decision to swap its old 500 and 1,000 rupee currency notes for its new ones has created uncertainty as consumers and businesses grapple with the short- and long-term implications of this decision. While the short-term pain is an obvious burden for consumers and businesses, we believe the long-term benefits may only gradually unfold. Those long-term benefits may be significant and wide-ranging, and may largely affect the process of capital formation in India resulting from the greater availability and enhanced productivity of that capital. Both in India and China, we see clear opportunities to add to existing positions and initiate new ones that largely focus on domestic demand.

Looking ahead, we see some clear risks; some of which, like the possibility of normalization in the U.S. interest rate cycle, are quantifiable. On the whole, the Asia region is much better-prepared for such an outcome than it was during the taper tantrum in 2013, when markets were negatively impacted. There are also other risks, like the drumbeat of de-globalization, which derive much more from empty rhetoric than sound logical thinking. Economically, our belief is Asia continues to be one of the few regions globally that is reforming and changing for the better, not always in a linear fashion, but in the aggregate forward-moving.

The views and opinions in this commentary were current as of December 31, 2016. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the Fund's future investment intent.

Statements of fact are from sources considered reliable, but neither the Funds nor the Investment Advisor makes any representation or guarantee as to their completeness or accuracy.

As of 12/31/2016, the securities mentioned comprised the Matthews Pacific Tiger Fund (Trades, Portfolio) in the following percentages: Orion Corp. 1.8% and Lenovo Group, Ltd. 1.4%. As of 12/31/2016, the Fund held no position in China Vanke. Current and future portfolio holdings are subject to risk.
This article first appeared on GuruFocus.


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