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Matthews China Fund 2nd Quarter Commentary

For the first half of 2019, the Matthews China Fund (Trades, Portfolio) returned 22.27% (Investor Class), while its benchmark, the MSCI China Index, returned 13.08% over the same period. For the quarter ending June 30, 2019, the Matthews China Fund (Trades, Portfolio) returned -1.46% (Investor Class), while the benchmark returned -3.92%.



Market Environment:



Chinese equities posted some of the strongest results in Asia in the first six months, even amid rising volatility during the second quarter. Equity prices rallied from January through April, then fell in May as trade-related uncertainty escalated. In June, equities regained a bit of ground as trade conflicts receded. While China's policymakers have not yet rolled out significant stimulus, market participants seemed reassured by incremental shifts in policy support for economic growth. These efforts include a mild easing in credit policy, accommodative monetary policy and a fiscal policy that includes consumer-friendly tax cuts. Chinese corporate earnings remain relatively robust and valuations continue to be some of the most attractive within emerging markets. While the Chinese economy is slowing slightly, the government's easing posture could help to mitigate some tail risks in the near term.



Performance Contributors and Detractors:



The Fund outperformed its benchmark in the first half, while also providing some downside protection during the volatile second quarter. From a sector perspective, stock selection in consumer staples, communication services, financials and real estate were all positive contributors to relative and absolute performance in the first half. The Fund's holdings in the information technology sector were the only relative detractors in the half due to stock selection.

Among individual stocks, a strong contributor was Wuliangye Yibin (SZSE:000858). As the second-largest liquor company in China, Wuliangye Yibin specializes in manufacturing "baijiu," a clear liquor made from grain. Demonstrating high return on invested capital, Wuliangye Yibin also enjoys improving earnings and a solid growth outlook. We believe the company has more room for expanding its profit margins relative to its largest peer. Wuliangye Yibin is introducing premium products into its line-up, which work in its favor and create an opportunity to grow its overall market share. Consumer spending is an important theme for our bottom-up research process and we find Wuliangye Yibin to be a compelling long-term growth opportunity within the consumer staples sector.

Meanwhile, a detractor was Focus Media Information Technology (SZSE:002027), one of the largest outdoor advertising companies in China. Focus Media's advertising capabilities include digital screens in the elevators of commercial buildings, as well as traditional billboards and outdoor poster boards. With access to hundreds of thousands of billboards and digital screens, Focus Media can easily deploy large-scale ad campaigns in China. Owing to softness in the general economy, however, advertising spending has slowed, hurting recent earnings and sending the stock price lower during the reporting period. Despite short-term weakness in its stock price, we continue to like the company's long-term prospects. We believe it enjoys a strong competitive and dominant position and remains well-positioned for future growth.



Notable Portfolio Changes:



During the second quarter, we added two new positions, Luxshare Precision Industry (SZSE:002475) and Lepu Medical Technology Beijing (SZSE:30003), both representing China's domestic A-share market. Luxshare Precision Industry is a handset component maker moving into new business areas by focusing on higher value manufacturing opportunities and diversifying its client base. The company demonstrates strong execution and its addressable market continues to expand. Lepu Medical Technology, a pharmaceutical and medical device company, has expanded its core business from medical stents to include cardiovascular drugs. Earlier this year, Lepu was also first to market with a new product line of biodegradable stents, designed to dissolve after use. The company projects attractive profit growth and is attractively valued. During the quarter, we exited a small position in China Shenhua Energy, as we saw little upside potential in coal prices, which remained the most important earnings catalyst for the company.



Outlook:



We are incrementally more positive in our outlook for China. Following the recent G-20 Summit, the tone of dialogue surrounding trade issues improved. Though negotiations provided few details, they likely represented the best outcome that the market could expect. Mindful of how fluid trade talks tend to be, we believe it is possible the upcoming 2020 U.S. presidential elections could put additional pressure on President Trump to negotiate. Skepticism around trade aside, Chinese corporate earnings continue to be among the strongest in emerging markets, albeit with a moderate slowdown in economic activity in China. Should the Chinese economy slow further, most market watchers expect Chinese policymakers to act swiftly to maintain economic stability.

We continue to find a lot of value in the current market, especially given frequent shifts in sentiment related to daily headlines. Investing with a long-term view, we ignore the noise and focus on the fundamentals that promote growth. We pay particular attention to company earnings, as well as secular trends we see on the ground. Amid the current news cycle, it is easy for investors to lose sight of the transformation that is taking place among China's enormous middle class. Income growth has expanded rapidly from the eastern seaboard of China to the country's vast interior. We expect consumers in less-developed urban centers to drive China's economic growth for many years and look for businesses geared toward those opportunity sets.


As of 6/30/2019, the securities mentioned comprised the Matthews China Fund (Trades, Portfolio) in the following percentages: Wuliangye Yibin Co., Ltd. 2.8%; Focus Media Information Technology Co., Ltd. 0.7%; Luxshare Precision Industry Co., Ltd. 1.1%; and Lepu Medical Technology Beijing Co., Ltd. 1.0%. The Fund held no positions in China Shenhua Energy Co., Ltd. Current and future portfolio holdings are subject to risk.



Average Annual Total Returns - Investor Class (6/30/2019)





1-year -3.79%

3-year 18.21%

5-year 8.43%

10-year 7.42%

Inception (2/19/98) 9.68%

Gross Expense Ratio



1.10%

All performance quoted is past performance and is no guarantee of future results. Investment return and principal value will fluctuate with changing market conditions so that shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the return figures quoted. Returns would have been lower if certain of the Fund's fees and expenses had not been waived. Please see the Fund's most recent month-end performance.



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The views and opinions in this commentary were as of the report date, subject to change and may not reflect current views. 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. It should not be assumed that any investment will be profitable or will equal the performance of any securities or any sectors mentioned herein. The information does not constitute a recommendation to buy or sell any securities mentioned.

The information contained herein has been derived from sources believed to be reliable and accurate at the time of compilation, but no representation or warranty (express or implied) is made as to the accuracy or completeness of any of this information. Neither the funds nor the Investment Advisor accept any liability for losses either direct or consequential caused by the use of this information.
This article first appeared on GuruFocus.