For the quarter ending 30 September 2020, the Matthews Asia Small Companies Fund returned 7.59%, while its benchmark, the MSCI All Country Asia ex Japan Small Cap Index, returned 13.05%.

Market Environment:

Asia ex-Japan equities continued their upward trajectory in the third quarter. Many Asian equity markets and currencies rallied as economic activity slowly resumed, with earlier pandemic-related lockdowns easing. Malaysia, South Korea and India were the best performing markets during the quarter, while South East Asian countries like Indonesia and Thailand were laggards. The Chinese renminbi gained on the U.S. dollar, as did the South Korean won and the Indian rupee, while the Thailand baht and the Indonesian rupiah depreciated.

For the second quarter in a row, small caps outperformed large caps suggesting that investors are anticipating broader improvement in economic activity. With an eye toward mitigating the health care and economic impacts of the pandemic, North Asia countries have generally been more successful, coordinated and effective in their public health response. South and Southeast Asia have had a relatively tougher time combatting the virus with intermittent imposition of localized lockdowns. For global equity investors, exposure to Asia provided meaningful diversification in the quarter through access to more varied return drivers, including positive local interest rates, faster normalization of economic activity and rising domestic consumption.

Performance Contributors and Detractors:

Among individual securities, Flat Glass Group, which manufactures glass for solar panels in China, was a notable contributor in the quarter. The growth in solar energy is reaching an inflection point in China, as it has reached grid parity. Given China’s goal of carbon neutrality by 2060, we believe continued growth in solar is a long-term secular trend in China. The company may also benefit from a drive toward increased efficiency in solar module performance due to usage of bifacial panels.

ASMedia, a Taiwanese chip design company that specializes in high speed interface integrated circuits (ICs) was among detractors during the quarter. After a strong performance during the first part of the quarter the stock gave up some of its gains during the second half. The key reason was worries about a competitive threat at its main customer, a U.S.-based CPU company. Our channel checks had suggested otherwise. The company has strong intellectual property (IP) accumulated over a decade in this area and we believe it is poised to benefit as newer, higher speed interface products become more mainstream over the coming years. The company is also very well positioned in our view to benefit from China’s focus on diversifying its chip supply chain by winning new Chinese customers. Given our positive outlook we had added to our position during the quarter.

From a country perspective, our under allocation to South Korea and over allocation (and stock selection) to China/Hong Kong detracted from performance. From a sector perspective, stock selection in the health care and information technology sectors were detractors. On the other hand, stock selection in industrials and an underweight in real estate were contributors.

Notable Portfolio Changes:

We were active in the quarter, initiating several new positions and rotating capital to reflect secular growth trends we are following. As South Asia’s response to COVID-19 in general has been less effective and lagged North Asia’s, we have initiated positions in Indian consumer companies such as Marico that we believe stand to benefit from  potentially changed consumption patterns in a post-COVID world. As a well-run consumer staples company in India, Marico has benefited from increased demand for its cooking oil products due to COVID-19 induced work from home situation. Its core hair care products also benefit from customers’ renewed focus on value. Marico has also rolled out several new products to address the increased hygiene/sanitation needs as well as more emphasis on health and wellness as India gets through COVID-19.

Another new position is IFB Industries, a leading Indian consumer appliances manufacturer. Consumer durables like washing machines and dishwashers in India are very underpenetrated and we believe the company stands to benefit from increased demand tailwinds as people look to reduce reliance on domestic help as a way to reduce COVID-19 exposure risk. We have also selectively initiated positions in cheaply valued consumer services companies (with leading market shares) in the region whose sales have been temporarily but severely depressed due to COVID-19 but that we believe will benefit from very attractive long-term growth opportunities.

Outlook:

Stepping back from some of the near-term issues in the region, we are encouraged by the progress of economic reforms in Asia. Amid the pandemic, many of Asia’s policymakers have accelerated efforts toward further opening capital markets to foreign investments, as well as toward reforming labor laws, giving employers greater flexibility in managing their workforces. While the nature of reforms varies among countries in different stages of economic development, the overall trend is unifying and positive for Asia’s capital markets. These economic reforms, combined with rising household incomes and growing domestic consumption, make Asia an attractive destination in our view for long-term equity investors.

Considering the outlook for small companies, the broadening of the economic recovery across Asia provides a potential tailwind for Asia’s smaller and more entrepreneurial businesses. Small companies remain a vibrant source of innovation and creativity in Asia. As always, we look for companies with strong management teams, healthy balance sheets and compelling growth prospects.