For the year ending 31 December 2022, the Matthews China Dividend Fund returned -16.29%, while its benchmark, the MSCI China Index returned -21.80%. For the fourth quarter of the year, the Fund returned 16.18% versus 13.53% for the benchmark.

Market Environment:

2022 will certainly be remembered as a year of volatility. Global equity markets reacted negatively to a series of events, including the Russian invasion of Ukraine, the spike in energy costs, aggressive rate rises by the U.S. Federal Reserve and other central banks, the lockdown in Shanghai, tensions over Taiwan, and the Chinese Communist Party’s selection of a new leadership team for the next five years. 

In November, Chinese equities markets hit their lowest point of the year. However, in that same month, China relaxed many of its COVID quarantine policies, signaling a change in policy direction in managing the virus and Chinese equities reacted favorably. Then, in early December, the government announced the scrapping of its zero-COVID policy and the removal of quarantine requirements for international visitors. Meanwhile, the U.S. Public Company Accounting Oversight Board (PCAOB) announced that it was able to fully inspect and investigate the audit workbooks of PCAOB-registered accounting firms working for Chinese companies listed on U.S. securities exchanges. This greatly reduced the risk of Chinese companies being forced to delist in the U.S. On the back of these positive developments, Chinese equities, especially those listed in the offshore market, began a strong rebound.

Performance Contributors and Detractors:

During 2022, at the sector level, stock selection in industrials, consumer discretionary and information technology were the biggest contributors to performance. On the other hand, stock selection in the energy sector was the biggest detractor. In terms of market capitalization, small-cap holdings continued to outperform their large-cap peers.

Among individual holdings, Yangzijiang Shipbuilding was the top contributor. Having spun off its financial and investment business to focus on its core shipbuilding business, the company has grown its order book and last year secured the first contract for its LNG (Liquified Natural Gas) ship. It also benefited from a weakening Chinese currency and declining steel price. China Tourism Group Duty Free was the second-largest contributor as its business in Hainan Island and international airports in China may benefit significantly when Chinese tourism returns to normal. Pinduoduo, an online shopping platform, was also a top contributor as COVID-related lockdowns forced many consumers to shop online and its discount pricing also attracted more spending. However, we are very mindful that its recent push into the U.S. market might significantly reduce its short-term earnings and we will adjust our position accordingly.

Conversely, consumer internet giant Tencent was the largest detractor to performance. Given a challenging operating environment, management has been doing a good job increasing long-term investor returns by distributing its investments in companies in specie to shareholders. China Suntien Green Energy was the second-largest detractor as its gas pipeline suffered from lower utilization due to reduced industrial activity. Pharmaron Beijing, a leading Contract Research Organization (CRO), was also a large detractor. The company and the clinical trial services industry is increasingly facing risks tied to U.S.-China tensions and it may be pressed to build facilities outside China which we believe would be a drag on profitability.

Notable Portfolio Changes:

During the year we added Ping An Insurance Group. While Ping An has been hampered by its exposure to the real estate sector and China’s zero-COVID policy, we believe its competitive advantage over state-owned insurance companies still exists. In addition, we added Wharf Real Estate Investment which owns some of the largest prime shopping centers in Hong Kong. We expect that the return of mainland Chinese consumers will increase retail sales of Wharf’s tenants and thus create drivers of higher rents down the road. We also added delivery company ZTO Express as we expect that a rebound of Chinese consumption growth in 2023 will create volume growth for the industry.

We exited BOC Hong Kong as we see limited credit-demand pickup while competition for deposits is driving up funding costs. We also exited Chongqing Changan Automobile as passenger car purchase-tax benefits are starting to be reduced and competitors will cut prices, in our view. We also exited battery-component maker Zhejiang Hangke Technology as changes to electric vehicles (EV) tax credits under the Inflation Reduction Act in the U.S. and slowing sales of EVs in China have created uncertainty for some of its key customers.

Outlook:

We are glad to see the Chinese government finally change course on its zero-COVID policy. The uncertain regulation of internet platforms, draconian cooling measures for the property market and zero-COVID have been the three main drags on the economy. But while policies are turning on all these areas there is still work to do. Many private entrepreneurs need to be incentivized to take risk and make investments and start hiring again while Chinese consumers who have stacked additional savings during the pandemic could also be helped with spending subsidies.

After the recent strong rally in Chinese equities we believe the next phase of the rebound will be driven by strong fundamentals. During this phase, high-quality companies with strong earnings and cash flow and healthy balance sheets could start to outperform. These companies have always been our focus. With their low valuations and strong growth potential we believe our portfolio could deliver an attractive total risk-adjusted return for shareholders.