Matthews China Small Companies Fund
Navigating change and finding opportunity in the world’s second largest economy
Market Insights from Portfolio Manager Winnie Chwang
This Fund has a focus on China’s small companies—could you explain the investment idea behind this? Why China? Why small cap?
Small-cap companies in China are at the forefront of the country’s economic shift away from fixed asset investments toward innovation, consumption and services and actively participate in the growth of China’s new economy sectors. Smaller companies in China may lack access to capital, meaning they must be more competitive, innovative and capital-efficient than their larger peers both to survive and thrive. This capital efficiency has the potential to drive a strong return on invested capital.
We believe China’s small-cap companies have the entrepreneurial spirit and flexibility to recognize and respond to changing local market trends, including changing patterns of consumption. In our opinion, small companies provide opportunities for higher growth at lower valuation because they are less well-known. This allows active managers to uncover opportunities among high-quality companies with good corporate governance at lower valuations.
The Fund performed very strongly last year—what were the drivers?
Our focus on finding innovative and capital-efficient small companies that are relatively insulated from macroeconomic uncertainties served us well during the year for the Fund. One reason that China’s small companies stood out in the year was their focus on domestic demand and opportunities.
China’s effective handling of the pandemic meant that its domestic economy re-opened much more quickly than other large economies globally. The rapid changes brought about by the pandemic created opportunities for innovative businesses to grow and consolidate market share. Our stock selection in the information technology, health care, consumer staples and industrials sectors were notable contributors in 2020. We continue to focus on innovative, efficient and sustainable growth companies, with an emphasis on businesses oriented toward domestic demand and rising income levels.
What investment themes do you like in the China equity universe?
We believe sectors such as industrial automation, consumer, health care and technology are among the most attractive from a secular growth perspective. Rising incomes continue to fuel the trend of consumer upgrades and sustain demand for premium consumer goods. Given the country’s aging demographic shifts and increasing wages, more robotics and automation solutions are used in today’s factories and provide interesting opportunities. We also see opportunities in many areas of technology and health care, spurred by a continued influx and a growing critical mass of talents in China. One key area we like is hyper-connectivity and the development of technological innovation in domestic firms, also known as indigenous tech innovation.
China’s large local market presents an unprecedented opportunity for small businesses to scale up quickly on the technology curve in areas such as data, semiconductors, productivity tools and software. This opportunity represents a “catch-up” story, where some companies can potentially gain market share quickly. In health care we are seeing pharmaceutical companies increasing their research and development spend substantially in efforts to pivot towards more innovative drugs. Finally, there are opportunities associated with a “greener China”—in our view renewable energy and Electric Vehicles can help China achieve its energy self-sufficiency plans. As always, we continue to look for attractive long-term growth opportunities driven by the Chinese consumer.
Three of your top 10 holdings* are in real estate. Could you share your views on this sector?
Within our real estate exposure, we hold two property developers and one property management firm—these are different businesses. Developers sell properties and sometimes require a strong capital base or leverage to build their land bank. The developers we hold have long track records and are very focused on the Greater Bay Area region of China, which is slated to be the Silicon Valley of China. Thus economic activity in the region is thriving and resilient. On the other hand, property management—e.g. maintaining of the grounds of either a residential complex or shopping mall—is a very asset light business. These businesses generally have very visible upcoming pipeline of projects with a sticky relationship with their clients. Cash flow in the property management industry is also generally quite good. Lastly, we believe valuations within this sector remain attractive.
Two of the Fund’s top 10 holdings* are in the auto industry. What is the outlook of China’s auto industry?
Because COVID is largely under control in China, people have been able to resume a normal life. Consumption is rising and auto sales are growing and the depth and diversity of the opportunity set among small companies in China continues to expand. Consumers in China continue to have strong product upgrading preferences and the ongoing demand for luxury autos continues to be very resilient. We are seeing this not just in higher tier cities but also in lower tier cities, as affluence levels increase. Luxury auto dealerships benefit from increased car sales given this aspirational demand for foreign luxury brands. They also benefit from increasing demand for after market needs for service work, as purchasers go back to the dealerships to get their service and maintenance needs. Increased revenues from service and maintenance work for dealerships provide a higher margin business opportunity for auto dealers, which boosts their profitability profiles as well over time.
In terms of the Fund’s sector exposure, the largest allocation is to information technology (IT)*. Where do you see the most opportunity?
We continue to see ongoing opportunities in China’s push towards more indigenous innovation especially in semiconductors and software. At this juncture, China still needs to rely on global semiconductor supply chains but is more equipped today with local talent and also technical know-how for basic and entry level technology products. We think the opportunity for catch-up bodes well for a promising revenue growth story for many Chinese firms in the IT space.
How do you think about the IT sector’s policy risk and valuation?
Policy risk in the IT sector of late has stemmed more from big technology companies on concerns about anti-trust practices and data management policies. We generally find that small IT companies are less affected by this risk. Sector valuations largely remain challenging in this space. Valuation range in the IT sector can be wide, and while we hope for cheaper valuations, we are also aware of the large total addressable market opportunity that exists in many of the IT names we invest in. Thus, this would be a sector where if we did identify good quality names, we would be more willing to endure the relatively higher valuations.
What’s a key misconception an investor may have about China’s small companies?
Smaller companies in China are perceived to be a higher risk investment but the historical volatility of Chinese small caps1 has been lower than the overall Chinese equity universe over the long term2. As mentioned earlier, we believe small companies provide opportunities for higher growth at lower valuation because they are less well-known. This allows active managers such as Matthews Asia to uncover opportunities among high-quality companies with good corporate governance at lower valuations. Through our rigorous research and due diligence, in a market that is relatively uncovered by the sell-side research community, we aim to identify quality businesses with sound fundamentals run by disciplined management teams. We continue to seek companies with sustainable, quality earnings streams, strong cash flows and good balance sheets that can weather uncertain economic conditions.
Given the growing conflict between the U.S. and China, including the latest ban on new investment for 59 Chinese companies, how would that affect Chinese equity and your investment strategy?
Matthews Asia complies with the Executive Order 14032 issued by the Biden Administration and we are monitoring the situation closely to ensure we continue to comply with the E.O.
Small companies in China are at the forefront of the country’s economy when you look across metrics such as contribution to GDP, percentage of patents and innovation number of new product development as well as urban employment. Small cap revenues also tend to be derived by domestic demand, insulating them from the direct impacts of trade related issues.
In our Matthews China Small Companies portfolio, 77% of total revenues are derived from the local economy3. This high percentage of domestically sourced revenues makes the domestic growth engine the most important driver for our small companies. We believe this also helps make our exposure in small businesses in China more insulated from geopolitical tensions and macro events.
*As of May 31, 2021
The Fund is a sub-fund of Matthews Asia Funds SICAV, an umbrella fund, with segregated liability between sub-funds, established as an open-ended investment company with variable capital and incorporated with limited liability under the laws of Luxembourg.
Investment involves risk. Past performance is no guarantee of future results. The value of an investment in the Fund can go down as well as up. This document is not a Prospectus/Offering Document and does not constitute an offer to the public. No public offering or advertising of investment services or securities is intended to have taken effect through the provision of these materials. This is not intended for distribution or use in any jurisdiction in which such distribution, publication, issue or use is not lawful. Investors should not invest in a Fund solely based on the information in this document. An investment in Matthews Asia Funds may be subject to risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. The current prospectus, Key Investor Information Document or other offering documents (“Offering Documents”) contain this and other information and can be obtained by visiting global.matthewsasia.com. Please read the Offering Documents carefully before investing as they explain the risks associated with investing in international and emerging markets. It is the responsibility of any persons wishing to subscribe for shares to inform themselves of and to observe all applicable laws and regulations of any relevant jurisdictions. Prospective investors should inform themselves as to the legal requirements and tax consequences within the countries of their citizenship, residence, domicile and place of business with respect to the acquisition, holding or disposal of shares, and any foreign exchange restrictions that may be relevant thereto.
An investment in the Matthews Asia Funds is not available in all jurisdictions. The Fund’s shares may not be sold to citizens or residents of the United States or in any other state, country or jurisdiction where it would be unlawful to offer, solicit an offer for, or sell the shares. No securities commission or regulatory authority has in any way passed upon the merits of an investment in the Fund or the accuracy or adequacy of this information or the material contained herein or otherwise.
Matthews Asia is the brand for Matthews International Capital Management, LLC and its direct and indirect subsidiaries.
Matthews International Capital Management is the Investment Manager to the Matthews Asia Funds, and is a U.S.-based investment adviser registered with the U.S. Securities and Exchange Commission who has not represented and will not represent that it is otherwise registered with any other regulator or regulatory body. Registration does not imply a certain level of skill or training.
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. Matthews Asia and its affiliates do not accept any liability for losses either direct or consequential caused by the use of this information. The views and information discussed herein are as of the date of publication, are subject to change and may not reflect current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles.
In Singapore, this document is available to, and intended for Institutional Investors under Section 304 of the Securities and Futures Act. It should not be circulated or distributed to the retail public in Singapore.
In the UK, this document is only made available to professional clients and eligible counterparties as defined by the Financial Conduct Authority (“FCA”). Under no circumstances should this document be forwarded to anyone in the UK who is not a professional client or eligible counterparty as defined by the FCA. Issued in the UK by Matthews Global Investors (UK) Limited (“Matthews Asia (UK)”), which is authorised and regulated by the FCA, FRN 667893.
1 Source: Bloomberg as represented by the MSCI China Small Cap Index 100 Day Volatility as of July 9, 2020
2 Source: Bloomberg as represented by the MSCI China Index 100 Day Volatility as of July 9, 2020
3 Source: FactSet Research System as of March 31, 2021