Matthews China Small Companies Fund


Period ended 31 December 2018

For the year ending 31 December 2018, the Matthews China Small Companies Fund returned -18.79%, while its benchmark, the MSCI China Small Cap Index, returned -19.53%. For the fourth quarter, the Fund returned -11.07% versus -11.24% for the Index.

Market Environment:

There was no shortage of alarming headlines in 2018. Trade war tensions, geopolitical risks and worries about a structural China slowdown dominated the news throughout the year. These factors all negatively impacted China's equity markets in terms of both performance and volatility. For the first time in a while, we saw a noticeable slowdown in domestic retail consumption of large-ticket items, such as autos and home decorations, driven by domestic deleveraging. Even though retail sales and industrial production figures continued to meet expectations through August, investors worried about a downward trajectory in the near term—thus ignoring the strong August data. China's central bank, the People's Bank of China, appeared to be cognizant of the near-term policy and geopolitical headwinds and therefore continued to be accommodative by lowering interest rates. The government's determination in steering China's longer term structural reform, however, remains solid as it maintained its strict controls over the riskier parts of the nation's lending system.
 
From both a top-down and bottom-up perspective, we continue to anticipate long-term sustainable growth in the Chinese economy and in corporate earnings. The market's concerns over escalating trade tensions should, in our view, have little impact on China's smaller companies given their domestic focus and lower dependence on financial leverage. China's recent policies toward the consumer services economy, however, do have near-term negative impacts on sentiment for smaller companies.

Performance Contributors and Detractors:

In 2018, our strong stock selection in the industrials and communication services sectors contributed most to the Fund's outperformance versus the benchmark. Our underweight position in the asset-heavy communication services sector also contributed positively to performance. The biggest drag to our performance came from the consumer discretionary sector due to poor stock selection. 

Among the top contributors to Fund performance during 2018 were CIFI Holdings and Yihai International Holding. CIFI Holdings is a top residential property developer in China with a sound land-banking strategy around cities with high productivity growth and a strong balance sheet. Yihai International Holding manufactures and sells a leading hot pot soup base and condiment brand for both restaurants and retail consumers. We believe the company has strong growth visibility given the popularity of its associated hot pot restaurant chain and its rapidly growing new business in restaurant supplies.

Silergy, China's analog semiconductor company, and China Aviation Oil Singapore, China's sole jet fuel importer and key stakeholder in Shanghai Pudong Airport's refueling operations, were among the top individual detractors to Fund performance in 2018. Over the long run, we firmly believe Silergy will continue to benefit from China's plans to become self-sufficient in semiconductor production. During the third quarter, however, Silergy was hit with a wall of worry as the global semiconductor industry was sold off on cyclical concerns. We believe these concerns over Silergy are misplaced because analog semiconductors are much less cyclical and the trade war actually accelerates China's need for self-sufficiency in the production of semiconductors. China Aviation Oil's price decline was due to worries about outbound travel from China as the economy weakened. Over the long run, however, we see structural growth in China's outbound tourism market and continue to see China Aviation Oil as a key beneficiary. 

Notable Portfolio Changes:

We have consistently held the belief that small-cap companies should compete on innovation and high returns on capital. During the year, we further reduced our exposure to companies with higher debt burdens and selectively added innovative companies to our portfolio, especially in the technology and consumer-related sectors. China's small-cap universe continues to be a fertile hunting ground for finding cash flow-rich growth stocks at reasonable valuations, and we have been able to easily replace our “graduates” with attractive new holdings.

During the final quarter of 2018, we initiated a position in Innovent Biologics, a leading biotech company in China. We believe the company has strong growth visibility given its product pipeline in more than a dozen biosimilars, which are similarly effective but less expensive versions of biopharmaceutical drugs whose patents have expired, and has strong execution capabilities to serve China's significant unmet oncology drug needs.  
 

Outlook:

We remain cautiously optimistic about China's small-cap market despite heightened market volatility as we focus rigorously on the sound fundamentals of our portfolio companies. From a macroeconomic perspective, we continue to believe China has the ability to stabilize its economy through fiscal spending, interest rate adjustments and currency management. In addition, steps taken to correct China's structural issues are continuing on the right track, despite the near-term pains of a deleveraging economy. We are focused on seeking innovative and capital-efficient small companies that are relatively insulated from macroeconomic uncertainties. We will continue to seek companies with sustainable, quality earnings streams, strong cash flows and good balance sheets that can weather uncertain economic conditions. We believe sectors such as industrial automation, health care and technology are among the most attractive from a secular growth perspective.
 

Rolling 12 Month Returns for the period ended 31 December 2018
Matthews China Small Companies Fund 2018 2017 2016 2015 2014
I (Acc) (USD) -18.79% 56.47% -1.96% 2.98% -3.20%
MSCI China Small Cap Index (USD) -19.53% 24.62% -5.95% 3.48% -0.34%

Risk Considerations

The value of an investment in the Fund can go down as well as up and possible loss of principal is a risk of investing. Investments in international and emerging market securities may involve risks such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. The Fund invests in holdings denominated in foreign currency, and is exposed to the risk that the value of the foreign currency will increase or decrease. The Fund invests primarily in equity securities, which may result in increased volatility. Investments in a single-country fund may be subject to a higher degree of market risk than diversified funds because of concentration in a specific country. The Fund invests in smaller companies, which are more volatile and less liquid than larger companies. These and other risks associated with investing in the Fund can be found in the Prospectus.



Investing in small- and mid-size companies is more risky than investing in large companies as they may be more volatile and less liquid than larger companies.

Performance figures discussed in the Fund Manager Commentary above reflect that of the Institutional Accumulation Class Shares and has been calculated in USD. Performance details provided for the Fund are based on a NAV-to-NAV basis, with any dividends reinvested, and are net of management fees and other expenses. Past performance information is not indicative of future performance. Investors may not get back the full amount invested.

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 International Capital Management, LLC (“Matthews Asia”) and its affiliates do not accept any liability for losses either direct or consequential caused by the use of this information. 

Information contained herein is sourced from Matthews Asia unless otherwise stated. The views and opinions in this commentary were as of the report date, subject to change and may not reflect the writer’s 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.

Investors should not invest in the Fund solely based on the information in this material alone. Please refer to the Prospectus for further details of the risk factors.

Sources: Brown Brothers Harriman (Luxembourg) S.C.A, Matthews Asia, FactSet Research Systems, Bloomberg