For the first half of 2021, the Matthews Asian Growth and Income Fund returned 4.29% (Investor Class) and 4.37% (Institutional Class), while its benchmark, the MSCI All Country Asia ex Japan Index returned 6.51% over the same period. For the quarter ending June 30, the Fund returned 2.03% (Investor Class) and 2.10% (Institutional Class), while the benchmark returned 3.66%.

Market Environment:

Asian equity markets started the year strongly as the steadily rising path of asset prices spurred by aggressive policy stimulus and expectations for an economic reopening and growth rebound was the dominant narrative for market participants. The belief in the goldilocks scenario of accommodative policy alongside robust growth shifted in the middle of the first quarter as concerns around growing inflation began to take hold. Rising prices in shipping costs to commodities helped to spark a slight reversal in styles, as the much awaited “value” rally began while “growth” stocks faded. The reality of lofty valuations and expectations weighed on this part of the market, albeit the growth index in Asia remains in positive territory year to date.

Taiwan was the strongest performing market in Asia over the first half, rising over 18% as the technology cycle continued to display strength, while India also gained double digits on hopes that the worst of the pandemic is over. Contrary to this was the majority of Southeast Asia, where many markets fell as renewed COVID outbreaks occurred in countries such as the Philippines and Indonesia, weighing on expectations for a swift recovery and reinforcing how divergent these paths may be across countries. China rose only slightly during the first half due to ongoing regulatory risks, as the Chinese government clamps down on monopolistic practices and perceived data security risks.

Performance Contributors and Detractors:

The largest contributor to absolute performance for the came from the technology sector, as portfolio holding Taiwan Semiconductor Manufacturing Co. (TSMC) rallied. The company enjoys a strong competitive position as the world’s leading semiconductor foundry with superior technology, buoyed by the current backdrop of decidedly strong silicon demand driven by structural trends including high-performance computing and 5G adoption. This led management to announce a US$100 billion capital expenditure plan for the next three years, demonstrating the enormous scale of demand it enjoys. Similarly, South Korean semiconductor equipment company Leeno Industrial rallied as a beneficiary of such ongoing investment in the sector, as it is the global leader in pins and sockets used in testing chips, allowing it to raise prices and grow volumes. Elsewhere within technology, services provider Tata Consultancy Services Limited rose on guidance for the next year, targeting double digit revenue growth as it believes it can win large deals across verticals as information technology spending recovers. Despite this, the Fund’s relative underweight to the IT sector and specifically Taiwan was a drag on relative performance, as the country’s technology-dominated equity index rose significantly over the first half.

The portfolio’s holdings within the industrials sector also benefited performance, with power-tool manufacturer Techtronic Industries Co., Ltd. rising. The company continued to gain market share from competitors and was helped by the stay-at-home do-it-yourself boom, growth of its new outdoor cordless equipment and excitement over its role in U.S. infrastructure spending. Within the communication services sector, Chinese games company Netease, Inc.gained on double digit earnings growth. In our view, management has done an excellent job in growing its game offerings to broaden out by genre and start to grow the business internationally. We believe this should continue as it aims to launch titles based on intellectual property with global appeal.

Although the consumer discretionary sector overall had positive attribution for the Fund, it was also an area where we saw some of our weakest performers. The largest drag to absolute perfomrance for the first half of the year came from Chinese white-goods manufacturer Midea Group on concerns that rising raw material prices will hurt margins and due to a temporary slowdown in China’s monthly air conditioner sales data. Indonesian home improvement retailer PT ACE Hardware Indonesia also dropped on continuing weak same-store sales growth, as foot traffic within its stores is still below pre-pandemic levels and recovery may take longer than expected due to renewed lockdowns in Indonesia.

Other detractors to absolute performance included gold miner Northern Star Resources Ltd., which struggled against a declining gold price and Chinese life insurer Ping An Insurance Group, which fell on weaker than expected new business value growth, while its proposed improvement in agency productivity has disappointed. It is also worth noting that the portfolio’s underweight in the health care sector hurt relative returns. This is a sector that we have been adding to as the investable universe expands.

Notable Portfolio Changes:

We added three new holdings to the portfolio during the quarter. The first of these was Taiwanese financial company Chailease Holdings Co. The business operates across Taiwan, China and Southeast Asia, offering equipment and vehicle leasing amongst other lending products to small- and medium-sized enterprises. Financial products are underpenetrated amongst this cohort as access to financing remains challenging and Chailease enjoys a strong competitive position, good customer relationships, and healthy spreads. Chailease’s management has also managed asset-quality issues well throughout economic cycles, leading to fairly stable profitability and an attractive return on equity. We believe that there is solid growth momentum and improving efficiencies that should lead to double digit earnings growth accompanied by a healthy ~3% dividend yield.

We also added a position in Indian consumer durables company Crompton Greaves Consumer Electicals Ltd. A leader in fans, pumps, lighting and home appliances, management has been focusing its energy on continuing to solidify the company’s brand as consumer behaviors evolve. We believe that a combination of increased digitalization and new product pipeline will allow the company to sustain double-digit growth and benefit from India’s rising domestic demand. Within convertible bonds, we initiated a position in Chinese pharmaceutical research and development (R&D) service platform Pharmaron Beijing Co. We believe that the issue has an attractive risk-reward skew as the underlying equity is likely to grow over 30% as more drug discovery and development is outsourced to leaders such as Pharmaron. Furthermore, it is a strong credit as its balance sheet is net cash with robust cash flow generation.

These new positions were funded through the sale of our holdings in Macquarie Group Ltd., Taiwan Secom Co., Ltd. and a Kakao Corp. convertible bond.

Outlook:

Both markets and the macroeconomic growth backdrop have become more challenging to decipher in recent months as debates around critical issues ensue. It is undoubted that the degree of both monetary and fiscal stimulus across the globe is almost unfathomably large. However, the emergence of new coronavirus variants alongside the inability or unwillingness of large swathes of the global population to become vaccinated continues to muddy the waters of how strong a recovery will be and quite how divergent it may be by country.

Added to this is the question over how transitory the recent surge in inflation is. Supply bottlenecks are playing a significant role in driving inflation up, exacerbated by apparent labor shortages in specific areas and low interest rates spurring asset prices, including housing, higher. Identifying how sustained these trends are likely to be is difficult, particularly as the pandemic may have structurally altered some business models and supply chains. This creates problems for policymakers in evaluating how quickly to taper quantitative easing and potentially increase interest rates to maintain stability.

The above are always important factors for future market returns, but arguably no more so than today as valuations are at extremes, bond yields seem unsustainably low and expectations for earnings growth are high. In Asia, policy is generally more “normal” while growth is more secular in nature and not as reliant upon a rebound from an end to the pandemic. However the fundamental factors of high expectations and valuations are present with an added complication of elevated regulatory and geopolitical risks in China.

We believe that the current environment may lead to heightened volatility and choppy markets. But it should be noted that it remains clear to us that there are parts of the equity market in Asia that are increasingly attractive. As capital has migrated toward both extremes of the spectrum of high beta cyclical stocks and those that could be deemed “conceptual growth,” we believe that this creates opportunities for long-term investors like ourselves. Our focus will continue seekthose high-quality compounders that are less susceptible to the whims of policymakers and inflation trends, with an aim of producing attractive risk-adjusted returns through the market cycle.

As of June 30, 2020, the securities mentioned comprised the Matthews Asian Growth and Income Fund in the following percentages: Taiwan Semiconductor Manufacturing Co., Ltd., 7.2%; Leeno Industrial, Inc., 1.6%; Tata Consultancy Services, Ltd., 1.5%; Techtronic Industries Co., Ltd., 2.0%; NetEase, Inc., 1.8%; Midea Group Co., Ltd. A Shares, 1.5%; PT Ace Hardware Indonesia, 1.1%; Northern Star Resources, Ltd., 1.1%; Ping An Insurance Group Co. of China, Ltd. H Shares, 1.4%; Chailease Holding Co., Ltd., 1.4%; Crompton Greaves Consumer Electricals, Ltd., 0.6%; and Pharmaron Beijing Co., Ltd., Cnv., 0.000%, 06/18/2026, 1.7%.  The Fund held no positions in Macquarie Group, Ltd., Taiwan Secom Co., Ltd. and a Kakao Corp.

Current and future portfolio holdings are subject to change and risk.

Earnings growth is not representative of the fund’s future performance.

Average Annual Total Returns - MACSX as of 06/30/2021