For the third quarter of 2022, the Matthews China Dividend Fund returned -17.08% (Investor Class) and -17.08% (Institutional Class), while its benchmark, the MSCI China Index, returned -22.44% over the same period.

Market Environment:

Chinese equities experienced another quarter of sell-off after a brief rally during the month of June. As the sporadic outbreak of COVID cases among Chinese cities continued, we witnessed the mass lockdown of mega cities such as Chengdu and Shenzhen as China’s government stuck to its zero-COVID policy. During the earnings season, many listed companies also reported weak first-half year results triggering poor sentiment. In addition, China’s housing market continued to struggle as potential buyers and local government cast doubts on whether some financially distressed developers can finish and deliver their pre-sold homes on time. In extreme cases, consumers who secured pre-sold homes with a mortgage started a campaign to boycott their loan repayments to pressure lenders and the state to help troubled developers complete projects. These rare protests added to concerns over systemic risk.

While China’s central bank reduced its long-term lending rate by 15 basis points (0.15%) in August, this is probably viewed as too small a stimulus and is being blunted by the global interest rate environment. During the third quarter, the U.S. Federal Reserve raised interest rates twice by a total of 150 basis points (1.50%). The increased rate differential between China and the U.S. and China’s worsening export outlook caused the Chinese renminbi to weaken against the U.S. dollar, falling below 7 for the first time since 2021. 

Performance Contributors and Detractors:

During the quarter, the Fund’s underweight and stock selection in the consumer discretionary and communication services sectors made the biggest contributions to relative performance. On the flip side, our stock selection in the energy sector was the biggest drag on performance during the quarter as oil and coal companies that we don’t hold performed well and our single energy stock, China Suntien Green Energy, experienced low utilization rates.

Among individual holdings, China Tourism Group Duty Free was the top contributor to absolute performance. We took advantage of the poor first day performance of the company’s Hong Kong IPO (initial public offering) and built a position at a significant valuation discount to the company’s A-shares which the Fund has held for a long time. AK Medical was another top contributor. The orthopedic implants-maker reported stronger-than-consensus first-half earnings and a national procurement tender result indicated that leading domestic players, such as AK Medical, may be poised to take significant market share from multinational national companies. Yangzijiang Shipbuilding also continued its strong first-half price momentum and was the third-largest contributor. A weaker renminbi is also usually positive for its business.

On the other hand, internet giant Tencent was the largest absolute performance detractor. The company reported its first ever drop in revenue as the Chinese economy weakened. However, with its cost-cutting measures and potential value crystallization from its large investment portfolio, we believe the stock deserves our long-term investment. Pharmaron Beijing, a leading contract research organization (CRO),  was the second-largest detractor as the company reported a weaker-than-expected margin for the first half. Given that management forecast a heavier investment in a new facility outside of China could continue to pressure margins we are carefully reevaluating the situation. Postal Savings Bank of China was also a big detractor as investors worried about homebuyer mortgage boycotting given the bank’s high exposure to home loans. We believe the concern is overdone as most of the bank’s loans are to the secondary home market.  

Notable Portfolio Changes:

We re-initiated a position in Alibaba Group as the valuation is too cheap to ignore, and we believe the company will benefit from a likely rebound in consumer spending some time next year. Alibaba has also been applying for primary listing status in Hong Kong and if successful, it could become accessible to mainland-based Chinese investors which could in turn give a boost to its share performance. We also added Hong Kong Exchanges & Clearing. Although there is tangible progress being made on the U.S.-China cross-border auditing inspection agreement we still believe many U.S.-listed companies could seek a dual listing in Hong Kong or upgrade to primary-listing status in Hong Kong to get increased access to the mainland-based investor pool. The exchange operator would be a big gainer from this trend in our view.

We exited our position in CK Hutchison, a Hong Kong conglomerate, as most of its businesses are facing strong headwinds. We also exited China Everbright Environment as its business performance didn’t meet our expectations and we sold out of Asymchem Laboratories as future international revenue growth may face increased uncertainty due to geo-political tensions.

Outlook:

Uncertain industry regulation, draconian real estate cooling measures and a zero-COVID policy have been the three largest challenges to China’s economic growth since last year. We believe the regulation risk to internet stocks is now largely behind us and the Chinese government is increasingly relaxing its restrictive property measures. A few cities have been pushing out policies to lure back property buyers as uncertainty over the economy and job security have made buyers hesitant about committing in the market.

It‘s now time for China to take a more pragmatic approach towards COVID and revive the mobility of its consumers. Hong Kong relaxed its COVID policy in September, essentially adopting a co-exist with the virus strategy. This could be a model for mainland China to adopt. If that happens it would bode well for our holdings positioned for a domestic consumption-led economic rebound. On the other hand, further delaying a re-opening of China could put its economy in a worse position and, given the recessionary threats to the global economy, China’s export markets would be hard pressed to help the economy recover.

Top 10 holdings as of September 30, 2022. Current and future holdings are subject to change and risk.

Average Annual Total Returns - MCDFX as of 09/30/2022