Matthews Asian Growth and Income Fund
Period ended September 30, 2019
For the quarter ending Sept. 30, 2019, the Matthews Asian Growth and Income Fund returned -3.86% (Investor Class), while its benchmark, the MSCI All Country Asia ex Japan Index, returned -4.39%.
Asian equities delivered disappointing performance in the third quarter as volatility remained elevated and markets dropped. Last year's tightening of monetary policy by the U.S. Federal Reserve is a distant memory as most central banks across the globe have begun to ease liquidity once again. A confluence of weakening growth in major economies, the length of this economic cycle, elevated debt levels and few signs of sustained inflationary pressure sparked this change in stance. Some of this slowdown and weakening in sentiment is due to continued geopolitical and trade tensions between the U.S. and China. These tensions escalated yet again in the third quarter with more tariffs and the U.S. Department of Treasury labeling China a “currency manipulator.”
This unhelpful backdrop alongside worsening protests in Hong Kong left few of the region's equity markets unscathed. Taiwan was the only market in Asia that finished the third quarter in positive territory as it is perceived as a trade war beneficiary with some technology companies keen to relocate manufacturing to the island.
Performance Contributors and Detractors:
The largest contributor for the third quarter was TSMC as the Taiwanese chip maker and world's biggest foundry is likely to be a beneficiary of continuing growth in silicon content. We expect the company to achieve double-digit earnings growth over the next few years as growth in leading-edge technology appears strong in areas such as high-performance computing and 5G technology. Further, TSMC's leading position may help to capture additional market share.
A couple of the portfolio's holdings within the consumer discretionary sector also rose strongly during the quarter. Minth Group, a Chinese auto parts supplier, saw previous price weakness reverse as the outlook for earnings improved. Despite a challenging auto market globally, Minth's client portfolio in China appears better-positioned than some, while it is growing in Europe through rising penetration and it has a number of new product launches to come. Australia-based Domino's Pizza Enterprises also gained. The stock similarly had been weak as the market had concerns over franchisee profitability in Australia. The company plans to improve this through increasing the rate of stores per franchisee, however, while the outlook for growth in Europe is strong on improving margins and increasing store counts. Elsewhere, Bank of the Philippine Islands was another stock that gained meaningfully over the quarter with management pushing further into the superior yields offered by consumer lending, which should help to drive double-digit earnings growth.
Amid the protests in Hong Kong, a number of the portfolio's weakest performers came from the city-state. AIA Group was the largest detractor as concerns pervade that its value of new business will be hit in the near term as cross-border sales from mainland China come under strain due to a lower number of visitors to Hong Kong. Similarly, shares of London-domiciled life insurer Prudential sputtered on concerns over Hong Kong and the implications of Brexit.
A couple of the portfolio's domestic Chinese consumer staples companies were also weak during the quarter. Yili Industrial Group delivered weak second-quarter results as increased raw material prices and staff costs weighed on operating profit despite solid revenue growth. Jiangsu Yanghe Brewery also dropped on weaker-than-anticipated earnings. The company's second-quarter revenue growth disappointed at only 2% year-over-year as it struggled in its home market with rising competition. We will continue to monitor these trends.
Notable Portfolio Changes:
With continued market volatility, the portfolio remained reasonably active as market dislocations created opportunities. The Strategy added six new holdings during the third quarter, with four of these in India. We have long had challenges in marrying valuations and growth expectations with the reality of cash-flow growth in the Indian market, but recent weakness allowed us to buy shares of a number of leading companies at appealing valuations. Further, we believe that the decrease in tax rates, partial recapitalization of the state banking system and planned state bank mergers are significant positive reforms by the government, albeit we accept that recent tumult in the non-bank financial company sector will likely constrain growth and liquidity for the economy in the near term.
The first of these additions was Sanofi India, the local subsidiary of the French pharmaceutical company. We believe that the company has solid growth opportunities driven by its leading brands in high-growth markets such as diabetes. Although not cheap, shares were at a discount to peers despite an attractive portfolio, an impressive operational track record and a strong balance sheet. ITC, the leading domestic tobacco company, was another addition as the stock was trading at an attractive 19x P/E. This is roughly 1.5x standard deviations below average, despite what we believe to be a return to growth in combustible volumes and a potential improvement in the profitability of its fast-moving consumer goods business. We also added two real estate investment trusts, Ascendas India Trust and Embassy Office Parks. Both are office-park owners, and we believe that the market is attractive as debt costs and competition for assets drop. We believe both are excellent operators, have a strong growth outlook on development and rental reversions, and pay attractive dividend yields of 5% and 5.8% respectively.
Amid the protests, we bought a position in local bank BOC Hong Kong as valuations appeared detached from fundamentals with the stock offering a 5.9% dividend yield. Finally, we added a convertible bond holding in Luye Pharma. We believed the security to be undervalued given that it is strong credit offering a 2.6% yield and a 50% delta on an underlying equity trading at only 11x P/E. Although historically reliant upon its oncology drug Lipusu, the company has expanded its pipeline into a broader suite of therapeutic areas. These new holdings were funded through exiting exchangeable bond CP Foods and Japanese consumer staples company Kao Corp.
Looking ahead, major monetary and political decisions likely will create further volatility for risk assets. Unintended consequences of a decade of unorthodox monetary policy continue to present themselves, while rising populism and the prospective retrenchment of globalization are areas for concern. At the forefront is the trade war between the U.S. and China. For Asia, this is further compounded by protests in Hong Kong, which are likely to weigh on domestic growth in the near term. Added to this are weakening PMIs globally, with some of Europe at risk of recession and the scale of negative-yielding debt instruments a symptom of the globe's challenges.
The microeconomic climate has not been shielded from such problems. Earnings estimates for the Asia ex Japan region have been cut once more and are now expected to demonstrate no growth for 2019.
As fiduciaries aiming to protect and grow our clients' wealth, we don't claim to know better than others how these major issues will be resolved. We continue to believe, however, that such an environment is fruitful for a strategy such as ours. As we often write, volatility is a friend to active managers as dislocations provide opportunities. We remain focused on using these dislocations to buy quality companies that can continue to grow earnings and, more importantly, cash flow even against such a weak backdrop. Businesses with strong moats, solid balance sheets, capable management teams, sensible capital allocation policies and good corporate governance standards can use this environment to solidify their positions. Further, our keen eye on income generation also creates a more visible avenue to producing returns as we look to provide a portfolio that balances both growth and income.
As of 9/30/2019, the securities mentioned comprised the Matthews Asian Growth and Income Fund in the following percentages: Taiwan Semiconductor Manufacturing Co., Ltd. 4.0%; Minth Group, Ltd. 1.3%; Domino's Pizza Enterprises, Ltd. 1.3%; Bank of the Philippine Islands 1.6%; AIA Group, Ltd. 3.4%; Prudential PLC 1.6%; Inner Mongolia Yili Industrial Group Co., Ltd. 1.4%; Jiangsu Yanghe Brewery Joint-Stock Co., Ltd. 1.5%; Sanofi India, Ltd. 1.3%; ITC, Ltd. 1.2%; Ascendas, REIT 1.7%; Embassy Office Parks, REIT 0.6%; BOC Hong Kong Holdings, Ltd. 1.0%; Luye Pharma Group, Ltd., Cnv., 1.500%, 07/09/2024 1.0%. The Fund held no positions in CP Foods Holdings, Ltd., or Kao Corp. There are no guarantees that any company will increase or continue to pay a dividend. Current and future portfolio holdings are subject to change and risk.
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The views and opinions in this commentary were as of the report date, subject to change and may not reflect 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.
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. Neither the funds nor the Investment Advisor accept any liability for losses either direct or consequential caused by the use of this information.