Period ended June 30, 2019
For the first half of 2019, the Matthews Asia Small Companies Fund returned 12.65% (Investor Class), while its benchmark, the MSCI All Country Asia ex Japan Small Cap Index, returned 5.34%. For the quarter ending June 30, the Fund returned 2.89% (Investor Class), outperforming its benchmark, which returned -2.94%.
Asia's equity markets and investor sentiment were strong during the first four months of 2019 due to optimism over a resolution in trade talks between the U.S. and China. Developments took a negative turn, however, as President Trump threatened to impose certain tariffs on Chinese goods, as well as certain restrictions on the trading of technology products and services. China announced it would increase tariffs on U.S. goods in response. The escalated tensions led to immediate sell-offs in global markets. In addition, investors braced for the possibility that prolonged political and economic conflicts would weaken the global economy. Hopes for interest rate cuts by the U.S. Federal Reserve grew as recent economic data in the U.S. suggested that the economy might have softened, while investors awaited positive news from negotiations between Trump and President Xi during the late June G-20 summit.
Meanwhile, national elections in Indonesia and India concluded during the second quarter of 2019. As anticipated in Indonesia, President Joko Widodo (Jokowi) won by a wide margin. For his second-term agenda, it is expected that he will act rapidly on major policies aimed at improving efficiencies in the economy and conducive to attracting foreign direct investments (FDI). In India, a major overhang on its equity market was removed following its late May election, which saw a victorious ruling National Democratic Alliance (NDA) led by Prime Minister Narendra Modi.
Performance Contributors and Detractors:
During the first six months of 2019, the portfolio's absolute return was largely driven by both our overweight and stock selection in China/Hong Kong. Favorable stock selection in South Korea, Taiwan and India were also key factors that helped propel solid absolute performance, especially amid the market sell-offs in the second quarter. For the first six months, our China/Hong Kong holdings Yihai International and Times China Holdings were key performance contributors. Yihai, a hotpot soup-based condiment manufacturer, registered a strong run-up thanks to solid earnings momentum. Likewise, real estate developer Times China impressed investors with solid earnings and project pipelines. However, some holdings in Vietnam and Malaysia were performance detractors due to an uncertain outlook that stemmed from negative corporate developments during the first half of 2019. Vietnam's Yeah 1 Group, a media platform company, experienced operating issues with a subsidiary, which stood to adversely impact the company's growth momentum. The company's share price fell sharply and we exited the holding during the first half of the year.
By sector, our overweight and stock selection in health care, industrials and consumer staples were key drivers for our outperformance over the benchmark, while some holdings in the communication services sector lagged. Our health care holding, Procter & Gamble Health, performed strongly in the first half of the year thanks to stable demand in India for vitamin supplements and over-the-counter medicines. Within the information technology sector, South Korea's Café24, an e-commerce platform enabler, experienced sharp drops in share price and contractions in valuations multiples. While the domestic business was growing well, investors were wary of its investment in overseas expansion plans that have eroded earnings in the short to medium term.
Notable Portfolio Changes:
During the second quarter, we initiated a few positions in China A-share holdings. One new such addition was application software firm Glodon, which focuses on construction engineering and project cost management verticals. We believe there will be a growing need for digitalization in China's construction industry and are favorably disposed toward Glodon's early mover advantage and willingness to make investments in cloud services. We also initiated a position in Innovent Biologics, a China-based biopharmaceutical company, during the market sell-off. Valuations became attractive while company fundamentals remained solid. We are constructive on the company's long-term prospects, namely its drug pipeline and commercialization plans. We did, however, exit China Yuhua Education due to growing uncertainty over the company's capital allocation decisions and acquisition strategy. In India, we exited auto parts maker Gabriel India due to lack of growth visibility as the end demand in the automobile market continued to soften. With the proceeds we selectively added to existing Indian holdings when we saw share price weakness to build up our positions.
In Indonesia, we initiated a position in Sarimelati Kencana, a master franchisee of Pizza Hut in Indonesia. While the company has been publicly listed for just over a year, it actually has been operating for decades. We like the company because it enjoys strong brand recognition and an ability to expand its store network methodically. We believe that the company is well-positioned to capture the demand of the country's young demographic.
With major elections having concluded without surprising outcomes in Thailand, Indonesia, the Philippines and India, investors now seem likely to focus on corporate earnings and economic fundamentals. Trade tensions between the U.S. and China may continue to cause market volatility, but we believe that many domestically oriented businesses in Asia could present opportunities for long-term investors as their revenue streams are tied to structural growth in domestic demand propelled by digitization and connectivity. With this backdrop, we have built a portfolio of holdings that possess strong market positioning and sound financial health. We believe that they are well-positioned to grow with a niche focus. We are hopeful that there will be plenty of attractive investment opportunities for us to uncover as market expectations are not currently elevated.
Looking ahead, the trajectory of U.S.—China relations remains unpredictable as the two countries work through conflicts. We are mindful of challenges, such as the impact on consumer sentiment and corporate spending cycles. We remain constructive, however, on China's solid prospects for transitioning its economy to one that is more service-oriented. We believe this will help mitigate external shocks. China continues to strengthen due to innovation occurring in its health care and technology sectors, as well as the expansion of its digital economy. In spite of an uncertain geopolitical backdrop, we continue to focus on selecting companies that possess the attributes that can lead them to grow and compound in size over the long term.
As of 6/30/2019, the securities mentioned comprised the Matthews Asia Small Companies Fund in the following percentages: Yihai International Holding, Ltd. 1.6%; Times China Holdings, Ltd. 1.3%; Procter & Gamble Health, Ltd. 1.6%; Cafe24 Corp. 0.9%; Glodon Co., Ltd. 1.1%; Innovent Biologics, Inc. 0.9%; and PT Sarimelati Kencana 1.0%. The Fund held no positions in Yeah1 Group Corp.; China Yuhua Education Corp., Ltd. and Gabriel India, Ltd. Current and future portfolio holdings are subject to risk.