Period ended December 31, 2018
For the year ending December 31, 2018, the Matthews Asia Small Companies Fund returned -18.05% (Investor Class), while its benchmark, the MSCI All Country Asia ex Japan Small Cap Index, returned -18.63%. For the fourth quarter, the Fund returned -8.85% (Investor Class), while its benchmark returned -8.35%.
Throughout most of 2018, market sentiment was dominated by macroeconomic factors. Ongoing U.S.—China trade tensions were arguably the main drivers of global market volatility. U.S protectionist trade policies that were expected to be one-off in nature had intensified, resulting in retaliatory gestures between the two countries. Such negative developments posed further challenges in gauging the prospects of corporate profits in the Asia region. China's economic slowdown was also a headwind. Discretionary spending on large-ticket items, such as autos and home furnishings, experienced noticeable weaknesses in China. During the third quarter of 2018, market sentiment toward Chinese equities soured even more as many of China's domestic policies toward regulating certain domestic services industries were deemed unfriendly to markets.
Meanwhile, the U.S. Federal Reserve continued to raise interest rates in 2018. Emerging market equities and currencies were hit hard as the strengthening U.S. dollar put further stress on some emerging market countries such as Argentina and Turkey. Within Asia, India's rupee and Indonesia's rupiah were among the worst-performing Asian currencies due to their capital account deficits and reliance on imported oil. In India, domestic liquidity in its financials sector tightened further since September following a default on a bond payment by a leading infrastructure finance company.
Performance Contributors and Detractors:
The Fund experienced some outperformance in the first half of the year; most of the portfolio holdings, however, saw their stock prices suffer along with the broader market during the second half of the year.
The largest absolute detractors to performance were our holdings in Taiwan as they were impacted by supply-chain weakness among handset hardware firms as well as slowing demand for their respective products in the uncertain trade environment. There were also some negative company-specific developments in some holdings elsewhere in the region. CLIO Cosmetics, for example, was a major detractor to performance in 2018. South Korean companies generally have suffered from poor sales in China due to geopolitical tensions, and CLIO Cosmetics was impacted consequentially. Performance among our Southeast Asia holdings was also hit by concerns over the economic growth outlook both locally and globally. Meanwhile, select holdings in China, South Korea and India generated decent absolute returns in a challenging market environment thanks to the defensive nature of their businesses.
By sector, our holdings in consumer discretionary, real estate, and industrials hurt relative performance due to their sensitivity to economic slowdowns. Our stock selection and overweight in information technology, health care and financials, however, benefited relative performance.
Notable Portfolio Changes:
We exited a number of highfliers in health care and information technology to lock in profits during the first half of the year. We exited Hutchison China MediTech, a China-based pharmaceutical company, and GDS Holdings, a China-based data center operator, after strong run-ups in share prices where we believed the valuations had become rich relative to company fundamentals. We initiated a few new holdings in Vietnam during the year as we identified attractive companies that are leveraged to structural growth trends in the country. Saigon Cargo Service is one of Vietnam's leading air cargo handling operators. The company grew its customer base in Vietnam's busiest airport, Tan Son Nhat International in Ho Chi Minh, and also expanded its profitability due to efficiency improvements.
In the second half of the year, we also exited positions in companies across multiple sectors where we believed the growth outlook was compromised. We took profits and reduced our exposure to India's non-bank financial companies such as Cholamandalam Investment and Finance as we believed the liquidity and asset-quality profile of the sector turned less favorable. However, we are still constructive on some Indian companies on a bottom-up basis, especially companies with predictable and recurring revenue streams. In the fourth quarter, we initiated a position in Galaxy Surfactants, an Indian manufacturer of specialty chemicals for personal-care products. We are constructive on the company's positioning in supplying to reputable fast-moving consumer goods (FMCG) companies domestically and abroad. We believe the company's long-term growth trajectory is promising.
The outlook for global growth has turned increasingly negative amid uncertainties over U.S.—China trade tensions and the impact of higher U.S. interest rates. We are cautious about various macroeconomic factors impacting corporate profits and the heightened capital market volatility. As such, we maintain our bias toward companies with strong balance sheets and cash flows, as well as business models that are not overly capital-intensive. That said, China has since taken steps to stabilize its internal markets through fiscal and monetary policies and currency management. We are hopeful that structural growth drivers for China's private sector such as domestic consumption, productivity improvements and innovations in the fields of science and technology remain sound.
In 2019, key elections are slated to take place in Thailand, Indonesia and India. There could be volatility leading up to the events or related to the election outcomes, which we will monitor and assess in terms of the implications for company fundamentals.
On the positive side, valuations of many high-quality, small-cap companies have turned attractive after the recent market correction, which should present opportunities for long-term investors. We believe that after an extended period of negative macroeconomic news surrounding global markets, investor expectations are very low. We will continue to seek growth companies with sound fundamentals and management teams that can weather short-term challenges and emerge stronger in the long term.
As of 12/31/2018, the securities mentioned comprised the Matthews Asia Small Companies Fund in the following percentages: Saigon Cargo Service Corp. 1.8% and Galaxy Surfactants, Ltd. 1.4%. The Fund held no positions in Hutchison China MediTech, Ltd.; CLIO Cosmetics Co., Ltd.; GDS Holdings, Ltd. and Cholamandalam Investment and Finance Co., Ltd. Current and future portfolio holdings are subject to risk.