Period ended March 31, 2018
For the quarter ending March 31, 2018, the Matthews Asia Innovators Fund returned 4.16% (Investor Class), while its benchmark, the MSCI All Country Asia ex Japan Index, returned 0.70%.
Asia's markets continued their upward momentum in early January. Broad-based synchronized global growth across most developed countries and major Asian economies set the stage for a strong start to the quarter. Cyclical sectors including financials, energy and materials benefited from global growth trends. Volatility in global equity markets picked up, however, in the middle of the quarter. This volatility was fueled in part by U.S. interest rate increases, as well as the re-emergence of protectionist rhetoric in the U.S. The resulting correction in the U.S. stock market affected markets across Asia.
The fundamental health of the companies we invest in for the portfolio remains solid. Metrics we consider include earnings, cash flow and balance sheet analysis. While fundamentals remain sound, valuations for certain segments of innovation-driven companies are starting to look expensive. Growth companies tend to have higher valuations than the broader market, but these higher stock prices so far have been supported by strong earnings growth.
Performance Contributors and Detractors:
Our holdings in the health care sector made the largest contribution to the Fund's positive performance during the quarter. Jiangsu Hengrui Medicine, one of our top-performing securities during the quarter, is at the forefront of innovation in China's growing pharmaceutical industry. In our view, Hengrui has the potential to become a global pharmaceutical leader. China is already one of the world's largest pharmaceutical markets and it continues to expand its reach. Wuxi Biologics Cayman, another of our top-performing securities, provides clinical research services for many of China's leading drug manufacturers. Both companies are examples of the innovation driving earnings growth in China's health care sector.
Our largest detractor from performance during the quarter was BGF Retail, a convenience store operator in South Korea. Upcoming increases in South Korea's minimum wage have some investors worried that increased labor costs may hurt the company's bottom line. However, we remain optimistic about the company's long-term prospects. While a rising minimum wage may have some short-term impacts on profitability in the retail sector, we believe that rising wages will ultimately help increase consumption. In addition, we believe the company has a head start in an underdeveloped market segment with continued growth potential. The convenience-store model continues to evolve in South Korea and we expect to see growing demand for prepackaged foods as South Korea's middle class continues to expand.
Notable Portfolio Changes:
During the quarter, we subscribed to a couple of initial public offerings (IPOs), including China's GreenTree Hospitality, a chain of budget and mid-tier business hotels. As wages continue to increase in China, travel and tourism are greatly on the rise. We believe GreenTree Hospitality is well-positioned to capture demand for affordable travel lodgings across China. In addition, the offering price was very reasonable compared with industry peers already listed in the market. We also added to our position in DBS Group in Singapore, a pioneer in digital banking serving ASEAN markets, which include Indonesia, Malaysia, the Philippines, Singapore and Thailand. DBS Group has strong growth prospects and benefits from a large market share in digital banking services. We also sold our common shares in Samsung Electronics, a semiconductor manufacturer in South Korea, for the company's preferred shares. Overall, we are reducing our exposure to the semiconductor industry, which is cyclical in nature. We feel semiconductors are likely at the high end of the cycle, with little room for further growth.
Trade conflicts escalated during the quarter. If trade issues spin out of control, they would have a negative impact on global growth and global equities. To date, however, China has made measured responses. At the Davos World Economic Forum in January, for example, Liu He, China's top economic advisor to President Xi Jinping, voiced strong support for global trade. In our portfolio, we tend to invest primarily in sectors driven by domestic consumption, which may be more insulated from trade issues than export-driven sectors and hence less volatile.
Overall, corporate earnings in Asia improved over the past 12 to 18 months. Earnings growth, which started with cyclical sectors, including information technology, expanded to a broader range of sectors. In addition, elections cycles will pick up over the next two years in parts of Asia, including India, Indonesia, Malaysia, Taiwan and the Philippines. Elections could create volatility in the markets. At the same time, incumbent governments tend to increase spending during election cycles, which can be supportive of underlying fundamental demand and provide further support to earnings improvement.
Looking ahead, we see a healthy environment for equity markets with decent growth. We also expect reasonable valuations, backed by continued improvements in earnings. In our view, emerging markets may be poised for stronger earnings growth than developed markets. The U.S. Federal Reserve has signaled that it is likely to continue to raise short-term interest rates. Long-term borrowing rates continue to be stable, however, and should not disrupt the domestic economic cycle in Asia, especially given healthy consumer balance sheets. We believe that innovative companies are well-positioned to continue to benefit from rising wealth in the region, especially as consumers continue to upgrade their consumption patterns by seeking higher quality products and services.
As of 03/31/2018, the securities mentioned comprised the Matthews Asia Innovators Fund in the following percentages: Jiangsu Hengrui Medicine Co., Ltd., 4.2%; Wuxi Biologics Cayman, Inc., 2.9%; BGF Retail Co., Ltd., 1.9%; GreenTree Hospitality Group, Ltd., 1.8%; DBS Group Holdings, Ltd., 1.8%; and Samsung Electronics Co., Ltd., Pfd., 3.3%. The Fund held no positions in Samsung Electronics Co. Common Shares. Current and future portfolio holdings are subject to risk.