Matthews China Small Companies Fund
Period ended September 30, 2019
For the quarter ending Sept. 30, 2019, the Matthews China Small Companies Fund returned 2.64% (Investor Class), outperforming its benchmark, the MSCI China Small Cap Index, which returned -7.88% over the same period.
Global markets struggled between positive and negative territory in the third quarter. While headlines on trade tensions remained negative, earnings generally were positive—thus keeping global markets in a trading range. Markets in Asia were generally weak and especially weak in Hong Kong where street protests negatively impacted investor sentiment. China also saw declines during the third quarter as the U.S. moved ahead with its tariff threats.
Economic data from China, however, were generally healthy. On the consumer end, value-added tax cuts and payroll tax reductions continued to drive positive effects on consumer spending, driving retail sales up 7.5% year-on-year in August. The targeted stimulus toward helping small to medium enterprises announced near the end of the second quarter also helped business sentiment. Both the Caixin China PMI for manufacturing and non-manufacturing PMI signaled continued expansion. Longer term, we still expect structural growth in China's economy—particularly among companies that benefit from an increase in domestic sourcing of key value-added components as the trade conflict may escalate.
From both a top-down and bottom-up perspective, we continue to anticipate long-term sustainable growth in the Chinese economy and in corporate earnings. The market's concerns over escalating trade tensions should, in our view, have little impact on China's smaller companies given their domestic focus and lower dependence on financial leverage.
Performance Contributors and Detractors:
During the third quarter, strong stock selection in the information technology and industrials sectors contributed to most of the Fund's outperformance versus the benchmark. The only drag on performance came from the real estate sector due to poor stock selection and our structural underweight.
Top contributors to Fund performance during the quarter included Silergy and Alchip Technologies, both semiconductor companies. Silergy is our top holding and is the largest fabless analog semiconductor company in China. Silergy has strong product, process and systems technologies to allow it to make integrated analog circuits for its clients' various needs. In a seemingly deglobalizing world, Silergy's scarcity value has emerged as China tries to become more self-sufficient. Although the semiconductor cycle is still far from a full recovery, we expect Silergy to gain share as the cycle recovers. Alchip helps semiconductor companies design their products and also has its scarcity value in this highly technical field. Alchip is a global leader in high-performance computing circuit design and also benefits from the structural growth in global data centers and China's domestic CPU (central processing units).
Asia Cement China and Joy City Property were the top detractors to Fund performance during the third quarter. Asia Cement China is a subsidiary of Taiwan's Asia Cement Corp. and a top producer of cement, concrete and other related products in China's Jiangxi, Hubei and Sichuan provinces. The cement industry continues to benefit from supply-side reform due to higher environmental considerations in China. The cement business also is relatively insulated from trade conflicts given the difficulty in profitably transporting such materials over long distances.
The stock retreated from record highs set in the second quarter of 2019 as the market was disappointed by the lack of infrastructure and housing stimulus. Joy City Property is a commercial property developer focused on creating malls that cater to the millennial generation of consumers. We hope to see more progress with parent-company integration, which has been disappointing thus far.
Notable Portfolio Changes:
During the quarter, we initiated a position in Koolearn Technology, which is the online education arm of New Oriental Education. The company has a strong brand, thus it has a more-competitive cost structure because most of the costs for its competitors are in marketing. Koolearn also benefits from policy changes that have negatively impacted its offline-education peers. Online education also has the benefit of better scalability, which ultimately may lead to better profitability opportunities. On the flipside of the same thesis, we exited our position in China Beststudy Education, a local offline tutoring company that was negatively impacted by regulation.
We remain optimistic about China's small-cap market amid heightened market volatility as we focus rigorously on the sound fundamentals of our portfolio companies. From a macroeconomic perspective, we believe China can stabilize its economy through fiscal spending, tax reform, interest rate adjustments and currency management. In addition, we believe that steps to correct China's structural issues are on the right track, despite the near-term pains of a deleveraging economy. We are focused on finding innovative and capital-efficient small companies that are relatively insulated from macroeconomic uncertainties. We will continue to seek companies with sustainable, quality earnings streams, strong cash flows and good balance sheets that can weather uncertain economic conditions. We believe sectors such as industrial automation, health care and technology are among the most attractive from a secular growth perspective.
As of 9/30/2019, the securities mentioned comprised the Matthews China Small Companies Fund in the following percentages: Silergy Corp. 7.3%; Alchip Technologies, Ltd. 1.5%; Asia Cement China Holdings Corp. 1.8%; Joy City Property, Ltd. 2.6%; Koolearn Technology Holding, Ltd. 1.0%. The Fund held no positions in China Beststudy Education Group or New Oriental Education & Technology Group Inc. Current and future portfolio holdings are subject to change and risk.
Investing in small- and mid-size companies is more risky than investing in large companies as they may be more volatile and less liquid than larger companies.
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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.