Matthews China Small Companies Fund


Period ended March 31, 2020

For the quarter ending March 31, 2020, the Matthews China Small Companies Fund returned 10.52% (Investor Class), outperforming its benchmark, the MSCI China Small Cap Index, which returned -13.19%.

Market Environment:

The COVID-19 pandemic created significant disruption to businesses around the world. Equity markets reflected this fear. Governments around the world reacted quickly to falling asset prices by providing strong monetary and fiscal support. Although there are still no proven cure or vaccines for COVID-19, social distancing measures taken by various countries seem to flatten out the curve. This gives us a glimmer of hope in managing this pandemic going forward. 

Without COVID-19, China was on track for a strong earnings recovery 2020 after a first phase trade deal was signed by China and the U.S. in January 2020. Business spending, which was muted for three years due to the U.S. - China trade conflict, was set to rebound and domestic consumption continued to be strong. The recovery in 2020 was disrupted by COVID-19 briefly. Given China's quick response to quarantining the epicenter city of Wuhan and other high-infection rate cities, businesses in China have largely resumed work. The government has also put into place targeted stimulus towards elevating small to medium business cash flow disruptions with easier access to loans and reduced tax burdens. Overall, we expect gradual recovery in business activity in China for the rest of the year. 

From both a top-down and bottom-up perspective, we anticipate long-term sustainable growth in the Chinese economy and in corporate earnings. Market concerns over trade disruption 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 first quarter, strong stock selection in the health care, consumer discretionary and information technology sectors contributed the most to the Fund's outperformance versus the benchmark. Our significant overweight in health care also benefited our performance. There were no significant drags on performance during the first quarter. 

Top contributors to Fund performance included CanSino Biologics and China Youzan. Both companies saw increased demand for their products during COVID-19. CanSino is a top vaccine manufacturer in China. It has a strong track record in in developing vaccines for infectious diseases. CanSino developed the first China Food and Drug Administration approved Ebola vaccine and is currently enrolled in global clinical trials for the COVID-19 vaccine. Longer term, the company has a strong pipeline of pneumonia and pediatric vaccines. We believe CanSino will continue to execute well to deliver shareholder value. China Youzan, a top ecommerce software-as-a-service (SaaS) company in China, helps businesses create various online storefronts and tools to help attract and retain end consumers. It also offers ERP (enterprise resource planning) software to help these businesses with ongoing operation online or offline. The company also has payment licenses in China to facilitate business tractions. The COVID-19 pandemic has quicken the pace of connecting the real world to the digital economy. We expect China Youzan to benefit longer term from this structural trend. 

Asia Cement (China) Holdings, SITC and Yuexiu Transport were the top detractors to Fund performance during the quarter. Asia Cement (China) suffered from reduced construction demand during COVID-19. It also paid a high dividend which could be at risk of a dividend cut if construction activity continues to remain weak. However, given the government's intention to stimulate the economy, we expect modest recovery into the second half of the year. SITC is an integrated shipping logistics company that focuses only on routes within Asia. Given the disruption to trade and manufacturing during the COVID-19 pandemic, business activity have been hurt. We trimmed our position early in the year after signs of COVID-19 spreading outside of China. Longer term, we believe SITC is still one of the best shipping logistics companies in Asia. Yuexiu Transport operates expressways in China and had to discontinue tariff collection temporarily for its assets in Hubei province where COVID-19 originated. We also trimmed our exposure to Yuexiu Transport until we have better visibility on when the company can resume tariff collection and how it could be compensated for its loss in tariff collection.

Notable Portfolio Changes:

During the quarter, we initiated positions in Airtac International and Winning Health Technology. Airtac is a leading automation component company in China with a strong market position in pneumatic components. The company is well positioned in 5G infrastructure equipment automation and should benefit from continued general machinery automation demand post COVID-19. As labor costs and labor productivity are key areas of operational improvement for Chinese businesses, we believe Airtac stands to benefit from this structural trend. Winning Health Technology is the largest hospital information management software provider in China. It helps hospitals digitalize patient records and hospital assets. It also has business lines to profit share from online hospital services. After COVID-19, we expect to see more government focus towards strengthening China's health care infrastructure, and in particular the documentation and reporting of data. This will accelerate the already secular growing business of Winning Health Technology.

During the quarter we exited our position in Honma Golf, a luxury golf brand that originated in Japan. The company struggled with the headwind of a sluggish golf-equipment market, despite its success in signing Justin Rose as its sponsored golfer. The company's turnaround was slower than our expectations and we expect the COVID-19 pandemic to have a material impact to the company's financials. 

Outlook:

We remain optimistic about China's small-cap market amid heightened market volatility as we continue to focus rigorously on the sound fundamentals of our portfolio companies. From a macroeconomic perspective, we believe China can stabilize its economy through monetary flexibility, 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. 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, consumer, health care and technology are among the most attractive from a secular growth perspective.

As of March 31, 2020, the securities mentioned comprised the Matthews China Small Companies Fund in the following percentages: CanSino Biologics, Inc. H Shares 2.6%; China Youzan. Ltd. 3.1%; Airtac International Group 1.6%, Winning Health Technology Group Co., Ltd. A Shares 1.4%. 

The Fund held no positions in Honma Golf, Ltd. 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.