Period ended June 30, 2018
For the first half of 2018, the Matthews China Dividend Fund returned 3.10% (Investor Class), outperforming its benchmark, the MSCI China Index, which fell -1.69%. For the quarter ending June 30, the Fund returned 1.14% (Investor Class), outperforming its benchmark, which dropped -3.44%.
For much of the first half of the year, Chinese equity markets were marked by volatility amid some alarming headlines. There was muted response to the 2017 full year earnings reports for many Chinese companies, meanwhile, as the market already expected healthy earnings growth. In May, markets appeared encouraged by a possible deal between U.S. and China to avoid a trade war after a state visit to Washington by China's Vice Premier Liu He. Global equity markets climbed further in June following the historic summit meeting between President Trump and North Korean leader Kim Jong Un in Singapore. China's equity markets reversed into panic mode, however, when U.S.-China trade negotiations in Beijing did not bear fruit. With additional U.S. tariffs on US$50 billion of Chinese imports on the horizon, Chinese equities suffered heavy selling. Although China's domestic A-share market received an initial boost from the inclusion by MSCI indices, it ultimately lagged behind overseas-listed Chinese equities during the second quarter—again highlighting the risks involved in investing in this young market.
Performance Contributors and Detractors:
During the first half of the year, our security selection in the financials and consumer discretionary sectors contributed most to the Fund's outperformance versus its benchmark. Conversely, we continued to face challenges identifying health care sector firms that fit well with our investment criteria.
Hua Hong Semiconductor, a leading semiconductor foundry in China, was a top contributor to performance for the six month-period, amid sentiment that China would boost efforts to drive the growth of more domestically manufactured semiconductors following rising trade tensions with the U.S. In addition, a main competitor to Hua Hong raised its contract pricing significantly during this period, further exciting the market considering the industry's tight capacity levels. China Maple Leaf Educational Systems, an operator of private schools in China, was the second-best performance contributor to Fund returns for the year-to-date period. In fact, the entire for-profit education industry has done well year to date as more clarity on newly created industry regulation was introduced.
On the flip side, WH Group, a pork producer with significant operations in both the U.S. and China, became a visible casualty of trade war rhetoric. Although the company does not import U.S. pork to China by any meaningful amount, Mexico is a major destination for its U.S. exports. As Mexico introduced additional tariffs targeting U.S. goods, including pork, U.S. pork prices declined further. This could depress the company's profit margins for its U.S. business. We are closely monitoring this situation.
Notable Portfolio Changes:
During the second quarter, we initiated a position in SUNeVision, a data center operator based in Hong Kong. We believe demand for data centers will be very strong as businesses increasingly need these to locate their mission critical servers. These servers are used to transmit, store and analyze data that is undergoing explosive growth as consumers become increasingly reliant on smartphones and smart devices. As the largest data center owner in Hong Kong, SUNeVision should enjoy strong pricing power. We believe it benefits from the additional rental revenue from its newly completed data center. We also initiated a position in Sunny Friend Environmental Technology, a leading industrial and medical waste treatment company in Taiwan. We believe the company's strong safety track record will help it to successfully duplicate its business model in China, where the potential market size is much bigger, and upstream customers such as semiconductor companies also experience strong growth.
During the second quarter, we meaningfully trimmed our exposure to holdings in China's domestic A-share market. We exited our holdings in Midea Group, Shanghai International Airport and China International Travel Service. Although we like the business models of these companies, the high valuations for their stocks compelled us to take profits and deploy capital elsewhere.
The news flow around the prospects of a U.S.-China trade war is likely to weigh on markets over the near term. As we stated in our first-quarter commentary, this trade tussle could have broader economic and geopolitical implications. At this time, we are still cautiously optimistic about a resolution and have already seen many positive signs. Both Tesla and Ford, for example, have announced new investment commitments into China. In the case of Tesla, it would be the first time China allows a foreign car company to set up a wholly owned manufacturing facility on its mainland. For our strategy, we look for companies that can sustain and grow their earnings and dividends in this environment. Just like the executives making multi-billion dollar investment commitments in China, we also believe the potential return from the growth of a vast Chinese consumer market is too attractive to ignore.
As of 6/30/2018, the securities mentioned comprised the Matthews China Dividend Fund in the following percentages: China Maple Leaf Educational Systems Ltd. 1.6%; Hua Hong Semiconductor, Ltd. 2.6%; WH Group, Ltd. 2.1%; SUNeVision Holdings, Ltd. 1.3%; Sunny Friend Environmental Technology Co., Ltd. 1.5%. The Fund held no positions in Midea Group Co., Ltd, Shanghai International Airport Co., Ltd, China International Travel Service Corp., Ltd., Tesla, Inc. or Ford Motor Company. Current and future portfolio holdings are subject to risk.