Period ended June 30, 2020
For the first half of 2020, the Matthews China Dividend Fund returned 4.02% (Investor Class), while its benchmark, the MSCI China Index, returned 3.58%. For the quarter ending June 30, 2020, the Matthews China Dividend Fund returned 19.18% (Investor Class), while its benchmark, the MSCI China Index, returned 15.37%.
Asia's markets experienced considerable volatility related the global COVID-19 pandemic, but Chinese equities generated the strongest returns in the region, as domestic Chinese sentiment gained strength on the back of a quick resumption of economic activity. China, along with South Korea and Taiwan, made considerable progress in flattening its curve of new virus infections in the reporting period. Amid strong returns, we also saw some volatility related to the Chinese government's amendment of national security laws in Hong Kong during China's annual gathering of its top legislative body, the People's Congress. Although the nature and legislative process of this law is arguably controversial, it was passed and became effective in Hong Kong on July 1, which attracted international attention and protests from Hong Kong citizens.
On the economic polices front, China's central bank refrained from adopting unconventional monetary policy tools such as Quantitative Easing and zero interest rate. It only guided down the benchmark lending rate by 10 to 20 basis points (0.10% to 0.20%) during April, while cutting the required reserve ratio to release liquidity from banking system. In terms of fiscal policy, the People's Congress adopted a budget with historical high fiscal deficit of 3.76 trillion renminbi, and for the first time, it breached 3% of China's GDP.
Performance Contributors and Detractors:
Stock selection made a significant contribution to relative performance in the first half of the year, with Hope Education Group, Tencent Holdings and Sun Art Retail Group contributing the most. Hope Education, a provider of educational services including training and knowledge point sharing, had very limited revenue impact from the COVID-19 outbreak, and the company also reported strong earnings. Tencent Holdings, the leading social media company in China has a wide range of product offerings including online games, mobile messaging and mobile payment. These offerings significantly gained their popularity during lock down and social distancing period in China. The Fund's third largest contributor was Sun Art Retail Group, China's largest hypermarket operator. Sun Art Retail benefited significantly from consumers stocking up on food and groceries and spending less time eating out. From a sector perspective, the Fund's significant underweight allocation to financials and security selection in real estate contributed most to the Fund's outperformance during the first half of the year.
On the other hand, Geely Automobile was the largest performance detractor as passenger car sales plunged due to the pandemic. However, we believe the company will continue to be a leader among China's domestic branded passenger car makers. However, the planned merger with its parent controlled Volvo Cars could impair its ability to pay dividends in the near future, thus we decided to exit the position. Security selection in communication services and industrials sectors also caused a significant drag to Fund performance during the first half of the year. Two of the top three detractors were China B share market listed industrial companies, Shanghai Mechanical & Electrical Industry, a leading elevator maker in China, and Guangdong Provincial Expressway Development, a regional toll road operator in Guangdong province. China's B share market, originally designed for only foreign investors, has been gradually marginalized as A shares are now accessible to global investors. However, there are still companies listed as B shares on the Shanghai and Shenzhen exchanges in foreign currency with sound fundamental while offering attractive dividend yields and valuations. But, due to the less liquid nature of the B share market, they could underperform further in a severe sell off.
Notable Portfolio Changes:
During the second quarter, we initiated a new position in Tsingtao Brewery, one of the oldest Chinese companies listed in Hong Kong. We believe Chinese beer industry is entering into a market share consolidation phase with top four market share leaders all focusing on premium products and profitability. In addition, for the first time of its history, Tsingtao Brewery launched a share based management incentive program to align management's interest with minority shareholders. We believe the positive industry dynamics and management incentive could revitalize one of the best known consumer brands in China. We also initiated a position in Zhongsheng Group Holdings, a large premium car dealership network operator in China to replace Geely Automobile.
During the quarter, we exited our position in Hua Hong Semiconductor as the company decided to cut its dividend to maintain financial flexibility. We also exited China Merchants Bank as we expect the liquidity injection by central banks both domestic and globally will impact commercial banks' ability to keep their profitability.
As China has started to recover its economic activity, its leaders have also been cautioning that the country is increasingly likely to be isolated politically and economically due to potential sanctions and diversification of global supply chain. “Internal Circulation” strategy of domestic consumption and home grown technology—key investment themes for us—has been proposed as potential solution. We believe these themes will become even more attractive investment areas.
In the meantime, we are encouraged to see China has not given up its effort to open further to the world. In June, the Chinese government announced some major policy initiatives to make Hainan Island a free trade port benchmarked to Dubai and Singapore. These include significantly increasing Chinese tourists' duty free spending limit, lowering corporate and personal income tax on the island to a low rate comparable to Hong Kong and Singapore and allowing more business areas for foreign investors to invest. These efforts could sow early seeds of a much freer open economy very much like China launching a few special economic zones along its coast 40 years ago.
As of 6/30/2020, the securities mentioned comprised the Matthews China Dividend Fund in the following percentages: Hope Education Group Co., Ltd., 3.0%; Tencent Holdings, Ltd., 7.6%; Sun Art Retail Group, Ltd., 2.2%; Shanghai Mechanical and Electrical Industry Co., Ltd. B Shares, 1.6%; Guangdong Provincial Expressway Development Co., Ltd. B Shares, 1.9%; Tsingtao Brewery Co., Ltd. H Shares, 2.6%; Zhongsheng Group Holdings, Ltd., 2.5%. The Fund held no positions in Hua Hong Semiconductor, Ltd.; China Merchants Bank Co., Ltd. or Geely Automobile Holdings, Ltd. Current and future portfolio holdings are subject to change and risk.