Period ended December 31, 2018
For the year ending December 31, 2018, the Matthews China Dividend Fund returned -9.98% (Investor Class), while its benchmark, the MSCI China Index, fell -18.75%. For the fourth quarter, the Fund returned -6.94% (Investor Class) versus -10.73% for the Index. The Fund began 2018 with a share price of US$17.61 for both the Investor and Institutional Classes, and shareholders who were invested throughout the year would have received total distributions of approximately US$1.61 (Investor Class) per share.
2018 was a year of turbulence for Chinese equities. Protracted U.S.—China trade tensions and rising U.S. interest rates became two significant overhangs for Chinese markets. In addition, China's financial de-leveraging campaign, which is designed to rein in excessive shadow-banking activities and to reduce systemic risk, nevertheless caused a near-term economic slowdown. A further worsening of sentiment stemmed from policy flip-flops that left investors casting doubts on some industries, such as education services and pharmaceuticals, which have long been perceived as benefiting from China's secular growth potential. Facing such external and internal headwinds, Chinese equity markets across domestic A-shares, listings in Hong Kong and U.S. American Depositary Receipts all suffered steep, double-digit losses.
Performance Contributors and Detractors:
Given the fragile market sentiment in 2018, those of our holdings that were in a good position to ensure earnings growth, generate healthy cash flow and maintain resilient balance sheets performed well during the downturn. Not surprisingly, the Fund's top three performance contributors for the year, CITIC Telecom International Holdings, HKBN and China Gas Holdings, all shared these characteristics.
On the contrary, companies with shorter track records of being publicly listed, as well as those that faced uncertain regulatory environments, performed badly. Hope Education Group, the Fund's top performance detractor, unfortunately fell into this category as it completed its IPO during the year. Its management team fell short in delivering on an acquisition that it had planned to complete before the IPO. This failure, combined with an uncertain regulatory environment for China's private education industry, led to its shares being sold off aggressively. We are closely monitoring the situation.
On a sector basis, stock selection in the newly created communication services sector contributed most to relative performance. Shares of telecom operators CITIC Telecom International and HKBN outperformed those of internet service companies in the sector. In 2018, our stock selection in the energy sector posed a drag as two small-cap energy companies underperformed their larger peers. Our small-cap holdings overall for the year, however, generated significantly more relative positive performance than our larger-cap holdings. This highlighted that a total return approach can be beneficial in selecting attractive investment opportunities even when small-cap companies face a challenging market environment.
Notable Portfolio Changes:
During the fourth quarter, we switched out one Chinese property management company for another. We exited A-Living Services and initiated a position in China Overseas Property Holdings. As valuations for the two companies neared the same level, we felt compelled to swap holdings in favor of the company that we believe has more organic growth potential.
In addition, we exited a few positions, including Sporton International and China Aviation Oil, as their total return potential no longer met our criteria.
Near-term market volatility is likely to remain elevated as investors grapple with a decelerating Chinese economy and a possible slowdown in U.S. GDP growth. Ironically, such reversals in growth trajectories might pave the way for removing two large external overhangs for Chinese equities—a full-blown trade war between China and the U.S. and U.S. dollar strength driven by monetary tightening. A dimmer growth outlook in China and the U.S. could add both incentive and a sense of urgency for the two nations to reach a deal. While the struggle between China and the U.S. goes well beyond just trade issues, a compromise that averts an all-out trade war could still significantly reduce market uncertainty. Similarly, if the U.S. dollar starts to weaken on the back of less hawkish U.S. Federal Reserve policy, emerging markets, led by China, could also start to recover. Chinese policymakers have already prioritized the stabilization of the country's economic growth with both fiscal policy support and more accommodating monetary conditions. A combination of the above policy outcome, together with a Chinese equity valuation that is already well below its long-term average after the 2018 sell-off, could set the stage for an equity market recovery.
As of 12/31/2018, the securities mentioned comprised the Matthews China Dividend Fund in the following percentages: CITIC Telecom International Holdings, Ltd. 4.0%; HKBN, Ltd. 3.7%; China Gas Holdings, Ltd. 1.9%; Hope Education Group Co., Ltd. 0.9%; China Overseas Property Holdings, Ltd. 2.0%. The Fund held no positions in A-Living Services Co., Ltd.; Sporton International, Inc.; or China Aviation Oil Singapore Corp., Ltd. Current and future portfolio holdings are subject to risk.