Period ended June 30, 2020
For the first half of 2020, the Matthews Pacific Tiger Fund returned -4.73% (Investor Class), while its benchmark, the MSCI All Country Asia ex Japan Index, returned -4.65% over the same period. For the quarter ending June 30, 2020, the Fund returned 20.35% (Investor Class), while the benchmark returned 16.79%.
Asia's markets experienced considerable volatility stemming from the global COVID-19 pandemic with significant decline in capital markets in the first quarter followed by a sharp recovery in the second. As the efforts to contain the spread of the virus are starting to take hold, especially in North Asia, the narrative is clearly shifting from survival to the revival in many of these economies. While most of the country-specific indices and currencies recovered from the sharp drop in the first quarter, there remained noticeable bifurcation between sectoral indices with health care, technology and consumer discretionary being the best performing, and real estate and utilities barely recovering. This dynamic reflects a world of intangible investments, automation, and low to zero interest rates.
Chinese equities generated the strongest returns in the region on the back of expectations around a return to normalcy in economic activity. The continued recovery and unattractiveness of other investing alternatives is drawing investors into China's equity markets, albeit the participation is still narrowly focused on a select group of sectors. Towards the end of the quarter, expectations have started to build around greater infrastructure spending as is being reflected in some of the high frequency indicators, but the Chinese government remains mindful of the risks stemming from excessive stimulus.
South Korea and Taiwan also made considerable progress in flattening their curves of new virus infections in the reporting period. South Korean equities were roughly flat on fears of slowing global growth. Korea's valuations are some of the region's most attractive although a significant shift in corporate capital allocation decisions may be needed for a sustained rerating of equities. Meanwhile, Taiwanese equities are well positioned to benefit from the increasing adoption of technology in everyday lives.
Elsewhere, equity prices in parts of south and Southeast Asia—including India, Indonesia, the Philippines and Thailand—suffered as investors feared a slower recovery from the pandemic for these economies, in spite of a partial recovery in the second quarter. Less developed parts of Asia have had a harder time flattening their rates of new infections. And smaller government balance sheets may allow for less fiscal and monetary stimulus. However, we continue to see these economies playing a vital role in Asia's growth over the long term.
Contributors and Detractors:
In the first half, the Fund's performance was roughly in line with its benchmark. The portfolio's overweight to India and Indonesia detracted from performance in the first half. From a sector perspective, stock selection in health care and real estate detracted from performance. Turning to contributors, strong stock selection in China was additive to relative performance. China's equity markets experienced a notable rebound in the second quarter as sentiment improved on progress toward containing the spread of COVID-19 in China.
In the second quarter, the Fund outperformed its benchmark, primarily driven by strong stock selection. Stock selection in China and South Korea contributed to relative performance. In China, domestic tourism is starting to resume, consumer spending is recovering and businesses are looking for improved productivity solutions, trends that benefited portfolio holdings. In South Korea, portfolio holdings benefited from the potential for increased demand for IT solutions and online games and entertainment. Meanwhile, stock selection in India and Indonesia detracted from performance in the second quarter. Consumer spending in India and Indonesia was particularly weak amid pandemic. Many of the portfolio's consumer-related stocks, while generated positive absolute returns in the quarter, trailed the benchmark.
Among individual securities, a contributor to relative performance in the first half was Hong Kong Exchanges & Clearing Ltd. The prospect of dual listing for some of the larger Chinese companies currently listed in U.S. exchange, coupled with continued capital raising by mainland Chinese companies may lead to greater trading volumes on the exchange. The portfolio's holdings in Indian financials HDFC Bank and Kotak Mahindra Bank were the biggest detractors from relative performance in the first half as worries about the impact of the lockdown on banking balance sheets weighted on investor sentiment.
Notable Portfolio Changes:
From a country perspective, the Fund's exposure to China has continued to increase during the first half with new additions, especially in the first quarter. From a sector perspective, we continue to add exposure to consumer discretionary, industrial businesses and IT. With new types of companies emerging within IT across Asia, we are interested in companies that compete on intellectual property, companies with strong competitive moats and companies that capture the growth of consumer spending.
In the second quarter, we initiated a position in Tata Consultancy Services, a leading IT services company with clients in a variety of economic sectors. The company remains well positioned to help their clients navigate the journey towards higher digitization in their businesses, and has been able to secure larger-sized deals which create a moat for the company. We also exited Surya Citra Media Tbk PT, an Indonesian mass media company. Although the company remains a respectable player in the market with leading market share, we believe the overall shift from TV to digital advertising is a significant structural headwind for the company. While it has taken steps to address this shift to digital it was hard for us to see meaningful progress going forward, given the competitive environment. As such, we decided to exit our position in order to pursue other opportunities.
The pace of recovery from economic lockdowns across Asia varies by geography. In some parts of Asia like China, the worry is about a potential second wave, while in other countries like India, the first wave still continues unabated. These challenges can act as a stimulant for structural reforms. China continues to open up the capital markets to allow for greater flow of capital across borders and ease the constraints for companies to access funding. In India, there has been an effort on the part of the government to deregulate the agricultural market, and some state/local governments have also eased onerous labor provisions.
In addition to the health care and economic challenges, the political climate has also deteriorated with tensions between the U.S. and China ratcheting up as we close in on U.S. elections in November. It is hard to predict the course of actions by either administration. But from an economic standpoint, China has become increasingly self-sufficient, with the ability to drive economic growth within the country although sectors like technology are still dependent on critical imports. The portfolio's Chinese holdings are less exposed to trade between the U.S. and China.
In spite of all the above headwinds, it is encouraging to see a steady recovery in economic activity in countries like China, South Korea, and Taiwan—all of which have benefited from decisive action early on in controlling the spread of the virus. However, equity markets remain quite focused on sectors like IT, consumer discretionary, and communication services. This reflects a conundrum whereby there is a clear and widening gap between stocks in the top quintile and bottom quintile of valuation multiples. Some of this dichotomy may be justified as there continues to be considerable change in corporate Asia, which may favor those companies with access to capital and a willingness to embrace technological disruption. At the same time, as economic recovery strengthens, there may be an opportunity in a broader variety of sectors, which may have been ignored so far. We continue to remain vigilant for such opportunities in businesses that are capable of sustained growth with good profitability and cash flows.
As of 6/30/20, the securities mentioned comprised the Matthews Pacific Tiger Fund in the following percentages: Hong Kong Exchanges & Clearing Ltd., 3.9%; HDFC Bank, 0.2%; Kotak Mahindra Bank, Ltd., 1.4%; Tata Consultancy Services, Ltd., 0.5%. The Fund held no positions in PT Surya Citra Media. Current and future portfolio holdings are subject to change and risk.