Period ended June 30, 2019
For the first half of 2019, the Matthews India Fund returned 2.28% (Investor Class) while its benchmark, the S&P Bombay Stock Exchange 100 Index, returned 8.52%. For the quarter ending June 30, the Fund returned -3.06% (Investor Class), while its benchmark returned 1.78%.
India's equity markets were somewhat more volatile during the second quarter of the year compared to the first quarter. We continued to see investors pull funds out of small- and mid-capitalization stocks in favor of large capitalization stocks.
Earlier in the year, India's general elections were conducted over seven phases, spanning about six weeks and concluding with the victory of Prime Minister Narendra Modi's party by a decisive mandate. Stock market reaction after Modi's party easily secured a majority in the lower house of parliament was relatively muted, suggesting that markets were already discounting Modi's success.
The Reserve Bank of India (RBI), the country's central bank, continued with monetary policy easing, cutting repo rates twice during the second quarter amid benign consumer inflation and a softer economic growth rate. The U.S. Federal Reserve indicated a more accommodative monetary policy stance and also allowed the RBI greater freedom to bring down policy rates.
India's financials sector continued to witness tight liquidity on the back of solvency concerns for some non-banking financial (NBFC) firms. Lack of funding to NBFCs has negatively impacted asset financing across the country. This, in turn, has contributed to slowing GDP growth. Thus far, the central government has been averse to infusing capital in these failing NBFCs, a prudent decision in our view.
Performance Contributors and Detractors:
The Fund's underperformance during both the second quarter and year-to-date periods could be attributed to a mix of challenges with stock selection and allocation. India's small- and mid-cap equity markets had underperformed for quite some time and the portfolio's higher allocation to these segments contributed to the relative underperformance versus the benchmark. Also, our exposure to a few banks with significant exposure to risky assets such as infrastructure leasing and financial services firms was a performance detractor. One such holding was Yes Bank. We had hoped that the bank's change in management as well as increased scrutiny by the central bank would improve its governance and accounting transparency. However, it had brought forward hitherto undisclosed risk exposure, which led to the stock's significant underperformance. While we believed the current management had the right intentions, we exited our position as we became more wary of the holding amid its crisis of liquidity and solvency. We also trimmed our exposure to IndusInd Bank, where the problem was less pronounced but our conviction in the management's ability to deliver secular and profitable growth was shaken.
Another stock-specific challenge to the portfolio during the second quarter came from our position in Blue Dart Express, India's leading express logistics provider. Blue Dart has not benefited enough from the growth in e-commerce, where it had underinvested in expanding its last-mile reach compared to certain start-up competitors. In recent quarters, the company began to try to rectify the situation by investing more toward this end, and this led to its underperformance. This was driven by a margin contraction, part of which we believe should recover.
The Fund's underperformance in the second quarter was partly mitigated by our avoidance of energy stocks, and stock-specific factors within the communication services and health care sectors. Within communication services, we have avoided stressed media and telecom companies. Instead, we held Info Edge India, a profitable and growing internet company. Within health care, we initiated a new position in Syngene International, a leading clinical contract research organization that has been able to build a track record of quality outsourced custom research within small molecules. While Syngene is not immune to pricing pressures, its business is quite sticky and underpenetrated, leaving enough headroom for profitable growth.
Notable Portfolio Changes:
We exited Yes Bank and Emami during the second quarter. We had long held our position in Emami but had been trimming it over the years due to rich valuations amid deteriorating fundamentals. During the first half of the year, we sold out of the holding completely as we felt that the company's internal systems and practices were not robust enough to deal with certain external shocks, including India's demonetization program, the Goods and Services Tax and recent liquidity issues in the financial sector.
In addition to Syngene, we also initiated new positions in certain small-cap financial companies led by strong management in underpenetrated segments, and in Lupin, a transnational pharmaceutical firm. Lupin's stock price underwent substantial correction due to certain FDA observations in its plants, which also affected its approval for new molecules in the U.S. market. The company has, however, increased its addressable market size within the domestic market using innovation and by building relationships with doctors using practices that are more sustainable and, in our view, it should be able to recover from its earnings slump in the near to medium term.
A primary challenge seems to be growth, not just in India but globally, and it would be simplistic to believe that India would be immune to the global events such as U.S.—China trade conflicts, Fed policy moves and economic slowdown. Given the backdrop, we believe that India's central bank should continue to relax monetary policy and we expect Modi to continue pushing for reforms and policy stimulus to return the economy to a higher growth trajectory. Some specific initiatives include affordable housing, an “electricity-for-all” campaign and increasing farmer incomes through a multipronged approach of infrastructure spending, direct benefits transfer and farm productivity measures. Despite government efforts, weak monsoons in India can be a spoilsport. Monsoon rainfall across the country currently is far short of long-term averages, and if the trend continues it is likely to have a negative impact on farm productivity. That in turn would lead to a rise in food inflation. At a sector level, we expect the pricing pressures in overseas pharmaceutical companies to moderate. Within financials, we anticipate India's liquidity woes to settle and find equilibrium as stronger NBFCs, banks and corporations take over, replacing weaker ones.
As of 6/30/2019, the securities mentioned comprised the Matthews India Fund in the following percentages: Syngene International, Ltd. 1.6%; Blue Dart Express, Ltd. 1.3%; Info Edge India, Ltd. 2.0%; Lupin, Ltd. 1.0%. The Fund held no positions in Yes Bank, Ltd.; Emami, Ltd. Current and future portfolio holdings are subject to risk.