Period ended December 31, 2018
For the year ending December 31, 2018, the Matthews India Fund returned -10.09% (Investor Class) while its benchmark, the S&P Bombay Stock Exchange 100 Index, returned -6.00%. For the fourth quarter of the year, the Fund returned 3.76% (Investor Class) versus 4.54% for the Index.
During 2018, India's stock market experienced volatility alongside global stock market indices. Despite higher global oil prices, a weaker rupee and tighter monetary policy, its stock market delivered positive returns through the year until August. Improving GDP growth numbers and globally positive equity sentiment fueled a rally in India's equity market for much of the year. In late summer, however, the equity market changed course on account of domestic and global factors. By September, a quasi-governmental entity in India defaulted on its debt payments, which led to tight liquidity and a higher cost of capital across the board. This was accentuated by a global equity sell-off on the back of trade-related tensions between the U.S. and China. India's equity market approached year-end with some investor anxiety over questions around the autonomy of India's central bank, the Reserve Bank of India, as well as concerns over the potentially waning popularity and influence of Prime Minister Narendra Modi's government. Despite these challenges, December was more upbeat for India as a change of guard at the central bank signaled to investors the end of a hawkish monetary policy regime.
Performance Contributors and Detractors:
The portfolio's higher allocation to small-cap stocks and lower allocation to mega-cap stocks hurt our relative performance, which was mitigated by stock-specific factors. Small-cap stocks had become highly overvalued following India's demonetization as savings moved from physical assets to financial assets. While the Fund has reduced its exposure to small caps over time, we continue to have fairly significant exposure given our belief that the stocks we hold have solid underlying business fundamentals. By sector, our higher allocation to health care and consumer staples versus the benchmark detracted from our relative performance. Within health care, customer consolidation and a faster pace of new drug approvals by U.S. regulators led to significant pricing pressure for generic drug manufacturers. Within consumer staples, some of our exposure to small- and mid-cap companies struggled as they adapted to India's new regulatory environment imposed by its Goods and Services Tax and demonetization. In the third quarter of the year, India's credit markets took a hit after Infrastructure Leasing and Financial Services (IL&FS), a major financier of infrastructure and power plants, announced a default. The portfolio's higher allocation to non-banking financials became a detractor to performance given the liquidity concerns that resulted.
Our avoidance of holdings in the utilities and metals sectors, and stock-specific factors within communication services and consumer discretionary were performance contributors amid a volatile market. One such stock was Info Edge India, which owns an online classified ads business focused on recruitment, matrimony and real estate. Info Edge also has investments in Zomato, which is a privately held restaurant search and discovery service. Info Edge's stock did well after Zomato's valuations rose after it struck an agreement over fundraising with China's Alibaba Group.
Notable Portfolio Changes:
During the year, we exited or trimmed many companies across sectors where we deemed the risk/reward asymmetry to be unfavorable. We also added to new positions across sectors like information technology, financials, pharmaceuticals and materials. One such addition was UPL, a crop protection business that sells generic agrochemicals, industrial chemicals and seeds. UPL's stock had corrected following its acquisition of agrochemical firm Arysta LifeScience amid concerns over equity dilution and significant debt on its balance sheet. UPL, however, has a good track record with acquisitions. We believe its potential for synergy was far higher than most realized and its stock was trading at very attractive valuations.
Volatility in the short term is likely to persist. Modi's government is likely to push populist measures such as farm loan waivers, which will have a positive impact on consumption in the near term. There seems to be increasing sentiment, however, that India's upcoming general elections may likely result in a coalition government, which may not be popular with India's market participants. Given the correction in oil prices, coupled with the sustained low consumer price inflation we saw in 2018, it is likely that the Reserve Bank of India will become more dovish in its monetary policy outlook. Leading indicators suggest that corporate-level stress is past its peak and some of the corporate-focused banks are beginning to heal rapidly. This should result in greater availability of credit to corporate India. Lower cost of capital and greater availability of credit should bode well for the revival of private capital expenditure over the short to medium term. Valuations for large-cap stocks are in line with history and India's large-cap universe remains a good hunting ground for investments. There were sharp corrections within mid-caps and small-caps throughout 2018. Valuations seem to have normalized within mid-caps, and we are excited to now find more opportunities for bottom-up stock picking compared to 2017.
As of 12/31/2018, the securities mentioned comprised the Matthews India Fund in the following percentages: Info Edge India, Ltd. 1.7%; UPL, Ltd. 3.0%. The Fund held no position in Alibaba Group Holding, Ltd.; Arysta LifeScience or Infrastructure Leasing & Financial Services Limited. Current and future portfolio holdings are subject to risk.