Period ended March 31, 2018
For the quarter ending March 31, 2018, the Matthews Korea Fund returned -2.03% (Investor Class), while its benchmark, the Korea Composite Stock Price Index, returned 0.10%.
The South Korean stock market continued its upward momentum in early January. Broad-based synchronized global growth across most developed countries and major Asian economies set the stage for a strong start to the quarter. Cyclical sectors including financials, energy and materials benefited from global growth trends. Volatility in global equity markets, however, picked up in the middle of the quarter. This volatility was fueled in part by U.S. interest rate increases, as well as the re-emergence of protectionist rhetoric in the U.S. The resulting correction in the U.S. stock market impacted many markets worldwide, including South Korea's.
In February, South Korea hosted the 2018 Winter Olympics in PyeongChang. Athletes from South Korea and North Korea marched in the opening ceremonies as a single delegation, helping to de-escalate tensions on the Korean peninsula. With more than 90 countries participating in the Olympics, the media coverage shined a warm, global spotlight on South Korea's distinct culture and strong economy. Nonetheless, domestic investor sentiment in South Korea remained tepid during the quarter. Investors, unnerved by equity market volatility and looming trade issues, largely remained on the sidelines.
Both the U.S. and China remain important trading partners for South Korea. In a positive development, U.S. steel tariffs on South Korea were temporarily lifted during the quarter to allow for renegotiation of an existing free trade agreement. In addition, trade relations between South Korea and China seem to be improving. Meanwhile, military tensions with North Korea continued to abate. In early March, North Korea and the U.S. signaled a willingness to hold talks, offering the potential for a significant improvement in international relations. And in late March, North Korean leader Kim Jong-un made a surprise visit to Beijing to meet Chinese President Xi Jinping, laying the groundwork for potential multiparty talks and negotiations.
Performance Contributors and Detractors:
The Fund underperformed its benchmark during the quarter due to its underweight in the semiconductor sector. While companies in the semiconductor sector experienced recent gains in stock prices, we have been reducing our overall exposure to this cyclical sector. In our view, semiconductors are likely at the high end of the cycle, with little room for further growth.
While the Fund's overall performance was negative during the quarter, some of our individual holdings performed well. Modetour Network, one of our top performing securities, is a tour operator in South Korea. We believe the tourism industry is well-poised to benefit from growing disposable income in South Korea and across the region. As people spend more on travel, demand for Modetour's services may increase in line with this secular trend.
Our largest detractor from performance during the quarter was our holdings in BGF Retail, a convenience store operator in South Korea. Upcoming increases in the country's minimum wage have some investors worried that increased labor costs may hurt the company's bottom line. However, we remain optimistic about the company's long-term prospects. While a rising minimum wage may have some short-term impacts on profitability in the retail sector, we believe that rising wages will ultimately help increase consumption. In addition, we believe the company has a head start in an underdeveloped market segment with continued growth potential. The convenience-store model continues to evolve in South Korea and we expect to see growing demand for prepackaged foods as South Korea's middle class continues to expand.
Notable Portfolio Changes:
We added a position in E-Mart, a chain of discount retail stores with a strong online platform. Online sales are expanding in South Korea, creating new opportunities for retailers to attract and retain new customers. In addition, E-Mart has received additional funding from a private equity fund, allowing it to further develop and enhance its online platform. Against this backdrop, E-Mart has the potential to expand its business. During the quarter, we sold our position in Kangwon Land, a domestic casino operator. While we are generally optimistic about the travel and leisure sectors, the regulatory environment is changing in regard to oversight for casinos. New regulations may become a headwind for casino operators. Accordingly, we decided to exit our position in Kangwon Land.
Investor sentiment could improve if North Korea and the U.S. have a successful summit in the coming months. We do not expect major geopolitical issues to be resolved in a single meeting, but any constructive dialogue will likely be positive for South Korea's economy and financial markets. South Korean equities have historically traded at lower valuations than other growing economies in the region, in part because of investors' concerns about North Korea. If these concerns recede, the South Korean won may strengthen and equity market could enjoy higher valuations.
On the policy side, South Korea's government is focusing on improving corporate governance, which is a positive development for attracting both domestic and international equity capital. At the same time, the government is a bit left of center on labor issues. For example, it is currently raising minimum wages, which could put pressure on corporate profits in the short term. Over the longer term, we expect rising wages to translate into better domestic consumption. Our portfolio has an emphasis on the power of South Korea's domestic consumers and we are optimistic about the country's prospects for economic growth in 2018.
As of 03/31/2018, the securities mentioned comprised the Matthews Korea Fund in the following percentages: Modetour Network Inc., 4.1%; BGF Retail Co., Ltd., 2.5%; and E-Mart, Inc., 1.4%. The Fund held no positions in Kangwon Land, Inc. Current and future portfolio holdings are subject to risk.