Period ended December 31, 2018
For the year ending December 31, 2018, the Matthews Korea Fund returned -22.21% (Investor Class), while its benchmark, the Korea Composite Stock Price Index, returned -20.07%. For the fourth quarter, the Fund returned -10.56% (Investor Class) versus -13.29% for the Index.
In 2018, North Korean leader Kim Jong Un made history by stepping into South Korea for the first time. Delegates from the two Koreas agreed to pursue talks with the U.S. to officially end the Korean War, a conflict nearly six decades old. While diplomatic overtures provide a positive backdrop for growth, South Korean equities were among the region's weakest in 2018. Investors contemplated how trade talks among the U.S., China and rest of the world could affect South Korean exports. South Korea's economy also faced other difficulties, as a rising minimum wage pressured small- and medium-sized businesses. In addition, property prices surged over the past two years, resulting in historically high levels of household mortgage debt, and led to slowing disposable income growth.
Performance Contributors and Detractors:
For the full-year 2018, detractors from performance included auto maker Hyundai Motors and auto-parts manufacturer Hyundai Mobis, part of the larger Hyundai Motors group. Global automotive demand slowed and the Hyundai Motor group struggled to maintain its market share in China. A delay in restructuring plans further disappointed the market. Meanwhile, Naver, South Korea's largest search engine provider, also detracted from performance. Naver entered a heavy investment cycle in 2018, lowering its near-term profitability. However, we believe these steps are necessary for the long-term growth for Naver, helping the company continue to maintain a position of market leadership.
During the fourth quarter, the Fund held up better than its benchmark on a relative basis. Underweights in the information technology and industrials sectors have hurt the Fund's performance in the past, but helped during the fourth quarter. Among the top contributors in the fourth quarter were household product maker Lock & Lock and confectionary maker Orion. We expect Lock & Lock's share price to remain volatile during an upcoming restructuring process, but also expect the company to expand its addressable market and improve business efficiency. Orion's China operations were weak in 2017, but recovered in 2018. Orion's domestic business also gained market share with new products.
Notable Portfolio Changes:
There were no significant portfolio changes during the quarter. We took advantage of market volatility to rotate capital within the portfolio, adding to existing holdings. We purchased additional shares in Lock & Lock, pharmaceutical maker Hugel and tour operator Modetour Network. All three companies reported disappointing earnings in the third quarter, but we feel confident that each has the potential to grow earnings over time. Notably, many of the positions for which we increased our holdings are consumer companies, further increasing consumer exposure in the portfolio.
During the fourth quarter, Korean equities dropped to levels of low valuations last seen in 2008, during the Global Financial Crisis. Amid historically low stock prices, the dividend yield of Korean equities is very attractive, with more upside possible in near future. What's more, we continue to see signs of improved corporate governance and shareholder return policies, welcome news for long-term investors.
Korean equity markets seem to have priced in considerable negative sentiment, but risks remain. Government regulatory policies have shown mixed results as corporate earnings and hiring tendencies have been negatively affected by stiff hikes in the minimum wage over the past two years. Though the Korean government is trying to mitigate past policy missteps, regulatory risks could linger.
Looking ahead, we will continue to look for innovative companies with the potential to improve their shareholder returns over a full market cycle. We believe the consumer will play an important role in Korea's future, so we expect to maintain meaningful exposure to consumer-driven sectors across the portfolio. As always, we will continue to research individual companies and securities from the bottom up, focusing on those with the most attractive long-term growth potential.
As of 12/31/18, the securities mentioned comprised the Matthews Korea Fund in the following percentages: Hyundai Motor Co., Ltd., 2nd Pfd., 2.9%; Hyundai Motor Co., Ltd., Pfd., 0.8%; Hyundai Mobis, 3.8%; Naver, 3.7%; Lock & Lock, 3.3%; Orion Corp., 2.7%, Hugel, 1.8%; and Modetour Network, Inc. 2.4%. Current and future holdings are subject to risk.