Period ended September 30, 2018
For the quarter ended September 30, 2018, the Matthews Korea Fund returned -1.48% (Investor Class), while its benchmark, the Korea Composite Stock Price Index, returned 1.04% over the same period.
South Korean equities were volatile during the third quarter on weak earnings reports and ongoing trade concerns. Higher labor costs stemming from a recent minimum wage increase translated into lower earnings for domestic service sectors, including consumer staples and retail. Export sectors, including the information technology and chemical sectors, experienced a softer demand outlook, as trade concerns continued to weigh on wholesale inventory. In a bit of good news, South Korea has negotiated trade agreements with the U.S. in key industries such as steel and automobiles year to date. South Korea also does considerable trade with China for intermediary goods, however, making trade issues in the region highly intertwined.
South Korean President Moon Jae In and North Korean leader Kim Jong Un continued their series of diplomatic meetings in the third quarter. Warmer dialogue between the two Koreas is a welcome development, though unlikely to spark any immediate economic benefits. Over the longer term, greater economic cooperation between the two Koreas would likely offer benefits for both countries. Turning to domestic politics, President Moon's party, the Democratic Party of Korea, remains in power and is considering the impact of recent minimum wage hikes on South Korea's economy. Legislators could face political pressures going forward to ease regulatory hurdles on businesses over time.
Performance Contributors and Detractors:
The Fund underperformed its benchmark during the quarter. The Fund was underweight in industrials relative to the benchmark, which detracted from performance. Industrials including shipbuilding and the construction sector had a strong run-up in stock prices during the quarter, perhaps on rising oil prices. Our focus tends to be more on long-term growth driven by domestic consumption. This means our exposure to industrials tends to be underweight in the portfolio.
Also detracting from our performance was our stock selection in the health care sector. Hugel and Interojo, two health care stocks in our portfolio, experienced volatility during this quarter. Hugel, a pharmaceutical company that manufactures botulinum toxin, the main ingredient for Botox, suffered from declining demand among Chinese distributors. Interojo, a manufacturer of hydrogel lenses, faced a tougher domestic business environment, resulting in lower sales. We believe the sector as a whole presents attractive opportunities for long-term growth, however, as we expect demand for health care services to rise.
Our holdings in the information technology sector were on balance a positive contributor to performance during the quarter. While the sector as a whole generated slightly negative returns during the quarter on softening demand for technology products, we were underweight the sector relative to the benchmark. In addition, our stock selection within the sector contributed to returns, as our IT holdings generated positive returns in aggregate.
Notable Portfolio Changes:
During the third quarter, we exited our position in Hyundai Construction Equipment, a manufacturer of excavation and digging equipment. While the firm currently has attractive market share in both India and China, we felt its business model could be vulnerable to competition in the future. The firm lacks the types of deep competitive moats we tend to favor for long-term holdings. In addition, we believe the firm could face financing and liquidity risks should lending recede in the region. Accordingly, we exited the stock. During the quarter, we acquired no new securities, but rather simply reallocated capital among our existing holdings, adding a bit around the margins to stocks that we already own where valuations look attractive and the growth potential appears sustainable.
In a positive sign for Korean markets, tensions between South Korea and China around the THAAD missile tests conducted by the U.S. in 2017 have largely receded. THAAD stands for Terminal High Altitude Area Defense systems and is designed to intercept a possible missile attack from North Korea. As military tensions have quickly abated in 2018, beginning with the Winter Olympics and continuing with U.S. President Donald Trump's meeting with Kim Jong Un in June; South Korean companies have resumed marketing activities in China.
Korea's equity market seems to reflect various negative scenarios for the economy, including high labor costs, demographic challenges stemming from low birth rates and the impact of trade conflicts between the U.S. and China. From our recent visits to Korea and meetings with management teams, we see a chance of regulatory hurdles on businesses easing over time.
Property prices have been strong in urban areas, especially in neighborhoods in and around Seoul. Rising property prices generally had a positive impact on Korea's consumer confidence in 2017. The government, however, has been instituting regulations designed to curb runaway property sentiment. Should property prices start to cool, there could be a downside risk to investor sentiment. As always, we will continue to look for Korean companies with attractive growth potential that can tap into the purchasing power of Korea's consumers and provide attractive growth over a full market cycle.
As of 9/30/18, the securities mentioned comprised the Matthews Korea Fund in the following percentages: Hugel, Inc., 1.3%; and Interojo Co., Ltd., 1.8%. The Fund held no positions in Hyundai Construction Equipment Co., Ltd. Current and future portfolio holdings are subject to risk.