Period ended June 30, 2019
For the first half of 2019, the Matthews Korea Fund returned -0.87% (Investor Class), while its benchmark, the Korea Composite Stock Price Index, returned 0.69% over the same period. For the quarter ending June 30, 2019, the Matthews Korea Fund returned -2.16% (Investor Class), while the benchmark returned -2.24%.
South Korea's equity market was mostly flat in the first half and lagged broader emerging markets as fears of a slowdown in global growth and trade conflicts weighed on sentiment. Exports represent a significant part of South Korea's GDP, making its economy vulnerable to disruptions in export volume. In addition, corporate earnings were weak, causing valuations to appear more expensive than South Korea's historical average. The Bank of Korea (BOK) is poised to lower rates to support its sluggish economy but most market participants expect a slow and measured response as the BOK seems content to wait out the U.S.—China trade negotiations before taking monetary action.
Performance Contributors and Detractors:
The Fund underperformed its benchmark in the first half, primarily due to our underweight in the information technology (IT) sector relative to the index. IT stocks rebounded and outperformed South Korea's broader equity market in the first quarter of 2019, dampening our relative performance. Information technology makes up close to a third of the Korea Composite Stock Price Index, representing what we feel is a high level of concentration risk in a single sector for index-based strategies. As active managers, we seek to manage concentration risk by building a diversified portfolio from the bottom up. From a sector perspective, a contributor to performance was strong stock selection among our health care holdings. The health care sector benefits from a drug development pipeline, an aging domestic population and rising demand for lifestyle upgrades.
Turning to individual securities, Samsung Electronics was a contributor to performance in the first half. As one of the world's largest supplier of memory chips, Samsung's stock price rose in the first half on market expectations of a rebound in chip demand and prices. LG Household & Heath Care, a South Korean cosmetics and skin care company, also contributed to performance. A rise in the company's stock price reflected its solid earnings growth and strong brand recognition. Hyundai Mobis, the parts and services arm of Hyundai Motors, also contributed to returns as a result of the company's restructuring efforts and earnings recovery. Chat platform Kakao performed well after successfully building a strong customer base within the platform for an integrated payments system and gaining market share in digital advertising.
In contrast, South Korean confectionary maker Orion detracted from performance. Following the gradual easing of tensions between South Korea and China around the THAAD missile tests conducted by the U.S. in 2017, some investors hoped that Orion's sales to Chinese consumers might regain ground. The recovery ended up being slower than expected and the company's stock price declined. However, we remain constructive on the company's underlying business with footprints across the region. Household product maker Lock&Lock's share price was also volatile amid a restructuring process, but we expect the company to expand its addressable market and products and improve business efficiency. Meanwhile, e-commerce company Café24's stock price suffered on an earnings miss on hiring, but we maintain a positive view as South Korea's e-commerce market is still growing and Café 24 should benefit from growing demand in the sector.
Notable Portfolio Changes:
During the first half, we exited brick-and-mortar retailer E-Mart, which was getting squeezed by online competitors and saw declining same-store sales growth. Losing conviction in the company's long-term prospects, we decided to exit the position. Meanwhile, we also exited electronics retailer Lotte Hi-Mart.
A high domestic minimum wage and slowing global trade both present near-term challenges for South Korea's economy. Regionally, trade conflicts between Japan and South Korea have also begun to surface, driven by political concerns on both sides.
On a positive note, South Korea's high minimum wage and aging population could encourage more businesses to invest in products and services that improve efficiency and productivity over time. It is early days for these efforts, but we are seeing examples of software as a service, a variation of cloud computing, gain traction as a way for companies to get more productivity out of their workforces. We also continue to see signs of improved corporate governance and shareholder-return policies, which is welcome news for long-term investors.
As South Korea's overall economic picture remains mixed, we believe active security selection is essential to capturing the country's long-term growth potential. As bottom-up investors, we look for companies that can grow organically without the assistance of strong macroeconomic tailwinds. We continue to look for companies that can benefit from domestic consumption within South Korea, as well as those companies headquartered in South Korea that are effectively competing and innovating in global markets.
As of 6/30/2019, the securities mentioned comprised the Matthews Korea Fund in the following percentages: Samsung Electronics Co., Ltd., Pfd. 10.6%; Samsung Electronics Co., Ltd. 4.1%; LG Household & Health Care, Ltd., Pfd. 5.0%; Hyundai Mobis Co., Ltd. 4.9%; Kakao Corp. 1.3%; Orion Holdings Corp. 1.5%; Lock&Lock Co., Ltd. 1.8%; and Café24 Corp., 1.6%. The Fund held no positions in E-Mart, Inc. or Lotte Hi-Mart Co., Ltd. Current and future portfolio holdings are subject to risk.