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Matthews China Fund First Quarter 2014 Commentary

May 13, 2014 | About:

For the quarter ending March 31, 2014, the Matthews China Fund (Trades, Portfolio) declined -8.49% while its benchmark, the MSCI China Index, fell -5.87%.

During the first quarter, China’s equity markets reacted negatively to signs of an economic slowdown. In particular, investors appeared most concerned about China’s industrial production, export data and retail sales figures that suggested a further downturn in the economy could be taking place. In addition, a corporate bond default from a Chinese solar company added new concerns regarding the health of China’s financial sector. Under these circumstances, the first quarter experienced substantial selling pressure across most major sectors in the country’s equity markets.

The Fund underperformed the benchmark by 2.6% during the quarter, mainly due to the information technology and consumer discretionary sectors. Tencent Holdings, which comprises about 10% of the benchmark, continued to perform strongly during the quarter. We also held Tencent in our portfolio, albeit at a much a much lower percentage than that of the benchmark. We have become cautious over its high valuation since its strong rally.

Meanwhile, many of the Fund’s holdings in consumer discretionary sectors continued to suffer from weak performance over the quarter. The operating environment in China remains challenging due to weak macroeconomic conditions coupled with poor consumer sentiment. However, higher quality and better run companies are doing better than their peers, and we believe they should benefit, over the long term, as the market consolidates. Our positions in companies such as Sun Art Retail Group, China’s most efficient hypermarket operator, as well as Belle International, a market leader in women’s footwear outperformed their peers during the quarter.

The financial sector also posed a drag on performance during the quarter following the corporate bond default. While we believe that it could be necessary for more defaults to occur in order to clean up the financial industry, we are taking a more cautious stance toward Chinese financials and are underweight the sector.

Over the course of the first quarter, the Fund’s health care and industrial sectors did relatively well. In the health care space, our holdings in Sino Biopharmaceuticals, an R&D-centric company, made positive contributions to performance. China’s pharmaceutical sales are expected to grow more than 15% annually through 2016, despite a weaker macroeconomic backdrop. In the industrial sector, our exposure to high value-adding segments such as the automation industry has also benefited portfolio performance.

During the first quarter, we trimmed our exposure to the financial sector while maintaining our relative overweight in the consumer sectors in China. We did, however, consolidate our consumer positions to focus on better quality management teams that have been able to deliver above industry average performance. We also continued our focus of adding positions in service-related sectors such as health care, and initiated a position in one of the largest contact lens manufacturers in China, Ginko International. This company has benefited from increasing contact lens penetration and also product mix upgrades coming from consumers who are starting to shift toward monthly or even daily disposable lenses.

With near-term economic indicators turning more bearish, it is becoming increasingly likely that China will roll out more accommodative monetary policies and supportive fiscal measures in order to boost its economy. However, we do not expect a stimulus plan as significant as the one the government rolled out in 2009. It appears that China is prepared to undergo short-term pain to achieve its longer-term goal of rebalancing its economy for a more sustainable growth path. Over the longer term, we feel that the consumer sector and service industries will develop well as domestic consumption becomes increasingly important amid China’s more market-oriented economic landscape.

The views and opinions in this commentary were current as of March 31, 2014. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the Fund’s future investment intent.

Statements of fact are from sources considered reliable, but neither the Funds nor the Investment Advisor makes any representation or guarantee as to their completeness or accuracy.

As of 3/31/2014, the securities mentioned comprised the Matthews China Fund (Trades, Portfolio) in the following percentages:

Tencent Holdings, Ltd. 3.6%, Sun Art Retail Group, Ltd., 1.2%, Bell International Holdings, Ltd., 1.5%, Sino Biopharmaceuticals, 1.6%, Ginko International Co., Ltd., 0.8%. Current and future portfolio holdings are subject to change and risk.

Performance and distribution figures discussed in any of the Manager Commentaries reflect that of the Investor Class Shares.

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