Matthews Japan Fund First Quarter 2014 Commentary

For the quarter ending March 31, 2014, the Matthews Japan Fund (Trades, Portfolio) declined -2.22% while its benchmark, the MSCI Japan Index, lost -5.47%.

Japan’s equity market corrected during the quarter as the country readied itself for its April 1 sales tax hike. There was some undue speculation late last year that the Bank of Japan would preemptively expand its quantitative easing policy before the tax hike. Those policies did not materialize, prompting the unwinding of long positions in Japan by short-term investors. Net selling by overseas investors totaled more than US$18 billion during the quarter, the first quarterly outflow since mid-2012.

During the quarter, stock selection in health care was the top contributor to the Fund’s relative outperformance. We had increased our exposure to health care names toward the end of last year after the sector underperformed in anticipation of drug price revisions in the National Health Insurance program that the government makes every two years. This shift worked in our favor and health care information company M3 and health care service provider N Field performed well during the quarter.

Industrials were another bright spot for the Fund during the quarter. Our small- and mid-capitalization selections in the sector performed well on the back of strong earnings. Harmonic Drive Systems, a manufacturer of precision speed reduction gears for robots, and Nihon M&A Center, an intermediary that facilitates mergers and acquisitions between small and medium enterprises, were the top performers in the sector. Our all-cap approach continues to pay off as most of the top 10 contributors to absolute performance were smaller firms.

Not all small-cap holdings did well, however. The Fund underperformed the benchmark in the IT sector, partly due to the decline of Bit-Isle, a data center operator. Bit-Isle revised down its earnings guidance due to some customer cancellations. We expect the business to stagnate for a while but believe its long-term outlook remains positive with growth in Internet data traffic ongoing. Additionally, several large-cap tech companies not included in the portfolio did well during the quarter, which hurt the Fund’s relative performance.

There appear to be strongly conflicting viewpoints in terms of Japan’s growth outlook. Headline GDP numbers for the fourth quarter of 2013 were poor. GDP growth of a mere annualized 0.7% fell woefully short of market expectations, and was particularly disappointing for top-down investors. On the other hand, the latest set of quarterly earnings was strong, with many companies revising up their earnings guidance. In that sense, the bottom-up perspective is encouraging. This divergence in the numbers has shaken confidence somewhat ahead the oft-discussed consumption tax hike.

The tax hike is widely expected to slow consumption over the next few quarters. While it will not be surprising to see negative news reports regarding consumption, we believe the majority of the impact is already baked in to valuations. Most importantly, with Japan out of its long-lived deflationary environment, the country’s tight labor market is expected to put pressure on wages, and we are encouraged to see the pieces finally starting to fall into place for a sustained recovery. More time is needed for the complete picture to emerge. One thing is clear—patience is still required.

Despite the uncertainties, we believe the valuations of Japanese equities are now quite attractive and there are strong buying opportunities for bottom-up fundamental stock pickers—especially relative to other developed markets. Given this environment, we intend to stay close to our core competence of picking stocks based on bottom-up fundamental research.

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 Japan Fund (Trades, Portfolio) in the following percentages: M3, Inc., 1.7%, N Field Co., Ltd., 0.7%, Harmonic Drive Systems, Inc., 1.0%, Nihon M&A Center, Inc., 1.5% and Bit-isle, Inc., 1.0%. 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.