Market Environment:
During the first quarter of 2016, China’s equity markets continued to come under pressure following notable volatility in 2015. At the onset of the year, investors were particularly worried about the direction of the renminbi after the currency posted sizable declines and policymakers issued ambiguous communications. During the first week of the year, China’s domestic markets also appeared spooked after its freshly implemented circuit breakers were twice breached. While these circuit breakers were meant to stabilize the markets, they actually increased anxiety among an already jittery market. This, in turn, led to the heavy sell-off of local equity markets. Although China has since stopped using this mechanism, ongoing concern over China’s economic health, including declining GDP and a weaker Purchasing Manager’s Index continue to concern investors.
Performance Contributors and Detractors:
During the quarter, the industrials sector detracted from overall Fund performance. One of our largest portfolio holdings, China State Construction International (CSCI, Financial), posed a significant drag on relative Fund performance. We believe CSCI continues to be one of China’s highest quality construction companies both in terms of growth outlook and profitability. However, there were some market concerns that dampened its stock performance, including the company’s higher-than-usual debt levels and weak China revenue growth. Investors have also expressed concern that CSCI has not received any recent asset injections from its parent company—which tends to boost earnings—as has been done in the past.
The Funds current positioning in A-shares listed on the mainland is about 14%, and most of these stocks were not a significant drag on performance.
Consumer staples and health care were among the sectors that were positive contributors to relative Fund performance. Within the consumer staples space, Kweichow Moutai (SHSE:600519, Financial), China’s leading liquor brand, continued its profit recovery with stable wholesale prices and improving sales momentum seen from growing advance orders. During the quarter, we exited the stock to take profits at a time when we believed valuations had also become less appealing.
Health care companies in China are anticipating a more negative outlook on pricing in 2016. China’s medical reimbursement fund continues to experience strains from increased health care expenditure and, as a result, the government is attempting to lower prices across the board to ease the burden. However, the Fund’s health care holdings have held up relatively well. Sinopharm (HKSE:01099, Financial) is China’s largest drug distributor and has managed to consistently outpace industry growth through increased industry consolidation. Sinopharm’s strong market position has also resulted in good bargaining power which has allowed them to maintain stable margins despite lower drug prices.
Notable Portfolio Changes:
Over the quarter, we exited our position in Haier Electronics (HKSE:01169, Financial), the distribution and logistics arm of Qingdao Haier, China’s leading white appliances manufacturer. While Haier has a leading distribution presence in large appliances in China, the main channel it distributes to is an offline channel that experienced meaningful cannibalization of sales from e-commerce and as well negative impact from the China’s weak property market. Haier is also restructuring its business but we believe it will be unlikely to see growth revived in the near term.
During the quarter, we added to China’s leading e-commerce platform provider, Alibaba (BABA, Financial). This portfolio addition is based on the belief that the e-commerce industry as a whole will continue to benefit and take market share away from traditional brick-and-mortar sales in China. Alibaba also continues to generate high growth in both revenues and profitability, making it a sustainable business model in this industry.
Outlook:
Concerns over China’s economy have continued to keep investors at bay. However, when taking a longer-term view on the economy, we continue to believe that the appropriate long-term steps toward gradual but deliberate economic reforms are being taken. The transition toward a consumption- and services-led economy has resulted in a noticeably rapid development in these value-adding industries. Further into 2016, we believe that China should aim to improve overcapacity issues in some of its traditional industries and continue its progress on capital market reforms. In the meantime, as China stabilizes its economic footing, we note that valuations for companies in the MSCI China Index now appear quite reasonable with price-to-earnings levels less than 10x and a dividend yield of around 3%.
The views and opinions in this commentary were current as of March 31, 2016. 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 3/31/2016, the securities mentioned comprised the Matthews China Fund (Trades, Portfolio) in the following percentages: China State Construction International Holdings, Ltd. 3.0%, Sinopharm Group Co., Ltd. 2.2% and Alibaba Group Holding, Ltd. 3.1%. The Fund held no positions in Kweichow Moutai Co., Ltd. or Haier Electronics Group Co., Ltd. Current and future portfolio holdings are subject to risk.
