For the year ending December 31, 2017, the Matthews China Fund (Trades, Portfolio) returned 59.37% (Investor Class), outperforming its benchmark, the MSCI China Index, which returned 54.33%. For the fourth quarter of the year, the Fund rose 9.58% (Investor Class) versus 7.62% for the Index.
Market Environment:
2017 marked a noticeable year of outperformance for Chinese equity markets after an extended period of mediocre returns. We believe that this inflection point for China was reached following years of concerted government effort in transitioning its economy to one that focuses on domestic consumption and sustainable, quality growth. For the first time in many years, China’s equity markets did not disappoint in terms of corporate earnings growth expectations. Underscoring the economy’s robust earnings growth has been the further implementation of China’s supply-side and state-owned enterprise reforms as well as the continuation of a stable macroeconomic environment, which further promotes investment and income growth. While the global political environment remains noisy, the popularity of President Xi Jinping provides welcome stability and ensures his market-oriented reforms for the mainland continue to benefit the economy. Xi’s goals for quality growth and increased innovation were reiterated at the 19th National Congress of the Communist Party meetings and aligned with what we believe are long-term growth opportunities in China.
Performance Contributors and Detractors:
During both the fourth quarter and 12-month period, stock selection was the main driver of the Fund’s outperformance against the benchmark. For 2017, the portfolio’s best-performing sectors were information technology, financials and consumer discretionary. Ping An Insurance Group (SHSE:601318, Financial), a financial conglomerate and China’s second-largest life insurer, was one of the top contributors to Fund performance. We expect the company to maintain sustainable and quality growth as its focus on long-term protection products and its success in consumer finance business start to bear fruit. China Merchants Bank (SHSE:60036), a leading retail bank, also was a top performer during the year. The firm delivered strong results thanks to its solid retail franchise, high asset quality and solid risk management. While internet services provider Tencent Holdings and e-commerce platform provider Alibaba Group were the top contributors to the Fund’s absolute return, they were relative detractors during the year as together they accounted for a much higher weighting in the index, about 27%. Both companies delivered results above expectations and further solidified their dominance in their respective arenas.
Conversely, Semiconductor Manufacturing International (SMI, Financial), the largest semiconductor manufacturer in mainland China, was a detractor to Fund performance. We exited the position early in the year amid a major management change that we believed could significantly impact its future operation. Bitauto Holdings (BITA, Financial), a leading auto information and financing platform operator, also performed poorly as investors became concerned about margin pressure due to expenses associated with a separate listing of its spin-off division. We maintain a position in Bitauto, however, as we believe the company's longer-term outlook remains intact.
Notable Portfolio Changes:
During the fourth quarter, we initiated a position in Minth Group (HKSE:00425, Financial), a leading manufacturer of auto body parts and trim. With its strong R&D and solid execution, we expect Minth to increase its market share for its existing product line and also to expand into new product areas. We also added CIFI Holdings (HKSE:00884, Financial), a residential real estate developer focused on the Yangtze River Delta and Pan-Bohai Rim areas of China. We believe the company's ample land bank in these highly sought-after regions will provide high visibility to its future growth.
During the quarter, we exited our positions in Beijing Capital International Airport due to uncertainty surrounding a second airport in the capital and a new round of import tariff cuts in China.
Outlook:
Despite the strong equity performance in 2017, we found the lack of market volatility throughout the year to be surprising. This has led us to believe that many global investors have not participated in the rally and may reconsider their underweight exposures to China in the coming year. From a fundamental standpoint, we are optimistic that 2018 will continue to show solid corporate earnings growth. While the property sector is expected to slow as the government reins in rapid price appreciation, consumer discretionary items such as home appliances should benefit as new homeowners begin to outfit new residences. In the heavy industrials segment, we expect moderate growth as a lack of demand could translate into inadequate volume growth. Despite this forecast, we believe pricing trends should improve as consolidation continues to remove excess capacity in the system. The debate over whether China could face a banking crisis may continue in 2018 as it has every year over the past decade. As in years past, we continue to believe that financial system risks are contained and the likelihood of China experiencing any widespread banking collapse remains small. As China remains firm in controlling its debt levels, its banking system may see further regulation security within areas such as wealth management products. We are also encouraged that banks continue to position their loan books toward healthier mortgage loans. On the political front, we expect a stable environment under the leadership of President Xi and continued progress in the country’s reforms. In addition, yearlong worries of a trade war between China and the U.S. faded during the second half of 2017, and should become less topical in the coming year. Trade is only a small engine for China’s overall growth and will continue to diminish in significance as its domestic economy continues to evolve and grow.
As of 12/31/2017, the securities mentioned comprised the Matthews China Fund (Trades, Portfolio) in the following percentages: Ping An Insurance Group Co. of China, Ltd. 5.2%; China Merchants Bank Co., Ltd. 2.0%; Tencent Holdings, Ltd. 10.1%; Alibaba Group Holding, Ltd. 7.1%; Bitauto Holdings, Ltd. 0.8%; Minth Group, Ltd. 1.4%; and CIFI Holdings Group Co., Ltd. 1.1%. The Fund held no positions in Semiconductor Manufacturing International Corporation or Beijing Capital International Airport Co., Ltd. Current and future portfolio holdings are subject to risk.
The views and opinions in this commentary were as of the report date, subject to change and may not reflect current views. 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. It should not be assumed that any investment will be profitable or will equal the performance of any securities or any sectors mentioned herein. The information does not constitute a recommendation to buy or sell any securities mentioned.
The information contained herein has been derived from sources believed to be reliable and accurate at the time of compilation, but no representation or warranty (express or implied) is made as to the accuracy or completeness of any of this information. Neither the funds nor the Investment Advisor accept any liability for losses either direct or consequential caused by the use of this information.
