Matthews Asia Funds China Small Companies Fund
Navigating change and finding opportunity in the world’s second largest economy
Market Insights from Portfolio Manager Winnie Chwang
- Investment involves risk. Past performance is not a guide to future performance. It is possible to lose the principal capital of your investment.
- The Fund invests primarily in China-related companies. Investments in such companies may be subject to increased risks such as political, tax, economic, policy, market, liquidity, trading, custody and settlement, currency, legal and regulatory risks.
- The Fund invests primarily in equity securities, which may result in increased volatility.
- The Fund may invest in smaller companies, which are likely to carry higher risks than larger companies.
- The Fund may invest in financial derivative instruments (“FDIs”). Risk associated with FDIs include counterparty/credit risk, liquidity risk, valuation risk, volatility risk and over-the-counter transaction risk. Exposure to FDIs may lead to a high risk of significant loss by the Fund.
- The Fund may use hedging techniques to attempt to offset certain market risks but there is no guarantee that hedging techniques will fully and effectively achieve their desired result.
- Pandemics and other public health emergencies can result in market volatility and disruption.
- Investors should not invest in the Fund solely based on the information in this document.
This Fund has a focus on China’s small companies—could you explain the investment idea behind this? Why China? Why small cap?
Small-cap companies in China are at the forefront of the country’s economic shift away from fixed asset investments toward innovation, consumption and services and actively participate in the growth of China’s new economy sectors. Smaller companies in China may lack access to capital, meaning they must be more competitive, innovative and capital-efficient than their larger peers both to survive and thrive. This capital efficiency has the potential to drive a strong return on invested capital.
We believe China’s small-cap companies have the entrepreneurial spirit and flexibility to recognize and respond to changing local market trends, including changing patterns of consumption. In our opinion, small companies provide opportunities for higher growth at lower valuation because they are less well-known. This allows active managers to uncover opportunities among high-quality companies with good corporate governance at lower valuations.
The Fund performed very strongly last year—what were the drivers?
Our focus on finding innovative and capital-efficient small companies that are relatively insulated from macroeconomic uncertainties served us well during the year for the Fund. One reason that China’s small companies stood out in the year was their focus on domestic demand and opportunities.
China’s effective handling of the pandemic meant that its domestic economy re-opened much more quickly than other large economies globally. The rapid changes brought about by the pandemic created opportunities for innovative businesses to grow and consolidate market share. Our stock selection in the information technology, health care, consumer staples and industrials sectors were notable contributors in 2020. We continue to focus on innovative, efficient and sustainable growth companies, with an emphasis on businesses oriented toward domestic demand and rising income levels.
What investment themes do you like in the China equity universe?
We believe sectors such as industrial automation, consumer, health care and technology are among the most attractive from a secular growth perspective. Rising incomes continue to fuel the trend of consumer upgrades and sustain demand for premium consumer goods. Given the country’s aging demographic shifts and increasing wages, more robotics and automation solutions are used in today’s factories and provide interesting opportunities. We also see opportunities in many areas of technology and health care, spurred by a continued influx and a growing critical mass of talents in China. One key area we like is hyper-connectivity and the development of technological innovation in domestic firms, also known as indigenous tech innovation.
China’s large local market presents an unprecedented opportunity for small businesses to scale up quickly on the technology curve in areas such as data, semiconductors, productivity tools and software. This opportunity represents a “catch-up” story, where some companies can potentially gain market share quickly. In health care we are seeing pharmaceutical companies increasing their research and development spend substantially in efforts to pivot towards more innovative drugs. Finally, there are opportunities associated with a “greener China”—in our view renewable energy and Electric Vehicles can help China achieve its energy self-sufficiency plans. As always, we continue to look for attractive long-term growth opportunities driven by the Chinese consumer.
Three of your top 10 holdings* are in real estate. Could you share your views on this sector?
Within our real estate exposure, we hold two property developers and one property management firm—these are different businesses. Developers sell properties and sometimes require a strong capital base or leverage to build their land bank. The developers we hold have long track records and are very focused on the Greater Bay Area region of China, which is slated to be the Silicon Valley of China. Thus economic activity in the region is thriving and resilient. On the other hand, property management—e.g. maintaining of the grounds of either a residential complex or shopping mall—is a very asset light business. These businesses generally have very visible upcoming pipeline of projects with a sticky relationship with their clients. Cash flow in the property management industry is also generally quite good. Lastly, we believe valuations within this sector remain attractive.
Two of the Fund’s top 10 holdings* are in the auto industry. What is the outlook of China’s auto industry?
Because COVID is largely under control in China, people have been able to resume a normal life. Consumption is rising and auto sales are growing and the depth and diversity of the opportunity set among small companies in China continues to expand. Consumers in China continue to have strong product upgrading preferences and the ongoing demand for luxury autos continues to be very resilient. We are seeing this not just in higher tier cities but also in lower tier cities, as affluence levels increase. Luxury auto dealerships benefit from increased car sales given this aspirational demand for foreign luxury brands. They also benefit from increasing demand for after market needs for service work, as purchasers go back to the dealerships to get their service and maintenance needs. Increased revenues from service and maintenance work for dealerships provide a higher margin business opportunity for auto dealers, which boosts their profitability profiles as well over time.
In terms of the Fund’s sector exposure, the largest allocation is to information technology (IT)*. Where do you see the most opportunity?
We continue to see ongoing opportunities in China’s push towards more indigenous innovation especially in semiconductors and software. At this juncture, China still needs to rely on global semiconductor supply chains but is more equipped today with local talent and also technical know-how for basic and entry level technology products. We think the opportunity for catch-up bodes well for a promising revenue growth story for many Chinese firms in the IT space.
How do you think about the IT sector’s policy risk and valuation?
Policy risk in the IT sector of late has stemmed more from big technology companies on concerns about anti-trust practices and data management policies. We generally find that small IT companies are less affected by this risk. Sector valuations largely remain challenging in this space. Valuation range in the IT sector can be wide, and while we hope for cheaper valuations, we are also aware of the large total addressable market opportunity that exists in many of the IT names we invest in. Thus, this would be a sector where if we did identify good quality names, we would be more willing to endure the relatively higher valuations.
What’s a key misconception an investor may have about China’s small companies?
Smaller companies in China are perceived to be a higher risk investment but the historical volatility of Chinese small caps1 has been lower than the overall Chinese equity universe over the long term2. As mentioned earlier, we believe small companies provide opportunities for higher growth at lower valuation because they are less well-known. This allows active managers such as Matthews Asia to uncover opportunities among high-quality companies with good corporate governance at lower valuations. Through our rigorous research and due diligence, in a market that is relatively uncovered by the sell-side research community, we aim to identify quality businesses with sound fundamentals run by disciplined management teams. We continue to seek companies with sustainable, quality earnings streams, strong cash flows and good balance sheets that can weather uncertain economic conditions.
Given the growing conflict between the U.S. and China, including the latest ban on new investment for 59 Chinese companies, how would that affect Chinese equity and your investment strategy?
Matthews Asia complies with the Executive Order 14032 issued by the Biden Administration and we are monitoring the situation closely to ensure we continue to comply with the E.O.
Small companies in China are at the forefront of the country’s economy when you look across metrics such as contribution to GDP, percentage of patents and innovation number of new product development as well as urban employment. Small cap revenues also tend to be derived by domestic demand, insulating them from the direct impacts of trade related issues.
In our Matthews China Small Companies portfolio, 77% of total revenues are derived from the local economy3. This high percentage of domestically sourced revenues makes the domestic growth engine the most important driver for our small companies. We believe this also helps make our exposure in small businesses in China more insulated from geopolitical tensions and macro events.
*As of May 31, 2021
The Fund is a sub-fund of Matthews Asia Funds, an open end umbrella fund with variable capital and incorporated with limited liability under the laws of Luxembourg. NOT FOR SALE IN THE U.S. OR TO U.S. PERSONS. This document does not constitute or contain an offer, solicitation or investment advice with respect to the purchase of the Fund described herein or any security. This information is not to be construed as a prospectus, a public offering or an offering memorandum as defined under applicable securities legislation.
Matthews Asia is the brand for Matthews International Capital Management, LLC and its direct and indirect subsidiaries.
The information contained herein has been derived from sources believed to be reliable and accurate at the time of compilation, however, no representation or warranty (express or implied) is made, including, without limitation, that the information is complete or timely. Matthews Asia and its affiliates do not accept any liability for losses either direct or consequential caused by the use of this information. Information contained herein is sourced from Matthews Asia and as of the report date unless otherwise stated.
The views and information discussed herein are as of the report date, are subject to change and may not reflect current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles.
Investors should carefully consider the investment objectives, risks, charges and expenses of the Fund before making an investment decision. The current prospectus, Supplement for Hong Kong Investors, Product Key Facts Statements ("Hong Kong Offering Document") or other offering documents contain this and other information and can be obtained by visiting hk.matthewsasia.com. Please read the Hong Kong Offering Document or other offering documents carefully for details including risk factors before investing. Prospective investors should consult professional legal, tax and financial advisers as to the suitability of any investment in light of your particular circumstances and applicable citizenship, residence or domicile. Fees and expenses vary among Funds and share classes. Portfolio characteristics for the Fund may vary from time to time from what is shown.
This document is issued by Matthews Global Investors (Hong Kong) Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.
1 Source: Bloomberg as represented by the MSCI China Small Cap Index 100 Day Volatility as of July 9, 2020
2 Source: Bloomberg as represented by the MSCI China Index 100 Day Volatility as of July 9, 2020
3 Source: FactSet Research System as of March 31, 2021