Investment Manager Report

May 2012

Dear Fellow Sharehodlers,

It was a difficult 12 months for Asia’s equity markets, which ended more strongly than they began despite media coverage about the sluggish U.S. recovery and debt problems in the Eurozone. While macroeconomic news seemed to overwhelm sentiment in the markets, valuations in Asia at the end of March remained below long-run historical averages. Over recent months I have commonly heard investors say: “I’m waiting for the pullback.”

The Funds held up well relative to markets, which were volatile: rising and falling in line with short-term news on growth and risk sentiment. During brief rallies, the Funds typically lagged, for this is when commodity companies and more cyclical business did well. Our Funds, which own comparatively less in such businesses, did not keep pace. However, the Funds’ focus on investing for the long run in businesses with more transparent cash earnings streams helped relative performance for the 12 months ending 31 March 2012. We do not seek to time abrupt cycles. Rather, we continue to test our long-term assumptions and beliefs and "get on the road" to speak with managers in Asia.

Three areas received particular attention of late: Japan, India and small Chinese companies. Japanese valuations are very low—shares on average trade at book value. In addition, new markets are opening up for some Japanese companies, including factory automation, health care, and consumer goods. All of these industries benefit from rising wages in Asia—a trend that we believe will continue and can only bring prosperity to Asia's households. India and smaller companies in China suffered severe dislocations in 2011. India's stock market and currency fell: despite a recent rally in both, the market capitalisations of many Indian businesses in U.S. dollar terms are still well below levels attained in the last five years and valuation multiples have also contracted. Several members of our investment team, from different Funds, spent some 50 person-days in India during the first quarter of 2012 alone to research ideas. China's smaller companies were hit hard by corporate governance scandals among some Chinese companies listed in the U.S. and Canada. In addition, there was a credit squeeze in China as bank lending dried up and informal capital-raising became a high-profile legal issue.

Several lead portfolio managers visited and talked extensively with entrepreneurs from Wenzhou, the heartland of Chinese entrepreneurialism and informal financing. The entrepreneurs reported that labour and raw material costs were more challenging than funding, but that business was good. Entrepreneurs candidly admitted mistakes of over-diversification and unrelated property investments, but noted that their mistakes just made them more determined than ever to focus on their core business.

We remain confident in the long-term growth and prosperity of Asia. Therefore, our approach, in the midst of what are admittedly absorbing macro discussions, has been to focus on finding good businesses, rather than try to speculate on events. As much as we all like to discuss the big issues of the day, for members of the Matthews investment team, the real excitement and challenge comes in discovering businesses whose future prospects are underappreciated by the average view of the investment community.

It is a privilege to act as your investment advisor in Asia's equity markets.

Robert Horrocks, PhD
Chief Investment Officer
Matthews International Capital Management, LLC