Period ended 31 December 2018
For the year ending 31 December 2018, the Matthews Asia Dividend Fund returned -12.85%, while its benchmark, the MSCI All Country Asia Pacific Index, returned -13.25%. For the fourth quarter, the Fund returned -10.26% versus -10.92% for the Index.
2018 was a year of turbulence for Asian equities. Protracted U.S.—China trade tensions and rising U.S. interest rates became significant overhangs for Asia's equities and its currencies. Within Asia, China's financial deleveraging campaign, which is designed to rein in excessive shadow-banking activities and reduce systemic risk, nevertheless caused a near-term economic slowdown. Facing such external and internal headwinds, investors became increasingly concerned about a potential deceleration in global growth. Most major Asian equity markets suffered steep, double-digit losses. Only individual markets that had lower exposure to global trade but were more driven by domestic consumption, such as India, were able to contain equity market losses.
Performance Contributors and Detractors:
Fund performance in 2018 was lackluster, finishing the full year only slightly ahead of its broad Asia Pacific benchmark. Our approach toward dividend investing is anchored by what we call a "total return" approach—one that balances stable, high dividend-yielding stocks with slightly more cyclical, but higher dividend, growth stocks. Following a very strong 2017 for Asian equities, the Fund's outperformance by some of our dividend growth holdings started to make valuations less compelling. This prompted us to re-position the overall portfolio by gradually reducing some cyclical dividend growth stocks while adding exposure to higher dividend-payout stocks with stable cash flow that were trading at more reasonable valuations. While such rebalancing positively contributed to the Fund's relative outperformance, the year's market volatility was more severe than we initially anticipated. Ultimately, the portfolio struggled to provide better downside protection as we had hoped.
Given the overall fragile market sentiment, those of our holdings that were in a good position to deliver solid earnings growth, generate healthy cash flow and maintain a resilient balance sheet performed well during the market downturn. One of those stocks was a long-term holding, Shenzhou International Group, a Chinese textile original equipment manufacturing business that had a healthy share price return and was a top contributor to Fund performance for the year. In addition to its cost competitiveness, owing to its vertical integration, Shenzhou International Group is one of the few mainland Chinese exporters to have successfully diversified its manufacturing bases beyond mainland China by expanding into other low-cost countries such as Vietnam. Today, about 30% of the production capacity is outside of China. This diversification minimizes the risk from U.S.—China trade tensions, a development welcomed by investors in 2018. With the founder and his family owning more than 50% of the listed entity, the firm's dividends over the years have also grown steadily alongside strong earnings growth.
On a sector basis, communication services and the Fund's overweight in the consumer staples sector were the top contributors to performance for the full year period. Stable cash flows, strong balance sheets and high dividend payouts all contributed to the "defensiveness" of the performance of those stocks, especially amid market turmoil. On the other hand, the Fund's overweight in the consumer discretionary sector was detrimental to its overall performance. Specifically, several of the Fund's holdings of auto parts companies within the Asian region, such as Minth Group, Fuyao Glass Industry Group, Nifco and Hyundai Mobis, suffered significant share price setbacks, partially due to the overall automobile industry slowdown and partially due to investor concerns about their exposure to U.S. tariff risks. For Minth, Fuyao Glass and Nifco, we believe the de-rating of those stocks was driven by a cyclical factor and we expect their long-term competitiveness to remain intact. In addition to industry cyclicality, Hyundai Mobis's share price underperformance followed a delay of the Hyundai Group's restructuring.
On a country basis, our holdings in China/Hong Kong were the top contributors to Fund performance. Good stock selection, including companies such as Shenzhou International Group, China Gas Holdings and HKBN, more than offset the negative effort from the Fund's overweight allocation to China/Hong Kong. On the flip side, the Fund's exposure to India was the top detractor to performance. Both our underweight in India, which held up significantly better than the broad Asia market, and poor stock selection, including companies such as Bharti Infratel, detracted from the Fund's relative performance.
Notable Portfolio Changes:
During the fourth quarter, the Fund initiated a new position in WH Group, a China-based, major global pork processing company with significant business presence both in mainland China and in the U.S. WH Group's share price declined significantly in 2018 as the company was caught in the crossfire of the U.S.—China trade spat. An outbreak of African swine fever, a viral disease that spread through China in August, also hurt sentiment toward the stock. We saw WH Group as an attractive investment opportunity at its valuation late in 2018. The company's main earnings come from its downstream, branded meat product business (sausage, ham, etc.) in mainland China, which is rather stable and quite cash-generative.
Also during the fourth quarter, we reduced our exposure to sectors that tend to be more sensitive to economic cycles, mostly by reducing our holdings in several commercial banking businesses in the region. The capital was partially redeployed into a few newly initiated positions, including WH Group.
Near-term market volatility is likely to remain elevated as investors grapple with a decelerating Chinese economy and a possible slowdown in U.S. GDP growth. Ironically, such reversals in growth trajectories might pave the way for removing two large external overhangs for Asian equities—a full-blown trade war between China and the U.S. and U.S. dollar strength driven by monetary tightening efforts. A dimmer growth outlook in China and the U.S. could add both incentive and a sense of urgency for the two nations to reach a deal. While the struggle between China and the U.S. goes well beyond just trade deficit issues, a trade compromise that averts an all-out trade war could still significantly reduce market uncertainty. Similarly, if the U.S. dollar starts to weaken on the back of less hawkish U.S. Federal Reserve policy, emerging markets, including Asia, could also start to recover. Chinese policymakers have already prioritized the stabilization of the country's economic growth with both fiscal policy support and more accommodating monetary conditions. A combination of the above policy outcome, together with an Asian equity valuation that is already well below its long-term average after the 2018 sell-off, could set the stage for an equity market recovery. However, investors should be mindful that policymakers are walking a tightrope, leaving little room for making policy errors. Therefore, while the current market sell-off is giving us an increasing number of attractive investment opportunities, we believe it is prudent to position the portfolio neutrally between dividend growth and dividend yield at this juncture.