The Matthews China Dividend Fund (MCDFX) seeks to achieve its investment objective by investing at least 80% of its total net assets (about $14 million) in income-paying equity securities of companies located in China and Taiwan (China includes other districts, such as Hong Kong). Jesper Madsen is the lead portfolio manager of the fund. Prior to joining Matthews in 2004, he was an Analyst at Charter Equity Research.
China is one of the fastest-growing countries in the world. Last year, the Chinese economy grew at an average annual rate of about 8.5%. Moreover, the economy started out 2010 with a bang, increasing nearly 12% in the March period. There have been many concerns that the country has too much capital, the pace of growth of capital has been excessive, and that the recent acceleration in growth has resulted in debt quality problems.
Although there may be overcapacity in certain industries in China, such as steel, the overall situation isn’t overly concerning, according to the fund’s management. For example, Matthews notes that net capital per person in China today is roughly 3% of the level in the United States. What’s more, the New York metropolitan area has 10 times more office space than Shanghai, even though the population of both areas is about 19 million. Too, certain industries have ample room for growth, in management’s view. Medical equipment per capita, for example, is just about 10% of the United States’.
There are also arguments that China’s investment is growing too quickly. Matthews doesn’t believe that this is the case, however. Although it appears that China’s fixed asset investment ratio to GDP is high, management thinks that this requires an explanation. In economies that are transforming from a centrally planned to a market-oriented structure (such as China), the fixed asset investment ratio can be misleading. For example, if a Chinese company builds a new power plant for $100 million and scraps the old one, then this counts as a $100 million fixed asset investment. (The scrapping of the former facility does not get subtracted.)
Also, the fund’s management doesn’t believe that China has taken on too much debt. Overall leverage in China’s economy is not significant, and bank lending is about 150% of GDP, with the ratio falling during the boom years of 2003 through 2008. What’s more, loan deposit ratios of approximately 70% suggest China’s banking sector is very liquid.
What does this mean for the Matthews China Dividend Fund? It appears that returns on capital in China have been rising in many instances, which suggests that productivity and the underlying economy remain strong. This has resulted in solid earnings for many Chinese companies, along with healthy share-price gains. For example, over the past three months, through April 30, 2010, the fund’s benchmark MSCI China Index returned nearly 7.5%, while the Matthew’s portfolio generated returns of nearly 9%.
The fund’s main contributors were its two healthcare holdings, pharmaceutical manufacturer United Laboratories and St. Shine Optical, a Taiwanese contact lens manufacturer. Management believes that the healthcare sector (6% of the portfolio’s holdings) is set to benefit as income levels in China continue to climb and the government’s focus on expanding healthcare coverage continues. However, the solid growth prospects of the healthcare sector have been well recognized by investors, and valuations are high. Management intends to focus on companies that have a competitive advantage either through technological know-how or low-cost manufacturing. Indeed, United Laboratories is one of the world’s largest low-cost manufacturers of antibiotics. The company is also initiating the production of insulin for diabetes, a lifestyle disease that is growing rapidly in China.
The fund continues to be underweight in financials (19% of assets, compared to 38% for the benchmark) and holds no Mainland Chinese banks, even though they are among the country’s largest dividend payers. This is because management believes that there is some potential for an increase in nonperforming loans in two or three years, resulting from lending growth of 95% in 2009 (driven by the need to fund a recent government stimulus package). The fund, instead, chooses to have exposure to the Chinese financial sector indirectly, through holdings, such as HSBC Holdings and Hang Seng Bank, a leading bank in Hong Kong.
The common denominator among all of Matthew fund’s holdings are an above-average dividend yield, proven dividend record, a clearly stated dividend policy, and a more-conservative business model. Although yields have contracted in recent months, reflecting higher equity prices, companies in Hong Kong, Mainland China, and Taiwan still offer attractive payouts relative to their U.S. counterparts. Matthews expects these trends to continue given the strong growth rate for China as a whole.
Matthews China Dividend Fund has handily outpaced its benchmark index by nearly 7.5% since its inception on November 30th of last year (approximately a 6% gain versus a 1.5% loss for the index). We believe that the management team is savvy and it has a long history of investing in Asia. Also, the expense ratio is relatively low, at 1.5%, after fee waiver, reimbursement, and recoupment expenses. However, there are a couple of factors to keep an eye on. First, the portfolio’s top-10 holdings account for nearly 40% of assets. This implies that the fund could be putting a few too many eggs in one basket. Also, the fund has only been in existence for about six months or so, which means it has a limited track record despite Matthew’s long record of investing in Asia. What’s more, this is a country-specific fund, which means that if China experiences an economic downturn, the fund’s performance might be markedly hurt. In conclusion, investors seeking a stake to China and believe that dividends provide important investment signals, may want to consider this fund.