Matthews Japan Fund Second Quarter 2014 Commentary

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For the first half of 2014, the Matthews Japan Fund (Trades, Portfolio) gained 2.96%, outperforming its benchmark, the MSCI Japan Index, which returned 0.85%. For the quarter ending June 30, the Fund returned 5.30%, underperforming the benchmark, which returned 6.69%.

Matthews Japan Fund: Market Environment

Japan’s equity market rebounded during the second quarter as market participants digested the impact of the consumption tax hike. It is noteworthy that Japanese markets advanced even while the yen strengthened over the course of the quarter. Previously, market performance had been closely correlated with the currency’s movements.

In June, Prime Minister Shinzo Abe announced his renewed growth strategy, more commonly known as the “Third Arrow.” One key measure includes efforts to reduce Japan’s statutory corporate tax rate from the current 35.64% to below 30% in phases over the next several years. Neither the media nor the markets have given much credit to Abe for his growth strategy, which is somewhat unfair. If you compare this effort against the minimal efforts in the U.S. to cut corporate tax rates—which are now the highest in the Organisation for Economic Co-operation and Development—Japan is arguably making more progress.

Matthews Japan Fund: Performance Contributors and Detractors

During the second quarter, specialty retailer Workman CO., LTD. (TYO:7564) was a top contributor to Fund performance. Workman operates a chain of retail outlets that caters mainly to construction workers for uniforms and such related goods as gloves and safety shoes. The firm has been taking market share from mom-and-pop operators while demand remains firm due to increased construction spending. Japan has been experiencing an acute shortage of construction workers and the resulting higher wages should be an added bonus for this solidly managed retailer.

Meanwhile, holdings in the information technology sector posed the biggest drag to Fund performance. Yokogawa Electric Corporation (TYO:6841) (OTCMKTS:YOKEY), an electrical engineering and software company, had the largest negative impact on relative returns. Orders for Yokogawa’s components, used in the oil, gas and petrochemical industries, have been weak in recent months compared to the market as well as against our expectations. However, orders in this business tend to be lumpy, and we do not expect any trend of weakness. Thus, we added to this position during the quarter.

Matthews Japan Fund: Notable Portfolio Changes

During the quarter, we initiated a position in Mabuchi Motors Co., Ltd. (OTCMKTS:MBUMY) (TYO:6592), a manufacturer of miniature motors used primarily in automobiles. Mabuchi’s business has struggled over the past decade as demand for CD and DVD players contracted sharply. Mabuchi had a virtual monopoly on motors used in such products, which led to a significant decline in revenue. The bulk of its business now comes from the automotive industry, within which the adoption of certain motors is rising, and revenues seem to have finally turned a corner.

Additionally, with healthier job creation and low unemployment in Japan, we expect consumption to become more robust. As a result, we have selectively added to consumer sector holdings.

Matthews Japan Fund: Outlook

The recently announced growth strategy included a plan to establish a corporate governance code by mid-2015. We believe Japan’s corporate sector needs to improve returns on capital, either by paying out more to shareholders or investing in profitable growth opportunities. We also believe measures to improve governance, and ultimately returns, will benefit investors over the long run and we will keep a close eye on developments in this area. In the short term, recent corporate earnings guidance has been very conservative while demand has been resilient. We believe there is potential for earnings estimates to be revised upward going into the latter half of the year. Additionally, an expected increase in the domestic equity allocation by Japanese pension funds may help set a floor on prices. In such an environment, we will continue to focus on identifying unique businesses with strong pricing power. In particular, consumption-related businesses in Japan that have struggled for many years under deflation may turn a corner should inflation be sustained.

The views and opinions in this commentary were current as of June 30, 2014. 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.

Statements of fact are from sources considered reliable, but neither the Funds nor the Investment Advisor makes any representation or guarantee as to their completeness or accuracy.

As of 6/30/2014, the securities mentioned comprised the Matthews Japan Fund (Trades, Portfolio) in the following percentages: Workman Co., Ltd., 1.4%, Mabuchi Motor Co., Ltd. 1.0% and Yokogawa Electric Corp., 1.6%. Current and future portfolio holdings are subject to risk.

Performance and distribution figures discussed in any of the Manager Commentaries reflect that of the Investor Class Shares.

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