Matthews Japan Fund commentary for the fourth quarter 2014.

For the year ending December 31, 2014, the Matthews Japan Fund returned -2.60% (Investor Class) while its benchmark, the MSCI Japan Index, returned -3.72%. For the fourth quarter of the year, the Fund returned -4.19% (Investor Class) versus -2.40% for the Index.

Matthews Japan Fund: Market Environment

2014 was a mixed year for U.S.-dollar based Japanese equity investors. The MSCI Japan index notched gains of 9.83% in local currency terms, buoyed by robust corporate earnings growth despite weak macroeconomic figures. However, such gains were negated by the rapid decline in the Japanese yen, which fell 12.02%. The drop was seen particularly in the latter half of the year as the Bank of Japan expanded its already aggressive monetary policies. Inflation rates have been slowing due to soft commodity prices, particularly oil, and weak household consumption, prompting the central bank to respond in order to meet its inflation goals.

Meanwhile in December, Prime Minister Shinzo Abe and his Liberal Democratic Party clinched a landslide victory in a key Lower House election to secure four more years during which they may further advance reform policies. As a result, the plan for a second round of consumption tax increases, originally scheduled for October 2015, was postponed to April 2017.

Matthews Japan Fund: Performance Contributors and Detractors

Our holdings in the health care sector were leading contributors to performance in 2014. Long-term holding Sysmex, a global leader in hematology equipment, performed well on the back of solid growth globally, particularly in China where growing household incomes are driving demand for health care services. Medical device company Asahi Intecc and medical information firm M3 also delivered solid performance, driven by revenue growth through new products and services.

On the other hand, non-bank financial company ORIX was the biggest detractor to Fund performance, despite delivering solid earnings returns. The poor performance likely had more to do with the weak macroeconomic environment, rather than any individual issues with the business. Internet and telecom giant SoftBank ended the year on a sour note despite the successful IPO of its largest investment—Chinese e-commerce giant Alibaba. Poor performance of SoftBank’s U.S. telecom unit, Sprint, also weighed on investor sentiment.

Matthews Japan Fund: Notable Portfolio Changes

As a result of the merger of the Nomura Japan Fund into the Matthews Japan Fund in October, the number of holdings increased beyond its typical range. However, we intend to manage the Fund so that over time, the number of holdings will return to its typical range of approximately 50 to 75 holdings.

Over the course of the year, we significantly reduced our exposure to Japanese banks. Earnings at the country’s major banks have been solid on the back of increased overseas lending, low credit costs and robust fee revenue. There has also been some improvement in shareholder return policies. However, already low interest rates in Japan have been even lower due to the flood of money being supplied by the Bank of Japan. Given these extraordinary and aggressive monetary measures, interest rates in Japan are likely to remain low over the medium term. Low rates combined with more stringent regulatory requirements on capital adequacy will limit the ability of banks to generate sufficient returns on capital. Therefore, we sought to redeploy the funds elsewhere.

Matthews Japan Fund: Outlook

Lower oil prices and the postponement of a second consumption tax hike should be a relief for households that have seen real incomes decline. Nominal base wage growth has remained positive for the past several quarters, and the pace of wage growth may accelerate following spring wage negotiations. Abe’s administration has announced plans to cut the corporate tax rate and introduce incentives for companies that increase wages or hire more workers. Though import cost inflation may remain a challenge for importers and households, in general, we expect the consumption environment to stabilize. Additionally, the government is in the final stages of implementing a Corporate Governance Code, which will effectively require listed companies to appoint multiple independent directors and publish financial targets, such as a return on equity. Such measures may not have an immediate effect on corporate earnings or stock price performance, but we believe it will lead to a gradual change in corporate mindsets, benefiting Japan investors over the long term. Given this background, we remain bullish on the outlook for select Japanese companies.

The views and opinions in this commentary were current as of December 31, 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 12/31/2014, the securities mentioned comprised the Matthews Japan Fund in the following percentages: Sysmex Corp. 2.4%, Asahi Intecc Co., Ltd. 2.0%, M3, Inc. 2.5%, ORIX Corp. 2.8% and SoftBank Corp. 2.4%. Current and future portfolio holdings are subject to risk.

Matthews Japan Fund Q4 2014 Letter