Matthews China Fund Second Quarter 2014 Commentary

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Matthews China Fund commentary the second quarter of 2014.

For the first half of 2014, the Matthews China Fund (Trades, Portfolio) declined -5.17%, underperforming its benchmark, the MSCI China Index, which declined -0.50%. For the quarter ending June 30, the Fund gained 3.64% while its benchmark gained 5.70%. Most of this underperformance was due to the information technology and energy sectors.

Matthews China Fund: Market Environment

Following a sharp decline earlier in the year, Chinese equities experienced volatile trading during the second quarter. In April, stocks came under pressure amid weak macroeconomic data. Investor sentiment later recovered following stimulus measures that the government rolled out in targeted areas. The central bank also cut its reserve ratio requirements for select banks. Most notably, the government announced a new program that links the Hong Kong and Shanghai Stock Exchanges, and paves the way for easier trading access between the two equity markets.

While it has been a challenging first half of the year, we have seen positive developments in China’s domestic consumption. Strong growth momentum resumed among auto sales in China, spurred by the launch of some new vehicle models. There were also indicators that retailers, particularly apparel firms, have experienced some recovery in sales. Macau’s gaming companies improved from the slowdown of the first quarter and while we still await further signs of a broad-based recovery, overall valuations in the consumer discretionary space have declined to more attractive levels.

Matthews China Fund: Performance Contributors and Detractors

During the quarter, a sharp increase in global oil prices significantly boosted share prices for energy-related firms. Our somewhat limited exposure in the energy sector impacted relative performance during the period.

Information technology is an area where we have put a lot of emphasis. Compared to the benchmark’s IT exposure, which is mostly concentrated on one individual company, Tencent Holdings, the Fund’s IT exposure is more diversified, and more towards smaller companies. So far this year, our holdings in this area did not work well and the overall IT sector performance was dragged down especially by two small-cap companies – SINA Corp (NASDAQ:SINA) and Digital China Holdings Limited (HKG:0861). Sina (SINA), one of China’s most popular web portals, came under selling pressure due to market concerns that its Twitter-like online communications services Weibo, may be losing its growth momentum to a main competitor. However, we continue to hold Sina as we believe the target market for its competitor is different from Weibo and we also believe Sina’s current valuation does not reflect its other attractive underlying assets.

Digital China Holdings Limited (HKG:0861) is a major distributor of foreign IT products in China and also provides system integration and IT services. The company has been losing revenue in its IT products distribution business among a weak economy and changing operating environment. However, we continue to hold Digital China as we believe the company is selling at a deep discount to the market value of its listed subsidiaries in the IT services sector, which is still growing nicely. During the quarter, Tencent (HKSE:00700) performed well on the back of strong growth in China’s e-commerce industry. While the Fund also holds Tencent, our relative underweight was a detractor.

Matthews China Fund: Notable Portfolio Changes

During the second quarter, we continue to consolidate our holdings in the consumer sector. We also increased our weighting in areas involving industrial automation as we believe that businesses in this sector will benefit from China’s ongoing wage inflation.

Matthews China Fund: Outlook

Looking ahead, we expect that Chinese government is likely to continue its minimal-stimulus policy implementation to keep its targeted GDP growth level of 7.5%. Compared to the first half, we turn more positive on the outlook in the second half as government’s stimulus policies are taking effects and that corporate earnings seem to be gradually recovering. Potential risk may still come from the property and the banking sector. Property prices in some Chinese cities started to see some declining along with transaction volumes and we expect that some relaxation of restriction on property purchasing may happen in the second half.

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 China Fund (Trades, Portfolio) in the following percentages: Tencent Holdings, Ltd. 3.8%, Sina Corp.1.5% and Digital China Holdings, Ltd. 1.5%. 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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