Near-term headwinds aside, the fundamental drivers of China’s long-term economic growth remain intact. This fund’s savvy manager has positioned the portfolio to weather the storm and participate in the upside.

 

In the minds of many US investors and analysts, Chinese equities inhabit the vexed position of being both a part of and apart from the global economy. The bull-market fervor that reigned for roughly five years pushed share prices of the country’s largest and most liquid securities to unseen heights, as foreign investors bought into the myth of a decoupled Chinese economy where domestic demand provided insulation against a worldwide slowdown.

 

Increasing urbanization and the emergence of a growing middle class will continue to strengthen domestic demand–a powerful economic catalyst given the size and savings rate of the country’s population–but the Chinese economy doesn’t exist in a vacuum.

 

Declining foreign demand in the wake of a global economic swoon has weighed on Chinese exports and industrial production, both of which remain substantial contributors to the country’s GDP. And leverage-induced selling among institutional investors exacerbated declines suffered by the largest and most widely traded equities: Last year the MSCI China Index lost 50.8 percent.

 

Even the savviest of investors have struggled amid this broad-based selloff. Matthews China (MCHFX) finished 2008 down 49 percent, though fund manager Richard Gao still managed to outperform the fund’s category and generate three-year and five-year returns of 5 and 6 percent, respectively. This slight outperformance stems from Gao’s decision to pare positions in certain high-flying sectors in favor of utilities and staples. And the fund’s focus on identifying and holding lesser-known stocks likewise provided a degree of stability.

 

Near-term maneuverings aside, the Gao’s long-term focus and understanding of the fundamentals underpinning China’s emergence as an economic power commend this fund to patient investors. Not only are many Chinese equities trading at attractive valuations now that the average share prices have fallen from 33 times earnings to the high single-digits, but domestic demand has also remained relatively resilient despite declines in exports and industrial production.

 

And government efforts to stimulate consumption through tax and interest rate cuts as well as massive spending on infrastructure construction should provide a bit of a cushion. In fact, many analysts expect the country’s GDP to grow at a rate of 6 to 8 percent in 2009, an impressive number given the slowdowns and contractions afflicting many developed countries.

 

One company that Gao believes should offer relatively stable earnings in the coming quarter and will profit from an expanding middle class is Tingyi (Hong Kong: 322, OTC: TCYMY), one of China’s biggest instant noodle, baked goods and beverage companies. Its Master Kong brand of noodles boasts an almost 50 percent market share as do its line of bottled teas and waters; over the next several years, Gao expects the company to capitalize on opportunities to grow its business among rural customers.

 

Though home prices have weakened–mainly in the built-up coastal cities–Gao also sees long-term opportunities the real estate construction sector, especially as development ramps up in second and third-tier cities in inland China. That’s the thesis behind the fund’s longstanding investment in China Vanke Company (Shanghai: 200002, OTC: CVKEY), which stands to benefit the geographic diversity of its construction portfolio as well as the country’s increasing urbanization.

 

Certain Internet-related companies have also proved relatively recession proof thus far and offer considerable growth potential. China has surpassed the US in terms of Internet usage, boasting more than 300 million users; however, unlike the US and other developed nations, the penetration rate remains quite low and the leading firms have ample opportunity to grow revenues as more Chinese come online.

 

Chief among the fund’s Internet-related plays is Tencent Holdings (Hong Kong: 700, OTC: TCEHY), China’s leading online instant messaging service provider which controls about 77 percent of the market. Since its inception in 1998 the company has successfully monetized its 355.1 million user accounts by cross-selling value-added services to members of its Internet and mobile communities as well as subscriptions to its popular online gaming platforms. Online advertising provides additional income. Gao believes that steady revenues from a dedicated user base position the firm to weather any economic weakness, while its brand recognition and leading market share should enable the company to capture a substantial number of new users.

 

NetEase.com(NSDQ: NTES) is another company that should benefit from the coming deluge of Chinese Internet users. The Internet portal derives some of its revenues from online advertising, but subscriptions to its popular multiplayer games continue to grow and a recent deal to license content from a successful US publisher should further bolster revenues.

 

Although the Chinese growth story remains as compelling as ever–perhaps even more so because of last year’s selloff–investors should remember that the country’s economy faces very real headwinds going into 2009 and that this fund is a long-term play for patient investors.

 

At the same time, given the volatility of region-focused funds, whose holdings are closely tied to the fate of a specific market, prospective investors should consider whether their portfolio provides sufficient diversity to offset this risk.

 

Matthews ChinaSan Francisco CA 800-789-2742
www.matthewsfunds.com MCHFX
Sales fee: none
Assets: $730 million
Early withdraw: 2%; less than 90 days
No. of holdings: 64
Turnover rate: 22%
Expense ratio: 1.17%
Assets in top 10 holdings: 28.6%
Min. initial investment:  $2,500; $500 if IRA
Largest quarterly loss*: -22.5%; 1^st Qtr 2008
Largest quarterly gain*:  33.2%; 3^rd Qtr 2007
Top five positions (symbol): Cheung Kong Infrastructure Holdings (1038), Hong Kong and China Gas (0003), SINA Corp (SINA), Dongfeng Motor Group (0489), China Mobile (CHL)

 

*Past three years

 

Source: Morningstar