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Matthews China Fund

March 25, 2002

Welcome to “Manager Insight.” In this issue, mutual fund journalist James Skahan interviews Richard Gao, co-portfolio manager of the Matthews China Fund. China currently reports GDP growth nearly three times that of the U.S. or any other Western country; is now the time for you to consider a China fund?

By James Skahan, FundEmail journalist

After sweeping government-sponsored economic reform began in 1979, China has evolved from the world’s largest centrally planned economy to one of the world’s most vibrant market economies.

Richard Gao, co-portfolio manager of the Matthews China Fund and native of Guangzhou, China, is proud of how far the country has come in the last twenty years, and he is excited about where it is going. While China’s economy in the next decade might not match the remarkable growth of the last ten years, Richard believes China is just now hitting its stride.

I spoke to Richard Gao from the Matthews Asian Funds offices in San Francisco.

FundEmail: What kind of person should invest in a China fund?

Richard Gao: First of all, they need to be long-term investors. China is the largest emerging market in the world. The economy and the reform they have been doing are quite substantial but also very volatile. We are very positive on the future development of China’s economy, but investors in our fund should have a long-term view. Secondly, investors in our fund should have a high tolerance for risk. And finally, this fund is suited for investors who want to diversify their domestic portfolios with a single country fund that has had historically low correlations with the U.S. market.

How does the Matthews China Fund differ from other China funds?

Our fund is a little bit different than other funds in the category. We invest mostly in companies that have direct business in China, while most other funds invest mostly in Hong Kong or Taiwanese companies.

The Matthews China Fund is a diversified portfolio that consists of top quality mainland Chinese companies in different industries. These companies adhere to our strict bottom-up investment approach. We believe that by focusing on these mainland Chinese companies, the Fund is in a good position to benefit from the substantial economic growth of the mainland.

The majority of the fund invests in H shares, Red Chips, and China Plays. H shares are mainland Chinabased companies that do business exclusively with the mainland. Red Chips are Mainland Chinese companies that do business with both the mainland and Hong Kong. However, the majority of Red Chip business is done with the mainland. H share companies generally focus on just one type of business such as auto manufacturing, infrastructure, real estate, etc., while Red Chips are usually conglomerates that invest in different types of industries. China Plays are companies that are listed on the Hong Kong Stock Exchange that derive the majority of their revenue from mainland China.

How do you decide on stocks to buy?

We are bottom-up stock pickers. In selecting stocks for the portfolio, we use an approach called “Growth at a Reasonable Price.” We like growth stocks, but we won’t pay excess for that growth. Our ideal company candidate will be growing at double-digit growth rates but selling at a single digit P/E ratio. First, we look for companies that are leaders or have a dominant position in their different industries. After that screen, we will go ahead and do a qualitative analysis. At this stage we will call the management team or call analysts that cover those stocks. We will also travel to Asia and visit with company management. I fly to Asia two or three times a year, and every trip I visit twenty to thirty companies in mainland China or Hong Kong. The two other co-managers of the fund travel even more frequently than I do.

When we become comfortable with the company’s business strategy and satisfied with their management, we will do a quantitative analysis. We’ll analyze financial statements and asset qualities and we look at growth strategies and earning projections. After we buy a company, we do ongoing analysis and keep a very close eye on everything related to the company.

Is there a mainland Chinese equivalent of the Securities and Exchange Commission?

Yes, there is. It is called the China Securities Regulatory Committee. (CSRC). It is the top priority of the CSRC to strengthen regulations in the mainland Chinese stock market and protect shareholder interests. It is a growing capital market right now in China. China has about 1,000 listed companies, but the stock market only has a history of about eleven years. Most domestic Chinese stocks are not available to foreign investors. China is the second largest stock market in Asia, just behind Japan. The only stocks we are able to buy are H Shares, Red Chips, and domestic B Shares. Combined, our investment universe totals around 200 stocks. Because the domestic Chinese market has a bad reputation in terms of compliance and transparency, we hold hardly any domestic B shares in the Matthews China Fund.

Fortunately, H Shares and Red Chips are listed on the Hong Kong Stock Exchange, and they have to abide by the exchange laws of the Hong Kong Stock Exchange. It is a developed stock market, which has much tighter rules and regulations. Companies that are listed on the Hong Kong stock exchange have to be audited by one of the top five international accounting firms.

Does the Japanese recession affect China’s economy?

I would argue that the problems in Japan will have a larger impact on other Southeast Asian countries than they will on China. That’s mainly because China’s economy is more driven by their domestic demand than countries like Taiwan or Singapore. Those countries are export driven. For example, 50% of Taiwan’s GDP comes from exports. Exports only account for around 20% of China’s GDP, although this ratio is becoming higher as China continues to connect to the global economy.

Have economic government reforms had a substantial impact on the lives of the Chinese people?

Yes. Just one example is that now people can own their own homes. China instituted a big reform in the housing market that allows individuals to buy their homes from the government. In the past, all housing was free as long as you were a government official or working in a state-owned enterprise. 90% to 95% of people used to work for the government. In 1996, the Chinese government began a program of housing reform. Individuals were allowed to buy their homes from the government.

Now, in some large coastal cities in China, 75% to 80% of people own there own apartments. This has created a consumption boom in China. After you buy a house or apartment, you have to do the remodeling, buy some consumer electronics, upgrade your appliances, etc. These home improvements have been one of the major forces behind China’s consumption growth. China has launched a mortgage program to encourage people to buy their house or apartment. Five years ago, mortgages did not exist in China.

Do you expect the Chinese economy to continue to grow as quickly as it did in the last decade?

I expect the Chinese economy to continue to have a very high rate of growth, but probably not as high as the last decade. But while the growth rate may be slowing down, the quality of the growth will be improved quite substantially, especially when China joins the World Trade Organization (WTO). Entry will basically open up competition between Chinese and multi-national companies. Many Chinese companies are in the midst of restructuring in anticipation of WTO entry. They are laying off redundant people and closing down unprofitable factories. They are focusing more on profits and on gaining market share. So the quality of China’s growth continues to get better and better.

Do you expect these reforms to continue at their present pace? Is there any chance that the Chinese government could reverse course?

When I visit my friends and family in Guangzhou, they tell me that they are quite satisfied with what the government is doing economically. I think once China opened up to the outside world it became very hard for them to go back to the old socialist planned economic model, even if they wanted to.

What aspect of the Chinese economic picture is most exciting?

China just joined the WTO at the end of last year. We believe that entry will bring a lot of opportunities to Chinese companies, along with a lot of challenges. It will make for a much more competitive environment in China. WTO entry will further accelerate the reform process in China and bring more foreign direct investment and new technologies to China.

I’m quite positive on the long-term development of China. I believe that China’s economy is heading in the right direction. That said, in the meantime, it is still an emerging market, and there are still a lot of things to be done in the reform process. I believe this will be a volatile market going ahead.

Can you name some of your current favorite stocks?

We like Huaneng Power (HNP). This company is the largest power producer in China, and has a diversified power portfolio. It has power plants in eight different locations around the coastal region and the Beijing area. Because China’s economy has been growing quite rapidly, the demand for power in the past decade has been skyrocketing. Huaneng Power, because of their good locations, has been benefiting from this demand.

AsiaInfo (ASIA) is a NASDAQ listed company that provides network solutions and software solutions to the major telecom companies in China, including telephone equipment companies and mobile phone companies. They are also a pioneer in building up China’s Internet network, and are definitely the leader in the industry. Their management is very strong. Most of their senior management has been educated in the U.S. They have had experience working for large U.S. technology companies. Their growth has been very strong because China’s Internet and cell phone usage have been growing rapidly. 145 million people in China have cell phones, as compared to 120 million in the U.S., and the number of users is still growing very fast. We believe that AsiaInfo has a leading position in the industry, and has very strong growth potential and very good management.

China Unicom (CHU) is a one of the two mobile phone providers in China. China has only two mobile phone licenses available for the whole country, and the number of mobile phone subscribers has been growing substantially. China Unicom stock has been suffering from general weakness in the global telecom sector. At these levels we are starting to see some good values available for the company. Most importantly, Chinese mobile phone subscribers will be upgraded to 2.5 G service later this year. China Unicom just launched their CDMA services this year. We believe their subscriber total will grow substantially next year.

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