Commentary

Year ended December 31, 2009

For the year ending December 31, 2009, the Matthews Pacific Tiger Fund gained 75.37%, while its benchmark, the MSCI All Country Asia ex Japan Index, increased by 72.53%. More than half of these gains were recorded in the second quarter underscoring the virtues of staying fully invested through some of the worst periods in the history of Asia ex-Japan’s equity market. The outperformance relative to the benchmark was driven by consumer stocks in China and Indonesia, while the portfolio’s underweight in energy and materials stocks hurt relative performance.

The consumer in Asia, particularly in China, continues to be a driver of the region’s growth. The Fund’s primary emphasis is on investing in companies that benefit from spending related to the consumption of staples such as food items and personal care—areas we added to in 2009. We remain convinced of the secular growth that is underpinned by a rise in household income and believe it will continue for several years. If anything, the recent crisis has highlighted the breadth and depth of the Chinese economy: even as some of China’s coastal and southern cities were experiencing slow to negative growth, western areas of the country and its other smaller cities registered sustained momentum helped by government programs. These cities saw a rise in prices of food commodities over the last few years and better availability of credit. As we enter 2010, we remain focused on leveraging opportunities arising from the advancement of social infrastructure programs needed to spur domestic consumption across the region, most notably in China.

In the face of one of the worst crises to hit the global economy, Asian consumers, particularly in China, India and Indonesia, demonstrated their strength and resilience. The portfolio’s automotive holdings in China and Indonesia were up significantly as the year progressed, benefiting from government subsidy programs, growing consumer income and a low interest rate environment. During the year, China eclipsed the U.S. as the world’s largest market for auto sales—this news sparked a sharp recovery in Dongfeng Motor Group. This outcome is in stark contrast to the severe decline the stock suffered in 2008 when it was being priced for value destruction. After Dongfeng’s outperformance last year, valuations are pricing in some fairly high growth expectations for the company. While we believe Dongfeng’s business model and management team are key drivers of shareholder value creation, we do not intend to overpay for the company’s earnings or production capacity.

The Fund’s financial holdings were positive contributors for the year, due primarily to a sharp recovery in real estate stocks. Beyond the ongoing demand for residential housing in economies such as China and India, some important structural reforms took place that may benefit commercial property owners. In October, China amended legislation to allow insurance companies to invest a greater percentage of their assets in properties. Across the region, the risks associated with real estate stocks stem from monetary policies being pursued outside Asia. In particular, if the U.S. Federal Reserve persists with a loose monetary policy then the odds of an acceleration in overseas inflows to Asia’s capital markets increases. This could then lead to overvaluation and asset prices that deviate from fundamentals. There is already some evidence, albeit spotty, of lofty prices being paid for residential real estate in Hong Kong and in some cities in China. For the most part, prices across a broader segment of cities in China and India are still rising in more controlled fashion. We remain alert to the risks of a “melt up” and continue to monitor the quality of the underlying assets within each of our investments.

While we do not select stocks based on political outcomes, there were important political transitions in 2009, and a number of events that impacted stock performance in the region. Taiwan’s relations with China are improving and there were some tangible developments in normalizing cross-strait trade and economic integration, including the first instance of a Chinese telecom company investing directly in Taiwan. Stronger capital links between the two economies should benefit both countries, including Taiwan’s Yuanta Financial Holdings, a new Fund holding. Yuanta is one of Taiwan’s largest brokerage firms with a market share of around 12%—nearly double that of the second-largest player. The firm is trying to position itself to benefit from the opening of financial markets in China following progress on an Economic Cooperation and Framework Agreement between China and Taiwan in 2009. There may be setbacks and delays in cooperation between the two sides, but we take comfort in Yuanta’s dominance in its home market.

Elsewhere, results from general elections in India and Indonesia in 2009 provided a boost to the equity markets in those countries, and may set the stage for a longer-term pick up in investment spending. Coupled with the domestically driven nature of both these economies, the election results sparked a sharp rally that lifted several different asset classes, local currencies being one of them. Indonesia’s rupiah was one of the best-performing currencies in 2009, and bond yields there have also tightened sharply. Despite reasons to be optimistic about Indonesia, inflation remains among the risks, and it was not so long ago—the end of 2008—that the rupiah depreciated by almost 35% in a single month. Our holdings in Indonesia are, therefore, more defensively oriented.

At the start of the year, we argued that “sudden withdrawal of foreign investors can often lead to a dislocation between fundamentals and stock prices,” and it seems that we have come full circle. In today’s environment, the risk stems from investors rushing into Asia, attracted by enticing headlines and past performance. It is important to note that valuation levels are at or above historical averages. We remain committed to a discipline that searches for long-term growth but strives to avoid overvalued assets. This can be challenging when investors fixate on a particular country or sector over a short-term horizon. As we look ahead to the next decade, it seems clear that Asia is entering a period of somewhat more mature growth relative to its own history, but one that could be more profitable. In building the portfolio for the next decade, we believe that the best ideas may emanate from areas that are not obvious at present. We will continue to canvas all of Asia ex-Japan, including some of the region’s smaller markets, for compelling long-term investment opportunities.

The views and opinions in this commentary were current as of December 31, 2009. 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 Funds' 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 12/31/2009, the securities mentioned comprised the Matthews Pacific Tiger Fund in the following percentages: Dongfeng Motor Group Co., Ltd. 1.8% and Yuanta Financial Holding Co., Ltd. represented 1.6% of the Fund.