CHN - China Fund: Invest In China's Leading Platforms At A Steeper Than Usual Discount

2023-05-12 01:29:35 ET

Summary

• Following a multi-year streak of relative and absolute underperformance, the Matthews Asia-managed China Fund has seen its NAV discount widen to multi-year highs.
• Post-reopening and with the policy backdrop for tech platforms finally turning supportive, the China Fund could outperform from here.
• With a sizeable performance-linked tender offer also in place, there's a lot to like here for contrarians.

China's private sector is finally catching a break this year. Following a series of policy crackdowns over the last year or two and steep valuation de-ratings for major tech platforms like Tencent ( TCEHY ) and Alibaba (BABA), the policy backdrop is now turning supportive. Also playing a key role is the better-aligned state/investor interest following the adoption of golden shares in the major tech companies, as well as the pending restructurin g of their conglomerate-like businesses. The consumer/tech rapprochement bodes well for funds focused on internet platforms like the China Fund ( CHN ), having been punished for its concentration here in recent years. With earnings momentum also gathering pace in 2023, led by last year's worst-performing sectors (property, tech, consumer discretionary), CHN could still outperform in the coming months. While there are lower-cost ways to play China consumer/tech, the CHN fund stands out for its mid-teens % NAV discount (even wider than when I last covered the fund). And with a performance-linked tender offer policy (up to 25% of outstanding shares) now in place, there is a clear catalyst for a narrower discount going forward.

Fund Overview - Actively Managed China Fund Overweight Tech/Consumer

The US-listed China Fund, actively managed by Andrew Mattock from the Matthews International team, seeks to outperform the MSCI China All Shares Index, a >780-constituent index tracking the large and mid-cap segments of Chinese equities listed domestically and abroad. In line with the Matthews investment philosophy, the fund allocates capital with a long-term focused bottom-up stock selection approach. The closed-end fund held $140.4m of net assets per its latest factsheet . It charged a 1.4% expense ratio (~70bps for management fees and the remainder allocated to other expenses such as fund administration, insurance, and investor relations, etc.). This is in line with comparable active offerings like the Templeton Dragon Fund (TDF), though China ETF offerings like the Invesco Golden Dragon China ETF ( PGJ ) and the iShares China Large-Cap ETF ( FXI ) typically maintain expense ratios in the 0.8% range. A summary of key facts about CHN is listed in the graphic below:

As reflected in the chart below, the fund's sector allocation remains heavily skewed toward the Consumer Discretionary sector at 32.1% - while down from the ~38% pre-Q1, the 13.9%pt delta to the benchmark is still massive, highlighting the manager's conviction here. Financials comes in second on the list at 19.6% (up from ~16% prior), followed by Communication Services at 12.1% (up from ~8% prior) and Industrials at 8.5% (down from ~9% prior). CHN also has meaningful positions in Information Technology (6.5%) and Real Estate (6.2%), while more defensive sectors like Consumer Staples, Health Care, and Utilities represent some of the fund's most notable underweight allocations. On a cumulative basis, the top five sectors accounted for a combined 78.8% of the total portfolio.

Per the fund's April factsheet, CHN's single-stock exposure is relatively concentrated as well, most notably in China's largest consumer/tech platforms. The largest single-stock exposure is e-commerce giant Alibaba Group at 7.6% (down from ~8% prior), replacing online retailer PDD Holdings ( PDD ) as the largest position (the PDD holding is now down to 4.8% from ~8% prior). Tencent has moved up the list at 6.6% (up from <5% prior), while shopping platform Meituan ( MPNGF ) remains the third-largest holding at 5.4% (albeit down from ~6% prior). Other notable holdings include China Merchants Bank (CIHKY) at 4.5% (unchanged) and another e-commerce player, JD.com (JD), at 4.5% (slightly down). With five of the six largest holdings in consumer tech and the top ten holdings accounting for ~46% of the overall portfolio, the manager certainly doesn't shy away from concentration.

Fund Performance - Underwhelming Recent Performance, but There Are Silver Linings

Per the latest factsheet, the fund was down by -6.0% in NAV terms and a steeper -9.0% in market price terms as a result of the widening NAV discount. The underwhelming start to 2023 comes on the heels of consecutive years of drawdowns - 2021 and 2022 saw the fund decline by 24.1% and 12.9%, respectively. And on a relative basis (vs. its benchmark MSCI China All Shares Index), returns haven't been great recently, either. Where the fund has excelled, however, is over longer timelines. Since its inception in 1992, CHN has compounded in the high-single-digits % (NAV and market price terms), while over a five-year period (the longest comparable timeline for the MSCI China All Shares Index), the fund has outperformed as well.

A key contributor is the portfolio's biggest overweights in Chinese tech/consumer platforms, which have undergone turbulence in recent years. The fund's concentration didn't help, with the portfolio composition staying largely consistent through the cycles. If the monthly commentary is anything to go by, expect more of the same going forward, with the manager still firmly bullish on the major Chinese tech platforms, given their cheap valuations and secular growth potential. Thus far, the pace of net income growth and upward revisions in CHN's overweight sectors indicate they may just be on the right track.

This isn't a fund investors will want to own for the distribution, though. While the $0.67/share distribution last year equates to a solid ~6% yield, most of this was down to the realization of prior capital gains. The recurring income portion tends to run <1% and can be inconsistent, so income-focused investors should probably look elsewhere. On the other hand, the fund's wider-than-usual NAV discount stands out - the current mid-teens % discount is a multi-year low, likely reflecting worsening investor sentiment following multiple years of underperformance. The tender offer announced in January (up to 25% of CHN's outstanding shares) has done little to alleviate concerns either. But the performance-linked nature of the offer is a step in the right direction, in my view, and offers some downside protection should the fund's relative performance (vs. the benchmark MSCI China All Shares) disappoint over the next five years.

Invest in China's Leading Platforms at a Steeper Than Usual Discount

After the 'zero-COVID' U-turn last year, Chinese policymakers appear to have done another about-face on its stance toward the private sector. In particular, commentary about the role of major tech platforms such as Alibaba as an engine of growth and job creation has been encouraging. With a streamlining of the tech conglomerate structure (see BABA's recent split-up announcement) set to improve regulatory oversight and unlock shareholder value down the line, beaten-down consumer/tech funds like CHN should benefit. With earnings momentum only just beginning to gather pace in China, led by rate and policy-sensitive sectors like property, tech, and consumer discretionary, expect the CHN portfolio to outperform as well. The catch with CHN is the expense ratio at 1.4%, which seems unwarranted given its below-par track record in recent years vs. its benchmark and the many low-cost passive options available to investors. But CHN's historically wide NAV discount is compelling, particularly with some degree of downside protection now in place via a performance tender offer (<25% of outstanding shares). Hence, investors looking for a higher-beta China play may find CHN worth a look.

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