Commentary

Year ended December 31, 2009

For the year ending December 31, 2009, the Matthews India Fund gained 97.25%, while its benchmark, the Bombay Stock Exchange (BSE) 100 Index rose 95.83%, with most gains recorded in the first half of the year. In fact, the BSE 100 Index surged nearly 20% in a single day in May, reflecting investor excitement over the results of India’s general elections. The Fund participated in the sharp single-day move in Indian markets as we maintain a philosophy of being fully invested at all times.

During the fourth quarter, the Fund returned 10.95%, while its benchmark increased by 7.05%. The relative outperformance stemmed from some of the portfolio’s smaller and mid-size companies that benefited from better-than-expected earnings performance in the third quarter. Operating performance for these companies, in sectors such as consumer staples and industrials, is particularly noteworthy as it provides a favorable contrast to the mixed performance of their larger peers.

While 2008 was the worst year in the history of India’s equity market, 2009 proved to be the second-best year of annual returns per the BSE 100 Index (only 2003 posted better returns). The volatility in U.S. dollar-denominated returns was especially exaggerated due to the fluctuation of the Indian rupee on the back of uneven foreign capital flows. We believe the past two years have shown it is difficult to predict the short-term course of the markets, and may be a fruitless exercise to attempt. In periods of such turbulence, we have maintained our discipline of investing in companies and businesses for the long term.

The volatility of capital and foreign exchange markets lies in stark contrast to the relative stability of the Indian economy, which has grown at a mid-single digit rate through the worst periods of the financial crisis and is recovering faster than many other world economies. The depth in the Indian economy has been particularly visible in the past two years with the increasing importance of rural spending as a component of the country’s overall personal consumption. The Fund strives to identify such emerging opportunities, and maintains a strategy of focusing on smaller and mid-size companies that are nimble enough to benefit from such bottom-up growth.

This strategy was tested during the start of the year. In the aftermath of one of the worst corporate governance scandals to hit India, small and mid-size companies suffered a disproportionate decline in market capitalizations compared to their larger peers. The decline was fairly broad-based with little differentiation between companies. In this environment, we stayed consistent with our belief of building portfolios anchored in the analysis of individual companies. It was our conviction in the sustainability of these businesses that enabled us to stay invested, and to participate in the rather steep recovery that followed through the rest of the year.

The Fund’s investment in Crompton Greaves, a manufacturer of power transmission and distribution equipment, demonstrates our approach of scouting for companies that may not be index heavyweights. Crompton Greaves has been competing with more established multinational companies in India for the last several decades. In recent years, the company has abandoned the “cost-plus” business model to focus on becoming technologically competitive with its multinational peers. In a sign of a calculated expansion strategy, the management team has deployed its cash flows from existing businesses, and made foreign acquisitions intended to enhance its technological expertise and keep pace with competitors. In spite of these promising acquisitions, and better operating performance, buyers of Crompton Greaves equities enjoy a valuation discount compared to its larger peers. With India’s peak power deficit rising to 14% in recent years, there will likely be opportunities for Crompton Greaves to benefit from rising investments in the power sector. At the same time, we believe the real challenge for the management team is to continue to deploy its cash flow in accretive projects to sustain long-term returns for shareholders.

On a sector basis, the portfolio continues to maintain an overweight in industrials and a significant allocation to financials, which includes banks, insurance companies and real estate firms. As Indian banks posted stable results over several consecutive quarters, the perception of risk associated with global financials subsided, and stocks in the sector recovered strongly. By contrast, the recovery in the real estate sector seems more tenuous, and challenges stemming from a lack of transparency remain a hurdle for investors. However, both residential and commercial properties in the real estate sector are likely to grow at least in line with, if not faster than, the rest of the economy. One of the real estate holdings in the portfolio is Ascendas India Trust (AIT), a Singapore-listed firm with commercial real estate holdings in southern India. We were attracted to the stock’s yield of close to 10% last year as well as the company’s more robust accounting and governing principles, relative to those typically found in India’s real estate sector. One risk we will monitor is the limitations of AIT’s geographical concentration.

Given the recent appreciation in India’s broader indices, valuations are at or slightly above historical averages. The volatility in the capital and foreign exchange markets underscores the importance of a longer investment horizon when investing in India. From that perspective, India offers much to be excited about. Compared with other emerging markets, India has a greater depth and breadth in the quality of its companies, and entrepreneurs who are mindful of returns on equity. In addition, the country’s capital market infrastructure helps facilitate investment in these companies; firms which are driven mainly by domestic demand.

Several challenges remain for the Indian economy, including the structural challenge of attracting more stable, long-term foreign capital, particularly as the economy embarks on a much-needed investment cycle. It is encouraging that in the past two years, foreign direct investments (FDI) have accelerated sharply to a rate of almost 2% of GDP, up from less than 1% at the start of the century. To put this in perspective, the Chinese economy was attracting FDI at a rate of 4% to 6% of GDP during the investment-led growth of the 1990s. Beyond the changes in global risk appetite, the gradual removal of regulatory hurdles has been the biggest driver of this jump in FDI. India’s political transition earlier this year set the stage for a continuation of these reforms, but history has shown that progress can come haltingly and require close monitoring.

India’s more pressing and immediate risk stems from the prospect of a sharp rise in inflationary expectations driven by a combination of structural and cyclical factors like the recent rise in food prices. The central bank has already started to withdraw from the loose monetary policies enacted in the past two years. The risk is that the tightening process can lead to a disorderly rise in interest rates. Furthermore, India’s equity market is likely to remain exposed to changes in global risk assessment. Pullbacks driven by these shorter-term factors are often investment opportunities as we continue to look for companies that are providing solutions to some of India’s structural challenges.

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 India Fund in the following percentage: Crompton Greaves, Ltd. represented 3.5% and Ascendas India Trust 1.6% of the Fund.