For the year ending December 31, 2020, the Matthews Japan Fund returned 29.82% (Investor Class) and 29.85% (Institutional Class), while its benchmark, the MSCI Japan Index, returned 14.91%. For the fourth quarter of the year, the Fund returned 15.87% (Investor Class) and 15.87% (Institutional Class), versus 15.29% for the Index.

Market Environment:

Japan’s equity markets were volatile but resilient in 2020. Equity prices declined sharply in February and March, triggered by the COVID-19 pandemic, but had rebounded strongly by year end. Swift monetary expansion actions by the major central banks, along with large-scale fiscal policy measures to offset the negative economic impact, improved sentiment toward growth-oriented stocks globally, including Japan. The Bank of Japan announced an option to double exchange-traded fund (ETF) purchases, while the Japanese government passed a significant stimulus package to help bolster the economy.

Against this backdrop, Japanese equities handily outperformed their EAFE counterparts in 2020. We believe this was driven by Japanese corporates' ample cash balance, which helped to cushion against extreme situations during the COVID outbreak. Equity prices were also bolstered by an incremental improvement in the outlook for corporate profits and economic conditions. Ample liquidity provided by the central banks around the world also benefited the Japanese equity market, as this liquidity lead to improvements in the global manufacturing cycle.

At current levels, we view the recovery scenario has somewhat been reflected in share prices. Going forward, it will be a tug of war between the trajectory of the COVID-19 situation and the pace of vaccine distribution, which will influence the pace and the magnitude of economic recovery.

Performance Contributors and Detractors:

From a sector perspective, stock selection in industrials, health care and information technology contributed to Fund performance over the course of the year. On the other hand, stock selection in consumer staples, real estate and financials was a slight detractor, even though these sectors in aggregate were contributors due to allocation effects. From a market-cap perspective, stock selection contributed across all capitalizations—mega, large, mid and small.

Turning to individual securities, photomask inspection equipment maker Lasertec was the largest contributor to the overall performance for the full year. Currently the only provider of mask and mask-blank inspection equipment using EUV (extreme ultraviolet lithography) as a light source, EUV adoption in major foundries and increased usage in memory makers is likely to further enhance the business opportunity of the company. However, we exited the name during the year, as we viewed the market is starting to build lofty expectations to justify the share price momentum.

Medical platformer M3 was also a major contributor to the performance with its Japan platform now covering 90% of all doctors. The company is utilizing the platform to expand and disrupt the areas of contract research organizations and career business recruitment and networking, in Japan and other markets. Overseas is a meaningful part of overall revenue, with China being the largest growth driver.

On the other hand, engineer-staffing company Technopro dragged within our portfolio companies. We see long-term trend of labor tightness and trend of outsourcing in IT engineering remain intact. However, the slowdown of the economy in Japan and other economies overseas may impact the staffing industry both in terms of demand and pricing for staffing services. We exited the stock during the year.

Notable Portfolio Changes:

Our portfolio actions in 2020 occurred in two phases. During the first three months of the year, we reduced the number of names in the Fund and shifted to high-quality names that we believed could generate positive cash flow regardless of the macro economic situation. Later in the year, during July and August, we started to increase our exposure to cyclical growth companies as economic activity started to improve.

In the fourth quarter, we initiated a new position in medical equipment manufacturer Olympus. Olympus had previously struggled with governance issues, including past accounting issues and several large-scaled recalls. However, under a new management along with much stronger board oversight, we are seeing some positive changes, especially over the past year, in fundamentals and ESG measures.

We have also participated in a few IPOs, including musical instrument manufacturer Roland and application development platform Yappli. Roland has strong brand equity in its digital musical instruments, with a strong following of "Roland sound" by many professional and amateur music enthusiasts. We also believe with the current capable management, there are company specific margin improvement opportunities in product average selling price growth and reducing stock keeping units (SKUs). Yappli is one of the leading no-code mobile app development companies based in Japan, benefitting from e-commerce growth in Japan.

Outlook:

In terms of market leadership, 2020 turned out to be another great year for growth equity investing. In a recessionary environment coupled with lower interest rates and ample money supply, high-quality, stable growth, large cap, innovation sectors outperformed strongly against value, small cap, cyclical and lower-quality names. We think 2021 will not be such a one-way street like 2020. With profit recovery already baked in current consensus estimates and valuation levels, upside surprise in profits will ever be more important in investment returns going forward. We will continue to look for investment opportunities in high-quality companies that are able to execute well. At the same time we will also seek for opportunities in cyclical areas that have a potential to achieve high growth via lower and easier competition.

For many years, Japanese equities have not been considered a place to invest by many investors, but rather a place to trade in and out of. Investors tend to buy Japan when things bottom out and improve, then get out when things start to peak. However, the dynamic has meaningfully changed since 2010 as Japanese corporates have been generating improving levels of profits in each bottom of the cycle. 2020 showed another year of resiliency of Japanese corporate profits. We believe Japan’s equity market fundamentals have turned from pure value to cyclical growth, but many global investors are still skeptical of this change. In our opinion, this creates opportunities for attractive alpha generation through bottom-up, active stock selection.

As of 12/31/2020, the securities mentioned comprised the Matthews Japan Fund in the following percentages: M3, Inc., 3.0%; Olympus Corp., 1.5%; Roland Corp., 0.5%; Yappli, Inc., 0.5%. The Fund held no positions in Lasertec Corporation or Technopro Holdings Inc.o. Current and future portfolio holdings are subject to change and risk.

Average Annual Total Returns - MJFOX as of 12/31/2020