A Renewed Focus on Earnings Growth, Shareholder Returns & Valuations

Key Takeaways

» We are placing an emphasis on growth potential and sufficient margin of safety.

» By combining companies with different return drivers across different macroeconomic environments, we seek to reduce the portfolio’s dependence on any single macroeconomic outcome.

» We view rising interest rates in Japan as part of a structural normalization.

» Increased dividends, share buybacks, and a greater emphasis on the cost of capital, ROE and ROIC, and capital allocation reassessment show the effects of corporate governance reforms.

» AI is an important long-term structural theme with the potential to enhance productivity and economic growth, and we remain constructive on demand for AI infrastructure. However, a great growth theme does not necessarily translate into a great investment opportunity.

» We believe Japanese equities still retain some relative valuation appeal compared with other major developed markets.

Where are you finding opportunity following Japanese equities’ 25%+ year-to-date return?

As the Japanese equity market has risen significantly, we believe investment opportunities have become more selective. High growth expectations are increasingly priced into stocks, particularly in artificial intelligence (AI) and semiconductors, so we are placing greater emphasis not only on growth potential but also on whether there is a sufficient margin of safety at the current price. From this perspective, we are focusing, for example, on relatively lagging areas such as Seven & i Holdings Co., Ltd. and major Japanese homebuilders. 

At Seven & i, we see cash-generation capabilities that are not necessarily fully captured by reported accounting earnings, alongside ongoing shareholder returns and management reforms.

Among the homebuilders, we believe companies such as Sekisui House Ltd., Sumitomo Forestry Co., Ltd. and Daiwa House Industry Co., Ltd. have medium- to long-term growth potential, supported by their strengths in construction efficiency, quality and financial resources, despite near-term headwinds in the operating environment.

In our view, these sources of underlying value are not yet fully reflected in current share prices and could provide sources of return that differ from those driving the broader market.

Meanwhile, we remain constructive on this year’s positive contributors. Whether it’s Recruit Holdings, ORIX Corp., or the three non-life insurance groups, we believe their long-term prospects remain solid relative to their current valuations.

Would you please provide your thoughts on how current macroeconomic risks affect your evaluation of companies in the portfolio?

We do not construct the portfolio based on macroeconomic forecasts. Instead, we focus on identifying companies with strong competitive positions, high profitability and robust balance sheets we believe can navigate a wide range of operating environments. As a result, the portfolio is diversified beyond manufacturing into areas such as financials, services and retail.

Within manufacturing, we tend to favor higher-valueadded businesses with pricing power such as Hitachi and Keyence Corp., in contrast to manufacturers of more commoditized products that are prevalent in many emerging markets. Elsewhere, at Shin- Etsu Chemical Co., Ltd., we believe the strength of its business platform, including local production, enhances its resilience to changes in the external environment.

At the same time, rising interest rates may represent a headwind for housing-related companies, while potentially providing a more favorable environment for banks and non-life insurers.

By combining companies with different return drivers across different macroeconomic environments, we seek to reduce the portfolio’s dependence on any single macroeconomic outcome.

How is the higher rate environment affecting Japanese companies?

We view rising interest rates in Japan as part of a structural normalization as the economy moves away from the prolonged low-interest-rate and deflationary environment. Rather than being uniformly negative for companies, this environment could increasingly differentiate businesses that can deploy capital efficiently from those that cannot.

Financials are one area that may benefit, with the potential for an improved earnings environment for banks, non-life insurers, and financial services companies like ORIX.

At the same time, we also see opportunities in areas where higher rates are currently a headwind. Japanese homebuilders such as Sekisui House, Sumitomo Forestry, and Daiwa House have faced valuation pressure amid near-term headwinds in the U.S. housing market. However, given medium- to longterm housing demand and the companies’ underlying business strengths, we believe they continue to offer growth potential.

How are corporate governance reforms translating into better capital allocation and higher returns for shareholders?

We believe the impact of corporate governance reform can be seen not only in increased dividends and share buybacks, but also in management teams placing greater emphasis on the cost of capital, returnon- equity (ROE) and return-on-invested-capital (ROIC), and reassessing capital allocation more broadly.

• For example, major non-life insurers have been reducing their strategic shareholdings and redeploying capital toward growth investments and shareholder returns.

• At ORIX, a diversified financial conglomerate, we see efforts to improve capital efficiency through initiatives including the expansion of its asset management businesses.

• Hitachi has also continued to reshape its business portfolio while placing greater emphasis on profitability, capital efficiency and cash generation.

We believe these developments illustrate a broader shift in corporate priorities in Japan from expanding scale toward enhancing value per share, which should support improved shareholder returns over the medium to long term.

Would you please discuss one or two holdings that are “growth stocks in disguise”?

We define “growth stocks in disguise” as companies that may not be viewed as conventional high-growth stocks, but which we believe can generate attractive shareholder returns over the medium to long term through a combination of earnings growth, dividends and share buybacks. 

Major non-life insurers such as Tokio Marine Holdings, Inc., MS&AD Insurance Group Holdings, Inc. and SOMPO Holdings Inc. are representative examples. We see multiple potential return drivers, including improving underlying profitability, overseas businesses, changes in the interest-rate environment. The investment case is further supported by attractive shareholder return policies, including robust dividends and share buybacks that we believe are sustainable over the long term, given their inherently asset-rich balance sheets.

ORIX, mentioned above, is another example. While the company is often viewed as a complex conglomerate, we focus on its capital-allocation capabilities. We believe it is important to assess companies based on their potential total shareholder return, incorporating not only earnings growth but also dividends, share buybacks and improvements in capital efficiency.

How are you balancing the long-term growth opportunity in AI with increased valuation risk in parts of the market?

We view AI as an important long-term structural theme with the potential to enhance productivity and economic growth, and we remain constructive on demand for AI infrastructure. However, a great growth theme does not necessarily translate into a great investment opportunity. When high growth expectations are already embedded in share prices, even a modest disappointment can lead to downward revisions in both earnings expectations and valuation multiples. Rather than simply pursuing the stocks currently attracting the most attention, we therefore consider where demand could emerge next within the AI value chain.

Our investment in Shin-Etsu Chemical is one example. We see the potential for broader AI-related investment eventually to translate into increased demand for semiconductor materials. The approach is similar to anticipating where the puck is heading in ice hockey rather than focusing on where it is today. 

While recognizing AI’s long-term potential, we remain disciplined about investing at prices where we believe there is a sufficient margin of safety relative to our estimate of intrinsic value.

Beyond semiconductor companies, where are you seeing Japanese businesses use AI?

One company we are particularly focused on outside the semiconductor sector is Recruit Holdings, the parent company of Indeed.

At Indeed, the company is using AI to improve the matching of job seekers with employers and enhance the recruitment process. Importantly, we see AI not simply as a replacement for existing activities, but as a tool that can enhance the value of the company’s existing data and customer base. More efficiently connecting the right people with the right jobs could increase the value of the platform for users.

For companies that already possess strong customer relationships and meaningful data assets, we believe AI can potentially strengthen existing competitive advantages while opening up new avenues for growth.

What change did you make to the portfolio during the third quarter?

We added to our position in Shin-Etsu Chemical Co., focusing on silicon wafers as the next potential beneficiary of AI infrastructure expansion rather than chasing AI-related stocks that have already rallied significantly. We believe the company’s world-leading market position and high barriers to entry position it well to capture a medium- to long-term recovery in wafer demand.

How do valuations of Japanese equities compare with historical levels and with other developed markets today?

Following the rise in Japanese equities over the past several years, we believe the substantial valuation discount that existed one or two years ago has begun to narrow. At the same time, corporate profitability and capital efficiency have also improved, so this has not simply been a matter of valuation multiples expanding. Corporate governance reform has encouraged greater focus on capital efficiency, shareholder returns and business portfolio restructuring, all of which are important when assessing the evolving quality of Japanese companies.

We believe Japanese equities still retain some relative valuation appeal compared with other major developed markets, as shown above, although we would not characterize the market as uniformly inexpensive. More important, in our view, is the dispersion between individual stocks. While high growth expectations are already reflected in valuations in some popular areas of the market, we continue to find companies with solid earnings growth and scope for shareholder returns that we believe remain relatively attractively valued.

As a result, we believe selecting individual companies where there is a sufficient margin of safety relative to intrinsic value is becoming increasingly important.

As you look toward 2027, what developments could broaden investor interest?

Looking toward 2027, we believe investor interest could broaden beyond AI- and semiconductor-related stocks toward a wider range of companies. One potential catalyst would be a renewed focus on the combination of earnings growth, shareholder returns and appropriate valuations. A further expansion of corporate governance reform into areas such as capital efficiency and business portfolio restructuring could also support a broader reassessment of Japanese companies. Another potential trend is a shift in the AI investment thesis from “AI infrastructure builders” to “AI adopters.”

Rather than chasing this year’s winners, our approach is to identify companies where we believe these potential changes are not yet fully reflected in share prices.