A Portfolio Poised to Benefit from Japan's Economic Recovery

The Portfolio Managers of the Hennessy Japan Small Cap Fund discuss wage growth, the fluctuating Japanese yen, current valuations, new Fund holdings, and their outlook for the rest of 2023.

February 2023
  • Tadahiro Fujimura
    Tadahiro Fujimura, CFA, CMA
    Portfolio Manager
  • Takenari Okumura, CMA
    Takenari Okumura, CMA
    Portfolio Manager

Would you please discuss the progress in Japan on corporate governance reform, especially when it comes to wage growth? 

We believe significant progress has been made on the Corporate Governance in Japan. An increase in the ratio of outside independent directors who are unlikely to have conflicts of interest with general shareholders and an elimination of cross-held shares are some examples. 

When it comes to wage increases, we believe that the decline and weakening of labor unions have had an impact on this issue. However, at the root of the issue is deflation, declining productivity, and other challenges in the overall economy. Therefore, since April 2022, listed companies have been required to disclose indicators related to human capital in annual financial statements. These include the amount of time and money spent on workers’ education and training, the gender pay gap, and the turnover ratio. This requirement should encourage companies to increase spending on workers and improve productivity, resulting in wage increases. 

In addition, two years ago, a law was enacted to ensure equal pay and equal work. We believe it will limit inexpensive non-full-time employment, which has been one of the causes for low wages and could also lead to an increase in average wages.

Given the Japanese yen stands at a seven-month high, how does this affect the Fund and what are the expectations moving forward?

There is a reaction to the sharp rise to 150 yen, and we believe that the yen will be strengthened to around 120 yen for the time being. However, we do not think it will appreciate much beyond 120 yen, because Japanese interest rates are not likely to rise significantly and the trade deficit will deepen. 

We believe that a strong yen will be beneficial to the Hennessy Japan Small Cap Fund because of the high ratio of domestically oriented companies. On the other hand, we think the manufacturing sector with high overseas exposure will not experience a major profit decline as it did not benefit from the yen’s depreciation last year due to part shortages and other factors.

How are the domestic companies in the portfolio faring given the current economy and inflation?

The fact that the depreciation of the Japanese yen has calmed down is a good sign but we still consider the delay in price pass-on due to inflation as a risk. However, companies should be able to pass on higher prices to consumers in 2023. We expect inbound demand to expand significantly since the USD/JPY exchange rate level of around 120 means the prices in Japan are cheaper for overseas travelers. We think we will also benefit from it along with an improved Japanese economy. In our opinion, possible cost increases due to ongoing sharp rises of energy prices would be one of the risk factors.

Would you please discuss current portfolio valuations vs. the market and historical norms as of 12/31/22? 

The Hennessy Japan Small Cap Fund looks undervalued relative to the market. The portfolio’s price to earnings ratio (P/E) is approximately 11.8x for the current fiscal year and is 10.3x for the next fiscal period, lower than the benchmark Russell/Nomura Small Cap™ Index’s 14.0x and 12.3x, respectively. 

On the other hand, we estimate the Fund’s profit growth rate from the current fiscal year to the next to be +13%, which is around the same level as the benchmark. We believe that the Fund’s stocks are highly attractive, as many of them remain undervalued while still at the same growth rate.

Would you please mention a few new holdings that were added to the portfolio in the second half of the year? 

We invested in J. Front Retailing Co., Ltd. which operates department stores including Parco, a shopping center for young people, because we believe we can benefit from the expansion of inbound travelers. We believe the company is better positioned for growth over the medium term than other department stores because of its structural reforms and success with youth-oriented stores. 

Similarly, we invested in Keihan Holdings Co., Ltd. for its inbound tourism business. The company operates highly profitable trains and hotels, mainly in Kyoto, and develops new real estate while maintaining a stable balance sheet.

What companies were removed from the Fund, and why? 

The Fund sold Elecom Co., Ltd. which sells smartphone and personal computer accessories. This was due to declining sales of personal computer related products, which had previously been growing significantly during the COVID-19 pandemic. We are concerned that JPY depreciation will increase costs as the company has high sales ratio of imported goods. Furthermore, we sold all of the Fund’s holdings in Fuji Corp which mainly builds smartphone-manufacturing machinery. The reason was to reduce the risk posed by a slowdown in smartphone sales and the fact that many of its products are sold in China. 

What stocks or sectors in domestic Japan might outperform in 2023?

We are bullish on domestic capital investment. Japanese companies have ample cash, and in addition to the weak yen and high need for environment-related investments, labor-saving, and manpower-saving investments, we believe demand for a new plant construction and renewal is high due to the supply chain reassessment from the friction between the U.S. and China.

Would you please provide an outlook for the Fund for 2023?

In 2023, we believe the Japanese economy will perform better than the U.S. and Europe, as the issues of cost increases and parts shortages that had plagued the country until 2022 will be resolved, and inbound tourism demand will recover. Accordingly, we believe the Japanese stock market will follow this trend and perform well. We anticipate that small-cap stocks will be beneficiaries of the Japanese economic recovery given their high exposure to domestic demand industries and their low valuations.