Fund Performance Review
For the month of June 2020, the Fund generated a positive return of 2.02% (HJPNX), while the Tokyo Stock Price Index fell 0.33%. The Russell/Nomura Total Market™ Index, the benchmark for the Fund, declined by 0.45% over the same period.
Among the best performers were the Fund’s investments in SoftBank Group Corp., the telecom and internet conglomerate, Daikin Industries, Ltd., the leading global manufacturer of commercial-use air conditioners, and Uni Charm Corporation, Japan’s leading baby and feminine care products maker.
As for the laggards, Anicom Holdings,Inc., Japan’s largest pet insurer, Takeda Pharmaceutical Company Limited, a multinational pharmaceutical company, and Mitsubishi Corporation, the largest publicly traded company in Japan, negatively affected the Fund’s performance.
Growth Stocks vs. Value Stocks
Asset-light technology stocks, or growth stocks, that command high price-to-earnings (P/E) ratios and high price-to-book (P/B) ratios have been significantly outperforming value stocks (defined as low P/E or low P/B) for more than a decade. This trend further accelerated this year in the wake of the COVID-19 outbreak. However, even before the pandemic, the valuation gap and the performance divergence between growth stocks and value stocks were already wider than ever. This phenomenon is intriguing. Are growth stocks grossly overpriced? Our sense is that at least some of these stocks are not as expensive as they are perceived to be on conventional valuation metrics owing to the limitations of Generally Accepted Accounting Principles (GAAP) to properly capture the underlying profitability. There are two ways to approach this:
1. Are P/B ratios too high?
The value of intangibles is understated for growth stocks and the value of tangible fixed assets is overstated for value stocks.
Be it internet platforms, like Facebook, Amazon, and Google, or Software as a service (SAAS) providers, like Microsoft, Salesforce, and Adobe, intangibles are far more important to their competitive strength than the tangible assets on their balance sheets.
These intangibles come in different shapes and forms ranging from proprietary software, algorithms, and user data, to platform network effects. For these asset-light players, physical assets are small relative to their profit-size-making and their P/B ratios appear much higher than those of traditional manufacturing businesses.
For example, a successful internet business can increase the value of its platform by adding users. However, under the conventional accounting standards, the company is not permitted to write-up the value of such intangible asset on the balance sheet, no matter how robustly the network effect scales up the business. If one properly ascribes value to the intangible assets, the adjusted P/B multiples should look more reasonable.
On the other hand, the carrying value of tangible assets (e.g. factories and production equipment) for traditional manufacturers is difficult to adjust upward considering the lack of network-effect-like business dynamics and their generally low profitability relative to that of technology companies. Worse yet, some of the tangible fixed assets could be considered a liability due to rising environmental and other global issues. In such cases, these assets may need to be written down beyond what is currently required by the conventional accounting standards. Consequently, pro forma P/B ratios would be more elevated than the headline numbers, narrowing the gap between growth and value stocks.
2. Are P/E ratios too high?
Ordinarily, old-school manufacturing businesses needed to spend part of their retained earnings on capital expenditures (CAPEX) just to keep their existing production lines going, as capital equipment suffers from wear and tear over time (maintenance CAPEX). On top of this, the business needed to shell out additional capital to increase its capacity (growth CAPEX) if it wanted to grow. From an accounting point of view, most of these outlays do not have to be recorded on the income statement as they are incurred. Instead, they are capitalized on the balance sheet and expensed in the form of depreciation cost over the course of the asset’s depreciable life. This helps current year’s profit appear bigger than its true cash-based earnings.
Turning to asset-light tech companies, there are few elements of maintenance investment in the normal course of business. To grow scale, acquisition of new users is often the biggest investment they need to make. Under GAAP, such spending (i.e. cash incentives offered to new platform joiners, ad promotion costs, etc.) have to be recorded on the income statement in its entirety, depressing the current year’s earnings. This is despite the fact that each newly acquired customer is expected to bring in a steady stream of revenue over a long time under a subscription-model / platform business. This inevitably results in inflated P/E multiples. However, if these tech companies were allowed to capitalize the cost and amortize it just like manufacturing companies can spread their capital investment over the depreciable life of the assets, the “adjusted” P/E multiples should look more reasonable.
Large-cap tech growth stocks in Japan
At their core, today’s tech leaders require very little capital to grow compared to traditional manufacturers and retailers, which makes them less subject to the law of diminishing returns. Thanks to technology (the internet, artificial intelligence, cloud computing, etc.), they are also harder to be displaced and can grow at a rapid pace even at scale. This is unprecedented.
Unfortunately, Japan does not have too many world-class tech companies that are truly of interest to us. Historically, Japanese tech names have been mostly electronics manufacturers, hence they do not possess the characteristics of being asset-light, scalable business with hard-to-replicate moats. There are many small, domestic “wannabes” in the internet/ SAAS /cloud space, but most fall outside of our investment scope due to their small addressable markets as we look for “big elephants” with compelling global growth opportunities. As such, of the limited pool of investable tech-related names, we invested in Recruit, Sony, Keyence, and SoftBank Group as a way of indirectly investing in Alibaba and other tech companies around the world.
Despite the current lack of choices, we will continue to be on the lookout for attractive investment candidates within the tech arena. The next “Big Thing” could come out of nowhere since today’s tech companies can grow at lightning speed thanks to various digital infrastructures that did not historically exist. Such explosive growth has been demonstrated by the likes of Facebook and Alibaba over the last decade. It would be an opportunity we should not miss out on in Japan, though the challenge is how we can convince ourselves to invest in such circumstances given our investment style of relying on the long-term track record of a business to get comfortable with a new investment. As an investor, you can rest assured the Fund will stay invested in our time-tested, long-term holdings across the consumer, industrial, and healthcare sectors so you will not see any significant “style-drift.”