Fund Performance Review
For the month of November, the Hennessy Japan Fund (HJPIX) returned 9.80%, underperforming the Russell Nomura Total Market™ Index which returned 11.73%. The Tokyo Stock Price Index (TOPIX) returned 11.42% for the same period.
Click here for full, standardized Fund performance.
Among the best performers were our investments in Nidec Corporation, the world’s leading comprehensive motor manufacturer, Daikin Industries, Ltd., the leading global manufacturer of commercial-use air conditioners, and Fast Retailing Co., Ltd., the operator of “UNIQLO” brand casual wear stores.
As for the laggards, Z Holdings Corporation, the operator of the internet search engine “Yahoo! JAPAN” and provider of e-commerce, detracted from the Fund’s performance.
This month saw a comeback of value stocks and the Fund underperformed the broader market. Relative underperformance during a period of strong market is in line with our expectations.
The last time that value stocks made headway like this was 4Q 2016. The problem we have with value stock investing is that whenever a low price-to-book ratio, or PBR, (e.g. 0.5 times) gets corrected upwardly to, say 1x PBR, it is often the end of the investment case as the majority of these stocks are sub-par Return on Equity (ROE) generators in the first place. Any low-quality business can achieve temporary high earnings on various one-off reasons (ex. cost restructuring, etc.). But the sub-par nature still persists. Hence, in order to continuously produce market-beating returns, you need to constantly churn your portfolio by hunting for new “dirt-cheap” stocks. This is laborious. Furthermore, there is uncertainty as to whether such bargain opportunities will be available when you need them. The limitations of a low PBR “cigar butt” type investment are akin to reinvestment risk for bond instruments.
Interestingly, despite the charging led by value stocks earlier in the month, growth stocks held up well and performed even better towards the end of the month. A few months ago, we wrote about how the growth stocks of modern era should be treated differently than in the past from an accounting perspective. In addition to that note, we would like to highlight additional points below on why we think the growth stock driven market is so enduring:
• Today’s growth businesses as represented by internet platformers, software as a service (SaaS), and other tech companies have grown to possess extremely-hard-to-replicate business models compared to growth businesses of the past
• At the same time, the operating leverage of these businesses is far more powerful than the growth companies in the early days due to the absence of need for incremental capital for revenue growth
To illustrate the latter point, take the software industry as an example. When the package software industry was booming in the 80s (think Microsoft), it was the ultimate growth business. The beauty of a software business as opposed to a hardware business was that the cost of goods was no longer a linear function of revenue. Once proprietary software was developed, ramping up the mass production required very little incremental cost (all you had to do was copy the software onto new disks at the press of a button). However, sales distribution part of the business still needed physical saleschannel build-out (stores, staff, inventory) that required certain amount of capital. In other words, as far as mass distribution operation was concerned, revenue growth inevitably incurred proportional increases in costs like traditional manufacturing businesses, whereby the resulting profits only grew consistently (albeit at a fast clip). As such, they were still considered “linear business.”
On the contrary, today’s software business (SaaS) is completely free of such capital needs thanks to the cloud technology. Mass production as well as distribution can be done effortlessly at the press of the button. This implies that a successful SaaS company can enjoy significant operating leverage whereby every dollar increase in revenue can drop straight down to the bottom line almost entirely (the same dynamics also applies to internet platforms). As such, today’s growth businesses are not only more formidable in terms of competitive moats, but also more operationally leveraged than ever. Said differently, they are truly “non-linear business.” It is worth noting that many of them are also more defensive than ever (consumers turn to their services just when they are economically distressed). This is why growth stocks are so enduring in today’s market environment in my view.
Of course, a rise in interest rates could ultimately hurt their share price. High price-to-equity (PE) ratio stocks are akin to long-duration bonds. Since, in theory, you need a much longer time horizon to recoup your investment in high-PE ratio stocks, they are considered more sensitive to rising interest rates. For now, we think that our ultra-low interest rate environment is conducive to growth stocks.
In the case of Japan, the strong moat and high operating leverage combination is just one of the supporting factors for growth stocks. What’s equally important to know when investing in Japan is that still many of the biggest index constituents are mature, large enterprises with no growth prospects (i.e. financials, utilities, telcos, traditional manufacturing, etc). Such an index composition makes select, high-quality, wide-moat manufacturers stand out as growth stocks even though they may not possess the characteristics of extremely high operating leverage (the moat and high operating leverage do not necessarily go together). Japan’s perennial interest rate levels are another reason why we believe the current stock prices can be justified for those high quality “linear” names.
After such an eventful year, it is hard to forecast what 2021 will be like ahead of time. But we would like to give you some of our thoughts below.
On a macro level, Japan continues to be one of the cheapest markets despite the strong rally of late. Given the high degree of difficulty in forecasting next year’s earnings, let’s look at PB ratios.
Japan currently trades at 1.3x PBR, trailing behind the U.S. (4.0x) and Europe (FTSE 1.6x, DAX 1.7x). The cheapness can be attributed to the country’s perennial low ROE levels compared to other countries. However, we believe that continuous focus on corporate governance reforms and rising awareness around capital efficiency by Japanese companies point to further improvement.
In terms of stock market performance in relation to earnings trend, the TOPIX benchmark and TOPIX earnings per share (EPS) both have risen approximately 140% since the start of Abenomics in 2013. The EPS assumes FY2021 ending in March 2022 recovering to the previous peak recorded in March of fiscal year 2018 (right before the onset of U.S.-China trade war). Thus, one could argue that the current market already priced in a full recovery over the next 12-18 months. We do not disagree with such a view. However, for me, no matter how the overall stock market or the macro economy behaves, individual stock-picking remains the name of the game.
As of this writing, some countries are going back into lockdowns amid resurgence of new COVID-19 cases. This may or may not weigh on the near-term investor sentiment. On the other hand, recent news about prospective COVID-19 vaccines seem quite encouraging.
Notwithstanding vaccine hopes, we actually think that the world is slowly figuring out how to live with this virus. For example, we have seen many public buses crowded with passengers recently without a notable rise in case numbers as everyone wears a mask properly. So from here, our stance is that the upside risks of economic recovery are much higher than the downside risks of further deterioration. And while some industries may permanently be impaired, there will always be businesses that will thrive. Needless to say, we believe the Fund exclusively owns the latter type of businesses.
In terms of near-term financial performance outlook of the Fund’s holdings, we expect our high-quality industrial names and high-quality non-industrial economically sensitive names to perform well next year barring any exogenous events.
Outside of our long-term core holdings such as Keyence and Daikin, whose share prices have posted hefty gains this year, the Fund’s other cyclical industrial names like Misumi Group (precision machinery parts manufacturer / distributor) and Kubota (farming equipment maker) are poised for solid recovery in fundamentals as well as share price performance, which have been lagging relative to the former pair.
On the non-industrial side, Recruit Holdings seems well-positioned to enter a cyclical recovery phase as the economies around the world are expected to open up fully in 2021. Recruit is in the online advertisement media business covering many verticals such as job ads, restaurants, property agents, travel agents. These are all economically sensitive areas, which inevitably dragged Recruit’s earnings severely this year. However, what we like about Recruit is that their competitive position remained intact during this time, if not became stronger. For example, the company’s wholly-owned subsidiary, Indeed is seeing faster-than-expected recovery as the world’s number one online job search engine thanks to further refinement to its services to widen its moat this past year.
And then there is the environmentally friendly technology play such as Nidec and Shimano. Nidec, for example, is currently winning new orders for electric vehicle (EV) traction motors by leaps and bounds. Management is already confident that Nidec is slated to command at least 25% market share by 2025 based on the latest order backlog. The EV industry is in very early stages of penetration.
Elsewhere, there are portfolio holdings that we believe are attractively valued like Sony, Terumo, Kao and Rohto relative to their earnings outlook.
Lastly, a quick word on SoftBank Group. It is clear that the company’s Vision Fund has turned to be an important asset from being a liability (in a figurative sense—not in an accounting sense) thanks to sharp improvement in investment performance. As discussed in our previous letters, the Vision Fund is still a small part of the company’s overall shareholder value but should carry more importance going forward. Here, we look forward to benefiting from the Vision Fund’s investments in “non-linear” companies.
Click here for a full listing of Holdings.