Market Commentary and Fund Performance

Masa Takeda of Tokyo-based SPARX Asset Management Co., Ltd., sub-advisor to the Hennessy Japan Fund, shares his insights on the market and Fund performance.

September 2020
  • Masakazu Takeda
    Masakazu Takeda, CFA, CMA
    Portfolio Manager

Fund Performance Review

For the month of August 2020, the Fund rose 5.09% (HJPIX) while the Tokyo Stock Price Index climbed 7.85%. The Russell/Nomura Total Market™ Index, the benchmark for the Fund, returned 6.43% over the same period.  

Among the best performers were our investments in Recruit Holdings Co., Ltd., Japan’s unique print & online media giant specializing in classified  ads as well as providing HR services, Kubota 

Corporation, Japan’s largest and the world’s leading manufacturer of farming equipment, and Daikin Industries, Ltd., the leading global manufacturer of commercial-use air conditioners.

As for the laggards, Nitori Holdings Co., Ltd., the top manufacturing and retail chain of furniture and interior goods, Unicharm Corporation, Japan’s baby and feminine care products maker and Shimano, Inc., global top market share bicycle parts manufacturer, negatively affected the Fund’s performance.

An attractive business should possess the following attributes: high returns on capital, sustainable long-term above-average earnings growth, and strong cash flows. Of these, when it comes to evaluating long-term earnings, it is important to deep-dive into industry dynamics to determine if the expected growth rate will be faster than the broader GDP and the addressable market size is amenable to our long investment time horizon. The electric vehicle (EV) industry is one area we feel merits close attention. It has the potential to grow rapidly and the market size could become huge.  

In order to curb global warming and other environmental issues confronting society today, the automobile industry must pivot from the internal combustion engine vehicle (ICEV) model to new energy vehicle (NEV). Of all the technologies available currently, EVs appear to be the most viable option today. However, even for EVs, there are still obstacles to rapid penetration, not the least of which is the prohibitive cost of batteries. The critics say that today’s demand is only supported by government’s lavish subsidies, and hence in the absence of it, the industry cannot stand on its own. It will take years for the market to develop, they say. 

Contrary to this view, Mr. Nagamori, Chairman of the portfolio company Nidec, is a big believer in the EV industry’s explosive growth. The company has been going all out, making large investments in new factories for EV traction motors and E-Axles (drivetrain module). Drawing on the surging demand for white goods in Japan back in the 1950s after the prices fell to within reach of ordinary consumers, Mr. Nagamori calls 2025 a “watershed” year which will start to see significant adoption of EVs thanks to improved affordability.  

We also happen to believe that the EV industry will take off much faster than most people expect. One piece of research we came across was published by Ark Investment, the U.S. boutique investment firm that correctly predicted Tesla’s runaway success as the world’s top EV maker. According to the firm, EV sales are expected to increase at a much faster clip as industry-wide production costs continue to come down. The theory on which their argument is based is called “Wright’s Law.” Discovered and theorized by Theodore Wright in 1936, the theory states that the manufacturing cost of a given industry tends to decline at a constant rate at every doubling of cumulative production volumes. It is somewhat similar to the famous Moore’s Law for the semiconductor industry.

The predictive power of this theory has proven to be very strong spanning various industries including cars, TVs, solar panels, semiconductors, home appliances, etc. In the case of automobiles, the unit cost has declined by 15% every time the cumulative output doubled since the beginning of the 20th century. Ark argues that such a relationship should also apply to EV battery manufacturing, which in turn will bring down the costs of EVs.

The key argument here hinges on “cumulative” volumes as the determinant of the cost learning curve. Being a new category, EV’s total number of units produced to date is only around 5 million units. This compares to 2.6 billion units historically produced for gasoline cars ever since the first T-Ford rolled off the production line in 1909. This implies that the doubling of cumulative production volumes for EVs will occur at a much faster pace than gasoline-based vehicles. This will enable EVs to close the gap in per-unit manufacturing costs quickly (for gasoline cars to double from here, it would take 29 years assuming constant current annual production pace, while EVs will likely double its numbers every 2-3 years thanks to its low-base effect).

Interestingly, on a recent earnings call, Nidec’s new president Seki also laid out a projection for EV’s unit cost trend similar to Ark’s citing a more granular-level analysis. According to the China Automotive Technology and Research Center (CATARC), EV batteries’ average costs are expected to fall to $94/kwh by 2024 from around $155/kwh currently and  $280/kwh in 2018. If this becomes a reality, Mr. Seki explained that the average cost of a EV drivetrain module (i.e. motor, inverter, reducer and 40 kw battery) can be brought under JPY 500,000 (approximately  $4,700) per vehicle making EVs competitive with hybrids (a module of motor, inverter, battery, reducer and CVT goes for about JPY 600,000 (approximately $5,600) and ICEVs. Once the running costs of owning a car are taken into consideration, EV’s value proposition should become far more compelling.

Furthermore, consumer preferences are likely to become more diverse in China such that some  may want to purchase short-range models for city driving. For example, a 25 kilowatt (kw) battery with a driving range of up to 300 kilometers (km) on a full battery charge, is much cheaper and hence more affordable for most consumers, helping to add to annual production volumes. It is also noteworthy that some EV makers such as Nio and Baic Motor are experimenting with a new sales model dubbed  “battery-as-a-service,” allowing customers to lease the battery separately from cars, thereby lowering upfront purchase costs. These trends should provide further impetus to the EV industry’s total output.

As the world’s biggest and most comprehensive motor specialist, Mr. Nagamori believes that Nidec is perfectly positioned to ride this wave. First, Nidec has all the necessary manufacturing know-how within its group (machining, press die-casting, injection molding, etc.) enabling it to internalize  the entire production process. This allows for quick responses to changing customer requirements  as well as lowering costs as compared to its rivals who are less self-sufficient. Moreover, with current production volumes of 3 billion motors each year for a wide range of applications (hard-disk drives, home appliances, industrial, electric power steering, etc.), there can be significant economies of scale in raw material sourcing. Leveraging the engineering expertise from various types of motors to improve the quality and performance of its EV traction motors is another advantage.

Turning to the latest industry sales, China and Europe, the biggest EV markets, saw very different performances in the first half of 2020 with the former suffering a sharp slowdown (385,000 cars, down 42% year-over-year) in the wake of the COVID-19 pandemic and the latter registering a 57% increase year-over-year, approximately 414,000 cars, owing to stepped-up government subsidies for new purchases. We are not too worried about the Chinese market of late, as the government has already extended  the subsidy program until 2022. In addition, a host of new EV makers such as Li Auto, and Xpeng have been inspired by Tesla’s enormous success on the stock market this year and have succeeded in raising initial public offering (IPO) capital over the last several months, with more expected to come to the stock markets. These IPO proceeds are certain to be allocated towards manufacturing facilities and promotion spending, lending support to healthy growth of the EV industry.

Against this background, Nidec’s order book is ramping up quickly. Per management, they have won orders from a total of 22 makers (of which 15 are from China) so far, up significantly from 8 at the end of 2019. Their internal mid-term forecast is already eyeing over 10 million annual units by fiscal year 2025. In terms of market reception, newly launched EV models from GAC New Energy Automobile, a part of Guangzhou Automobile Group, equipped with Nidec’s E-Axle have emerged as one of the best-selling brands this year, trailing only to Tesla. Management mentioned that the hit has raised the profile of Nidec as a core component supplier in the EV industry. 

Nidec believes that because EVs will lower the barriers to new entry for car manufacturers, there will be an onslaught of newcomers trying to sell their own brand of EVs. This is already happening in China, where newcomers are continuously turning up. Mr. Nagamori is aiming to become a key supplier to these players, akin to how Intel reigned during the personal computer era as a monopoly chipmaker. Mr. Nagamori wants to emulate “Intel inside” type of dominance in the EV industry. 

Another interesting development taking place is within the traditional automobile industry. Until recently, incumbent car makers were designing  and manufacturing traction motors internally to be used in their own EV models. However, as the auto industry is confronted with more stringent emission standards and other environmental regulations amid the ongoing shift to EVs, car companies are coming around to the view that it is more economical and efficient to procure the motors externally from third parties. Such outsourcing needs by traditional car manufacturers should accelerate Nidec’s business, predominantly in Europe.