Fund Performance Review
For the month of March, the Hennessy Japan Fund (HJPIX) returned -2.47%, underperforming the Russell Nomura Total Market™ Index which returned 1.06%. The Tokyo Stock Price Index (TOPIX) returned 1.92% for the same period.
Among the best performers were our investments in Shimano Inc., a global top market share bicycle parts manufacturer, Takeda Pharmaceutical Company Limited, a multinational pharmaceutical company, and Daikin Industries, Ltd., a leading global manufacturer of commercial-use air conditioners.
Click here for full, standardized Fund performance.
As for the laggards, Fast Retailing Co., Ltd., the operator of “UNIQLO” brand casual wear stores, Z Holdings Corporation, a Japanese internet services pioneer, and SoftBank Group Corp., the telecom and Internet conglomerate, detracted from the Fund’s performance.
In March, while the broader market remained strong, rising interest rates and inflation concerns continued to weigh on investors’ mind. Generally, we do not hazard a guess on the macroeconomic direction beyond our home country. But if we may, we are of the view that a further rise of interest rates and/or rising inflation are more probable in the U.S. economy than they are in Japan’s.
As we wrote in last month’s commentary, Japan has struggled to overcome deflation even in the years leading up to last year’s pandemic. As such, it is hard to image inflation taking hold in our domestic economy at this point in time. The Bank of Japan (BOJ) will likely continue with the current monetary policy framework, keeping rates around zero through the so-called yield curve control along with other easing measures.
Meanwhile, as we see it, the U.S. is a much more resilient economy. U.S. businesses have a history of quickly adjusting to deteriorations in the economic landscape through layoffs and furloughs, as was the case last year. The flip side is that they can adapt just as quickly to improving economic conditions. Thus, once the current pandemic is brought under control, the unemployment rate may come down faster than expected. It is also worth noting that in the run-up to last year’s pandemic, the world economy didn’t have any structural excesses like production overcapacity, or debt-fueled over-consumption, which is typically a recipe for a deep recession. With the U.S. household savings rates climbing high (partially due to stimulus checks), consumers are itching to spend. All of these may cause demand for goods and services to outstrip supply down the road.1 In the wake of this, U.S. Treasury yields may continue their march higher.
The implication of this for Japanese stocks is that the widening of the rate differential with Japanese Government Bonds (JGBs) will probably work to weaken the Japanese yen (JPY) based on interest rate parity. In fact, since the beginning of the year, the yen has already depreciated by about 7% against the U.S. dollar (USD). Under such a scenario, the Fund’s portfolio has the distinct advantage of investing in global companies domiciled in Japan, which are direct beneficiaries of a weaker yen.
Contrary to our conjecture, what if the BOJ does somehow manage to induce higher inflation in Japan? Or if an ongoing rise in commodity prices may inadvertently trigger it? In these scenarios, the yen should again depreciate to reflect the relative purchasing power parity. Either way, a weaker yen will be the likely outcome which should boost the businesses of companies that operate globally.
Since the start of 2021, the Fund has been lagging the benchmark. In the fourth quarter of 2016, amid the so-called “Trump rally,” the Fund also trailed the bull market by a wide margin (and a few other times in the past). Understanding that occasional underperformance is unavoidable, we will continue to exercise patience.
As index-agnostic investors, we aim to maintain a high active share in the Fund (currently over 80%), such that the Fund’s performance will be meaningfully different from that of the benchmark. This approach stems from our view that Japan is not a particularly vibrant economy as a standalone country due to a declining population, aging society, persistent deflation, and lack of innovative forces compared to the U.S. or China. Owing to this backdrop, there are not a lot of attractive investment opportunities that meet our rigorous investment criteria and long-term investment horizon.
The good news is that the existing investment ideas on hand are large enough for us to keep running the portfolio in the long run, and we remain very positive on our core holdings, which we believe are Japan’s premier world-class companies with lots of growth runway left. Over the last 13 years, we have built positions in these companies one-by-one: Keyence in 2007/2008, NIDEC in 2013, SoftBank Group in 2015, Recruit in 2016, Fast Retailing in 2017, and Sony in 2019. Today, many of these companies have grown to be among the top decile stocks by market capitalization in Japan (in estimated U.S. billions): SBG $180, Sony $130, Keyence $110, FR $86, Recruit $83, and NIDEC $74.
Admittedly, shares of some of these companies have been driven up more by re-rating than earnings growth recently and we remain cognizant of this. But it is also true that their secular growth outlook remains as attractive as ever:
• NIDEC is on the cusp of riding the potential big wave of electric vehicle penetration through its traction motors and e-Axle business.
• Sony has a rich content library spanning video games, movies, and music that can appeal to global consumers.
• Keyence’s overseas sales, even after 10 years of accelerated revenue growth, still make up only half of total revenue, implying a long runway for revenue expansion.
• Recruit’s human resources business has an estimated total addressable market of $150 billion, in which Indeed (a wholly-owned subsidiary focusing on the internet job search engine) is rapidly gaining market share through geographic expansion.
• Fast Retailing’s growth potential is now comparable to Nike, a much bigger U.S. company, as the boundaries between casual apparel and sportswear become increasingly blurry post COVID-19.
• SoftBank Group achieved a sharp improvement in the Vision Fund’s performance, which may allow them to start raising new funds, a positive catalyst for the business as well as its share price.
Backed by quality management teams and sound financial track records, we believe the long-term prosperity of these companies is not yet fully captured in the current share prices. It is even our genuine hope that one of our portfolio companies will someday overtake Toyota (whose current market cap is approximately $250 billion), which has been holding the title of Japan’s largest market capitalization for the last two decades. Because of a buy-and-hold mindset, we always feel it sensible to gravitate towards companies with the potential to become the largest, both in profit terms and in market capitalization. In a country like Japan, we believe those opportunities lie exclusively in businesses with a global presence.
You will get our point by looking around the world. The biggest market capitalization is often awarded to global enterprises, be it Samsung Electronics (with a current market cap of $440 billion) in South Korea, or TSMC (whose market cap is approximately $540 billion) in Taiwan. Interestingly, both of these countries have population sizes and Gross Domestic Products (GDPs) that are much smaller than Japan, yet Samsung and TSMC both command a much greater market value than any listed Japanese company. Even in the U.S., the world’s largest economy with a deep domestic market, the stocks with the biggest capitalizations are all global tech companies, not domestic-oriented ones. As such, long-term compounding by Japanese global companies will continue to be our core investment focus going forward.
Click here for a full listing of Holdings.