Market Commentary and Fund Performance

Performance data quoted represents past performance; past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the fund may be lower or higher than the performance quoted. Performance data current to the most recent month end, and standardized performance can be obtained by viewing the fact sheet or by clicking here.

Fund Performance Review

In July, the Fund increased by 1.32% (HJPIX), underperforming its benchmark, the Russell/Nomura Total MarketTM Index, which rose by 3.39%.

The month’s positive performers among the Global Industry Classification Standard (GICS) sectors included shares of Industrials, Financials, and Information Technology while Consumer Staples and Communication Services detracted from the Fund’s performance.

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Among the best performers were our investments in Mitsubishi Corporation, the largest trading company in Japan, Hitachi, Ltd., one of Japan’s oldest electric equipment & heavy industrial machinery manufacturers, and Mitsubishi UFJ Financial Group Inc., one of Japan’s largest financial groups.

As for the laggards, Rohto Pharmaceutical, a leading skincare cosmetics and over-the-counter (OTC) ophthalmic medicines producer, Seven & i Holdings, a Japanese diversified retail group and operator of 7-11 convenience stores, and Keyence Corp., the supplier of factory automation related sensors, were the largest detractors.

This month, Fast Retailing, one of the Fund’s portfolio companies, announced its third quarter results for the fiscal year ending August 2023. The cumulative sales for the nine months increased by 21% compared to the same period last year, and operating profit increased by 22%, continuing its strong performance.

The company, under the Uniqlo brand, not only manufactures and sells high-quality clothing at affordable prices, focusing on basic items but also features a product strategy that emphasizes functional wear, such as their “HEATTECH” and “AIRism” brands. We commented last month on another retail stock, Seven & i Holdings, and its stock’s undervaluation. In contrast, Fast Retailing’s stock price appears relatively expensive in terms of the price to earnings ratio (PER). The reason why we think Fast Retailing’s stock price is highly valued in the market compared to Seven & i Holdings is attributed to the difference in execution by the management team. Both companies are global retailers originating from Japan, but Fast Retailing significantly outperforms in terms of sales and profit growth rates, return on equity (ROE), and other aspects of capital efficiency.

Even if the short-term valuation is high, considering its long-term growth potential, we believe that the investment in Fast Retailing is still attractive. For example, according to analysis conducted by Fundsmith, an asset management company specializing in long-term investment in global high-quality growth stocks, even if one had invested in L’Oreal, a famous global cosmetics maker, at a stock price equivalent to 281 times the earnings per share (EPS) at the time in January 1973, the long-term return through September 30, 2019, would have been 7% annually, outperforming the index (MSCI World) during the same period.1 Therefore, even stocks that appear to be overvalued in the short term can be attractive investment targets if they have a bright long-term outlook.

What has been steadily expanding the company’s performance is its overseas Uniqlo business. Just 15 years ago, international was only about one-tenth the size of its domestic business, but as of the Q3 2023 results, the nine-month cumulative sales of the overseas Uniqlo business have exceeded domestic sales by more than 50%, and operating profit has grown to nearly twice the size of its domestic business.

Over the past 10 years, sales growth in China has primarily driven the company’s overseas expansion. However, recently, the management team has been feeling the impact of the company’s “LifeWear” concept penetrating the European and American markets. By the fiscal year ending August 2027, management aims to achieve sales of 500 billion yen ($3.5 billion) in its European business and 300 billion yen ($2.1 billion) in its North American business. As the company continues to establish its presence worldwide, it is becoming increasingly appropriate to view it as a global clothing brand. How much potential does Fast Retailing have for global sales expansion? A common approach is to consider what percentage of the target market share can be captured. However, it is difficult to assume a reasonable market share in industries with diversified customer needs and preferences. For example, burger chains belong to the restaurant industry, but people reasonably can’t eat burgers three meals a day, 365 days a year, so the entire industry cannot be considered a potential market. Therefore, the argument that “there is a huge potential for expanding market share because the market share is only a few percent” lacks persuasiveness. The same is true for clothing. For example, consumers worldwide can’t wear winter clothes all year round, so discussing the market share of the entire clothing market does not make much sense.

In this case, we refer to the sales of other companies in the same industry that are well ahead of the curve in globalization, specifically comparing with American sportswear & shoemaker Nike and European fast fashion clothing retailer Inditex (which operates ZARA). The reason is that in recent years, the athleisure trend has increased the number of people wearing sports apparel as everyday wear, causing the target markets of Uniqlo and Nike brands to overlap. Also, Uniqlo, which focuses on basic designs, is also focusing on products incorporating fashion, so it is believed that the target audience overlaps with the ZARA brand.

Looking at the sales scale of each company’s domestic market, Nike’s North American segment sales are $22 billion (actual results for the fiscal year ending May 2023), and Inditex’s European sales are $23 billion (actual results for the fiscal year ending January 2023, using the exchange rate of 0.9167 Euro/$ as of the end of June 2023). Dividing these by the population2 of each region results in sales of $65 per consumer for Nike and $65 for Inditex. On the other hand, Fast Retailing’s Japan segment sales are $7.5 billion (actual results for the fiscal year ending August 2022, using the exchange rate of 144.31 yen/$ as of the end of June 2023), with per capita sales of $60. In other words, at this point, each company has a similar level of penetration in their domestic markets.

What about the overseas market, in which their brands can also be considered as a “foreign” brand? For example, Nike’s EMEA segment sales (Europe, Middle East, Africa) are $13 billion, Greater China is $7.2 billion, and Asia Pacific and Latin America are $6.4 billion. Inditex’s latest sales are $6.9 billion in the Americas segment and $4.9 billion in Asia & the rest of the world. To give additional insight, Germany’s Adidas and Sweden’s Hennes & Mauritz (H&M brand), which are slightly inferior in scale, have North America segment sales of $7.0 billion and North America and Latin America segment sales of $4.7 billion, respectively. As you can see, each of these well-known leading global brands boasts a sales scale of about 1 trillion yen ($6.9 billion) in major European and American regions and easily exceeds 500 billion yen ($3.4 billion) in other regions (Asia and South America) where purchasing power is still low. Therefore, the sales targets of 500 billion yen ($3.4 billion) in Europe and 300 billion yen ($2.1 billion) in North America that Fast Retailing aims for do not seem to be such a high hurdle, considering that the Uniqlo brand is starting to be recognized globally.

In terms of financial metrics, Fast Retailing’s past five-year average ROE of 17% is not to the same standards as Nike’s 41% and Inditex’s 21%, but it is a superior company, at least domestically, in the sense that it significantly exceeds the average ROE of listed Japanese companies. In addition, the Company’s past five-year average gross margin is about 50%, which is between Inditex’s 57% and Nike’s 45%, and it seems to have enough potential to compete with global players in terms of capital efficiency. Finally, the company’s sales and profit scale are less than half of Nike and Inditex, so we see that there is still room for growth, and we would like to expect an expansion of market capitalization.

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