Market Commentary and Fund Performance

Fund Performance Review

For the month of January, the Hennessy Japan Fund (HJPIX) declined 11.05% while the Russell Nomura Total Market™ Index lost 5.52% and the Tokyo Stock Price Index (TOPIX) decreased 4.89%.

Among the best performers were our investments in Mitsubishi Corporation, the largest trading company in Japan, Fast Retailing Co., Ltd., the operator of “UNIQLO” brand casual wear stores, and Ariake Japan Co., Ltd., a producer of natural seasonings and flavorings from meat products.

Click here for full, standardized Fund performance.

As for the laggards, Nidec Corporation, the world’s leading comprehensive motor manufacturer, Mercari, Inc., the operator of Japan’s largest online flea market app “Mercari,” and Recruit Holdings Co., Ltd., Japan’s unique print and online media giant specializing in classified ads as well as providing human resources services detracted from the Fund’s performance.

Since the start of the year, we are again witnessing a growth-to-value rotation on the back of rising bond yields around the world. As a result, our Fund was also negatively impacted this month.

Higher inflation and rising interest rates can impact the Fund’s growth-biased portfolio in two ways. One is through fundamentals of the businesses, where increases in input costs and borrowing costs hurt profitability. To cope with this risk, as we explained in a previous letter, we broadly balance the portfolio between “high quality holdings whose competitive strengths are rooted in manufacturing excellence” (be it industrial, medical device, apparel, consumer products) and “businesses whose compelling economics reside in intangible assets such as proprietary software, algorithms, user data, network effects and intellectual properties.” The former group is asset-heavy and can be generalized as businesses that sell ‘stuff’ (physical goods) while the latter tends to be asset-light in nature. It’s worth noting that over the last several years, new investments have mostly fallen in the latter category than the former.

In the face of rising prices of everything from raw materials, semiconductors, shipping, to labor, companies that make physical goods are feeling pressured. Meanwhile, companies that provide software and online services are feeling minimal impact, if any, in this regard. But we continue to consider one of the reliable competitive advantages for Japanese publicly traded companies to be manufacturing excellence. The country’s craftsmanship and its studious ethos helped many manufacturing companies to become global leaders in their respective fields with ample addressable markets still ahead of them. Particularly, the Fund’s investees have excellent track records of masterfully navigating through past recessions/crises thanks to the strong management leadership, be it during the Asian currency crisis in the late 90s, the burst of dotcom bubble in the early 2000s or the 2008 global financial crisis. Hence, we believe they have the ability to weather the inflationary headwind of late. Better yet, should the inflation turn out to be short-lived, these manufacturing stocks would come back strongly.

The other avenue through which higher yields can have an impact on the Fund’s portfolio is equity valuations (i.e. contraction of multiples). Here, some of the high price to earnings (PE) stocks with above average “linear” growth profiles are admittedly at most risk of de-rating. For instance, if the discount rate increases by 200 basis points (bps), say from 8% to 10%, the intrinsic value estimates can fall by as much as 30-40% with all the other growth rate assumptions being the same. The long-term holdings such as Keyence and Nidec could be the biggest victims of this.

Over the 14 years the Fund has invested in Keyence, the company has increased its market cap tenfold (from Japanese yen 1.5 trillion→15 trillion, ($13bn→$127.9bn)), making it one of the most successful investment cases to date. This value appreciation can be broken down into the profit growth and multiple expansion. During our ownership, Keyence’s net income grew five-fold 
(forward looking Net Profit JPY 60 bn ($518.9mn) at the time of the initial purchase to fiscal year (FY) 2022 ending March 2023 estimated JPY 300bn ($2.6bn)) while the forward price-to-earnings (PE) went from 25x to 50x. Nidec has been held since 2013 in the Fund, during which time the market cap nearly quintupled (Japanese yen 1.4tn→6.8tn, ($12.1bn→$58.7bn)), which can be divided into profit growth of 2.9x (forward looking NP JPY 60bn ($518.9mn) at the time of the initial purchase to FY2022 ending March 2023 estimated NP JPY 175bn ($1.5bn)) with the forward PE advancing from 23 to 40x (1.7x).

Of these two contributing factors, the profit growth factor should be relied upon more when thinking about the intrinsic value estimate moving forward. The reason being, the moats for Keyence and Nidec continue to stay intact and robust in our assessment, and their earnings growth prospects will likely remain bright with abundant addressable markets. As such, the accumulation in intrinsic value due to profit growth from the past is unlikely to be lost, which in turn implies that the part of market cap appreciation brought about by this factor will likely stick around although the multiple contraction (de-rating) on the back of rising interest rates may continue to take a toll. We would also like to emphasize that as price conscious stock pickers, we pay great attention to valuations upon entry. Keyence and Nidec were both first invested at near historical trough valuations.

It is extremely difficult (frankly we think it is impossible) to forecast how much the bond yields will rise over what timeframe and how long the phenomenon will persist. While the argument for the current inflationary trend being transitory has been largely dropped by the Fed, and some of today’s inflationary trend could be structural in nature such as due to demographic changes and environmental factors, there are always counter-arguments that assert technologically enabled innovations can be a deflationary factor. Putting all of these things together, we’ve come to the conclusion that long-term inflation and interest rates are too complex to predict ahead of time, hence we just leave this topic in the “too difficult pile” (as Warren Buffett often likes to stash away things that are too difficult for him to comprehend).

What we continue to focus solely on is the companies’ businesses and their progress. 
When we invest in promising long-term capital compounders at historically attractive valuations, our approach is almost like “buy-and hold” (unless the business’s moat suffers significant deterioration or the valuation becomes “irrationally” expensive). This mindset unfortunately hurt the Fund returns during the latest month but it is also true that 
such determination served well during the past interest hikes (by not selling too hastily). Even when we recognize that some of its holdings are disproportionately benefitting from multiple re-rating on top of rising profit levels, our de 
facto action is to just “let the winners run” with only occasional profit-taking (e.g. to meet Fund redemptions) but rarely exit the position completely.

We did allocate fresh capital to stocks with more attractive risk-return profiles rather than buying everything on a pro-rata basis though, as the Fund’s assets under management (AUM) grew with inflows over the last several years, effectively bringing down exposure to high flying long-term holdings. For example, over the past 24 months, we made significant new investments in Sony Group and Hitachi, both of which were trading at a below market average PE of 13x and 10x forward earnings, respectively, at the time of our purchases. 

An exception is Mercari, also a new recent investment, which came with rather a hefty multiple based on near-term earnings. Here, we would like to emphasize that it is a pure internet-based business model, which has just recently broken even on GAAP accounting, with significantly high returns on capital and high operating leverage, making it a potential candidate for “non-linear grower (exponential grower)” even under a rising interest rate environment. As mentioned above high PE multiple stocks with above average consistent “linear” growth outlook are at most risk of de-rating. On the other hand, high multiple stocks with “non-linear” growth potential can have the ability to defy the “gravity” in our view.

We hope this illustrates our philosophy around portfolio management and valuation discipline.

Mitsubishi Corporation 

On the valuation profile of the Fund, despite the Fund’s growth bias, we would like to point out that it does own several “value stocks” such as Hitachi (portfolio weight 4.45%, PE 10x, dividend yield 1.7%) and Mitsubishi Corp (portfolio weight 4.69%, PE 7x, dividend yield 3.8%), both of which are among the Fund’s top 10 positions by weighting. In our view, these stocks are “growth in disguise” as we believe these businesses are actually long-term compounders.

Mitsubishi Corporation has not gotten much mention in our letters in recent years, but the Fund has been invested in it for nearly 10 years and more famously, it is also heavily owned by Berkshire Hathaway.

Long-time readers of these letters may already be familiar that we view Mitsubishi as an investment house even though it traces its roots in wholesale trading. After many years of investment activities which leveraged on its expertise as a general trading house, the firm’s balance sheet today represents a unique collection of operating assets and securities with a wide variety of geographical exposure and industries that are not easily accessible through other means of investments. These assets range globally from energy/commodity projects in Australia, truck assembly supply chain business in Southeast Asia, electric power plant development/power generation business in Europe and the U.S., to a convenience store operation in Japan.

Mitsubishi generates returns through 1) operating businesses (i.e. operating income), 2) dividends  from investees, 3) equity income from affiliates,  4) realized gains from sale of investment securities and other fixed assets, 5) unrealized gains on investment securities (i.e. gains on other investments designated as “FVTOCI”), and 6) unrealized gains on investments in overseas subsidiaries (i.e. exchange differences on translating foreign operations).* As such, in our view, conventionally focusing on “profit before tax” or “profit for the year” does not give you a clear picture of how the company fared in a given year as there are some profit items that do not pass through net income but are only reflected in the OCI (Other Comprehensive Income) line. For an investment house, we are of the view that these profit items are just as important. For example, in fiscal 2009, the company posted a net income attributable to the parent of JPY 273bn ($2.4bn), a drop of 26% year-over-year (YoY). However, its comprehensive income came in at JPY 640bn ($5.5bn), rebounding sharply from a loss of JPY 385bn ($3.3bn) a year earlier, thanks chiefly to a significant recovery in unrealized gains on investment securities and investments in foreign entities.

This is why we eschew traditional metrics such as PE multiple or return on equity (ROE = profit for the year/total equity) when evaluating the stock. Instead, we focus on growth rate of book value per share (NAV per share) as a proxy for the growth in intrinsic value.

Against this backdrop, after paying out 20% of net income as dividends on average, the firm’s compound average growth rates (CAGR) of book value per share (BPS) for the last 5, 10, 15, 20 years (to fiscal 2022 ending in March) are as follows:

A few caveats:

1)     The company has been paying out roughly 15-30% of net income as dividends every year
2)     The accounting format was changed from USGAAP to IFRS in fiscal 2012 (this resulted in an approximately 8% increase in BPS at the end of FY2012 despite no economic changes to the underlying business)
3)     Total share count is little changed from 20 years ago, but has fluctuated modestly during the period
4)     Our estimate for BPS for the current fiscal year ending in March is 4,150 yen (+9.1% YoY)

Admittedly, per share NAV growth rate as a yardstick has its own shortcomings, however, we believe the growth above provides good-enough insights into the company’s solid mid-to-high single digit growth record over the years, and we would expect the firm to be able to continue at that pace going forward.

The unique strength of Mitsubishi and other trading houses, or so-called “sogo shosha,” is that they boast tens of thousands of staff spread all over the world to identify potential investment needs and oversee business activities. We do not believe there are any comparable peers with such scale elsewhere in the world. With a PE of 7.5x, a price to book (PB) of 0.97x, and a dividend yield of almost 4% as of the end of the month, we believe the stock is an attractive investment.

Click here for a full listing of Holdings.