Market Commentary and Fund Performance

Fund Performance Review

For the month of December, the Hennessy Japan Fund (HJPIX) declined 0.50% while the Russell Nomura Total Market™ Index gained 1.61% and the Tokyo Stock Price Index (TOPIX) increased 1.88%. 

Among the best performers were our investments in Daikin Industries, Ltd., the leading global manufacturer of commercial-use air conditioners, Sony Group Corporation, a diversified consumer and professional electronics, gaming, entertainment and financial services conglomerate, and Mitsubishi Corporation, the largest trading company in Japan.

As for the laggards, Mercari, Inc., the operator of Japan’s largest online flea market app “Mercari,” SoftBank Group Corp., the telecom and Internet conglomerate, and Z Holdings Corporation, Japanese internet services pioneer detracted from the Fund’s performance.

2021 continued to be hampered by the COVID-19 pandemic, yet liquidity remains abundant in the global financial system.
Though the Fund underperformed its index in 2021 and there were things we could have done better (as always), the Fund continued to outperform the TOPIX Index over the 5- and 10-year periods as of 12/31/21.

Of course, we will continue to do our best as your portfolio manager to produce positive absolute returns over the long term as well as to achieve relative outperformance versus the reference index as consistently as possible moving forward. To this end, we would appreciate your continued support.

The most notable outperformers in 2021 were Recruit and Sony.

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 Recruit

Recruit is Japan’s unique print and online media giant targeting job advertisement as well as other domestic industries such as property, travel, and restaurants. It also operates staffing agencies.

As a media business, its competitive barriers are characterized by its network effects, in which their media platforms attract many advertisers, drawing prospective individual customers, which in turn brings in more advertisers whereby creating virtuous cycles.

The company controls the entire process from dealing directly with advertisers to producing proprietary media platforms and attracting visitors/viewers through them.

Of particular importance is its wholly-owned subsidiary Indeed, which specializes in the online job search business to help match people with jobs (housed under the HR Technology segment), has been a great success and has been demonstrating remarkable resilience post the COVID-19 pandemic.

Its Q2 fiscal year (FY) 2021 (July-September 2021) results revealed that the segment’s revenue and earnings before interest, taxes, depreciation, and amortization (EBITDA) contribution have jumped to 30% and 61% of the consolidated results, respectively. Better yet, its operating margin has shot up to 40%. The sharp rise in margin offers a rare glimpse into what this business can potentially earn. Being a pure online platform business, Indeed possesses the three key attributes highlighted in our past commentary: high returns on capital, high operating leverage, and long-term secular high growth rate, making the business extremely attractive with a potential for “exponential” (non-linear) growth opportunity.

Reflecting on the continuously robust Q2 business performance, management cited a prolonged imbalance in the U.S. labor market between demand from hiring companies and job seekers looking for work. As the economy started to reopen in 2021 along the progress of the COVID-19 vaccination rollout, a sudden increase in recruiting needs far outstripped the pace of rise in job seekers’ activity. This turned into a godsend business condition for Indeed as the company adopts a pay-per-performance pricing model whereby hiring companies become willing to pay in order to prioritize job listings on the platform amid the extremely tight labor market.

Going forward, management is somewhat cautious, as they believe demand for new jobs is expected to catch up. Continued increase in vaccination rates as well as the end of government household subsidy programs are likely to bring job seekers back into the job market. As such, management expects the labor market supply/demand imbalance to lessen, which may dampen revenue momentum as finding qualified hires becomes less challenging.

Contrary to this narrative, we are actually of the view that the current favorable environment may persist longer than people think, as we believe there are some elements of permanent supply shock in the making. That is to say, if COVID-19 is here to stay like a seasonal flu and become a new normal, many young mothers will likely give up holding a job altogether and end up permanently staying home to take care of their children. We have been reading stories about rising fees and diminishing availability at daycare centers in the U.S., forcing working couples to quit one job for the sake of childcare at home. As a result, a big chunk of the talented workforce could be structurally removed from the labor market. Secondly, there are a certain number of people who don’t have to work for financial reasons anymore but still remain in the workforce. These people have amassed enough savings for retirement already through years of hard work as well as successful stock investments due to a decade-long bull market. With ever greater uncertainty at workplace related to the COVID infection risk, these people may choose to leave the workforce altogether for good. Thirdly, the work from home regime under COVID has changed the skills required by employers thanks to the advancement of new technologies related to remote working capabilities. White-collar skills such as coding, software engineering, designing are in heavier demand than ever. This led to the unemployment rate for white-collar workers having returned to pre-COVID-19 levels rather swiftly while that of people with a high school degree being much less the case. Good news is that Indeed primarily benefits from labor tightness in the former type of job market than the latter type.  

Lastly, one of the new missions named “Simplify Hiring” set by management is worth mentioning. As millions of people lost their jobs amid the pandemic and employers were unable to meet with job applicants face-to-face to facilitate hiring, automation of the application process/hiring process is becoming more crucial than ever. At the FY2020 full year results meeting held back in May, Hisayuki Idekoba, the newly appointed CEO who spearheaded the acquisition of Indeed, shared his grand vision, where “people who want a job can change jobs in one second” or “people can find a new job with the push of a button” by fully utilizing artificial intelligence (AI) and machine learning. It will be interesting to see how new services will develop from within Recruit in this endeavor.

Sony

After a series of drastic restructuring programs that commenced in 2012 under then-CEO Kazuo Hirai, the company has transformed from a low-margin, troubled consumer electronics hardware manufacturer to what management defines as 
“A Creative Entertainment Company with a Solid Foundation of Technology.”            

Today, Sony generates profits from an array of entertainment businesses consisting of games (PlayStation franchise), music (Sony Music), and movies (Sony Pictures), collectively accounting for over half of consolidated operating income. The firm also houses semiconductor, electronics hardware and financial services businesses. 

Armed with the large installed base of PlayStation consoles and rich intellectual property (IP) library in gaming, music and movies, management has been driving a “One Sony” initiative to bring together the pieces to facilitate collaboration among different divisions for synergies. Roll out of content IP across a wide range of media, development of original music for own title video games by the music division as well as production of virtual reality (VR) content featuring Sony artists by the gaming division are all examples of this. These initiatives are reasonably promising as existing content character IP generally requires limited incremental investment to generate additional revenue. From a content creators’ point of view, these opportunities along with Sony’s strength in electronic hardware technologies are major attractions to lure top movie directors, music artists and game developers. As such, we believe Sony’s much improved (return on equity) ROE and its ability to generate free cash flows can be sustained into the future.

During the last quarterly earnings season, managements at various companies unanimously complained about supply chain disruptions along with issues such as rising commodity prices, chip shortages, and labor inflation, which forced them to report worse-than-expected financial performance. Contrary to this, Sony has weathered the headwinds quite well. The company managed to improve profitability through premiumization of its product offerings, which helped them absorb the adverse impact through higher margins. Also, to address chip shortages, Sony has decided to invest in a joint venture with Taiwan’s TSMC for their first-ever chip manufacturing facility in Japan. This should help alleviate concerns around Sony’s ability to source logic chip wafers in the future. Furthermore, for the full year, its entertainment businesses such as music and movies are expected to help offset and ease pressure on the hardware business. We believe that there are benefits to being a conglomerate for Sony.

Softbank was a key detractor for the year.

SoftBank Group

The large decline in SoftBank Group’s shares weighed on the Fund’s performance in the back half of the year.

Since we became shareholders of the company in 2015, the stock has provided strong returns to the Fund’s performance. However, it has been far from smooth sailing as the company was often misunderstood by the market.

For example, there are divergent views about founder/CEO Masayoshi Son’s leadership quality due to his overly ambitious and at times seemingly reckless business decisions, which led to significant investment losses in WeWork, for example. We, 
on the other hand, take a more charitable stance. Given his entrepreneurial track record of 40 years, which includes numerous positive impacts he made on the Japanese society such as offering low-price broadband internet services in Japan and introducing the first iPhone to Japanese consumers, he should deserve more credit.

More recently, there were misunderstandings around the interpretation of its financial performance. When management reported an operating loss of over $10 billion in FY2019 owing to difficult investment performance of its holdings, news media slammed it as the largest ever recorded by a Japanese company. However, the company’s real value lies in its balance sheet, not in the income statement. Their significant investment holdings include Alibaba, ARM, and the Vision Fund. When marking-to-market these assets where applicable, the company’s net asset value exceeds its market cap by a large margin. 

As of September 2021, SoftBank Group’s net asset value (NAV) stood at JPY 21 trillion ($183.2 bn) while its market cap remains at approximately half of this. Furthermore, its wholly-owned subsidiary ARM, the UK-based chip design house with a monopoly-like market share, is currently in the process of being merged with Nvidia. As two-thirds of the consideration is to be paid in Nvidia stock, the ARM stake could be marked up a lot higher than the current appraisal value of JPY 3.3 trillion ($28.8 bn), which is what SBG paid to complete the acquisition back in 2016. Based on the current price of Nvidia stock, the price tag is estimated to be over JPY 5 trillion ($43.6 bn) (the gains are not yet reflected in the JPY 21 trillion ($183.2 bn) NAV mentioned above). We also think that management can explore other strategic options regarding its ARM stake should the merger fall through. As alternative exit plans, they can go at it alone with an IPO of ARM or tie up with another interested strategic partner to enhance value further.

Our view has been such that SoftBank Group is actually one of the most asset-rich companies in Japan, and that is still the case today. With many investments in “non-linear” businesses around the world in the private equity space being expected to drive its investment performance (albeit lumpy) over time, we remain positive on the name.

A new name added this year was Hitachi.

Hitachi

This year’s notable trade was the new purchase of Hitachi shares in spring of this year.

The company is a large-cap name with $60 billion in market value and one of Japan’s oldest electric equipment & heavy industrial machinery manufacturers. Its scope of business ranges from manufacturing of industrial machinery, home appliances, electronics, medical equipment, and the development of enterprise IT systems, to construction of social infrastructures such as rail systems, power plants, and building management systems.

Epitomizing Japan’s lost “decades,” Hitachi was a badly run enterprise in the years leading up to 2008 whose downfall culminated amid the global financial crisis, incurring the largest loss ever recorded by a Japanese manufacturer at the time. Post the crisis, management got their act together, went through numerous restructurings, significantly improving its base-line profitability. This turnaround phase is now largely complete with the quality of the company moving from “unattractive” to “average.” Now, we see the company poised to advance from “average” to “excellent”. We have been observing management making a transition from a manufacturing-driven hardware sales model to a scalable solution-based model built around their proprietary industrial IoT (Internet of Things) platform called Lumada. Following our research, I have the feeling that they have figured out a playbook to grow profitably and consistently going forward.

The stock is trading at a significantly below average price to earnings ratio (P/E) with ROE in the mid-teens and a reasonably healthy balance sheet. As the business portfolio shift progresses, we expect its ROE to improve further accompanied by above average earnings growth, increases in free cash flow and further strengthening of the balance sheet.

Despite a lack of a long-term sound track record prior to 2008, 13 years since the start of the turnaround combined with the stock’s current low valuation makes Hitachi a compelling investment case. We suspect the stock remains considerably undervalued due to the market’s “anchoring bias” from the times when the company was a lethargic, low margin, troubled hardware manufacturer.

If our investment view is correct, we expect both earnings growth and multiple expansion to drive up the share price. Why do we believe there will be re-rating? Firstly, as the proportion of the software-driven business increases, it should bring about earnings growth that will be accompanied by margin improvement. Secondly, it also implies less earnings volatility as some of the Lumada use cases have a recurring revenue component. Thirdly, Hitachi will likely consume less capital going forward than when it was a pure manufacturing concern, which means more free cash flow generation with scope for higher dividends and share buybacks in the future. All of these trends should contribute to a lower equity risk-premium, resulting in a re-rating. On the other hand, if we are proven wrong, Hitachi will just remain a cheap manufacturing stock with not much downside risk. However, thanks to the restructurings of the past years, the company already achieves mid-teen ROEs on a reasonably healthy balance sheet.  

There are 6 old tech giants in Japan who prospered mightily during their heyday in the 80s: Sony, Hitachi, Fujitsu, NEC, Panasonic and Toshiba. Over time, they all lost their luster and crashed to the ground during the 2008 financial crisis. Since then, it has been interesting to watch the polarization of their post-crisis fates.

For example, Sony, which was added to the Fund’s portfolio in 2019 and has provided meaningful returns for it, went on its own transformative path in the entertainment business (gaming, music and movies). Today, Sony has revived as one of the premier large cap global companies. Fujitsu and NEC also successfully re-established themselves in recent years as major computer system integrators and network system providers respectively riding Japan’s “digital transformation” wave (unfortunately we missed these two). In contrast, Panasonic is still struggling to redefine itself while Toshiba was caught up in corporate governance disarray yet again last year. In our view, Hitachi has now figured out a playbook to grow sustainably in its own right as discussed above.

Both investment cases for Sony and Hitachi may appear a bit antithetical to our track-record focused investing approach. But if there is a potential for the business to transform into a quality grower, we are always happy to invest. Who knows, these tech “dinosaurs” may continue to be fertile ground for attractive long-term growth stories in Japan? To that end, we will keep tabs on the corporate dramas as they unfold.

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