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 Japanese market and Fund performance.
Masakazu Takeda, CFA, CMAPortfolio Manager
Fund Performance Review
In December, the Fund lost 3.26% (HJPIX), while its benchmark, the Russell/Nomura Total MarketTM Index fell by 0.03%. The Tokyo Stock Price Index gained 0.93% in December.
The month’s positive performers among the Global Industry Classification Standard (GICS) sectors included shares of Consumer Staples, Financials, and Communication Services, while Health Care, Information Technology, and Industrials detracted from the Fund’s performance.
Click here for full, standardized Fund performance.
Among the best performers were our investments in Rohto Pharmaceutical Co., Ltd., a leading skincare cosmetics and over the counter ophthalmic medicines producer, Seven & i Holdings Co., Ltd., a Japanese diversified retail group and operator of 7-Eleven convenience stores, and Pigeon Corporation, a baby care goods manufacturer.
As for the laggards, Sony Group Corporation, a diversified consumer and professional electronics, gaming, entertainment and financial services conglomerate, Hitachi, Ltd., one of Japan’s oldest electric equipment and heavy industrial machinery manufacturers and Mitsubishi Corporation, the largest trading company in Japan, were the largest detractors.
The Fund’s performance in 2022 was very disappointing, with a negative absolute and relative return that was significantly lower than that of the Russell/Nomura Total Market Index. We will discuss the main reasons for the poor performance in more detail below, but the biggest difference between the macro environments at the beginning of 2022 and now is the growing reality of a global recession and stagflation. At the outset at 2022, we assumed the economy would return to a growth path with the end of the pandemic. We expected normalization would bring healthy inflation and rising interest rates, but both the economic and interest rate environment have rapidly deteriorated due to a much greater-than-expected deterioration in inflation and a sharp rise in interest rates. In Japan, on the other hand, there are signs that the country is finally emerging from the deflationary environment.
In light of the possibility of the first full-fledged inflation in 40 years and the accompanying global interest rates remaining high for a long period of time, as in the 1970s, we continue to hold existing stocks while diversifying by adding new stocks around the middle of the year. The active share of the Fund has remained at around 80%, and the Fund continues to be a highly differentiated portfolio.
Factors Contributing to the Poor Performance
There were several factors that contributed to the Fund’s poor performance, the most significant of which was the decline in valuations of the core growth holdings due to rising interest rates. We explained this point in our February 2022 commentary, citing examples such as Keyence and Nidec.
In the case of growth stocks, when long-term interest rates rise, the present value of expected future cash flows diminishes, which puts downward pressure on stock prices. However, we believe that continuing to invest in companies with global growth potential is the most effective approach in Japan where the population continues to decline. Companies that can grow on the global stage have a much larger potential market size than domestically focused peers, and can therefore be expected to expand their earnings over a longer period. Although Keyence’s current stock price has fallen by about 30% from its record high in 2021, we believe that the company’s medium- to long-term growth prospects have not changed significantly, and if it continues to grow profits at an annual rate of over 10%, it should be able to recover the decline in about three to four years. Until then, patience is required.
On the other hand, there are stocks that have little risk of devaluation and are expected to drive the absolute return of the Fund. These include Hitachi, which is expected to transform from a value stock to a growth stock over the coming years. The Fund made a new investment in Hitachi at a price to earnings (P/E) ratio of 10x based on the company’s FY2021 earnings forecast, and we believe the stock is still undervalued today. As a manufacturing-oriented company, it is difficult to expect significant growth in short-term earnings due to rising raw material costs, a shortage of semiconductors, and lockdowns in China. However, we expect that the structural change in the business model through the Lumada business will lead to continued profit growth over the medium to long-term and a possible revaluation.
Mitsubishi Corporation has also long been labeled as a value stock, with a P/E in the single digits and a price to book (P/B) ratio below 1x, but we consider so-called “sogo shosha,” or trading companies, to be investment business companies with a worldwide human network. Their balance sheets today have a portfolio of business assets that is unique in the world. We believe that the accumulation of these assets will lead to an increase in the intrinsic value of Mitsubishi Corporation, which in turn will be reflected in the growth of their net asset value per share. For example, over the past 5, 10, 15, and 20 years, the company’s net asset value per share has achieved an annualized growth ranging from low single digits to around 10%. Therefore, we view Mitsubishi Corporation as an undervalued growth stock, rather than a value stock with no growth potential.
While expectations for an economic recovery were high due to assumptions of the economy resuming post-COVID-19, contrary to our expectations, excessive inflation caused recession risk, is another factor contributing to the Fund’s poor performance. The Fund’s stocks are mainly global growth companies that are the pride of Japan, but these stocks include “economically-sensitive stocks” whose businesses are easily affected by the economy. These include not only manufacturing companies that leverage Japan’s competitive advantage in manufacturing, but also Internet service companies such as Recruit. Increased recession risk has led to decline valuations. However, while the share prices of economically sensitive stocks tend to fall ahead of a rise in recession fears, they also quickly turnaround when signs of economic recovery emerge.
With regard to Recruit, which has an economically sensitive aspect, we believe the company will benefit from labor inflation arising from the structural shortage of human resources around the world. Although the current stock market views the current economic downturn as having a negative impact on the company’s human resource matching business, Recruit’s competitive position in this business is overwhelming, and we have recently been buying more shares in anticipation of a normalization of labor market conditions within a few years.
A further factor is that some of the consumption that occurred during the Pandemic was “overdone” and has come off as the economy has resumed. For example, Sony’s game business, Shimano’s bicycle parts business, and Mercari’s online flea market business, consumers became aware of the quality and convenience of products and services in the wake of the pandemic, and this became a part of their lifestyle. However, we feel that 2022 has seen a temporary reactionary decline.
As for Mercari, the company has continued to run an “intended loss” by allocating cash flow generated from its solid domestic earnings base to cultivate its U.S. business, but under the recent environment of rising interest rates, the stock market has given the company a harsh appraisal. In addition, our ongoing company interviews and research have revealed that the probability of success of the company’s flea market business in the U.S. has not necessarily increased, and there is also scattered data indicating that the growth potential of the domestic business may be declining somewhat. Therefore, we have lowered the stock’s weight for the time being while assessing its progress.
Stocks We Trimmed
We reduced the holding in Nidec this year. As previously reported, the company is currently focusing on traction motors for electric vehicles, aiming to supply 4 million units in FY2025. However, there have been moves among local electric vehicle manufacturers in China to restrain Nidec’s exclusive supply of motors. There is also the possibility of Nidec losing market share to competitor MinebeaMitsumi in other business segments as the company focuses on the electric vehicle (EV) traction motor field. Lastly, there is the risk of a decline in the traction motor market as a result of rising interest rates. In addition, the company’s share price, which was based on the assumption of a certain level of success in the traction motor business, has become relatively overvalued due to the rise in interest rates. In addition, the sudden resignation of former President Seki, who was considered to be the successor to Nagamori, the founder and chairman of the company, has made it clear that the issue of a successor has become difficult to resolve. Although we were of the opinion that this issue would eventually be resolved successfully, we were concerned about the ungentlemanly manner in which Mr. Nagamori had handled the matter when he was seen at a financial results meeting naming and blaming former President Seki for the deterioration of the company’s culture during his tenure. The fact that the company’s culture would be easily weakened without his presence was also a factor in the decision to reduce the position.
In August of last year, news of SoftBank Group’s huge losses and restructuring of the Vision Fund business was reported, and we have lowered the weighting of the company in the Fund portfolio from early spring prior to that. This was because we judged that the external environment had deteriorated more than initially anticipated. We decided to take a cautious look at the future of the company’s Vision Fund business in light of the fact that the venture capital industry as a whole has been suffering due to rising interest rates worldwide and may take a considerable period to recover. There was further risk that the portfolio companies may see their operations decline before the industry as a whole recovers. We were also concerned for the prospects of Alibaba’s share price, the company’s main investment asset. Alibaba has achieved rapid growth backed by its overwhelming share of China’s e-commerce industry, but in recent years it has become subject to strict monitoring and regulation of Internet companies by the Chinese government. Finally, we also considered the risk of a devaluation of Arm, which is scheduled to be listed on the stock exchange, due to the recent rise in interest rates.
Stocks Contributing to Fund Performance
On a brighter note, Rohto Pharmaceuticals and Hitachi, Ltd. contributed to our investment performance.
Rohto began with the sale of gastrointestinal drugs when it was founded, added the over-the-counter eye drop business in the early 20th century, and the skin care business in the 1990s and 2000s. Both eye drops and skincare products are today’s breadwinners. In Japan, which accounts for about 60% of total sales, sales of high-priced eye drops, for which demand is increasing due to the increase in remote work post-COVID-19, sunscreens and Melano CC have grown substantially as opportunities to go outside have increased with the easing of behavioral restrictions. Overseas sales are also doing very well. In Asia, which accounts for about a quarter of total sales, Vietnam, where COVID-19 has come to a settlement, has achieved a V-shaped recovery, and Indonesia is also doing well. Sales and profits are also increasing in the U.S. and Europe, although on a smaller scale, which is a positive sign.
The company’s appeal lies in its niche brand power in Asia for over-the-counter eye drops (eye care division) and cosmetics (skin care division). Countries such as Indonesia, Vietnam, and Cambodia are expected to enter a so-called “demographic dividend” period in which the working-age population as a percentage of the total population is expected to increase.
We believe that making upfront investments at this stage to increase consumer awareness of the company’s brand is the right strategy from a long-term perspective. Another promising area is the company’s regenerative medicine business, which it started in Japan about 10 years ago, and its ophthalmic drug business, which it launched in recent years. In the area of regenerative medicine, the company is currently conducting clinical trials for regenerative medical products using adipose-derived stem cells for indications such as liver cirrhosis, new type of coronary pneumonia, pulmonary fibrosis, and severe heart failure. The company is also planning to start a full-scale business of contract manufacturing of cells for regenerative medicine using its proprietary automated culture system.
Through the Lumada business, Hitachi aims to shift from a business that simply manufactures hardware to a business that solves client companies’ problems. The Lumada business is expected to generate sales of JPY 1.87 billion ($14.5 million, 19% of consolidated sales) in the fiscal year ending March 31, 2022, and is a highly profitable segment with a profit margin that exceeds the company average despite prior investment. Therefore, the profit contribution of this business is higher than its sales appear to be.
According to Mr. Nakanishi, who served as President and Chairman from 2010 to 2021, Hitachi has 1) information technology cultivated as a system integrator, 2) operation and control technology cultivated through experience in social infrastructure (power plants, building elevators, railroad systems, etc.) and factory operation and operation, and 3) a strong track record in the field of information technology. By combining these strengths, the company is able to develop a solutions business that solves problems together with its clients, rather than competing solely on product technology and sales strength as in the past. The company’s unique system for collecting and analyzing on-site customer data via the Internet of Things (IoT) in order to discover solutions is called Lumada.
The specific flow of the Lumada business is as follows: First, Hitachi and the relevant company work together to identify the customer’s management issues and on-site issues. Next, a vast amount of digital data (operating data of facilities and stores, employee work data, product sales trend data, raw material data used in production processes, data related to production technology, etc.) generated in real time at business sites (factories, stores, social infrastructure, etc.) from facilities and IoT devices owned by the client company is collected and analyzed on Lumada. The ultimate goal is to create added value by introducing solutions derived from these data to customers. The solutions can vary from selling Hitachi’s own hardware, delivering information technology systems, undertaking operations, and providing maintenance and monitoring services, or any combination of these.
The company intends to standardize and accumulate internally successful problem-solving case studies (use cases) that have been implemented at client companies, so that they can be applied to other companies and industries facing similar problems. In the future, all business segments will be conducted from the perspective of “helping customers solve their problems through Lumada,” and the company’s once central manufacturing function will no longer be merely a part of the solutions business. Now that the use cases are in place, the company is entering a stage where it can expand without much cost, and profit margins and sales growth are expected to increase in the future. This is exactly the kind of scalable, asset-light business that we evaluate as an attractive business with high barriers to entry because of its ability to retain customers.
As mentioned at the beginning of this report, while maintaining a highly concentrated portfolio (active share of around 80%), we have decided to add new stocks somewhat aggressively starting in the summer.
Since the Fund has traditionally been a concentrated portfolio that invests in a small number of stocks, we had diversified as much as possible in terms of business lines. For this reason, the Fund has continued to invest in stocks during the past economic downturn without making any major changes. However, the stock market during COVID-19 provided a tailwind for growth stocks, and over the two years from 2020 to 2021, a number of growth stocks benefited, including Sony Group (entertainment), Keyence (factory automation sensors), Nidec (motors for electric vehicles), Unicharm (daily necessities), Shimano (bicycle parts), Terumo (medical equipment), Recruit (job advertising), Misumi Group (machinery parts), and Daikin (air conditioning), all of which had different business characteristics. In hindsight, this resulted in a “bias” in the overall portfolio. Since long-term interest rates play an important role in determining the prices of all financial assets, a sharp rise in interest rates, as was the case during the year, inevitably necessitated a reconsideration of the stock valuations of the current existing holdings. Therefore, we not only increased our purchases of some existing stocks, but also prioritized the addition of new stocks.
Typical examples of new investments during the year are Tokio Marine Holdings, Inc. and Seven & i Holdings Co. These stocks not only fit the Fund’s investment philosophy of simple and inherently safe businesses such as non-life insurance (Tokio Marine Holdings) and convenience stores (Seven & i Holdings), but also have businesses that are different from those of the existing stocks in the Melano CC portfolio, which we believe will contribute to lowering the overall risk of the portfolio. In addition, as a shareholder, the return on investment can be expected to be around 10% per annum (including dividend yield and the effect of share buybacks), which is comparable to other stocks in the Fund’s existing portfolio.
In addition, although the return on equity (ROE) of both companies may appear low at first glance, we believe they meet the Fund’s criteria for high return on capital (ROC) in the sense that their ROE is already high or is expected to become higher in the future. For example, the ROE of Tokio Marine is over 10% based on adjusted net income, which is more realistic than net income on the income statement, and the ROE of Seven & i is over 10% based on net income before goodwill elimination, and further improvement is expected in the future. Finally, valuations are low compared to the Fund’s average P/E, and are not considered overvalued compared to the average for Japanese stocks.
As of the end of December 2022, the number of stocks in the Fund has increased to 36, and the active share remains high at approximately 80%. 2023 will be a year in which we will focus on narrowing down the portfolio by identifying stocks that justify a high level of conviction.
Click here for a full listing of Holdings.
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