Fund Performance Review
For the month of June, the Hennessy Japan Fund (HJPIX) declined 8.02% while the Russell Nomura Total Market™ Index lost 8.35% and the Tokyo Stock Price Index (TOPIX) fell 7.25%.
In June, the positive performers among the Global Industry Classification Standard (GICS) sectors included shares of Consumer Staples, Financials, and Healthcare, while Industrials, Information Technology, and Materials detracted from the Fund’s performance.
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Among the best performers were our investments in Rohto Pharmaceutical Co., Ltd., a leading skincare cosmetics and OTC ophthalmic medicines producer, Tokio Marine Holdings, Inc., Japan’s largest general insurance group, and Fast Retailing CO., Ltd., the operator of “UNIQLO” brand casual wear stores.
As for the laggards, Recruit Holdings Co., Ltd., Japan’s unique print and online media giant specializing in classified ads as well as providing human resources services, Mitsubishi Corporation, the largest trading company in Japan, and Sony Group Corporation, a diversified consumer and professional electronics, gaming, entertainment and financial services conglomerate, detracted from the Fund’s performance.
We have recently added a general insurance stock to our portfolio. This is a new investment which we consider as a “growth stock in disguise,” which means the growth prospects are as compelling as the Fund’s other portfolio holdings but is valued at “value-stock” like price to earnings (P/E) multiples.
Over the past few years, we have made major investments in Sony Group and Hitachi, which are also in the “growth stock in disguise” category. Our decisions to invest in Sony Group at 13x forward P/E in 2019/2020 and Hitachi at 10x forward P/E last year were made thanks to the market’s misperception.
This time, Tokio Marine Holdings, is Japan’s largest general insurance group with the best track record in the domestic market as well as overseas expansion. At the time of our purchase, it was trading at 13x Generally Accepted Accounting Principles (GAAP) accounting-based estimated fiscal year (FY) 2022 net profit (10.9% return on equity (ROE)) and 10x adjusted FY2022 net profit, translating into an ROE of 12.0%. A quick note on adjusted net income. It can be calculated by adding back various provisions for insurance claims reserves as well as amortization of goodwill and other intangible assets, and valuation allowances to the consolidated GAAP accounting-based net profit. This approximates the business’s cash-earnings and is widely used as management key performance indicator (KPI) by many insurance companies. It is also used as a basis for dividend payment policy.
The reason for the below-market-average valuation is due to the market’s misperception, in our opinion. Insurance businesses are regarded as mundane and mature in Japan. While this is true to some extent, the industry as a whole has actually been growing faster than the country’s gross domestic product (GDP) growth (albeit anemic) and now is an oligopoly thanks to years-long consolidation. Furthermore, its now-sizable overseas underwriting businesses are driving the overall net premium growth rate to mid-single digits. As we will illustrate below, on a per share basis, this growth rate can be further increased to mid-to-high digits thanks to its ability to repurchase shares sustainably over the long-run.
As the saying goes, great businesses do sometimes hide in plain sight. For example, in the past we have discussed the baby diaper business and other baby care products business as attractive due its relatively strong pricing power and brand equity for Japan-made premium products. Tokio Marine is yet another example of “a great business hiding in plain sight” as explained below.
What makes Tokio Marine and the other two mega-insurance groups in Japan uniquely attractive is 1) after years of consolidation, they control nearly 90% of the domestic underwriting business, allowing them to generate abundant cash flows; 2) they own “strategic equity holdings” worth tens of billions of dollars, which used to be the target of shareholder criticism as under-utilized assets but now are being wisely utilized to create shareholder value.
Expected compounded annual growth rate (CAGR) for this investment should be comparable to other portfolio holdings. However, the sources of return differ. That is to say, for stocks with negligible share buybacks as an additional driver of earnings per share and meager dividend yields, the future investment return relies solely on earnings growth (aside from valuation multiple expansion). On the other hand, for stocks with continuous sizable share buybacks and fat dividend yields, the total investment return equals the sum of 1) aggregate profit growth; 2) incremental increase in earnings per share driven by share buybacks; and 3) dividend yield. In the case of Tokio Marine Holdings, this should add up to high single digits to over 10%.
Japan’s domestic general insurance industry has consolidated significantly over the last two decades. Today, the three “mega” insurance groups (Tokio Marine Holdings, MS&AD Insurance Group Holdings, Sompo Holdings) control nearly 90% of the auto and fire insurance underwriting business. As such, Tokio Marine, the industry leader by market cap, has achieved an average combined ratio of 92.9% from 2011 through 2020.
Another interesting aspect of Japanese general insurers is their “strategic equity holdings.” This customary, decades-old ownership of stakes in various Japanese publicly traded companies (mostly well-established large companies such as Toyota, etc. and amounts to around 200 names) have long been viewed as under-utilized “legacy” assets. But today’s management teams are determined to capitalize on them to increase shareholder value amid Japan’s corporate governance reform initiatives.
These equity holdings are long-term shareholdings in their publicly traded corporate clients and were mainly acquired during the1960s solely for the purpose of promoting business relationships. According to the insurance companies, these holdings were often justified to win business. However, the reality is most business relationships are now forged based on merits, not the presence of the equity holdings.
Today, the equity holdings still remain on their balance sheets. This has led to criticisms by the investor community as idle financial assets and there has long been call for their sales to put the proceeds to more productive use.
Good news is that insurance companies are now much more receptive to the idea of better capital efficiency. And they have been acting on this. For example, Tokio Marine is sitting on JPY 2,400bn ($17bn) worth of such holdings, of which about JPY 100bn ($720mn) (equivalent to 2% of its own market cap) is constantly sold each year.
The profitable domestic underwriting business combined with continuous sale of the strategic equity holdings give them the financial means to create shareholder value in the form of making value-accretive overseas acquisitions as well as share buybacks.
From an accounting perspective, it is important to note that the year-over-year changes in unrealized gains on such holdings (designated as available-for-sale securities) do not go through the income statement but are only reflected in the total net assets on the balance sheet. As such, when the value of its equity portfolio increases thanks to a bull market, the total net asset will be inflated without commensurate increase in net income, inevitably pushing down ROE. To address this, Tokio Marine’s management wisely uses the proceeds from equity sales to repurchase its own shares. We believe this is a sensible and logical capital allocation policy given the stock’s perennial low valuation.
Management also has the option of making savvy acquisitions overseas. The key motivation here is not just to grow scale, but to globally diversify underwriting risk exposures such that Japan’s inherent idiosyncratic natural disaster risks such as earthquakes and typhoons can be effectively mitigated. Tokio Marine’s management has accelerated acquisitions since 2008 making 5 notable purchases to date.
• Kiln (acquired for JPY 106bn ($763mn) in March 2008)
• Philadelphia Insurance Companies (acquired for JPY 499bn ($3.6bn) in December 2008)
• Delphi (acquired for JPY 205bn ($1.5mn) in May 2012)
• HCC (acquired for JPY 940bn ($6.8mn) in October 2015)
• Pure (acquired for JPY 325bn ($2.3mn) in February 2020)
Today, overseas contributions accounts for approximately 40% of their total net premiums written and underwriting profit, boosting by far the most diversified insurance business portfolio among the 3 groups.
Of the overseas business, 80% comes from the U.S., where they mainly target the specialty insurance category such as liability insurance, medical insurance and so on. Such additions can complement the existing domestic insurance portfolio, which
is concentrated in auto and fire insurance lines. According to Swiss Re Sigma Report, the U.S. market size is $1.9tn, 10 times larger than Japan, giving Japanese insurers plenty of acquisition opportunities.
The company’s disclosure shows that, the premium growth as well as underwriting profit have been consistently outperforming the industry average at all acquired entities but one since they were purchased, indicating its acquisition prowess so far.
One potential reason why Japanese insurers may have better negotiating leverage in deal talks is that the Japanese insurers have underwriting portfolios that are more complementary to the U.S. business than the U.S. insurers attempting to acquire their domestic rivals.
Owing to this strategy together with further bolt-on acquisitions made by the group subsidiaries as well as other potential merger and acquisition (M&A) deals in emerging countries, management believes they can grow its adjusted group net profit at 3.0% to 7.0% annually over the long haul. We find this guidance to be credible as it has grown at 8.7% CAGR in the last 7 years since FY2014.
Lastly, management has been steadily raising the payout ratio from the 20% range 7 years ago to almost 50% this year all the while sufficiently funding the growth initiatives necessary to maintain its organic growth. During this time, the dividend yield has risen from 2% to 4% today.
Putting all of these together, our estimated expected long-term total shareholder return can be calculated as follows:
• Adjusted group net profit growth rate (annualized) 3.0 - 7.0%*
• Incremental growth in earnings per share driven by share buybacks (annualized) 1.5% - 2.5%
• Dividend yield 3.5% - 4.5%
*annualized earnings growth rate is a proxy for annual increase in intrinsic value
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