Market Commentary and Fund Performance

Fund Performance Review

In May, the Fund increased by 3.17% (HJPIX), outperforming its benchmark, the Russell/Nomura Total MarketTM Index, which rose by 0.89%.

The month’s positive performers among the Global Industry Classification Standard (GICS) sectors included shares of Industrials, Information Technology, and Financials, while Consumer Staples, Communication Services, and Consumer Discretionary 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, Tokyo Electron Limited, a manufacturer of semiconductor equipment, and Tokio Marine Holdings, Inc., the general insurance company with the best underwriting.

As for the laggards, Olympus Corporation, the leading company in the medical field such as gastrointestinal endoscopy, which has a 70% share of the world market, Misumi Group Inc., the maker and distributor of metal mold components and precision machinery parts, and Seven & i Holdings Co., Ltd., a Japanese diversified retail group and operator of 7-Eleven convenience stores, were the largest detractors.

This month, the TOPIX recorded a 33-year high, making Japan one of the top performing markets this year. With fears of a recession globally, is Japan due for a correction? Since the bubble burst in 1989, there have been many false dawns in the land of the rising sun and “this time is different” is an ominous phrase to describe investments. That said, we would like to point out some of the key drivers behind this market rally and explain our views on why, indeed, this time “may be” different:

1) Continued efforts around corporate governance and stock market reform

In March of this year, the Tokyo Stock Exchange issued a request to listed companies with price to book (PB) ratios below 1 to come up with specific plans to increase shareholder value such that their share prices will improve to above PB of 1. While no timeline has been set, this is the first time in its history that the stock exchange took such a proactive action. Though the government is not the one taking the lead this time, this effort is considered an extension of the series of corporate governance reforms that have been making progress since the introduction of the stewardship code and the corporate governance code in 2014 and 2015, respectively, under the so-called Abenomics. Prior to these initiatives, shareholders’ interests were hardly among the top priorities of management resulting in below-cost-of-equity ROEs (return on equity) around mid-single digits. Fast forward to today, Japan’s ROEs have made meaningful improvement notching around 10% thanks to a greater focus on profitability and capital efficiency. Nevertheless, approximately 1,800 (out of 3,300 listed on TSE Prime and Standard section) or over 50% of the entire market as of the end of March, are still trading below book value. The Tokyo Stock Exchange’s aim is to reduce the number of such companies.

2) Continued expansive monetary policy by the Bank of Japan (BOJ)

On the macroeconomic front, Japan is showing resilience despite a darkening outlook abroad. One of the tailwinds is continued expansive monetary policy. Contrary to the rest of the world, the new BOJ Governor Kazuo Ueda has repeatedly reaffirmed that the current ultra-low interest rates will remain unchanged until there are clear signs of a stable 2% inflation rate. A pro-growth, pro-inflation central bank is what Japan needs to overcome a decades-long deflationary mindset.

3) Wage increases

During the latest spring wage negotiation season, labor unions of large companies across Japan have won an average of 3.9% base salary increases, a level that exceeds the current core consumer price index (CPI) and the highest in 31 years. This is positive as real wage growth could turn positive after many years of sluggishness. Domestic consumer spending accounts for over half of Japan’s gross domestic product (GDP). With these encouraging results from the wage negotiations, there are expectations that the working-age population will start to spend more on consumption. As for retired seniors, the recent rising Japanese stock market should also create a wealth effect as 40% of individual equity holders in Japan are over the age of 70.

4) Inbound tourist recovery

Since the belated reopening of Japan’s borders in October last year, foreign visitors have been coming back to Japan in a big way. The strong recovery is happening even in the absence of Chinese tourists, which accounted for 30% of a total 30 million visitors in 2019. Imagine Chinese people resuming their travel to Japan. The upside will be hard to ignore. Furthermore, equally important is tourism spending. At the previous peak in 2019, tourists spent an average of around $1,450, totaling roughly 1% of GDP. During the pandemic, the inbound tourists’ demand evaporated completely. Now that the worst is behind us, we are optimistic of a comeback of overseas holidaymakers. Better yet, with the yen’s decline against the U.S. dollar (USD) over the last 3 years, the same dollar amount gives you 30% more purchasing power today. All our foreign friends are keen to go to Japan for holiday. It appears the prosperity of Japan’s “inbound tourism market” is very promising.

5) Moderate Japanese yen depreciation

As a result of the widening of the interest rate differential between the Federal Reserve and BOJ decision, the yen has seen moderate depreciation against the USD. A weaker domestic currency bolsters exporters’ earnings. Given the relative importance of the export industry in Japan, the trend is positive. A favorable currency environment is also crucial for large exporters’ businesses in order to keep up the momentum behind wage inflation.

6) Warren Buffett and Japan’s geopolitical neutrality

After the famed investor’s surprise visit to Tokyo in April, the world has turned their attention to Japan as a “hot” investment destination. His large stakes in Japan’s five general trading companies came as a huge vote of confidence. As far as we know, this is a dramatic change of view from 20-30 years ago. Back then, Mr. Buffett did not regard Japan as a compelling investment due to the country’s perennially low return on equity ROE). At Berkshire’s annual general meeting this year, he commented that he feels more comfortable investing in Japan than Taiwan, which is at the center of a geopolitical quagmire. When asked about his exit from Taiwan Semiconductor Manufacturing Company Limited (TSMC) after an unusually short holding period, the legendary investor acknowledged that geopolitical considerations played a role in his decision. In the same vein, global semiconductor companies have made announcements of large investments in Japan to set up new chip factories. For example, Micron will invest a maximum of $5 billion to expand production capacity in Hiroshima, given the subsidy from the Japanese government. TSMC have been busy setting up a new factory in Kumamoto, Japan.

These events seem to indicate Japan is seen as geopolitically safe or a “neutral” place for businesses. Also, we think that the country is becoming an increasingly attractive place to find high-quality labor at cheaper wages when compared to other developed markets, a result of stagnant real growth rates.

What Could Derail Japan’s Ascent?

1. The timing of the BOJ’s rate policy change matters. Raising interest rates too hastily will stifle the economic recovery and could drag the country back into deflation. In other likely risk scenarios, if the BOJ’s rate hike coincides with the U.S. rate cut, the yen could reverse sharply hurting the export industry, which in turn dampens the domestic economy. Exiting from unprecedented quantitative easing measures is another tricky path for the new BOJ Governor Ueda.
2. The yen’s depreciation is positive for exporters but the pace of its decline needs to be moderate. A sharp fall in value could accelerate inflation through higher import prices as evident from the JPY’s downward spiral last year to a 32-year low past 150 yen per USD. Already in the last few years, low income households have been somewhat hurt by higher prices. Whether today’s inflation turns into good inflation (demand-pull) or bad inflation (cost-push) remains to be seen.
3. It is crucial that Japanese companies continue to raise salaries to keep the virtuous cycle going. However, this may prove to be a challenge considering Japan’s lifetime employment system. While the notion of working for the same employer for their whole career has somewhat become a thing of the past and there has been a gradual shift towards a merit-based compensation structure, the lifetime employment system is still very much alive in Japan. This means a single year’s base salary increase translates into a significant rise in overall labor costs. This is contrary to the U.S., where businesses can lay people off more flexibly and reward a small number of high-performers with competitive compensation packages.

Portfolio Positioning

Under the mature deflationary economy, above average ROE companies have been few and far between in Japan. That is why over half of listed companies are trading below net asset value. However, the pressure is rising to enforce capitalistic behavior. It is coming from the government, the stock exchange, as well as activist firms and public shareholders.

Share buybacks and dividends are sources of shareholder returns that are often overlooked and underestimated by the market. But they are crucial to improving Japan’s overall ROE, where many listed companies boost cash rich balance sheets and too much equity. If the bottom-half of listed companies in terms of ROE embrace this capitalism mindset, it will be a powerful force of re-rating for the entire market.

Over the course of last year, we have added several new names that we would categorize as “growth stocks in disguise” while holding high-growth capital compounders such as Sony Group, Fast Retailing, Tokyo Electron, Keyence, Daikin, etc. One of the examples of “growth stocks in disguise” are Japan’s general insurers (Tokio Marine Holdings, MS&AD Insurance Group Holdings, Sompo Holdings), which we have discussed in past letters.

Insurance is often seen as mature and boring but in a consolidated industry with only three players left domestically, the companies have been showing steady earnings growth of mid-single digits to around 10%. Plus, thanks to low valuation multiples given to this “unexciting” industry, these companies have been able to sustainably buy back 1.5% - 2.5% of outstanding shares per year and increase dividends to maintain 3.5% - 4.5% dividend yields.

These sources of return, namely earnings expansion, incremental growth in earnings per share (EPS) driven by share buybacks, and above-average dividend yields, add up to annual expected total returns of 10%+, which is comparable to “pure” growth stocks in the portfolio that come with minimal buybacks and dividends. Furthermore, these insurers still have roughly JPY 1.5 - 2.0 trillion ($10.7 billion - $14.3 billion) worth of public equity holdings acquired back in the 1960s (about 1/3 the size of the firms’ market caps). Today, they are sitting on massive unrealized gains, which have been tapped to fund growth. Strong cash flows from market oligopoly, ample proceeds from the periodic sales of equity holdings together with able management teams are what gives them a competitive edge and makes them uniquely attractive in the global insurance space. Particularly, Tokio Marine has successfully capitalized on this financial strength to go global and is now competing in the same league as Allianz and Chub (Tokio Marine may even eclipse these rivals in the future in terms of scale and capital efficiency). Elsewhere, Mitsubishi Corporation, which has been in the Fund’s portfolio for years and is one of the five trading companies Warren Buffett invested in, is another investment case in which management has significant ability to sustainably buy back shares and hike dividends. And we like these prospects.

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