Market Commentary and Fund Performance

Performance data quoted represents past performance; past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the fund may be lower or higher than the performance quoted. Performance data current to the most recent month end, and standardized performance can be obtained by viewing the fact sheet or by clicking here.

Market Highlights

In May 2025, Japan’s major stock indices showed strong gains, with the TOPIX rising 3.90% compared to the end of the previous month. The Japanese stock market surged in the first half of the month, then corrected mid-month before recovering in the latter half, ultimately maintaining an overall upward trend within a defined range.

At the start of the month, optimism about progress in U.S. tariff negotiations continued to support the market. Additionally, the Bank of Japan’s (BOJ) downward revision of its forecasts for real gross domestic product (GDP) growth and inflation in its Outlook Report, signaling caution toward further interest rate hikes, combined with a weakening yen, helped sustain the market’s strength. The market surged further after the announcement of a U.S.-U.K. trade agreement and unexpected tariff reductions by both the U.S. and China.

However, by mid-May, positive news had largely been priced in, and the market faced pressure from a stronger yen and weaker dollar, as well as growing concerns over U.S. fiscal deterioration triggered by a downgrade of U.S. government bonds. These factors weighed on investor sentiment, causing a temporary pullback.

In the latter half of the month, the market rebounded as the U.S. postponed additional tariffs on the European Union and speculation arose about a revision to Japan’s ultra-long-term government bond issuance plan, which contributed to yen depreciation and buying interest in major stocks. On May 28, the U.S. Court of International Trade ruled that the Trump administration’s tariff policies were illegal and ordered a halt to the tariffs, accelerating yen depreciation and pushing the stock market sharply higher. However, the market retreated again after The Court of Appeals for the Federal Circuit temporarily suspended enforcement of the tariff injunction, resulting in a stronger yen, a weaker dollar, and a pullback in stock prices.

In summary, despite fluctuations caused by uncertainty surrounding U.S. tariff policies, the Japanese stock market closed May with solid gains compared to the previous month.

The Fund’s Performance

This month, the Fund returned 3.81% (HJPIX), underperforming its benchmark, the Russell/Nomura Total Market™ Index, which returned 4.36%.

The month's positive performer among the Global Industry Classification Standard (GICS) sectors included shares of Industrials, Financials, and Information Technology while Real Estate and Consumer Staples detracted from the Fund’s performance.

Among the best performers were our investments in Hitachi, Ltd., one of Japan’s oldest electric equipment & heavy industrial machinery manufacturers, Mitsubishi UFJ Financial Group, Inc., one of Japan’s largest financial groups, and Recruit Holdings Co., Ltd., Japan’s unique human resources (HR) and media company and the owner of U.S. based online job advertisement subsidiary “Indeed.”

As for the laggards, Sompo Holdings, Inc., one of the three largest general insurance company in Japan, Rohto Pharmaceutical Co., Ltd., a leading skincare cosmetics and over-the-counter (OTC) ophthalmic medicines producer, and Daiwa House Industry Co., Ltd.,  a top Japanese developer of homes and commercial properties.

This month saw a series of full-year earnings releases from the Fund’s portfolio companies. Among them, Recruit Holdings, whose stock performance has been subdued since the start of the year, also announced its results. As the Fund continues to hold shares in the company, we would like to share our perspective on its outlook and the share price valuation.

May Commentary

For the fiscal year ended March 2025, Recruit reported record consolidated earnings. Revenue reached 3.56tn yen ($24.8bn), up 4% year-on-year, operating profit rose 22% to 490.5bn yen ($3.4bn), and net income attributable to owners of the parent company increased 16% to 408.5bn yen ($2.8bn). The company’s key performance indicator (KPI), adjusted EBITDA,¹ grew 14% to 678.9bn yen ($4.7bn).

Regarding the core HR Technology segment, the management noted that U.S. demand for job postings has been softening since around February this year. This appears to be partly driven by heightened (albeit potentially temporary) economic uncertainty in the U.S. following President Trump’s policies.

The HR Technology business is inherently susceptible to shifts in the labor market. However, we remain confident in its long-term potential for strong growth. As such, we plan to capitalize on opportunities to increase our holdings during periods of significant share price declines caused by cyclical downturns. Conversely, during economic upswings, when the stock becomes overheated, we take partial profits at times.

We applaud the management for doubling down on investment to further solidify its leading position when the operating environment is less unfavorable. It is not an easy decision to act this way. We view these efforts as further strengthening the company's already high entry barrier.

We consider entry barriers to be 'dynamic' and not static. That is, even if the barrier is high, if it is gradually weakened by competition, it does not qualify as a good investment. On the other hand, a company that can maintain its entry barriers, and better yet, continue to raise them is a wonderful business to own. Currently, Recruit is in such a phase through launching multiple new services to widen its lead over its competitors.

On this month's earnings call, management unveiled an artificial intelligence (AI) agent service called "Indeed Career Scout," which will allow job seekers to find suitable job opportunities based on their skills and experiences by interacting with the app using simple conversational language. For hiring companies, "Indeed Talent Scout" was introduced, which serves as an AI recruiting agent to match the best talent from Indeed's vast troves of candidate data according to the employers' criteria. Both are now being tested in the U.S. Likewise, in Japan, "Gakuchika AI" is expected to be rolled out. This AI assistant will be used as a virtual consultant to help university students identify what career paths to explore before starting a job search.

Under its mission of “Simplify Hiring,” the company aims to facilitate hiring and automate the applying process and hiring process, which enhance the utility of its online recruit platform.

Valuation Considerations for Recruit

When evaluating whether Recruit’s stock is undervalued, there are several important points to consider:

Key Consideration 1

The first notable point is that Recruit often generates free cash flow (FCF) that exceeds its net income.

In traditional manufacturing industries, companies typically allocate cash flows to both "maintenance capital expenditures (capex)"—such as renewing existing plant facilities to match depreciation—and "growth capex" aimed at expanding revenues over the medium to long term, such as building new factories. As a result, FCF, calculated by subtracting investing cash flow from operating cash flow, tends to remain lower than net income. Because of this, FCF multiples² tend to be higher than price to earnings ratios (P/E).³

In contrast, as an internet company, Recruit does not require significant additional investments in tangible fixed assets to sustain its operations. For example, the company acquired Indeed in 2012 and Glassdoor in 2018, both of which are core to its HR Technology segment. While it continues to record the amortization of intangible assets related to these acquisitions each year, the level of ongoing investment required to maintain and grow the segment has remained below the amortization expense. This dynamic enables Recruit to generate substantial FCF. As such, Recruit's FCF multiples are often lower than its P/E.

This fundamental difference was one of the reasons we initially invested in Recruit shares back in 2016; its valuation appeared more compelling when evaluated based on FCF rather than net income.

Key Consideration 2

Since around 2022–2023, the company has significantly increased its use of stock-based compensation. Payments to executives and other employees through stock options are recorded as personnel expenses that do not involve actual cash outflows. As a result, operating cash flow has been flattered, leading to "better-than-reality" FCF.

For example, in the fiscal year ending March 2023, the company reported net income of approximately 271.7bn yen ($1.9bn), while FCF reached 405.5bn yen ($2.8bn). This equates to a P/E of 24x, but the FCF multiple was only 16x (based on the share price at the end of 2022). However, this figure is somewhat overstated. Although stock-based compensation is a non-cash expense, it should be treated as an actual economic cost when analyzing the company’s stock valuation. Therefore, it should be deducted from FCF for a more accurate assessment.

In the above fiscal year, the company recorded stock-based compensation expenses of 72.7bn yen ($505.8mn), which accounted for 17% of operating cash flow. Adjusting for this, the "real" FCF would have been approximately 332.8bn yen ($2.3bn), resulting in an FCF multiple of 20x instead of 16x.

Key Consideration 3

Recruit has been actively conducting share buybacks as well. In each of the fiscal years ending March 2023, 2024, and 2025, the company completed buybacks amounting to 152.5bn yen ($1.1bn), 218.9bn yen ($1.5bn), and 824.5bn yen ($5.7bn), respectively. These figures correspond to 2–5% of the company’s market capitalization at the time. However, part of these amounts in financing cash flow should be viewed as reclassifications of stock-based compensation, which has been added back to operating cash flow.

For instance, in the fiscal year ended March 2023, the 72.7bn yen ($505.8mn) in non-cash stock-based compensation expenses we examined above was effectively offset by the 152.5bn yen ($1.1bn) share buyback recorded as a cash outflow during the same period.

As a result, the "real" shareholder returns through share buybacks for that fiscal year were 79.8bn yen ($555.1mn)—just over half of the reported amount. This adjustment provides a more accurate perspective on the company’s buyback activity and its impact on shareholder returns.As a result, the "real" shareholder returns through share buybacks for that fiscal year were 79.8bn yen ($555.1mn)—just over half of the reported amount. This adjustment provides a more accurate perspective on the company’s buyback activity and its impact on shareholder returns.

Economic Value Recognition

We suspect that the broader market participants fail to recognize these points, and it is likely that only a minority might analyze in detail beyond the surface-level accounting figures. If the majority does not pay attention to such accounting minutiae (though we do not think they are minutiae), one might think these efforts are just a waste of time. However, we believe that "real" economic values such as these will eventually manifest itself in the future.

For instance, companies that rely heavily on stock options for employee compensation may appear to have abundant cash flow due to reduced cash outflows. However, this comes at the cost of an increase in the number of outstanding shares, leading to the inevitable dilution of shareholder value. In another example, companies whose cash-based profits are significantly higher than accounting profits should accumulate cash faster than it may seem on the surface. This should lead to enhanced shareholder returns, benefiting shareholders through increased dividends. It also enables acceleration in future investments, whereby widening the economic moat of the business faster than most people realize.

Recognizing the importance of analyzing financial statements is crucial to evaluate companies and identify potential value gaps.

Current Investment View

Based on the company’s adjusted EBITDA guidance⁴  of 697bn yen ($4.8bn) for the current fiscal year, the FCF is estimated to be approximately 500bn yen 
($3.5bn).⁵ This translates to an FCF multiple of 26x relative to the current stock price, compared to a P/E of 30x calculated from its net income guidance of 428bn yen ($3.0bn).

At the present valuation, the stock appears to lack sufficient appeal for aggressive accumulation. The worsening labor market could potentially outweigh the company’s internal efforts to offset through improving its "take-rate" and result in earnings falling short of its forecast. A decline in the share price would present an attractive buying opportunity. Meanwhile, it is common for internet companies, characterized by high operating leverage, to announce earnings results that far exceed market expectations. For this reason, we believe that the current valuations are largely acceptable to hold.

The company’s proactive shareholder return policy also influences our investment decisions. The previous fiscal year's share buybacks amounting to 824.5bn yen ($5.7bn) exceeded FCF and thus should be unsustainable over the long term. This accelerated use of excess cash is in line with the company's plan to reduce net cash to approximately 600bn yen ($4.2bn) as part of its balance sheet optimization strategy (8,227bn yen/$57.2bn as of the end of last fiscal year). While high levels of shareholder returns are likely to continue through the current fiscal year, the total payout ratio is expected to drop below 100% thereafter.

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