Fund Performance Review
For the month of February, the Hennessy Japan Fund (HJPIX) returned -0.53%, underperforming the Russell Nomura Total Market™ Index which returned 1.62%. The Tokyo Stock Price Index (TOPIX) returned 1.33% for the same period.
Among the best performers were our investments in SoftBank Group Corp., the telecom and internet conglomerate, Recruit Holdings Co., Ltd., Japan’s unique print & online media giant specializing in classified ads as well as providing human resources services, and Fast Retailing Co., Ltd., the operator of “UNIQLO” brand casual wear stores.
Click here for full, standardized Fund performance.
Keyence Corporation, the supplier of factory automation related sensors, Unicharm Corporation, Japan’s baby and feminine care products maker, and Daikin Industries, Ltd., the leading global manufacturer of commercial-use air conditioners, all detracted from the Fund’s performance.
This month, Japanese equities marched higher through mid-month reaching 30-year highs. However, growth stocks took a beating towards the end of the month as the exuberance was curtailed by an acceleration of rising, long-term interest rates.
Prices of financial assets are determined by the present value of estimated future cash flows, be it stock, bond, or real estate. Discount rates used in deriving the present value is a function of risk-free rates, among other factors. Because the valuation of growth stocks requires discounting growing cash flows well into the future, as opposed to a stock investment which only looks at intrinsic value as a static number, growth stocks’ share prices tend to be more sensitive to rate fluctuations just like long-duration bonds are in the fixed income arena.
We believe that the recent rise of interest rates is part of a natural course of a short-term correction in financial markets. Last year’s pandemic prompted central banks around the world to go all out in easing the monetary system, driving down further what had already been historically low rates. If the pandemic turns out to be nearing an end, then this extra dip in rates should at least normalize to pre-pandemic levels relatively soon. With the ongoing roll-out of vaccinations and declines in new infection cases, we could be at that very stage. The good news is that the normalization of interest rates is validation of recovery in economic activity, so all is not so bad.
If history is any guide, the next thing people will be worried about is inflation, which effectively “swindles the equity investor” as Warren Buffett famously said in his 1977 Fortune column. This notion, however, we think is a little bit premature at this point in time. It is worth noting that in the run-up to last year’s pandemic, the world economy didn’t have any structural excesses like production capacity over-build, or debt-fueled over-consumption, which are typically a recipe for a deep recession. With the households’ savings rates climbing high, consumers are itching to spend. As such, it is reasonable to assume that once the pandemic is brought under control, demand for goods and services will likely outstrip supply in the short term, which may result in a temporary pickup in inflation.
Whether inflation will stick around is a big question mark, however. Particularly in Japan, even though well over a decade of ultra-loose monetary policy has created abundant liquidity in the financial system, it has not made its way to the real economy. For example, since the end of 2009, Japan’s monetary base has increased six-fold, but the money supply has not grown nearly as much while the consumer price index (CPI) has struggled to stay in positive territory to date. Aging demographics and a declining population are perennial problems that Japan does not seem able to escape from. Furthermore, the advancement of technology such as e-commerce and the digital economy has been effective at taming upward pressure on prices of everything, from goods to services, globally. Putting all these things together, our view is that a continuous rise in interest rates beyond the correction territory is unlikely. It is also worth noting that the Bank of Japan adopts yield curve control, which limits the fluctuations of 10-year yields to within 20 bps of 0% through bond purchase operations. Thus, once the current "adjustment" phase is over, we expect the selling pressure on growth stocks to subside in due course, and their favorable long-term growth prospects to take the lead once again. Meanwhile, we need to exercise patience.
But what if full-fledged inflation takes hold against all odds? At the end of the day, the world is full of uncertainty and surprises. As evident from the inflationary period in the U.S. of the 1970s, the following business characteristics should offer the best protection:
• Asset light businesses which consume little in the way of capital investments or large volumes of raw materials as input cost
• Labor “un-intensive” businesses that do not require huge manpower to scale up
• Businesses equipped with strong pricing power whose price hike does not affect end demand (low price elasticity of demand)
We believe that a good part of our portfolio consists of companies that possess these attributes. For instance, Sony is in the intellectual property business where the core strength lies in its rich entertainment content library. Keyence is a hard-to-replicate factory automation solution provider built on a fabless model. Recruit is an online advertisement media company which necessitates very little physical asset investments. SoftBank Group is a telco-turned tech-focused investment company.
We also own a handful of asset-heavy manufacturers, but they are all high-quality in nature who we believe can weather inflation. Companies like Nidec (precision motors maker with increasing focus on electric vehicle traction motors), Daikin (global leader in air-conditioner), Shimano (high-end sports bike parts maker), Terumo (manufacturer of cardio-vascular devices) and Unicharm (maker of personal hygiene products) all maintain strong profit-oriented cultures, and their dominant market shares in their respective industries allows for unmatched cost competitiveness as well as bargaining power.
Lastly, in the event that commodity-led inflation sets in, our portfolio should provide some cushioning through beneficiaries of higher commodity values such as Kubota (leading agricultural equipment maker) and Mitsubishi Corp (owner of mining/energy assets, brought to fame by a recent investment by Warren Buffett).
Click here for a full listing of Holdings.