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.

Fund Performance Review

In February, the Fund returned 8.32% (HJPIX), outperforming its index, the Russell/Nomura Total MarketTM Index, which returned 3.49%.

The month’s positive performers among the Global Industry Classification Standard (GICS) sectors included shares of Financials, Information Technology and Industrials, while Health Care and Communication Services detracted from the Fund’s performance.

Among the best performers were our investments in Tokyo Electron Ltd., one of the world’s largest manufacturers of semiconductor production equipment; Mitsubishi Corporation, the largest trading company in Japan; MS&AD Insurance Group Holdings Inc., one of leading non-life insurance company in Japan.

As for the laggards, Sony Group Corporation, a diversified consumer and professional electronics, gaming, entertainment and financial services conglomerate; Daikin Industries, Ltd., the leading global manufacturer of commercial-use air conditioners; and Olympus Corporation, the leading company in the medical field such as gastrointestinal endoscopy, which has a 70% share of the world market, were the largest detractors.

Continuing from last month’s commentary, another key to “investing in a great business at an attractive price” is to spot undervalued stocks even when they appear overpriced at first glance as the stock market may not have noticed their true value yet. Many market participants refer to the profit numbers disclosed in the headlines of the company’s financial disclosures. However, accounting profits do not always reflect the economic reality or intrinsic value of a company. We believe that how we interpret the information obtained from financial statements can be our competitive edge as an investor.

One example is the amortization of goodwill that occurs after a company acquisition. Under the Japanese accounting standards (J-GAAP), companies are required to record goodwill amortization on profit and loss (P/L) for up to 20 years to conservatively maintain financial soundness. As a result, the amount of net profit reported tends to be lower compared to International Finance Reporting Standards (IFRS) commonly used overseas, but this expense does not involve cash outflow. We believe that if there is no impairment risk for the acquired company, goodwill amortization should be added back to understand the true “cash-earning power” of the business.

In some cases, outstanding goodwill could be worth more than what is stated on the balanced sheet (BS). Consider a scenario where a company with a net asset of $10mn is acquired for $110mn. This implies that the goodwill, which is the excess of the purchase price over the net assets, amounts to $100mn. Assuming an amortization period of 20 years, this would result in an annual amortization expense of $5mn. However, what if the acquired company starts to make significant profit contributions a few years later? Suppose the acquired company, which was earning only $1mn in profit at the time of acquisition, earns $10mn the following year and $50mn thereafter. Given that the acquirer was able to buy for just $110mn, it can be concluded that this was a very inexpensive deal. In other words, the goodwill recorded is considered to have a value of more than $100mn.¹ Compared to IFRS, which does not require regular amortization (instead an impairment test is conducted annually), we sometimes feel that J-GAAP lacks economic rationality.

When analyzing companies where the proportion of share-based compensation is large relative to operating cash flow (CF) on the CF statement, we take a different view from accounting rules to assume a more conservative stance. Unlike regular salary payments, stock options do not involve cash outflows from the company, so they are recognized as expenses on P/L, and the same expenses are added back to the CF statement. However, in our analysis, we deliberately subtract it from operating CF. This is because if the stock price fell sharply, it would become difficult to rely on issuing stock options to cover personnel expenses. The other important thing to keep in mind is that share-based compensation can be viewed as being paid directly by the stock market instead of the company paying them in cash. This is no free lunch. If the options are exercised, the number of outstanding shares increases, which penalizes earnings per share (EPS) for existing shareholders.

These are just a few of the examples illustrating our approaches to evaluating financial statements. Below, we highlight some investment cases for which we had a different view from the market consensus at the time of our investing. All of these valuation discussions have been mentioned in our past monthly commentaries so the reader can revisit them as well (Please note that some investments are no longer in the Fund as the position has been exited).

Keyence

Keyence, Japan’s premier factory automation sensor maker, which the Fund has held since the late 2000s, is well-known as a cash-rich company. It is also known for its consistently high stock price due to its long-standing status as a high-quality/high-growth company. In our October 2010 commentary, when evaluating the stock price at that time, we stated that we viewed its market cap on a net-of-cash basis citing the company’s nearly 500bn yen ($3.4bn) in surplus cash (including various financial assets) on its balance sheet, and that the stock was undervalued relative to the company’s fundamental earning power. The company’s factory automation (FA) sensor business throws off extraordinary amounts of cash and requires very little in the way of capex to sustain growth. As of the end of September 2010, the company had financial assets worth 487bn yen ($3.3bn) (consisting of cash and cash equivalents, short-term investments, and investment securities), which effectively put the firm’s market cap at around 550bn yen ($3.4bn) (vs. quoted market cap 1,040bn yen ($7.0bn) at the time). The huge pile of cash was hard-earned money accumulated through the growth of their business and was not obtained through public offerings or debt procurement. Though the world economy was still licking its wounds in the wake of the 2008 Global Financial Crisis, the company’s global expansion was still in a nascent stage. The moat and the addressable market were so big that our outlook for the company was sanguine. Thus, in our eyes, the stock was trading at ex-cash price to earnings ratio (P/E) of less than 10x based on the then-all-time high profit of 63bn yen ($423mn) recorded in the year before the crisis. Our strong conviction led to an outsized bet on the name since 2008 and the stock went on to become a “ten-bagger” in the next 10+ years.

As a side note, despite being cash-rich, Keyence is often criticized for its extremely conservative approach to dividends and share buybacks. For many years, shareholders have been demanding a higher payout ratio, which on average has been less than 10%. In the past, we have indeed cast our votes against the company’s dividend proposal plans to express the same frustration. From a shareholder’s perspective, when a company retains profits, it is expected to reinvest them in the business to increase its intrinsic value. In the case of Keyence, the issue is that it is invested in safe assets (particularly low-yielding Japanese government bonds) without any concrete plans of redeploying it. That said, it is also true that Keyence shareholders have been rewarded handsomely for holding the company’s shares. From FY2007 through September 2023, the company produced roughly 2.5tn yen ($16.8bn) net profit (NP) in total, of which a whopping 90% was retained (financial assets increased by 1.9tn yen ($12.8bn) with total liquid financial assets² making up over 80% of total assets today), but the market cap far eclipsed that, increasing by 13tn yen ($87.4bn) (from 1tn yen to 14tn yen ($6.7bn to $94.0bn)) during this period driven by strong earnings growth (NP 20yr CAGR 14.6%). In other words, the company created far more than one dollar in market value for every dollar retained. It is also worth noting that despite the bloated BS (total assets 2.8tn yen ($18.8bn) versus shareholders’ equity 2.6tn yen ($17.5bn) and net cash 2.3tn yen ($15.4bn)), its return on equity (ROE) comfortably outstrips the average Japanese company. This is the reason that shareholder activists have not been able to exert their influence on their shareholder returns policy. We will address how we view Keyence from a corporate governance perspective on another occasion.

Terumo, Recruit Holdings, Seven & i Holdings

These three heavy goodwill carriers were invested in at different times, but all were argued to be undervalued based on pre-goodwill amortization profits as they were reporting under J-GAAP previously. Because the proportion of these non-cash costs as a % of overall accounting profits was large, their ability to generate cash profits was significantly understated. Moreover, their stock prices appeared expensive because of this.

Terumo, the world’s leading cardiovascular device manufacturer, which currently adopts IFRS, had seen its profits suppressed due to the amortization of goodwill and other intangible assets (“customer relationships,” etc.) resulting from the acquisition of CaridianBCT in 2011. In the 2Q 2016 commentary, we estimated pro-forma NP for FY2015 (ended in March 2016) by subtracting only the non-tax deductible amortization costs of intangibles from operating profit (OP) and applying a statutory income tax rate of 30%, which came out 73bn yen ($490mn) of “adjusted NP” vs. a reported NP of 50.6bn yen ($339.9mn).

Recruit Holdings, the online human resources services, and advertisement media platform company, which also currently adopts IFRS, had a long history as a private company before going public in 2014. At the time of listing, the company unveiled a growth plan that it would actively allocate funds raised through initial public offering (IPO) to overseas acquisitions to raise its international profile. By December 2016, when we first started buying its shares, the company had made numerous acquisitions, including today’s crown jewel U.S. subsidiary Indeed, resulting in significant annual amortization expenses. Therefore, based on accounting profit, P/E at the time was over well 30x and return on equity (ROE) was less than 10%, which made the shares look over-valued. However, in the 1Q 2017 commentary, we wrote, “Adding back acquisition–related non-cash expenses, P/E at the time of our investment was approximately 18 times forward earnings with an ROE of 16% and a well-capitalized balance sheet. We felt that the multiple was sufficiently attractive given the quality of the business.” In other words, Recruit’s cash profit was far greater than accounting profit by nearly a factor of two. Of course, goodwill impairment risks were always something to keep an eye out for but there were no signs of such risks at the time. What is more, the outstanding goodwill comprised multiple acquisition deals rather than one big transaction, hence we concluded that the likelihood of simultaneous write-offs on many of the past acquisitions was also low.

Another important indicator was the free cash flow (FCF) yield as Recruit is extraordinarily CF generative. At the time we were accumulating shares, FCF remained low because the bulk of operating CF was being deployed for acquisitions abroad. However, the nature of Recruit’s businesses is such that there are no production facilities that require regular heavy maintenance capex like in traditional manufacturing. Therefore, we argued that “when looking 3 years out, by which the current investment program is largely complete, its FCF generation will likely improve materially to a point where the entire operating CF equates to FCF.” In fact, the expected FCF of 7.5% was significantly higher compared to other stocks in the Fund’s portfolio.

The world’s largest convenience store operator Seven & i Holdings is a new investment made in 2022. The goodwill amortization of the U.S.-based Speedway, which was acquired in 2021, weighs heavily, and the discrepancy between the reported EPS and the pre-amortization EPS is as much as 40%. Based on the current year’s management guidance of “EPS before goodwill amortization” of 470.64 yen ($3.16) (excluding the one-time effect of the transfer of Seibu/Sogo shares) shown in the latest financial results briefing materials, the company’s stock price as of the end of 2023 was at just PER11.9x, substantially below the average of the broader TOPIX.

Furthermore, in our calculation, FCF yield is believed to be close to 10% based on the average cost of our purchases, making it one of the most undervalued stocks among large caps in Japan currently. Some adjustments are necessary in calculating FCF yield. Because the company also operates a banking business (Seven Bank), related CF items such as the changes in overnight call loan balance and customer deposits are also included in operating CF on the CF statement, which stymies the CF generating ability of the mainstay CVS business. If the banking service-related items are removed, it reveals that the retail business (including CVS as well as the low-margin struggling Ito-Yokado business) produces around 900bn yen ($6bn) of operating CF. If we estimate the capital expenditures (capex) associated with the expansion of the CVS business is about 400bn yen ($2.9bn) per year, the calculation results in FCF of close to 500bn yen ($3.4bn), which shows that FCF yield is quite attractive relative to the market cap (4,942bn yen ($33.2bn) as of the end of 2023).

Speaking of valuation, during last year’s proxy fight with the U.S. activist fund ValueAct, Seven & i management argued that the company’s EV/EBITDA multiple had increased since the acquisition of Speedway, touting the stock’s re-rating as if the company had created shareholders’ value. This should be misleading. In our opinion, the expansion of the multiple was more driven by the sharp increases in net debt (whereby pushed up the numerator) as the company raised a large number of borrowings to acquire Speedway than increases in EBITDA. The reality is, that the company’s multiples in terms of P/E have declined from an average of 20x< during FY2005-2019 to now only 12x as explained above. The valuation has been consistently lowered since the company became a holding company in 2005. As a shareholder, we have communicated this fact to Seven & i Holdings in our one on one meeting with them.

Mitsubishi Corporation, ORIX Corporation

We view both Mitsubishi Corporation, a general trading company, and ORIX Corporation, a comprehensive financial services company, as investment companies. While there are some fee-income businesses, the majority involve investing in financial assets as well as operating businesses and operating assets. These businesses grow intrinsic value by generating revenue from these investments and/or by raising asset values. Therefore, when valuing their shares, we focus on changes in net asset value (NAV) rather than using the discounted cash flow (DCF) model.

As discussed in our December 2023 commentary on Mitsubishi Corp., conventionally focusing on net income does not give you a clear picture of how the company fared in a given year as some profit items do not pass through NP but are only reflected in OCI (Other Comprehensive Income). It appears that the management of general trading houses does not consider OCI, which includes changes in unrealized gains on investment securities and foreign exchange gains on foreign assets, as part of their annual performance. On the contrary, we are of the view that these profit items are just as important for an investment house (they will become “real” gains once the investment is exited). As such, general trading companies, including Mitsubishi, should be evaluated based on CI (Comprehensive Income), which is reflected in changes in NAV. We also believe that a more appropriate measure of ROE should use CI as the numerator rather than NP, divided by equity.

ORIX discloses “base profits” and “investment gains” separately in its financial results. Base profits refer to the profit generated in each period from the assets held, while investment gains refer to the profit generated irregularly when selling businesses or assets as part of “capital recycling” activities. The latter is not a profit that can be expected to be stable every period, so it tends to be underappreciated in the stock market as a one-off factor. The following comment by CEO Makoto Inoue in the Integrated Report 2023 CEO Message is worth citing:

“As a result of capital recycling, we typically realize about 100bn yen ($671.4bn) in investment gains annually. We are devising ways to better present our past performance and future investment pipeline in our financial reporting, but incomplete understanding of the reproducibility and sustainability of our results is an issue. Many of the stock analysts who cover ORIX are experts in the financial sector, in which stable earnings tend to be a particularly important driver of higher valuations. The investment gains we generate from portfolio replacement are reproducible, not temporary, so we will further improve how we present our business and performance so that our audience better understands this aspect of ORIX.”

We could not agree with him more. In our evaluation of the company’s stock, we expect the NAV per share to continue to expand at a mid to high single-digit rate annually, including the periodic investment gains. The stock’s high dividend yield and the additional growth in EPS due to share buybacks are also important sources of return that cannot be ignored.

Tokyo Marine Holdings, MS&AD Insurance Group Holdings, and Sompo Holdings

The financial disclosures of the three mega general insurance groups are also based on J-GAAP, and there are major differences with IFRS adopted by overseas peers. Under the Japanese rules, various provisions such as “catastrophe loss reserves,” 
“contingency reserves,” and “price fluctuation reserves” are required to be set aside when calculating NP, which makes the profit level appear lower compared to overseas competitors.³ To make global comparisons easier, each company adds back these set-aside items (all are reserves so non-cash expenses) and publishes an “adjusted net income” equivalent to the NP of IFRS-compliant counterparts. Similarly, for net assets, they add back these reserve balances to present “adjusted net asset.”

When valuing their shares using these adjusted figures (as of Sept 2023),⁴ the forward P/E of Tokyo Marine becomes 10.6x (as of the end of 2023), which is cheaper than 12.1x based on the J-GAAP profit guidance. In terms of P/B, while Tokyo Marine exceeds one times, MS&AD and Sompo are sharply below at 0.6 to 0.7x (as of the end of 2023).⁵ If calculated based on basis points (BPS) under J-GAAP, the price to book ratio (P/B) of these two companies is around one times. In other words, if each company were to switch to IFRS,⁶ the valuation would suddenly appear cheaper to market participants.

We believe that stock price valuation based on IFRS reflects the reality better than J-GAAP and was particularly attracted to the fact that the “real” P/B of MS&AD and SOMPO were significantly below 1x. Intriguingly, the valuation of stocks changes vastly under different accounting standards and the stock market seems to ignore this, which may tell us about the inefficiency of the Japanese stock market.

Market Inefficiency

Interestingly enough, some of the financial figures we have discussed such as Seven & i’s “EPS before goodwill amortization” and the Japanese insurers’ “adjusted net income” are not exactly our invention but are disclosed in the companies’ financial disclosures and earnings presentations. Therefore, some of these figures are already known to the public. Then, why are these stocks still undervalued? There could be several reasons for this (apart from the possibility that our analysis and forecasts are utterly incorrect).

For one, compared to the high-profile tech industry stocks, insurance, and retail stocks, for example, may not receive as much attention due to their less glamorous image and widely held perception of being mature industries.⁷ Factors like these could be influencing the undervaluation.

Furthermore, in the case of the insurance industry, has numerous listed players worldwide, and there is not a significant difference in their business models, which typically involve insurance underwriting and investment management. This could mean that not many market participants pay close attention to every detail of all three major Japanese insurance companies, which also implies that the differences between Japanese and international accounting standards may not be fully understood.

Another plausible factor is attributable to institutional inefficiency. In the world of institutional investors, there are usually sector analysts who follow these industries closely. However, the final buy and sell decisions are made by fund managers, not analysts. Unlike sector analysts who analyze a limited number of stocks in their coverage, fund managers who have to follow a multitude of stocks across different industries may generalize global insurance stocks and use a heuristic approach to making investment decisions regardless of inputs from their analysts.

However, the attractiveness and uniqueness of Japan’s general insurance industry stand out in our view. As we mentioned in the August 2023 commentary, the Japanese insurance market is dominated by only three mega insurance groups with a total market share of 90% after decades of consolidation. To our knowledge, there is no other insurance market like this in the world. As such, the incumbents’ combined ratios have been consistently below 100%, a sign of profitable underwriting. Better yet, the three players hold massive unrealized gains on financial assets called “policy shareholdings.” These shares⁸ were acquired during the 1960s solely for building and promoting business relationships in corporate insurance. According to management, these holdings were often justified to win business. The reality is, that most business relationships today are forged based on merits, not the presence of the equity holdings, leading to criticisms by the investor community as an “under-utilized asset.” All the while, these equity holdings have amassed significant unrealized gains thanks to the long-term appreciation of the broader Japanese equity market. As such, the insurers have been liquidating these stakes year after year to put the proceeds to more productive use such as overseas acquisitions, increased dividends, and consistent share buybacks. Still, approximately 1.2-2.4tn yen ($8.1bn - $16.1bn ) worth of equity holdings remain on their BS (their cost base is almost negligible) amounting to 30~80% of their market cap⁹ even after they have reduced by some 70% of the holdings on a cost basis since 2002.¹⁰ These equity holdings will continue to be a source of shareholder value creation. To our knowledge, this is the other unique aspect of Japanese insurers that cannot be observed anywhere else in the world. Great businesses are sometimes hiding in plain sight.

In the “boring” insurance sector, when it comes to sector analysts (buy-side and sell-side alike), we suspect that:

•    Japanese domestic insurance analysts confine themselves to following only the domestic players, not bothering to compare them to the international peers in their analysis
•    Global insurance analysts only cover the most representative name in Japan (i.e. Tokio Marine) and do not bother to look at the rest (MS&AD and Sompo)

We believe there could be many similar inefficiencies that can be exploited in other industries in Japan.

Conclusion

For the Fund to achieve above-average performance, it is not enough to see the potential in the investees; but the broader market participants must also recognize and agree with our viewpoints. In some respects, stock markets are like a casino where anyone is free to enter. As such, we get the sense 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 stock prices will never get evaluated. However, we believe that the “real” value we advocate as theoretically correct will eventually manifest itself one way or another. For instance, 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 may enable acceleration in future investments, whereby widening the economic moat of the business faster than most people realize. It is rather beneficial if our investment opinion differs from the stock market consensus. The stock market is a product of collective wisdom, where the majority’s opinion is already priced into the stock, making it difficult to score a big win by following a widely held view. This is why our opinion about the investment should start with being in a minority camp even though people are skeptical about the perspective we have arrived at through our analysis. It is an important mental approach to outperforming the index. For the stock to rise faster than the broader market, the minority opinion would have to be proven correct over time such that other market participants belatedly come around to your view by bidding the share price higher.

However, this is easier said than done. At the end of the day, we all know that "Mr. Market" turns out to be a rather good predictor of the future. This has long been proven by the well-known fact that the majority of active managers fail to beat the index. The majority’s opinion and outlook on the future of the stock market are generally correct. Investing in stocks while the majority still holds a skeptical or negative view can be psychologically uncomfortable. Nevertheless, in a bid to win in the stock market, it is crucial to invest with a “minority opinion” that is also a “correct opinion.”

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