Market Commentary and Fund Performance

Masa Takeda of Tokyo-based SPARX Asset Management Co., Ltd., sub-advisor to the Hennessy Japan Fund, shares his insights on the Japanese market and Fund performance.

November 2021
  • Masakazu Takeda
    Masakazu Takeda, CFA, CMA
    Portfolio Manager

Fund Performance Review

For the month of October, the Hennessy Japan Fund (HJPIX) declined 2.52% while the Russell Nomura Total Market™ Index lost 2.78% and the Tokyo Stock Price Index (TOPIX) decreased 3.53%.

Among the best performers were our investments in Recruit Holdings Co., Ltd., Japan’s unique print and online media giant specializing in classified ads as well as providing human resources services, Sony Group Corporation, a diversified consumer and professional electronics, gaming, entertainment and financial services conglomerate, and Keyence Corporation, the supplier of factory automation related sensors.

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As for the laggards, Takeda Pharmaceutical Company Limited, a multinational pharmaceutical company, Murata Manufacturing Co., Ltd., a leading manufacturer specialized in electronic components with ceramic capacitors ranked top in the world market, and Fast Retailing Co., Ltd., the operator of “Uniqlo” brand casual wear stores detracted from the Fund’s performance.

Inflation has been a buzzword since the start of this year. As we discussed before, we initially thought that this problem would be transitory. However, over the past several months, various supply issues have been compounding like never before including supply chain disruptions, semiconductor shortages, energy and commodity price increases, labor inflation triggered by worker shortages, sharply increased employee safety costs to protect against COVID-19 and wage pressure due to workers’ strikes. Particularly, wage pressure is a concerning trend. If history is any guide, once inflation starts to accelerate, real wages are continuously eroded, giving rise to workers’ protests in the hope of even higher pay. This in turn gets passed onto the prices of final products and services, curbing real wage growth. Workers are left dissatisfied and start demanding more pay increases, setting off a vicious cycle. We also believe that the ongoing trend towards Environmental, Social and Governance (ESG) investment as well as various environmental protection initiatives on a global scale adds to long-term inflationary pressure as these activities inevitably increase the costs of doing business.

Speaking of labor inflation, one key beneficiary in the Fund’s portfolio is Recruit Holdings. We made our first investment in its shares back in December 2016, almost 2 years after its initial public offering (IPO). Since then, the stock has been a stellar performer, which generally causes us to turn cautious about its upside potential on valuation grounds. However, given the recent trends on the labor markets, we have turned modestly more bullish. So let us reintroduce the company below.

Recruit is Japan’s unique print and online media giant targeting job advertisement as well as other domestic industries such as property, travel, and restaurants. It also operates staffing agencies. The firm’s history dates back to the 1960s when the founder named Hiromasa Ezoe, who was an undergraduate college student, started an on-campus classified print ad business to connect job-seeking students with hiring companies, both of whom lacked an effective means of approaching each other. Achieving quick success, Mr. Ezoe formed a company around it and subsequently branched into different industries where the service providers remained fragmented and did not have an effective reach to attract prospective consumers. Since inception almost 50 years ago, the company thrived to become one of the largest privately held companies in Japan with household media names like “Rikunabi” (classified ads), “Suumo” (property), “Jalan” (domestic travel), “AB-Road” (overseas travel), “Zexy” (wedding hall), “Car Sensor” (used cars), and “Hot Pepper” (restaurants). Over the years, it has successfully evolved to embrace digital technology to keep pace with the changing media industry landscape.

As a media business, its competitive barriers are characterized by its network effects, in which their media platforms attract many advertisers, drawing prospective retail customers, which in turn brings in more advertisers whereby creating virtuous cycles. The company controls the entire process from dealing directly with advertisers to producing proprietary media platforms and attracting individual customers through them. As such, the business requires labor-intensive operations yet creates formidable high entry barriers to new entrants. The firm went public in late 2014 with a market cap of JPY 2 trillion ($17 billion) after spending half a century as a private company. Today, the market cap exceeds JPY 13 trillion ($113 billion), making it one of the 5 largest companies  in Japan.

The company meets most, if not all, of our 7 investment criteria. As laid out above, we consider the business model as simple and intelligible. The company is highly profitable and boasts a well-capitalized balance sheet with a net cash position. It has a long operating history with a solid financial track record. Operating cash flows are robust thanks to their entrenched positions in each of the industries they serve. They are also known for their corporate culture of fostering entrepreneurial spirits from very early stages in employees’ careers. Simply put, we believe that Recruit is an excellent company to own.

Of particular importance, its wholly-owned subsidiary Indeed has been a great success and has been demonstrating remarkable resilience recently. Indeed is a U.S.-based online job search engine company, which helps match people with jobs, acquired in 2012. Today, it is widely recognized by employers as the most powerful global recruitment channel, with 250 million monthly unique visitors, 320 million company reviews and 180 million resumes registered on its platform.

In terms of last year’s financial performance, Recruit was hit hard amid the COVID-19 crisis, as most of its businesses are economically sensitive. Even Indeed, which had been growing at a breakneck speed, came to a screeching halt with revenue growth turning slightly negative for the year. However, Q1 FY2021 saw a dramatic rebound with revenue soaring 2.5 fold from a year ago, exceeding the previous peak marked in FY2019 by 80%. Whilst the HR Technology segment, in which Indeed is housed, accounted for 20% of the total revenue and profits (adjust earnings before interest, taxes, depreciation, and amortization - EBITDA) as of last fiscal year, Q1 FY2021 results revealed that its contribution had jumped to 28% and 55%, respectively. Better yet, its margin has shot up to 38%. It was truly a blowout quarter. The sharp rise in margin offers a rare glimpse into what this business can potentially earn. Being a pure Internet platform business, Indeed possesses the 3 key attributes we highlighted in last month’s commentary: high returns on capital, high operating leverage, and long-term secular high growth rate, making the business extremely attractive with potential for “exponential” growth opportunity.

Management cited an imbalance in the U.S. labor market between hiring demand from companies and job seekers looking for work. As the economy started to reopen in 2021 with the progress of the COVID-19 vaccination rollout, a sudden increase in recruiting needs far outstripped the pace of rise in job seekers’ activity. This turned into a godsend business condition for Indeed as the company adopts pay-per-performance pricing model whereby hiring companies become willing to pay in order to prioritize job listings on the platform amid the extremely tight labor market. 

Going forward, management is somewhat cautious, as they believe demand for new jobs is expected to catch up. Continued increases in vaccination rates, as well as the end of government household subsidy programs, are likely to bring job seekers back into the job market. As such, management expects the imbalance in the labor market to lessen, which may put downward pressure on revenue momentum as finding qualified hires becomes less challenging.

Contrary to this narrative, we are actually of the view that the current favorable environment may persist longer than people think, as we believe that there is some element of permanent supply shock in the making. That is to say, if COVID-19 is here to stay like seasonal flu and becomes the new normal, many young mothers will likely give up holding a job altogether and end up permanently staying home to take care of their children. We have been reading stories about rising fees and diminishing availability at daycare centers in the U.S., forcing working couples to quit one job for the sake of childcare at home. As a result, a big chunk of talent could be structurally removed from the labor market. Secondly, there are a certain number of people who don’t have to work for financial reasons anymore but still remain in the workforce. These people have amassed enough savings for retirement already through years of hard work as well as successful stock investments thanks to a decade-long bull market. With ever greater uncertainty at the workplace related to COVID-19 infection risk, these people may choose to leave the workforce altogether for good. Thirdly, the work from home regime under the COVID-19 has changed the skills required by employers thanks to the advancement of new technologies related to remote working capabilities. White-collar skills such as coding, software engineering, designing are in heavier demand than ever. This led to the unemployment rate for people who can work from home having returned to pre-COVID-19 levels rather swiftly while that of people who cannot work from home is much less the case. Good news is that Indeed primarily benefits from labor tightness in the former type of job market than the latter type.  

Lastly, one of the new missions “Simplify Hiring” set by management is worth mentioning. As millions of people lost their jobs amid the pandemic and employers unable to meet with job applicants face-to-face to facilitate hiring, automation of applications/hiring process is becoming more crucial than ever. At the fiscal year 2020 full year results meeting held back in May, Hisayuki Idekoba, the newly appointed CEO who spearheaded the acquisition of Indeed, shared his grand vision, where “people who want a job can change jobs in one second” or “people can find a new job with the push of a button” by fully utilizing Artificial intelligence (AI) and machine learning. It will be interesting to see how new services will develop from within Recruit to meet this vision.

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