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 2022
  • Masakazu Takeda
    Masakazu Takeda, CFA, CMA
    Portfolio Manager

Fund Performance Review

In October, the Fund (HJPIX) gained 1.81%, while the benchmark, the Russell/Nomura Total Market™ Index increased 2.53% and the Tokyo Stock Price Index (TOPIX) rose 2.35%.

The month’s positive performers among the Global Industry Classification Standard (GICS) sectors included shares of Information Technology, Industrials, and Consumer Discretionary stocks, while Consumer Staples detracted from the Fund’s performance.

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Among the best performers were our investments in Keyence Corporation, the supplier of factory automation related sensors; Hitachi, Ltd., one of Japan’s oldest electric equipment and heavy industrial machinery manufacturers; Sony Group Corporation, a diversified consumer and professional electronics, gaming, entertainment and financial services conglomerate.

As for the laggards, Seven & i Holdings Co., Ltd., a Japanese diversified retail group and operator of 7-Eleven convenience stores; Kao Corporation, Japan’s largest manufacturer of home care and personal care goods; Unicharm Corporation, Japan’s baby and feminine care products maker.

We have owned three personal care products companies in our portfolio since 2007 with each one having different attractive characteristics. The companies are Rohto Pharmaceutical, Kao and Unicharm.

Rohto’s attractiveness lies in its niche-yet-solid brand image in greater China, Vietnam, and Indonesia. Today, the company sells a variety of personal care items such as skincare cosmetics, lip cream, sunscreen, eye drops, etc. to rising middle class consumers. Its extensive reach in China was first developed as early as in the 90s after the acquisition of the U.S. Mentholatum brand. Since then, management has been expanding its footprint into other countries in the region. Also, the company’s noteworthy development has been its foray into the regenerative medicine field. A few years ago when we first learned about the new venture, we were somewhat skeptical about its legitimacy due to seemingly lack of synergies with other segments. However, as the business details became more apparent, we have come to view the management’s decision as a positive move. In this new business, the company’s focus revolves around human stem cells derived from fat tissues. Similar to embryonic stem cells and induced pluripotent cells, this fat-derived stem cell has unique properties that enable itself to transform into various body tissue types, which can be used to develop a wide range of medical applications. Examples include regenerative medicine products for liver cirrhosis, pulmonary fibrosis, kidney disease, and COVID-19 pneumonia for which the clinical trials are underway. Furthermore, the company has built a state-of-the-art automated stem cell production line, which allows for manufacturing of the cells in large quantities at a reduced cost compared to manual process. Leveraging this proprietary technology, the company hopes to be a mass supplier of stem cells for research institutes, etc. The company has entered the prescription ophthalmology drug development business in recent years as well. Given the absence of a track record, we have yet to factor these new businesses into its intrinsic value estimate. That said, we will remain curious on the potential success of this venture.

Kao has been having a difficult time since its share price reached an all-time high in October 2018. Its brand image has become less appealing to Asian middle class consumers as local personal care goods companies have raised their profile thanks to improving product quality as well as savvy online marketing strategy. Due to the absence of inbound tourists into Japan following the outbreak of corona virus and intensifying competition in some of the household product categories domestically, the company continues to face challenging operating environment today. The recent rise in commodity prices are further weighing on their financial performance. In their assessment, Kao was a mass brand product company where they would take up large store shelves at retailers and use TV ads nationwide to promote their brands. This business model has apparently become obsolete as small start-ups can now easily tap into the market with niche products and advertise them using various online channels at a cheap cost. In response to this, management intends to reverse deterioration in profitability through introduction of more value-added products, refined marketing approach, product price hikes, organizational cost rationalization, and productivity improvement. While these tasks seem challenging, there are some signs of positive changes. For example, in the cosmetics segment, management drastically slashed the number of brands from 49 at the peak to just 19. This allowed for a more efficient and productive allocation of an advertisement budget, which led to several hit products in recent years. Now, they are applying a similar approach to other product areas to reduce the number of brands so that management can pour more resources into the remaining core brands aggressively. In the most recent earnings announcement, management has emphasized signs of domestic market share gains in detergents and sanitary products. Whether they can rapidly turn around remains to be seen but this is a company who had compounded per share earnings at 11% for 20 years leading up to 2018 with average return on equity (ROE) of 13% during the period. It also has an enviable track record of continuous dividend hikes for 33 years (and counting). Simply put, Kao is an able, well-executed organization.

Unicharm’s business has been thriving in recent years especially after the company took impairment charges on the baby diaper business in China and Indonesia and pivoted to sanitary napkins and adult diaper businesses as the new growth drivers. Today, their footprint covers a much wider geography ranging from China, Thailand, Indonesia, Vietnam, India, Saudi Arabia to Brazil. In most, if not all of these countries, the company commands number 1 or number 2 market share in sanitary napkins. Elsewhere, in the U.S., the company has been focusing on the pet care business (pet food and pet sheets) with China emerging as their next big target market. The company’s core competitiveness is its ability to survey local households in a meticulous manner to add new features to their products and sell them at premium price points. This way, Unicharm can localize their product offerings tailored for different countries. Unicharm’s overseas sales ratio now exceeds 60%, a significant increase from just 30% in 2007. Its core operating profit (OP) margin has been consistently averaging in the low teens, giving it superior profitability to the other two aforementioned peers. When 1H2022 ended in June, its consolidated revenue grew 12% year over year (yoy) but core OP was down 10% yoy mainly due to higher raw material costs and logistics costs. However, management is confident in achieving OP growth of 3% for the full year through price increases and in-house productivity improvement.

We view the three companies as having different investment attractions over the long term. Rohto, the smallest of the three, has the advantage of being nimble for new product launches. For Kao, we believe the company’s future growth potential lies in its breadth of product categories ranging from home cleaning products, toiletries to cosmetics, making it akin to Procter & Gamble in the U.S. On the other hand, Unicharm is a pure play on consumer absorbent products focusing exclusively on baby nappies, adult incontinence products, female sanitary napkins and pet care sheets, making it comparable to another U.S. company, Kimberly Clark. Unicharm has more extensive global reach in these segments than Kao.

All three are run by first class management teams with a sound track record spanning several decades. For example, Rohto’s 10 year compounded annual growth rate (CAGR) and 20 year CAGR for earnings per share (EPS) stand at 10.2% and 11.4%, respectively, while those of Kao’s 10 year CAGR and 20 year CAGR for EPS stand at 10.2% and 4.4%, respectively, while those of Unicharm’s are 7.4% and 10.8%. All three command superior ROE of around 12%.

In terms of management profile, they are somewhat different from one another. Rohto adopts co-head structure where Chairman Kunio Yamada, who is the fourth generation leader from the founding family, is spearheading new ventures such as the regenerative medicine while President Masashi Sugimoto oversees the mainstay business lines. Unicharm has been led by Takahisa Takahara, the son of the founder, since 2001, whereas Kao’s management team has a more institutionalized structure, where a new president is elected every few years from within the organization.

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