Market Commentary and Fund Performance

Fund Performance Review

For the month of September, the Hennessy Japan Fund (HJPIX) rose 2.94%, outperforming the Russell Nomura Total Market™ Index which increased 2.42%. The Fund also outperformed the Tokyo Stock Price Index (TOPIX) which gained 2.75% over the same period.

Among the best performers were our investments in Terumo Corporation, Japan’s largest medical device manufacturer, Mercari, Inc., an operator of “Mercari,” a flea market application having accumulated one hundred million downloads, and Sony Corporation, a diversified consumer and professional electronics, gaming, entertainment, and financial services conglomerate.

As for the laggards, Daikin Industries, Ltd., the leading global manufacturer of commercial-use air conditioners, Nidec Corporation, the world’s leading comprehensive motor manufacturer, and Asahi Intecc Co., Ltd., a manufacturer of precision medical components.

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In our typical slow-moving, low turnover maneuver, we only add a new name to the Portfolio very occasionally. One or two new investments per year on average. Whenever such position has been built into a significant size, we make it a point to write about the investment thesis at length in our monthly letter. It is as much for us to crystalize our thinking as it is for the benefit of our investors. Especially given the unique culture of Corporate Japan, which is vastly different from the West, we feel it necessary to lay out the case in a way that helps foreign clients put Japan in a global perspective.

We are always thrilled to introduce a new investment for obvious reasons that there are a lot of good things expected to unfold in the future about the business and we would like our investors to appreciate these. But in terms of short-term predictive ability of our calls, our track record has been mixed at best. For example, the Fund’s long-term holding Keyence, the fiber sensor maker with the second largest market capitalization in Japan today, has turned into a 10-bagger since the initial purchase, but it had taken several years before our call was vindicated. The Fund’s investment in Ryohin Keikaku (fully exited already), the purveyor of MUJI-branded household goods, required even more patience.

On the other hand, the timings of the investments in Nidec (purchased in 2013), Recruit (2016), and Sony (2019) were spot on. Soon after our position was built, their share price began its long-term ascend. Elsewhere, SoftBank Group was added in 2015 and it was a year later that the share price emerged from underwater. Shimano (2007) is another example of our patience having been tested in a different fashion. 

After a dramatic rise in share price from 2012 through 2015, it stagnated range-bound for 5 years in running until 2020 as the broader market continued to march higher. For an open-ended Fund for which investors generally look for constant good performance, 5 years of wait time was not easy to stomach.  

Let’s revisit these investment cases in a bit more detail:

Keyence

Shares in the developer/marketer of customized fiber sensors (still a top holding in the Fund) were picked up during 2007-2008 in stages to build up the position. Especially, in 2008, when the world economy took a nosedive on the back of the subprime mortgage crisis, we accelerated our buying to take advantage of the market turmoil. Unfortunately, post-purchase, its earnings continued to remain under pressure amid the repercussions from the financial debacle. Its net profits had declined for 2 consecutive years since the end of our purchase. The business did rebound in fiscal year (FY) 2010, but was once again hit by the Great East Japan Earthquake in 2011, which paralyzed the domestic economy. It was not until FY2012 that the earnings and share price both exceeded the pre-financial crisis levels. Fast forward to today, the stock price closed at JPY 66,130 at the end of last month, which is some 11 times higher than the 2007 year-end share price of JPY 5,696 (stock-split adjusted). Keyence is one of the most significant return contributors in the investment strategy’s history.

Ryohin Keikaku

The purchase of shares in the specialty retailer for MUJI-branded household items and clothing (fully exited already) was carried out over an extended timeframe from 2008 to 2010. At the time, it was a stock no one wanted to touch. Its domestic same-store sales were in doldrums declining consecutively for 5 years, and its share price was on a long downhill trend after topping out in 2005. Despite all this, what we saw in the company was 1) its potential to succeed overseas thanks to its unique product design with universal appeal and quality (a rare prospect for Japanese specialty retailers littered with failures of internationalization), 2) its ability to generate cash flow even under the toughest operating environment allowed management to keep opening new stores, laying the foundation for Asian penetration, and 3) extremely attractive valuation. The rest is history. The company went on to register rapid growth in Greater China thanks to its aesthetic brand image and aspirations for high quality Japanese products by Asia’s rising middle consumers. Its domestic operations also recovered nicely, propelling the stock price many times over through 2018. However, the great rally did not commence until 2013. That was a good 4 to 5 years of waiting.

Nidec

The position in the world’s largest precision motor manufacturer (still owned in the Fund) was completed in rather short order between February and April of 2013. At the time, Nidec was facing a dire prospect for its mainstay hard disk drive (HDD) small precision motors business, which was deemed to be entering a shrinking phase. Understandably, the stock was hovering around 52-week lows. We, on the other hand, assumed a contrarian approach believing that its founder/chairman had unwavering determination to grow the company, immaculate acquisition track record and on-going transition from being a one-product (HDD motors) company to the most comprehensive precision motor supplier in the world. Our contrarian bet paid off handsomely as the stock entered a long-term secular rising trend shortly after the completion of the purchase.

Japan Tobacco

We have to admit that before the environmental, social, and governance (ESG) investments became a global imperative, we were invested in the world’s third largest tobacco manufacturer (fully exited already) for a couple of years. Worse yet, the investment result was a loss making one all because of our poor foresight about this controversial consumer products business. Like any other thoughtful investor, we were attracted to the business’s incredible pricing power and high returns on capital. At the time of our investment, clouds were forming over JT because its domestic tobacco business was losing market share to an innovative next-generation “heat-not-burn” tobacco called iQOS by Philip Morris. Like Nidec, JT’s stock price was changing hands around the 52-week lows, reflecting the bearish sentiment. Our rational for taking a contrarian view on JT was predicated on the upcoming plan to launch its own next-generation tobacco, growth expectations in emerging economies, proven merger and acquisitions (M&A) track record and margin of safety features of the share price like below-average multiples as well as steep dividend yields. Alas, were we wrong. The company not only failed to bring satisfactory next-generation product to the market, but also faced anti-smoking regulations globally which accelerated much faster than we had envisioned, curbing JT’s foreign sales growth. Acknowledging our mistake, we sold all the Fund’s position by November 2018. 

Being Different Is a Necessity But You Need to Do It At Your Peril

As you can see, the backdrops of these investment cases are similar in nature in that we initiated the position when the outlook of the business was negative or uncertain. In an attempt to beat the market, we believe that an investment opinion needs to start in a minority camp. Then, in order 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. This is an important mental approach to outperforming the index.

Of course, being contrarian or opinionated means we run the risk of being utterly wrong on the future course of the business and losing money. At the end of the day, we all know that Mr. Market (or collective wisdom) turns out to be a pretty 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.

A 2004 book called “The Wisdom of Crowds” written by James Surowiecki describes the amazing predictive power of collective wisdom. In the opening chapter, there is an interesting episode illustrating this succinctly. In 1906, a British scientist Francis Galton came across a weight-judging competition for a fat ox at a livestock fair in Plymouth. About 800 people participated in the event, which included livestock farmers and butchers but the majority were ordinary “non-experts.” They were asked to guess its weight based on appearance of the ox on display. This piqued the interest of Galton as this might reveal something about the wisdom of crowds. He tallied up the entries, and sure enough the median number was 1,197 pounds versus the actual weight of 1,198 pounds of the ox. A clear example of the crowd outsmarting the “experts.”

There are certain conditions that need to be met for the collective wisdom to exhibit its powerful predictive ability, including:
1) the opinions have to be amply diverse, 2) each individual’s opinion has to be formed independent of others, and 3) the result of the aggregated opinions must be expressed into a single output like a number.

This is essentially what a stock market is. It explains the mechanism why fund managers struggle to beat the market despite being “experts.” Statistically, Mr. Market is more often than not correct so odds are not in your favor. But this does not mean the market is infallible. There have been occasions when the market can be completely wrong as we all know.

Given the omnipotence of the market in general, it should be well-understood that attempting to go against the stock market with a differentiated view is a risky endeavor in and of itself. Naturally, when you make an investment in a particular stock with a non-consensus view, it ought to make you feel scared and uncomfortable. However, counterintuitively, such feelings should also be regarded as a recipe for the future outperformance of your investment.

That is why in the Fund’s portfolio, there are certain names that some outsiders may be at odds with or may even be controversial or positions that seem excessively overweight (i.e. concentrated bets) relative to the benchmark. For us, the differentiated investment perspectives primarily come in two ways: 1) Our view is bullish about the short-term prospects of the business when the market is excessively pessimistic or conservative, 2) The market generally agrees with all the positives about the business but our view is even more bullish particularly on a much longer time horizon. This is by design. We see these conditions as a potential source of future returns.

The challenge is reconciling the conflicting mental forces in your inner-self (i.e. the desire to beat the market by being different versus the discomfort of being different from the market). Here, the key is to make sure you always invest within your emotional capacity. Exceeding your comfort levels often leads to the loss of your staying power when some bad news hits the stock. To this end, we have spent years watching the same companies in our universe, thoroughly researching the business and management along the way. This helps to build emotional capacity over time. Being cognizant that healthy discomfort with your investment should be a good sign for future success, you must learn to get comfortable with this “discomfort.”

Our investment strategy is built on maintaining a differentiated, high-active share portfolio. This requires a lot of emotional capacity. At the same time, there have been only a handful of instances where we could confidently say we should be more right than Mr. Market, which is the reason the Fund has had a low turnover. But when we identify such opportunities going forward, we promise to keep pouncing with high conviction as has been the case in the past. While this behavior may cause some “discomfort” among the Fund’s investors from time to time, we hope you understand the rationale behind the necessity of getting out of the comfort zone in search of higher returns.

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