Fund Performance Review
In September, the Fund decreased by 3.45% (HJPIX), underperforming its benchmark, the Russell/Nomura Total MarketTM Index, which fell by 1.57%.
The month’s positive performers among the Global Industry Classification Standard (GICS) sectors included shares of Financials and Communication Services, while Industrials and Information Technology detracted from the Fund’s performance.
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Among the best performers were our investments in Mitsubishi UFJ Financial Group, Inc., one of Japan’s largest financial groups, Rohto Pharmaceutical Co., Ltd., a leading skincare cosmetics and over-the-counter ophthalmic medicines producer, and Tokio Marine Holdings, Inc., the general insurance company with the best underwriting track record in Japan.
As for the laggards, Recruit Holdings Co., Ltd., Japan’s unique print and online media giant specializing in classified ads, as well as providing HR services, Socionext Inc., a fabless semiconductor vendor involved in the development, design and sales of custom SoC (system on a chip), and Shin-Etsu Chemical Co., Ltd., Japan’s largest chemical company negatively impacted the fund’s performance.
In this month’s letter, we will uncharacteristically share our perspective on the current trends of Japan’s macro-economy and what we believe needs to be done for sustained growth going forward.
Over the past two years, emerging signs of much-awaited inflation have been drawing attention in Japan, a country that had been plagued by deflation for over two decades. Based on our experience, deflation accompanied by ultra-low interest rates (or negative rates) can give rise to various problems and many side effects. When prices of goods and services are continuously falling, consumers hold off their purchases in anticipation of further price drops. This leads to deterioration in corporate profits, which in turn squeezes workers’ wages, reducing their purchasing power, and businesses suffer more—a vicious cycle. In an environment where interest rates are near or below zero, the economy encourages consumers’ discretionary spending on purchases such as houses and cars and boosts corporate capital expenditures.
However, at the same time, many investment projects are executed with poor internal rate of returns (IRR). It allows many poorly managed companies to stay in business, resulting in the misallocation of capital within the economic system. Furthermore, the lack of industry consolidation brings endless futile price competition, prolonging deflation as we know it.
The recent inflationary trend and the expectation for interest rate hikes in Japan can be seen as positive developments for the economy, which has been stagnant since the 1989 collapse of the bubble. But the prospects are not “definitive positive” yet as it remains to be seen whether the current inflation becomes “good inflation” or “bad inflation.” Good inflation refers to moderate inflation creating virtuous cycles whereby inflation stimulates private consumption, prosperous businesses can increase wages, leading to more consumer spending. On the contrary, bad inflation is essentially stagflation, where households struggle to make ends meet under ever-rising prices. Looking at the recent economic trends, though we are cautiously optimistic, Japan is at a crossroads today. There is a persistent view that Japan could always fall back into deflation if a recession hits, but we see the possibility of unexpectedly high and sticky inflation. We learned last year that overseas inflation could spread to Japan when a sharp rise in U.S. treasury yields triggered a rapid depreciation of the yen fueling domestic inflation through soaring import prices.
As listed below, there are many structural factors behind the current global inflation:
• The globalization that continued for more than 20 years has reached a turning point due to the U.S.-China trade tensions. Companies are being forced to diversify global supply chain networks. The Russia-Ukraine conflict is also accelerating this trend. These events inevitably raise the cost of doing business for companies.
• Since the 2008 global financial crisis, there have been under-investments in natural resources development around the world, causing commodity prices to stay elevated, pushing raw material and energy costs higher. Due to its capital-intensive nature, new supply takes years to come online. Environmental restrictions also make it increasingly difficult to develop and consume hard commodities.
• Labor shortages are also a global phenomenon. For example, in the U.S., we are seeing an aging labor population, more stringent immigration policies, and workers choosing early retirement due to changes in people’s social values, etc. Similarly in Japan, over the past 10 years, the increasing female and elderly labor participation is reaching its limit and is no longer able to offset the overall working-age population decline. Unfortunately, the inflow of foreign workers into Japan has been minimal owing to language and cultural barriers as well as the weak yen. All of these are contributing to a short supply of new labor and wage inflation.
• Environmental, Social, and Governance (ESG) investment is the global new norm. Companies are required to monitor the impact they have on the environment as well as corporate governance. Associated costs are increasing to comply with regulations. This also results in the inflation of costs for companies to do business.
All the above eventually get passed on to consumers. So, what do we need to usher in “good inflation?” The positive news is that Japanese consumers have become tolerant of price increases over the past two years. According to a 2021 survey conducted by Professor Tsutomu Watanabe of the University of Tokyo, as much as 60% of respondents had answered that they would avoid buying products after a price increase and only 40% of them had opined that price hikes were acceptable. A year later, this ratio reversed with nearly 60% of consumers being accommodative of this trend, a level like the U.S., the UK and Germany, where inflation has been the norm for many years. When people begin to expect prices to rise, real wage growth is what matters. Since the early nineties, real wage growth has been essentially flat in Japan. Even after this year’s unprecedented victory by labor unions in the spring wage negotiation season (achieving an average base salary increase of 3.6%, highest since the early 90s), consumers’ purchasing power is still under pressure. We believe the quickest way to achieve positive real wage growth is to raise the labor share of corporate profits, but that would deteriorate the profitability of the business. Consumers’ purchasing power can also be increased by taking on household debt. But that too is not an ideal solution. History is rife with examples of severe backlashes ensuing many years of debt-fueled consumption as seen in the post-bubble Japanese economy in the nineties and the global economy during the 2008 financial crisis. For these reasons, income growth should be brought about by productivity gains.
According to The Organization for Economic Cooperation and Development (OECD), Japan’s labor productivity is among the lowest in the world (27th out of 38 countries in 2021),1 and worse yet, is ranked at the bottom among the G7 countries for 50 straight years.2 This is a shocking revelation. Fixing the perennially low labor productivity is therefore vital for companies to continuously give wage increases. Consequently, households will become confident in future income growth. Japanese companies can tackle this issue by investing more in digital transformation (DX) (the country is widely known for its slow adoption of innovative technologies), breaking away from excessive customer services that do not necessarily translate into sales revenue, and introducing more meritocracy into the compensation system. Among these solutions, we are particularly keen to discuss our thoughts on the last point.
It is a well-known fact that many Japanese companies still adopt a seniority-based wage system, in which employees are implicitly guaranteed a small but steady pay raise every year. This cultivates staff’s loyalty to their employer; hence the Japanese labor practice is referred to as “lifetime employment.” In our view, merit-based compensation should do a better job of boosting employee morale and motivation, whereby productivity gains can also be made. Japanese companies significantly lag their foreign counterparts in this regard. For instance, the remuneration of directors at large Japanese companies is said to be about one-fifth of that in the UK and less than one-twentieth of that in the U.S.3 Such uncompetitive remuneration de-motivates C-suite executives and discourages them from taking appropriate risks to grow the business. Even more egregious is that there are often significant differences in compensation between Japanese and non-Japanese executives within the same company. Earning only a fraction of the fellow non-Japanese directors just because you are a Japanese national seems utterly absurd to us. This situation needs to be rectified by establishing a more equitable compensation structure.
Raising profitability by implementing price hikes is another approach worth considering as improving labor productivity is not only about maximizing the physical volume of production per unit of labor but also about increasing value per unit of labor.4 The latter measure focuses on maximizing the dollar amount and can be addressed by proper pricing of goods and services, which have been priced too low compared to global standards. In other words, it is imperative to proactively raise prices such that businesses will have more capacity to raise wages. Once the path to sustainable salary increases is established through better productivity, new consumer demand will be created, leading to “good inflation.” Incidentally, these same measures for good inflation should also be effective in correcting the “price to book (P/B) less than 1x” that the Tokyo Stock Exchange requested of listed companies earlier this year. Labor productivity betterment and capital efficiency improvement are two sides of the same coin. Nearly 40% of the listed companies on the Tokyo Stock Exchange fall into the “P/B of less than 1x” group. In most cases, a stock price below book value indicates that management has been a poor steward of shareholders’ capital. Since P/B is calculated by multiplying price to equity (P/E) and return on equity (ROE), the management of publicly listed companies should strive to increase ROE.
In Japan, the awareness of capital efficiency such as ROE seemed non-existent a decade ago. Indeed, this was one of the main reasons for the prolonged under-performance of Japanese equities post-1989 bubble burst. However, in recent years, we have begun to observe that things are slowly changing. Since the start of the corporate governance reforms in 2014-2015 under Abenomics, corporate management has come to embrace the basic concept of “ROE” or “returns on capital (ROC)” as a key determinant of financial performance. This is evident from the fact that these terms are now frequently used in Investor Relations (IR) materials and annual reports today. We even feel that there is a sense of embarrassment among corporate directors if their stock price is languishing at less than P/B of 1x.
To keep up the positive momentum, management needs to install a capitalistic mindset not just at the board level but throughout the organization. Our research confirms that growth companies with a strong focus on capital efficiency are more highly valued in the stock market. To this end, operational metrics such as ROC should be linked to the employees’ compensation system, and employers should reward them accordingly. We firmly believe that continued efforts by Japan Inc. will eventually pay off in a way that will bring about a favorable inflationary environment and at the same time achieve the Tokyo Stock Exchange’s market reforms.
Lastly, regardless of how the macroeconomy may play out, we believe the portfolio is positioned well. It continues to remain concentrated around select attractive mid-to-large cap Japanese companies with global operations yet sufficiently diversified to weather unexpected adverse macro-economic events be it higher-than-expected inflation, interest rates or forex movements. Some of the Fund holdings are genuinely fast-growing companies with valuation premiums (e.g., Tokyo Electron, Fast Retailing, Recruit, Keyence, Daikin, SocioNext etc.), while others are growth companies trading at value stock-like multiples with significant ability to buy back shares and high dividend yields (ex. Mitsubishi Corp, Tokio Marine, Mitsubishi UFJ Financial Group, Orix, MS&AD, Sompo, etc). The overarching characteristics of all these names are that they have strong durable competitive advantages and huge addressable markets.
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