Market Commentary and Fund Performance

Fund Performance Review

In August the Fund (HJPIX) returned -3.96%, while the Russell/Nomura Total Market Index lost 3.00% and the Tokyo Stock Price Index fell 2.42%.

Among the best performers were our investments in Mitsubishi Corporation, the largest trading company in Japan, Hitachi, Ltd., one of Japan’s oldest electric equipment and heavy industrial machinery manufacturers, and Shimano, Inc., global top market share bicycle parts manufacturer.

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As for the laggards, 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 Santen Pharmaceutical Co., Ltd., a pharmaceutical company specializing in ophthalmology, detracted from the Fund’s performance.

This month, we had the April-June quarterly earnings season. Below we describe how some of the Fund’s major holdings fared during the quarter and their outlook for the year (and onward). Some of the Fund’s holdings started the new fiscal year on a high note despite the challenging business environment (most companies discussed below have a March-end fiscal year, which will end in March 2023) while some are off to a rather weak start but expected to be resilient later in the year. Regardless of their quarterly financial performance, these businesses possess strong economic moats ranging from consumer brand equity, manufacturing economies of scale, online network effects, and intellectual properties, among others, which allows them to enjoy above-average returns on capital and above-average long-term growth track record. Companies whose earnings results were solid and the full year outlook is positive:

Keyence;

The customized factory automation sensor developer/marketer saw its revenue grow by 13% year over year (YoY) while operating income climb 10% YoY (record high), outperforming most, if not all, industrial names in Japan (yet again). Its operating margin came in at 53.5%, in line with its historical average. Demand was strong in all regions except for China, where COVID-related lockdowns resulted in lower sales. The company’s unique direct sales channel strategy allowed management to respond quickly to secure enough parts supply, while those companies with sales agency model were unable to effectively deal with the problem. Management does not provide full year guidance but the company is loosely tracking its 10-year and 20-year operating profit (OP) compounded annual growth rate (CAGR) of 16.5% and 13.5%, respectively. Its 5-year average return on equity (ROE) stands at 13.8%, despite its extremely cash-heavy balance sheet and bloated shareholders’ equity.

Nidec

The world’s largest brushless direct current motor manufacturer recorded revenue growth of 20% YoY with flat performance in operating income. On a pretax profit basis, the company registered 30% YoY increase thanks to favorable currency effects (weak yen). The company has been investing heavily in the traction motor business for use in electric vehicles, where the latest order projection is now 4 million units by FY2025, up from previously announced 3.6 million units. According to management, this business is currently incurring an annual operating loss of around JPY 20 - 30 bn ($139 - $208 mn), but they reiterated that the segment will breakeven by next fiscal year. As such, the segment’s profit improvement together with growth in other segments can point to robust earnings growth in the coming years. Nidec’s 10-year and 20-year pretax income CAGR are 9.2%and 14.3%, respectively with 5-year average ROE of 11.1%, which should rise over the next few years. Lastly, there was a news report during the month that President Seki will be removed from his post by the Founder/Chairman Nagamori given his unsatisfactory performance as CEO. Subsequently, the company has announced Seki’s resignation. It is the second successor to be ousted by Chairman Nagamori for not living up to expectations. We will keep monitoring the situation of how Nagamori (now 77 years old) will work out a succession plan.

Rohto Pharmaceutical

Japan’s mid-sized personal care products maker reported an increase in revenue of 24% YoY with operating income soaring 38% YoY. In Japan, its premium eye drop products sold well thanks to strong demand from eye-fatigued, work-from-home consumers. Sunscreen and anti-blemish skin lotion also registered nice revenue growth as consumers have increasingly spent longer hours outdoors. The company is adept at adding extra functions to existing personal care goods, and launching them at affordable prices through drug store channels. The company’s current hit product “Skin Aqua” color-correcting sunscreen is one such example. Elsewhere, Vietnam saw a V-shaped recovery after the COVID-19 pandemic was brought under control while Indonesia also saw robust top line growth. It is also worth mentioning that management is actively pushing into new business territories such as regenerative medicine and prescription ophthalmic medicine whilst keeping tabs on the size of investment they commit. Although it is yet unknown whether these ventures will succeed in the future, we value management’s determination to be on offense. The company’s OP CAGR for the last 10-year and 20-year periods stand at 8.0% and 9.8%, respectively. Its 5-year average ROE is 10.1%, but last year it rose to 12.6% with further improvement expected for the current year.

Mitsubishi Corporation

The company saw its core net profit excluding one-off items more than doubled during the quarter, putting it at 52% of its full-year projection. The strong business performance was driven by increased market prices in the Australian metallurgical coal business (more details below), strong earnings at the ASEAN automotive business (car assembly and sales) as well as at the power solution business (power generation and power trading). We see the company as an investment company disguised as a general trading house or “sogo shosha.” The firm’s balance sheet represents a unique collection of operating assets and securities with a wide variety of geographical exposure and industries that are not easily accessible through other means of investments. These investment opportunities are identified by an extensive network of staff all around the world with a long operational history. These assets range globally from energy/commodity projects in Australia, a truck assembly supply chain business in Southeast Asia, electric power plant development/power generation business in Europe and the U.S., and convenience store operation in Japan. Its per-share book value has grown 8.1% and 10.1% per annum in the last 10-year and 20-year periods, respectively.

The company has announced in 2021 a long-term plan to invest a total of JPY 2 tn ($14 bn) in de-carbonization related areas such as renewable energy. We give credit to management for this large-scale commitment to sustainability.

Companies whose earnings results were somewhat lackluster but are expected to be resilient this fiscal year (FY):

Hitachi

The century-old industrial conglomerate makes everything from heavy machinery, electrical equipment, home appliances, medical-diagnostic equipment, develops IT systems for Japanese financial institutions, and operates mission-critical social infrastructures such as railway systems, power grids/power plants. During the quarter its revenue grew by 9% YoY to JPY 2,569 bn ($18 bn) thanks to a weaker yen while adjusted earnings before interest, taxes, depreciation, and amortization EBITDA)* slipped by JPY 6.3 bn ($44 mn) owing to profit declines at its automotive business and home appliance business, both of which were hampered by semiconductor shortages and COVID-related lockdowns in China. However, the all-important Lumada business saw its revenue jump by 58% YoY, now accounting for 16% of total sales thanks to strong performance at its newly acquired subsidiary Global Logic, which posted a 47% YoY sales growth during the quarter. Through the Lumada business, Hitachi is in the midst of transitioning its business model from a traditional hardware sale model to a more profitable hardware/software solution model to solve the corporate clients’ management bottlenecks as well as high-level operational issues. This can be facilitated by its existing in-house capabilities in IT technology, operational technology and product engineering as mentioned above. Hitachi’s 5-year average ROE is 10.2%, but last year it rose to 14.8% with further improvement expected given the increasing contribution from the Lumada business down the road.

Daikin Industries

The world’s largest maker of air conditioners recorded revenue growth of 21% YoY but operating income declined slightly owing to higher raw material costs as well as lockdowns in China. Nevertheless, management has raised its full year earnings forecast to 11% growth, which is attributable to product price hikes, cost cutting measures as well as stepped-up marketing efforts. Sales trends are robust in the Americas and Asia for air conditioners and in Europe for heat pump hot water heaters in particular. The company’s OP CAGR for the last 10-year and 20-year periods stand at 14.6% and 10.6%, respectively. Its 5-year average ROE is 12.7%

Misumi Group

The distributor/manufacturer of high quality precision machinery components reported revenue growth of 2% YoY while operating income slipped by 2%. The company’s services are known for its breadth of product selection on its catalogue (exponential variations if customization is included) and short delivery times. Misumi can deliver even for the smallest order lot (1 piece) on average within 2 days. For manufacturing factories, suspension of production lines caused by mechanical component failure can be extremely costly. Thus, having Misumi as a supplier of these vital components when needed is well-appreciated by its clients. Misumi has also been rolling out a customized machinery component procurement service called “Meviy.” By uploading 3D CAD data onto its website, the user can get an instant quotation and order placement for quick delivery. The company’s OP CAGR for the last 10-year and 20-year periods stand at 12.1% and 12.5%, respectively. Its 5-year average ROE is 11.6% (last FY’s ROE 14.3%).

Terumo

The medical device company with a leading global market share in catheters registered a revenue increase of 15% YoY thanks to a recovery in the number of cardiovascular surgeries performed as the COVID-19 impact waned. Its operating income, however, fell 16% YoY due to higher raw material costs and an increase in research and development (R&D) spending. Nevertheless, management left its full year guidance unchanged at 14% profit growth citing product price hikes. The price hikes were implemented during the quarter and are expected to become a bigger offsetting factor as the year progresses. Management has also been planting new seeds for future growth opportunities. For example, in the blood and cell technologies segment, the company has recently developed a new plasma donation system, which allows for much superior donor experience than the conventional types. In the medical care solution segment, it will no longer just sell hospital supplies but work closely with pharmaceutical companies to provide contract manufacturing services such as “pre-filled” syringes for use in hospitals. The company’s OP CAGR for the last 10-year and 20-year periods stand at 6.3% and 7.4%, respectively. Its 5-year average ROE is 12.2%.

Companies whose short-term outlook may look challenging but long-term prospects are positive:

Recruit Holdings

The HR and marketing media company, owner of U.S.-based online job advertisement subsidiary “Indeed,” enjoyed a revenue increase of 27% YoY and adjusted EBITDA growth of 16% YoY during the quarter. However, management acknowledged that they are seeing deceleration in the HR Technology segment in July, reflecting a slowdown in the broader economy amid a series of interest hikes in the U.S. For this reason, management has cost control measures ready in the event a severe recession hits. The company has a dominant position in the online job advertising market and has been gaining market share. For example, last fiscal year Recruit’s HR technology segment revenue grew more than 100% while the overall industry expanded by 36% YoY according to the company. In the Matching & Solution segment, which offers various advertising media services catering to domestic hair salons, travel agents, property agents etc., revenue should gain momentum in the post-COVID-19 normalized business environment. Plus, for its advertising clients (most of whom are small mom & pop business owners), Recruit has been rolling out SAAS services (called “Air Business Tools”) in order for these clients to efficiently manage their store operations. We believe this could potentially become another growth driver for the company going forward. During the last 5 years, Recruit’s earnings (adjusted EBITDA) has doubled with average ROE hitting 18.8%.

Sony Group

Japan’s premier entertainment group reported revenue growth of 2% YoY with operating income up 10% YoY, reaching an all-time high. However, management lowered its full year guidance for the gaming business citing faster-than-expected slowdown in stay-home consumption trends. In order to reverse the weakness, management vowed to ramp up the production of PS5 game consoles and cited a few blockbuster gaming title releases in the 2nd half in order to stimulate demand. The company’s strength lies in having multiple segments that can cover for each other in any given quarter/year. Also, its ability to maximize revenue for its intellectual property is another reason why we like their entertainment businesses. For example, its Spiderman franchise is available not only in movie format but also arranged in music and gaming to monetize to the fullest. These initiatives are reasonably promising as existing content character IP generally requires limited incremental investment to generate additional revenue. We believe Sony Group has the benefit of being a tech/entertainment conglomerate. Its 5-year average ROE is 19.2% thanks to one-off profit items in some years but it was 13.9% last FY even in the absence of such one-off effect.

Tokio Marine Holdings

Japan’s largest general insurance company, with arguably the best underwriting track record and successful overseas expansion, reported net premiums received rose 11% YoY, however due to out-of-season hail damages in Japan among other reasons, the quarter’s adjusted net profit was weaker than usual at 25% as a percentage of full year guidance. In recent years, with increasing incidents of abnormal weather due to global warming, general insurers have been seeing favorable pricing environment to increase premium in order to cover rising loss ratios. This is especially being made relatively easy as the industry has consolidated into just 3 mega insurance groups domestically over the last two decades. Thus, long-term prospects for Tokio Marine are positive. Furthermore, Tokio Marine has a substantial U.S. underwriting business in the area of specialty insurance, which accounts for nearly half of its overall adjusted net profit. This helps diversify risk exposure away from traditional domestic auto and fire insurance, which contributes to earnings growth with less volatility on a consolidated basis. In terms of full year guidance, thanks to a robust U.S. business, management has kept its full-year guidance unchanged. Its 5-year average ROE based on adjusted net profit stands at 9.6%, but with improving profitability in recent years plus continuous share buybacks (& cancellations), it reached 14.4% last FY. On shareholder returns, this year’s dividends per share (DPS) is JPY 300 ($2.10), up 18% YoY (4% dividend yield currently). Management bases their source of dividends on 5-year average adjusted net profit. As the average is expected to rise in the coming years, DPS should also increase further.

Kao

In the first half (Jan-June, 2022) of this year, Japan’s largest home products/personal care goods company saw revenue grow 8.7% YoY, yet operating income fell 24% YoY, due to multiple headwinds including intensifying competition in several product categories as well as rising raw material costs. 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, the company has emphasized signs of domestic market share gains in detergents and sanitary products in the most recent earnings announcement. Whether they can rapidly turn around, remains to be seen but this is a company that has compounded per-share earnings at 10.8% for 20-years leading up to 2018 with an average ROE of 13.2% during the period. It also has an enviable track record of continuous dividend hikes of 33 years (and counting). Simply put, Kao is an able, well-executed organization.

ORIX

ORIX Japan’s largest non-bank comprehensive financial services company. During the April-June quarter, its total revenue grew 8% YoY but net income fell 5% YoY due to the absence of capital gains from asset sales compared to last year. The 6th wave of COVID-19 in Japan also resulted in increases in loss claims for hospitalization benefits at its life insurance arm while the real estate loan origination business in the U.S. grew slower than last year. Over the last 5 and 10 years, the company has grown its book value per share at 7-10% per annum, which is a proxy for the growth rate of intrinsic value. During its history since 1964, it has never reported a net loss.* Over the next 3 years, ORIX likely see faster growth in earnings as the company’s mid-term outlook calls for 12% CAGR by FY 2025. This is primarily due to an expected recovery in pandemic-stricken business lines such as hotel operation, aircraft leasing, and airport concession businesses. These business lines reported a segment loss of JPY 22 bn ($153.8 mn) in FY2021 but should recover to at least JPY 60 bn ($419.5 mn) over the next 3 years assuming the normalization of businesses back to pre-COVID levels. This seems reasonably achievable to me.

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