Market Commentary and Fund Performance

Performance data quoted represents past performance; past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the fund may be lower or higher than the performance quoted. Performance data current to the most recent month end, and standardized performance can be obtained by viewing the fact sheet or by clicking here.

Market Highlights

In January 2026, Japan’s equity market posted solid gains. The TOPIX, a representative index of Japan’s stock market, rose 6.31% month-over-month.

During the first half of the month, strong rallies in U.S. semiconductor-related stocks boosted demand for Japanese semiconductor and artificial intelligence (AI) related names, sending the Nikkei sharply higher from the first trading day of the year. Although there was a temporary sharp pullback following reports that the Chinese government might tighten export restrictions to Japan on products including rare earth materials, major Japanese indices continued to set new highs through mid-month. This was supported by expectations that Prime Minister Takaichi’s growth strategy would advance more easily amid speculation of a dissolution of the Lower House and early general elections.

In the latter half of the month, market sentiment shifted markedly. Rising uncertainty around domestic politics—driven by the Prime Minister’s call for an ultra-short snap election and the formation of a new opposition party—combined with geopolitical concerns, including fears of increasing U.S.-EU trade frictions, weighed on investor confidence. Additionally, long-term Japanese government bond yields rose more quickly than expected due to concerns about fiscal deterioration from expansionary policies, adding to the downward pressure on equities.

Toward the end of the month, the yen experienced sharp volatility following reports of “rate checks” by Japanese and U.S. authorities. The yen briefly strengthened to the JPY 153 per dollar range, creating turbulence particularly for export-related stocks. Despite this late-month weakness, Japan’s equity market finished January at a significantly higher level compared with the previous month-end.

The Fund’s Performance

Within the environment, the Fund returned 5.17% (HJSIX), underperforming its benchmark, the Russell/Nomura Small Cap™ Index, which returned 5.72%.

This month, key positive contributors to the Fund’s performance included Nishi-Nippon Financial Holdings, Inc., CKD Corporation, and Towa Corporation. Nishi-Nippon Financial Holdings’ share price rose as the banking sector continued to perform well amid growing expectations of interest rate hikes. Shares of CKD and Towa advanced on expectations that soaring memory prices and continued robust demand for AI semiconductors would lead to increased capital investment. CKD’s share price was further supported by a buy-side analyst rating upgrade, while Towa benefited from a newly issued buy recommendation by a securities firm.

Meanwhile, key detractors from the Fund’s performance included Maeda Kosen Co., Ltd., Daikokutenbussan Co., Ltd., and Tosei Corporation. Maeda Kosen’s share price declined despite the absence of company-specific news. Daikokutenbussan announced its second-quarter results, reporting a decline in profit margins due to sluggish sales growth and a downward revision to its full-year performance forecast, which triggered widespread selling. Tosei’s shares also fell after the announcement of its full-year results. Although there were no major surprises, the share price was weighed down by the fact that the company’s current-term projections were below market consensus.

From an investment perspective, we continued to increase holdings in existing positions while selling shares of companies where recent price appreciation had reduced their relative attractiveness. We initiated a new position in a regional bank, where we believe the improving industry environment is not yet fully reflected in its current valuation.

The Japanese stock market has risen on expectations of a Liberal Democratic Party victory in the House of Representatives election and the promotion of expansionary fiscal policy. However, depending on the election results, fiscal discipline may continue to weaken, heightening concerns over fiscal deterioration. This remains an important risk to monitor. We continue to focus on improvements in corporate profitability driven by changes in management mindset that anticipates inflation. With steady wage increases expected to continue in this year’s spring wage negotiations, We believe the impact of corporate pricing policies on business performance will become increasingly significant. Through direct meetings with individual companies, we aim to increase the likelihood of meaningful progress in changing their mindsets and focus on identifying attractive investment opportunities.

We did not take an active investment stance toward financial stocks against the backdrop of structural challenges such as population decline and stagnation in regional economies. However, with rising inflation expectations in recent years, conditions are increasingly favorable for banks’ earnings. Banking stock indices are also trending upward, and we have shifted our previous approach. Based on our analysis of individual companies, we have decided to increase our investments in banks where we believe their future growth potential has yet to be reflected in their share prices.

As we are not a macroeconomic specialist, we do not seek to generate excess returns through our own distinct outlook on interest rates. Nevertheless, we believe that current valuations of regional bank stocks have yet to fully price in expectations regarding the ultimate policy interest rate, the so-called terminal rate, already implied by the bond market.

Compared with megabanks, regional banks are structurally characterized by a high dependence on interest income within their overall earnings and higher expense ratios resulting from their relatively smaller scale. In a rising interest rate environment, these characteristics make them well positioned for profit expansion. Their high reliance on interest income means that rising rates easily translate into improved net interest margins, boosting earnings, while their cost structure with its high fixed-cost ratio creates additional operating leverage during periods of revenue growth. We are focusing on regional banks that may be capable of boosting profits in a rising interest rate environment, such as those with a high proportion of variable-rate loans or short-maturity bond holdings. While deposit competition is often cited as a concern during periods of rising rates, no intensification of such competition among regional banks has been observed at this time. Regional bank customers’ sensitivity to interest rates is relatively low, with long-standing business relationships and community-based connections acting as barriers to entry for other banks. Furthermore, banks are actively investing in systems and digital channels, including the development of user-friendly apps to strengthen customer retention. These efforts also underpin the stability of the deposit base.

Progress in corporate governance reform is also a significant tailwind for the regional bank sector. Amid requests from the Tokyo Stock Exchange, a management mindset focused on capital costs and return on equity (ROE) is becoming more entrenched among financial institutions. Banks are increasingly allocating capital to areas offering attractive risk-return profiles, such as structured finance (a method of pooling and repackaging financial assets into different tranches to raise funds according to their respective risk and return profiles). An increasing number of companies are also strengthening shareholder returns through measures, including dividends and share buybacks, rather than hoarding excessive capital. We believe these efforts to improve capital efficiency will lead to a reassessment of the market that has traditionally been undervalued.

The potential restructuring of regional banks cannot be overlooked as a medium-to-long-term investment opportunity. While moves such as mergers and alliances among regional banks have already progressed to a certain extent, the Financial Services Agency is seeking to further encourage restructuring through additional regulatory improvements. In our view, this suggests that the trend will continue and expand going forward. We believe that restructuring improves profitability through synergies, including cost efficiency. In addition, management is increasingly motivated to take concrete actions to improve the company’s share price, particularly as a defensive measure against becoming a merger and acquistions (M&A) target. This can consequently drive improvements in capital efficiency and spur management reform.

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