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 the first half of the month, concerns about excessive gains in artificial intelligence (AI)-related stocks triggered a sharp correction in the U.S. market, which subsequently weighed on Japanese equities. In contrast, value stocks and domestically oriented names showed resilience. Differences in index composition, particularly the weighting of these groups, led to divergent performance, with the Nikkei 225 Stock Average posting a larger decline, while the TOPIX remained relatively stable.

Mid-month, heightened Japan-China relations and the Chinese government’s call for voluntary travel restraint to Japan rattled markets. Both the Nikkei 225 Stock Average and TOPIX declined sharply, with the Nikkei 225 Stock Average briefly dipping below the key 50,000-yen level. Japanese equities subsequently rebounded, supported by semiconductor-related names such as Advantest and Tokyo Electron, as well as SoftBank Group. NVIDIA’s strong earnings release triggered buying of its shares in U.S. after-hours trading, lifting the Nikkei 225 Stock Average by about 700 yen ($4.49) at one point. However, gains were capped by continued caution over excessive AI-related investment.

Toward the end of the month, expectations for a December rate cut strengthened following dovish comments from a high-ranking Federal Reserve Board official, contributing to a recovery in both U.S. and Japanese equities. As a result, the Nikkei 225 Stock Average posted its first monthly decline in eight months, while the TOPIX ended slightly higher.

The Fund’s Performance

Within the environment, the Fund (HJSIX) returned 1.67%, underperforming its benchmark, the Russell/Nomura Small Cap™ Index, which returned 3.58%.

This month, key positive contributors to the Fund’s performance included Penta-Ocean Construction Co., Ltd., Nishi-Nippon Financial Holdings, Inc., and The Musashino Bank, Ltd. Penta-Ocean Construction reported strong second-quarter earnings, supported by steady progress in its domestic project backlog. Construction-related stocks broadly rose amid heightened expectations for improved profitability. The company also attracted attention as a defense-related stock, which further increased buying activity. Nishi-Nippon Financial Holdings’ share price rose after its second-quarter earnings results indicated steady progress in performance. Musashino Bank also released its second-quarter results and revised its full-year earnings forecast upward, driving its stock price higher. Both banks also benefited from sector-wide momentum amid growing expectations of interest rate hikes by the Bank of Japan (BOJ).

Meanwhile, key detractors from the Fund’s performance included Musashi Seimitsu Industry Co., Ltd., Daihen Corporation, and CKD Corporation. Musashi Seimitsu Industry’s share price fell after its second-quarter earnings results failed to provide updates on hybrid supercapacitors for AI servers, a topic the market had been focused on. Daihen, despite raising its full-year forecast on strong energy management performance, saw its stock price decline as the positive outlook was already priced in. CKD’s shares also fell following a downward revision to its full-year forecast, amid a slower-than-expected recovery in demand for semiconductor-related equipment and a reduced dividend forecast.

During the month, we continued to increase holdings in existing positions while selling shares of companies whose price appreciation had reduced their relative attractiveness. We also initiated new positions in a construction company and other names where industry conditions appear to be improving but valuations have yet to fully reflect the underlying fundamentals.

The Japanese stock market remains highly volatile. AI-related stocks, which had driven the market until last month, have entered a correction phase amid concerns over intensifying competition. Within the Fund, several holdings also sharply declined due to conservative guidance and short-term earnings stagnation, weighing on short-term performance. However, our research confirms that these companies maintain solid fundamentals, which we believe presents a favorable opportunity to add to positions. Going forward, we will remain focused on generating medium- to long-term returns through a fundamentals-driven investment approach.

We recently initiated an investment in a real estate company specializing in the acquisition, value enhancement, and sale of mid-sized office buildings, mainly in central Tokyo. While the number of small and medium-sized businesses in the area remains stable, new office development is extremely limited. This creates structurally resilient demand for existing mid-sized office properties. Additionally, older buildings offer significant potential for rental income growth through renovations and tenant turnover. The company has achieved strong growth by acquiring such properties, improving profitability through refurbishments and rent negotiations, and ultimately selling them.

The Japanese economy has recently shifted from a prolonged period of low inflation to a more inflationary environment. This transition creates room for office rents to increase through two main channels: improved corporate sentiment and greater earnings resilience supported by higher nominal sales and profits. These factors are favorable for the office market. Furthermore, stronger corporate performance typically encourages hiring and business expansion, further increasing office demand. At the same time, rising construction costs make it more challenging to develop new mid-sized offices, reinforcing demand for existing properties.

In an environment of strong underlying demand and constrained supply, we are more confident in the company’s growth prospects and have invested accordingly.

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