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

Japanese equities delivered mixed performance in September 2026, with the TOPIX rising 1.35% from the end of the previous month.

During the first half of the month, the market traded weakly. Geopolitical tensions in the Middle East resurfaced following a U.S. military strike on Iran, while higher crude oil prices and rising long-term interest rates globally weighed on investor sentiment, leading to declines in artificial intelligence (AI) and semiconductor-related stocks. Although the market temporarily rebounded on the back of strength in U.S. semiconductor shares, renewed yen appreciation and a further rise in oil prices pressured equities once again. In addition, comments from the CEO of a major U.S. AI company advocating a slowdown in the development of advanced AI heightened concerns over a moderation in AI-related investment, triggering another bout of selling.

In the latter half of the month, however, the market recovered. Interest rate hikes by the central banks of Japan and the United States were absorbed smoothly, helping to reduce market uncertainty. Subsequently, optimism regarding expanding AI demand supported gains in U.S. technology stocks, which in turn fueled a rebound in Japanese AI- and semiconductor-related shares. Financial stocks also attracted buying interest amid continued increases in interest rates, driven by expectations of improving lending margins. By month-end, the TOPIX finished slightly higher than at the end of August.

The Fund’s Performance

In this environment, the Fund (HJSIX) returned 1.09%, underperforming its benchmark, the Russell/Nomura Small Cap™ Index, which returned 1.40%.

This month, key positive contributors to the Fund’s performance included The Ogaki Kyoritsu Bank, Ltd., Hokuhoku Financial Group, Inc., and Nishi-Nippon Financial Holdings, Inc. Shares of all three banks advanced amid growing expectations that the Bank of Japan (BOJ) would continue to raise interest rates after its latest hike, supported by their relatively high sensitivity to interest rates and attractive valuations.

Meanwhile, key detractors from the Fund’s performance included CyberAgent, Inc. and Maeda Kosen Co., Ltd. CyberAgent came under selling pressure ahead of its full-year results, as concerns increased over the company’s typically conservative guidance. Uncertainty regarding the impact of AI on the advertising industry as a whole also weighed on the shares.  Although an analyst made modest revisions to earnings estimates for Maeda Kosen, lowering the forecast for the fiscal year ending June 2027 and raising forecasts for the fiscal year ending June 2028 and beyond, there was no significant catalyst to trigger buying interest.

September Commentary

From an investment activity perspective, we made a new investment in a construction company. Although the company operates in an area with substantial structural demand potential, a temporary slowdown in demand has kept its share price at a low level. We therefore believe the value gap has widened.

This investment was made against a backdrop of rising interest rates globally and higher material and labor costs, which have weighed on construction and real estate stocks. As a result, concerns have increased that higher construction costs will reduce project profitability and that construction demand may slow in the future, leaving share prices across the industry subdued. However, construction demand and the ability to pass on higher costs vary across business areas. Therefore, the market’s assessment of the industry as a whole may diverge from conditions in specific segments.

We have previously invested in selected construction companies where we believed the market had not fully reflected improving profitability resulting from the completion of unprofitable projects and successful cost pass-through efforts. These improvements subsequently became visible in earnings, and rising share prices narrowed the value gaps that we had initially identified. We therefore reduced the Fund’s weighting in these holdings. However, more recently, weakness in share prices across the industry prompted us to broaden our research coverage again. Through this work, we have come to believe that the relative investment appeal of the civil engineering repair and maintenance field has increased, supported by expected growth in demand over the medium to long term.

This medium- to long-term demand outlook is underpinned by the aging of Japan’s infrastructure. Roads, bridges, and tunnels were developed intensively during the period of rapid economic growth after World War II. From around 2030, much of this infrastructure will reach the 50-year mark in succession. As the proportion of aging infrastructure rises, demand for repair, replacement, and preventive maintenance is expected to expand structurally. Unlike new construction, repair work needed to maintain existing infrastructure cannot easily be postponed for long periods. As a result, demand in this field is generally more predictable than demand for new general construction activity.

This growing awareness of infrastructure-related risks has also influenced public policy. The risks associated with aging infrastructure became more apparent following events such as the Great East Japan Earthquake in 2011 and the collapse of ceiling panels in the Sasago Tunnel in 2012. The government subsequently moved forward with legal and regulatory measures, together with budgetary provisions for large-scale renewal work. In the expressway field in particular, long-term renewal projects began in earnest in 2015, expanding demand for civil engineering repair work, which had previously been a niche market. Against this backdrop of growing demand, industry participants with specialized construction technologies and proven track records have steadily expanded their earnings.

In recent years, however, increases in material, labor, and subcontracting costs have pushed construction expenses above initial assumptions and placed pressure on the budgets of expressway operators. As a result, the ordering or construction schedules of some projects have been postponed, causing orders and earnings at civil engineering repair companies to stagnate. We believe the stock market has focused on both the deterioration in profitability caused by rising construction costs and the risk that weak order activity may persist. As a result, share prices of related companies have remained under pressure.

While the market has focused on these risks, we believe that the current slowdown is more likely due to project budgets not yet adjusted sufficiently to the rapid increase in costs, rather than a decline in the underlying need for repairs. If repairs to aging expressways and bridges are postponed for too long, safety may deteriorate and renewal costs may rise further. Accordingly, once funding is secured, postponed projects could resume and new repair projects may increase, allowing the market to re-enter a growth phase.

Several developments support this view. One factor supporting this investment thesis is the progress of discussions on extending the toll collection period for expressways and reviewing toll levels. Toll revisions are already being considered or implemented for expressways in urban areas, helping to clarify a path toward securing long-term funding for repairs and renewal through user charges. More broadly, as the Japanese economy shifts from deflation to inflation, there is greater recognition that infrastructure services should reflect rising material and labor costs in tolls and budgets. This could support efforts to secure the funding needed for future repairs and renewal projects.

That said, even if funding is secured, a recovery in orders will not necessarily translate directly into profit growth for these businesses. Construction capacity may be constrained by shortages of engineers and partner contractors. Profitability may also recover more slowly than order volumes if higher costs cannot be fully passed on to customers. In addition, delays in toll revisions or budgetary measures could prolong project postponements. We therefore need to assess the structural strength of demand carefully. We must also consider the time lags between funding approval, placing orders, carrying out construction work, and recognizing profits.

To assess these factors, we will monitor project owners’ budget plans and ordering trends, changes to the toll system, the extent to which higher costs are passed on to construction prices, the profitability of order backlogs, and the availability of construction personnel and partner contractors. Through research on the related industry and peer companies, we will assess the timing and likelihood of a recovery in demand, as well as competitive positioning across the sector. As conviction in this thesis strengthens, we will provide more specific views on earnings prospects and valuation.

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