For the first half of 2020, the Matthews Japan Fund (Trades, Portfolio) returned 0.05% (Investor Class), while its benchmark, the MSCI Japan Index, returned -6.92% over the same period. For the quarter ending June 30, 2020, the Fund returned 18.18% (Investor Class), while its benchmark returned 11.64%.
Market Environment:
The first half of 2020 was turbulent for the economy and equity markets. In January and February, Japanese equities experienced steeper declines than those of other developed economies in anticipation of the global manufacturing cycle deteriorating to a recession territory. However, since March, Japan has been one of the strongest equity markets globally. The country experienced lower COVID 19 cases than other developed countries due to widespread adoption of masks and extensive contact tracing. Japanese corporates had strong cash positions to weather the economic downturn. Furthermore, while economic conditions remain weak globally, sentiment is improving.
Turning to monetary and fiscal policy, recent central bank actions and government spending bills offer ballast for Japan's overall market and economy. The Bank of Japan, Japan's central bank, announced plans to double its purchases of exchange-traded funds (ETFs). Reflecting monetary easing efforts around the globe, Japan's central bank is committed to providing liquidity. The Japanese government has also passed a stimulus package that are one of the largest in terms of percentage of GDP, both headline numbers and direct spending.
Performance Contributors and Detractors:
On a relative basis, the Fund outperformed its benchmark in the first half of the year. Mega-cap and large-cap stocks (those over US$10 billion in market cap) outperformed small- and mid-cap stocks (those under US$10 billion) in the reporting period. Although small- and mid-size companies make up nearly half of the Fund's portfolio, portfolio managers overcame the Fund's underweight to mega caps via strong stock selection. From a sector perspective, information technology (IT) and industrials were contributors to performance. The consumer staples sector was a lone detractor to overall results.
Turning to individual securities, Lasertec (TSE:6920, Financial), which makes photomask inspection equipment, contributed to overall performance in the first half. The company is currently the only provider of mask and mask-blank inspection equipment using EUV (extreme ultraviolet) as a light source. EUV adoption in major foundries and increased usage in memory makers is, in our view, likely to further enhance the business opportunity of the company. Property, casualty, and life insurance company Tokio Marine Holdings (TSE:8766, Financial) detracted from performance. Amid widening credit spreads, the firm announced no buybacks in the most recent fiscal year results. However, we continue to find the company's long-term prospects attractive. We believe the company is well run and growing globally with solid bolt-on acquisitions.
Notable Portfolio Changes:
In the quarter ending June 30, 2020, we continued to take advantage of the market correction to enhance the quality of the portfolio, making several changes in the quarter and reducing our total number of portfolio holdings.
New positions include ERP software and service company OBIC (TSE:4684, Financial). The company mainly serve medium-size businesses in Japan with a core software product called OBIC7. OBIC7 is a Microsoft SQL based ERP (enterprise resource planning) program that is component based (personnel, payroll, working hours management, marketing and production system) and configured by client base. The ongoing shift to cloud-based software is expanding the company's growth opportunities.
We have also re-initiated a position in HOYA (TSE:7741, Financial), a manufacturer of semiconductor mask blanks, optical lenses and endoscopes. We believe the firm may benefit from accelerating development of cutting-edge technology in the EUV area. To fund these positions, we exited several positions, including MUFG (MUFG, Financial), Kyowa Exeo (TSE:1951, Financial) and Shimadzu (TSE:7701).
Outlook:
Following the initial outbreak of the pandemic, economic conditions and the outlook for corporate profits were “less worse” than investors initially feared. The rally in global equity prices in the first half was driven by rising investor optimism, regardless of the absolute level of economic activity globally. Japanese equity prices shared in this sentiment-driven rally. Japanese equities are currently trading in a middle range of their long-term historical averages. Prospects for a strong recovery scenario are somewhat already reflected in share prices. In the near term, we expect to see a tug of war between the trajectory of COVID-19 infections globally and the magnitude of the government and central bank stimulus around the world.
In our view, Japanese equities are well positioned relative to other developed and emerging market peers because of their strong balance sheets. If the recovery of the economy becomes slower than expected by reacceleration in COVID-19 cases, Japanese corporates have some cushion available with high levels of cash reserves. Nearly half of Japanese listed companies are net cash. On the other hand, if COVID-19 case growth subside and we see faster recovery globally, Japanese corporate profits may benefit as well, as profits tend to rise when global manufacturing activity increases. Valuation levels are still at a discount to U.S. and European markets, both in PER and PBR basis.
From a structural point of view, we continue to believe the earnings capability of Japanese companies has improved meaningfully over the past economic cycle, driven by better corporate governance and a higher focus on capital efficiency. Multiyear trends such as productivity growth, health care, technology and material science innovation—where Japanese corporations excel versus global peers—remain intact. What's more, we expect the pace of change to accelerate as COVID-19 continues to stress test health care systems and costs. The pandemic also highlights the need for greater labor productivity among white-collar jobs as more people work remotely. Against this backdrop, we are optimistic about opportunities for generating long-term alpha within Japanese equities.
As of June 30, 2020, the securities mentioned comprised the Matthews Japan Fund (Trades, Portfolio) in the following percentages: Lasertec Corp., 4.6%; Tokio Marine Holdings, Inc., 2.8%; OBIC Co., Ltd., 1.5%; Hoya Corp., 2.5%. Current and future portfolio holdings are subject to change and risk. The Fund held no positions in MUFG, Kyowa Exeo and Shimadzu.
The views and opinions in this commentary were as of the report date, subject to change and may not reflect current views. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the Fund's future investment intent. It should not be assumed that any investment will be profitable or will equal the performance of any securities or any sectors mentioned herein. The information does not constitute a recommendation to buy or sell any securities mentioned.
The information contained herein has been derived from sources believed to be reliable and accurate at the time of compilation, but no representation or warranty (express or implied) is made as to the accuracy or completeness of any of this information. Neither the funds nor the Investment Advisor accept any liability for losses either direct or consequential caused by the use of this information.
