Dear Shareholder,
Global financial markets faced historic challenges during your fund's fiscal year, the 12-month period ended October 31, 2020, as the spread of the coronavirus and lockdown measures decimated economic activity in the spring and led to sharp sell-offs. Markets were resilient, though, and many sectors finished in positive territory.
The year began on a positive note, with major stock benchmarks in the U.S., Europe, and Japan recording gains through the middle of February, but global markets became increasingly volatile as the pandemic spread outside China. As the extent of the crisis grew, investors rapidly moved their assets into U.S. Treasuries and cash. By March 23, the S&P 500 Index had fallen by about a third from the start of the year, and even traditionally safer areas of the market, such as high-quality bonds, sold off during the downturn.
In response to the rapid economic contraction, governments and central banks around the world took extraordinary actions to support the economy. In the U.S., the federal government approved relief packages totaling $2.4 trillion, or over 11% of gross domestic product, while the Federal Reserve cut interest rates close to zero and began massive purchases of government, mortgage-backed, and corporate bonds to stimulate the economy and increase liquidity in the fixed income market. In just a few months, the Fed engaged in twice as much quantitative easing as it did during the entire global financial crisis from 2008 to 2010. The European Central Bank and the Bank of Japan also committed to significant asset purchase programs, and other central banks cut rates or bought bonds to support their economies.
Boosted by the stimulus and an easing of lockdowns during the summer, global economies began a rapid recovery, although most indicators remained below pre-pandemic levels at the end of the period. Financial markets also rebounded, but it was an uneven recovery.
Investors favored mega-cap information technology and internet-related firms, which benefited from the work-from-home environment and an acceleration in demand for online services, while other sectors have yet to bounce back. Energy companies were hit hard by a steep drop in oil prices due to declining demand, and airlines, hotels, and shopping centers struggled amid lockdown orders and consumer reluctance to resume activities where social distancing wasn't possible.
Growth stocks significantly outperformed value shares during the period, and U.S. equities, led by the tech giants, generally outpaced international benchmarks. Asian shares performed well as China and other countries in the region have been successful in controlling the coronavirus, while European stocks produced negative returns as a resurgence of the virus led to a second round of lockdowns at the end of the period. Despite steep losses in Latin America, emerging markets stocks recorded generally solid gains.
The U.S. dollar weakened during the period, as negative real (inflation-adjusted) interest rates and slower growth relative to the rest of the world made the greenback less attractive. Currency results varied widely at the country level, but a stronger euro and yen aided returns for U.S. investors in Europe and Japan, respectively. In the fixed income universe, Treasuries recorded solid gains as yields dropped to record lows, and investment-grade corporate bonds rallied on strong investor demand.
As the period ended in late October, rising coronavirus caseloads in the U.S. and Europe made it clear that the pandemic is not over, although we are hopeful that a vaccine will bring about an eventual return to normalcy in the new year. Whatever challenges we face in 2021, I can assure you that our commitment to fundamental research remains steady.
Our investment teams continue to meet regularly with executives from the companies we are investing in, although video conferencing has largely replaced on-site visits. We remain focused on the long term and continue to ground our decision-making in rigorous analysis, an approach that we believe will benefit our shareholders in this dynamic market environment.
Thank you for your continued confidence in T. Rowe Price.
Sincerely,
Robert Sharps
Group Chief Investment Officer
Management's Discussion of Fund Performance
INVESTMENT OBJECTIVE
The fund seeks long-term growth of capital through investments in common stocks of companies located (or with primary operations) in Japan.
FUND COMMENTARY
How did the fund perform in the past 12 months?
The Japan Fund returned 22.33% in the 12-month period ended October 31, 2020. As shown in the Performance Comparison table, the fund significantly outperformed its benchmark, the TOPIX Index Net, and the Lipper Japanese Funds Average. (Returns for I Class shares varied slightly, reflecting a different fee structure. Past performance cannot guarantee future results.)
What factors influenced the fund's performance?
Stock selection was the primary outperformance driver, and sector allocation also contributed positively to a lesser extent. Stock picking and an overweight in the information technology (IT) and services sector were the biggest absolute and relative contributors. Our choice of securities in the machinery and the pharmaceutical sectors also benefited performance, while stock selection and an underweight in electrical appliances and precision instruments segments hurt relative returns.
In the IT and services segment, our large overweight position in SoftBank Group (TSE:9984, Financial) was the top contributor. The telecommunications and internet conglomerate suffered sharp losses amid the coronavirus panic as investors grew skeptical about the outlook for its technology holdings, including its investments in office-sharing firm WeWork and ride-hailer Uber. Shares recouped their losses in April, however, and rose further on investor optimism fostered by ongoing plans to pay down debt and increase shareholder returns through stock buybacks. (Please refer to the fund's portfolio of investments for a complete list of holdings and the amount each represents in the portfolio.)
Miura (TSE:6005, Financial), a manufacturer of efficient gas-powered boilers, was the best performer of our machinery holdings. The shares reached record highs on growth both in its dominant domestic and in its international business. The latter has been helped by the reopening of the Chinese economy. In pharmaceuticals, our overweight holding in Chugai Pharmaceutical (TSE:4519, Financial) contributed positively. The shares rallied to an all-time high in June on stellar earnings. Sentiment for the stock was boosted by news that the company had started a clinical trial of Actemra, a rheumatic drug for the treatment of the symptoms of COVID-19, the disease caused by the coronavirus, with the aim of gaining production and sales approval by the end of this year.
The electric appliances and precision instruments sector was the only detracting sector due to stock selection. Our avoidance of Sony hurt relative returns, as the electronics and entertainment firm raised its profit outlook amid a surge in video game demand from homebound consumers.
How is the fund positioned?
IT and services, where Japan has many leading companies that are expanding globally, was the fund's largest allocation in both absolute and relative terms. We are also overweight machinery. Banks remained our largest underweight by a significant margin. We have no holdings in the space. Intense competition means that there is an excess supply of loans at very low rates. Although demand is improving for these loans, margins remain low given the backdrop of fierce competition and negative Japanese government bond yields.
We prefer investments where we see the potential for margin improvement, robust earnings growth, and an attractive dividend yield. In addition, we are also investing in companies that we believe stand to benefit from structural changes in Japan's economy, such as the shift to digital payments, changing consumer preferences, the aging population, and the tightening labor market. Most of the changes to the portfolio were the result of stock-specific investment themes, rather than a shift in our industry views.
We moved to an underweight in health care after the strong rally in the back half of the period. We locked in some profits in Chugai Pharmaceutical and Takeda Pharmaceutical (TSE:4502, Financial) and added to more cyclical areas of the market that had sold off and stood to recover with a gradual return to normalcy.
We added to our position in commercial kitchen manufacturer Hoshizaki (TSE:6465, Financial) throughout the year. The company, one of our largest positions in absolute and relative terms, has a large domestic presence and is expanding overseas. The coronavirus pandemic has severely crimped the company's growth and earnings this year—as commercial kitchens have closed due to virus containment measures—but we believe earnings will recover sharply as companies look to automate and improve kitchen services.
We also added to another large holding, Suzuki Motor (TSE:7269), on price weakness. The shares suffered as the carmaker shut down operations at Maruti Suzuki in India, one of its most important markets. Car sales in India fell around 40% to 50% year on year in March as authorities implemented lockdown measures to combat the spread of the coronavirus. We increased our position because we believe that Suzuki Motor remains a good long-term investment that stands to benefit from growing automotive penetration in India.
We reduced our overweight allocation to communication services, exiting our holding in NTT DoCoMo (TSE:9437), the largest mobile carrier in Japan, in the second quarter. It was a relatively defensive stock amid the coronavirus crisis, and we preferred other companies in the sector and added to them with the proceeds from the sale.
What is portfolio management's outlook
Japan is more exposed to the global economic cycle than many other markets. Therefore, we believe that the country is well positioned to benefit from the unprecedented fiscal and monetary easing measures implemented globally to support economies from the coronavirus pandemic and an improvement in earnings from depressed levels as the global economy enters the recovery stage.
Within Japan, the central bank and the government acted vigorously, swiftly expanding monetary stimulus and passing a large spending package to help cope with the economic slowdown. These measures have helped soften the recession and have bought time for companies and consumers facing near-term cash flow pressures. Corporate Japan is cash rich, which is providing the local market with some respite as investors are generally concerned about balance sheet risk.
Political uncertainty then intensified in the second half of the period with Prime Minister Shinzo Abe's resignation due to health issues. This was viewed negatively by investors amid concerns that his reform efforts and dovish agenda would be canceled. However, we are heartened by the actions taken by his replacement, Prime Minister Yoshihide Suga, and the early signs are encouraging. He has already introduced a Digital Reform Agency and seems even more focused than his predecessor on the economic reforms that we believe Japan requires.
With Japanese companies having strong cash positions and corporate governance standards continuing to improve—even as profits have come under pressure—the asset class is an attractive investment proposition, in our view, and trading at a discount to regional peers.
As we enter the next stage of the equity cycle and the evolution of domestic and international political governance progresses, we continue to believe that Japan is a compelling active management case, particularly as the market is under-owned and displays positive change dynamics. We also believe the expected global economic recovery next year will provide a cyclical tailwind for Japan.
The views expressed reflect the opinions of T. Rowe Price as of the date of this report and are subject to change based on changes in market, economic, or other conditions. These views are not intended to be a forecast of future events and are no guarantee of future results.
