Dear Shareholder,
Global stock markets produced very strong returns during the first half of your fund’s fiscal year, the six-month period ended April 30, 2021, while rising yields weighed on returns for bond investors. Although the coronavirus continued to spread in many regions, the beginning of vaccine distributions led investors to look beyond negative headlines in anticipation of a strong economic recovery.
All major global and regional equity benchmarks recorded positive results during the period, and returns in the 20% to 40% range were common across developed and emerging markets. Reports of successful vaccine trials in November increased hopes for a return to normalcy in 2021 and spurred a rotation toward segments that had been beaten down in the initial phase of the pandemic.
After a long period of underperformance, value shares outperformed their growth counterparts during the six-month period, and sector leaders also changed. Energy stocks produced strong gains as oil prices rebounded to their highest level in more than two years, and financials also outperformed as banks benefited from rising longer-term interest rates and improved lending margins. Meanwhile, information technology and consumer discretionary companies, which had been the big winners in the early days of the pandemic, trailed wider benchmarks, although they continued to produce solid gains. A weaker U.S. dollar aided returns for U.S. investors in most regions.
Besides the rollout of vaccines, extraordinary fiscal and monetary support from global governments and central banks remained a key factor in providing a supportive backdrop for markets. In the U.S., President Joe Biden signed the American Rescue Plan Act—a $1.9 trillion program that included direct payments of up to $1,400 to most Americans—into law in March. Central banks kept short-term lending rates near or even below zero, and both the Federal Reserve and the European Central Bank emphasized that the time had not yet arrived for scaling back asset purchases designed to keep downward pressure on long-term interest rates.
Although some regions continued to be impacted by lockdowns, there were signs of a rebound in many economies. The International Monetary Fund increased its forecast for global growth in 2021 to 6%, which would mark the fastest growth rate since 1976, and corporate earnings reports were generally better than expected.
While stock investors looked favorably on the continued accommodative policies and positive economic news, bond investors became concerned about rising inflation. As a result, yields of longer-term Treasuries and other high-quality sovereign debt surged during the period, weighing on returns in many fixed income sectors. High yield bonds, which are less sensitive to interest rate changes, produced strong results though, and tax-free municipal bonds recorded positive returns as states received pandemic-related financial assistance from the federal government and state tax revenues held up better than expected.
As we look ahead, the widespread rollout of vaccines, very supportive monetary and fiscal policies, and the release of pent-up consumer demand could provide support for additional market gains. However, we are aware that there are risks in this environment. Valuations are expensive under all but the most optimistic scenarios. In addition, there are signs of speculation in markets, as shown by the rapid rise in cryptocurrencies and capital formation through less conventional vehicles.
During the tumultuous market volatility of February and March 2020, our portfolio managers remained rooted in company fundamentals and focused on the long term—identifying companies with balance sheets that appeared strong enough to get them to the other side of this pandemic was a particular focus. As we hopefully move forward to better days, our investment teams will continue to follow this approach, applying strong fundamental analysis as they seek out the best investments for your portfolio.
Thank you for your continued confidence in T. Rowe Price.
Sincerely,
Robert Sharps
Group Chief Investment Officer
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 six months?
The Japan Fund returned 10.45% in the six-month period ended April 30, 2021. As shown in the Performance Comparison table, the fund underperformed its benchmark, the TOPIX Index Net, and the Lipper Japanese Funds Average. (Returns for I and Z Class shares varied slightly, reflecting their different fee structures. Past performance cannot guarantee future results.)
What factors influenced the fund’s performance?
Underperformance was primarily due to stock selection and, to a lesser extent, allocation effects. Stock picks in the automobiles and transportation equipment and electric appliances and precision instruments industries were the largest detractors. Security selection and underweight allocations to pharmaceuticals and financials (excluding banks) added value, however.
Within automobiles and transportation equipment, Suzuki Motor (TSE:7269, Financial) was a laggard. The carmaker has underperformed due to the coronavirus pandemic in India (affecting its subsidiary Maruti), as well as chip supply shortages and raw material price inflation—issues that are transitory, in our view. Hino Motors (TSE:7205, Financial), a consolidated subsidiary of Toyota that produces trucks in Japan, alsohurt performance. Issues relating to engine certification have weighed on the shares. (Please refer to the fund’s portfolio of investments for a complete list of holdings and the amount each represents in the portfolio.)
In the electric appliances and precision instruments industry, our large overweight position in Keyence (TSE:6861, Financial), which sells sensors used in factory automation, lagged. Its shares gave back some ground after reaching a record high late last year. However, we believe longer-term performance should remain supported by a recovery in both sales growth and demand. Within the raw materials and chemicals segment, Kansai Paint (TSE:4613, Financial) posted a modest loss in the reporting period. Its margins have come under pressure stemming from rising logistics and raw materials costs. In the information technology (IT) and services industry, SMS (TSE:2175, Financial) also detracted. The leader in nurse and care worker recruiting has suffered amid sluggish hiring activity and reductions in its own hiring of recruiters due to the coronavirus.
In contrast, the top contributor to relative returns in the IT and services industry, and the portfolio overall, was SoftBank Group Corp. (TSE:9984). The telecommunications and internet conglomerate’s Vision Fund benefited from the listing of South Korean e-commerce giant Coupang and other portfolio companies, and the firm is widely expected to report record earnings in May. Within financials (excluding banks), WealthNavi (TSE:7342), one of Japan’s leading roboadvisors and a disruptor in the wealth management industry, was another strong contributor. It is a beneficiary of the equitization of savings.
Kubota (TSE:6326), a producer ofsmall tractors and rice field equipment, rose over the period. The company generated strong growth in China and Thailand, and inventory restocking in the U.S. should help fuel its North American growth in the next two quarters. Exposure to pharmaceutical manufacturer Kyowa Kirin (TSE:4151) also boosted returns. The company has benefited from good sales of Crysvita in Europe. Elsewhere, shares in leading internet advertising agency Cyberagent (TSE:4751) finished the period higher.
Investors grew more optimistic that advertising demand will recover this year, which would benefit both the internet ad agency business and online TV advertising revenue.
How is the fund positioned?
The portfolio’s biggest overweight positions are in the IT and services and machinery industries. The largest underweight exposures are banks and commercial and wholesale trade.
Over the six-month period, we made few changes to the portfolio’s industry allocations after the relatively large adjustment in the second quarter of 2020, when we rotated into high-quality cyclical companies that appeared cheap relative to their earnings expectations and that we believe would improve from depressed levels.
Within the automobiles and transportation equipment industry, we initiated a position in Hino Motors, a subsidiary of Toyota Motor that produces trucks. We believe the company has a number of tailwinds; in our view, earnings will likely recover from a cyclical recovery of truck demand outside of Japan and cost restructuring measures.
We participated in the initial public offering (IPO) of Coconala (TSE:4176). The company operates a skills-matching marketplace where users can contract for services provided by skilled individuals such as designers, copywriters, and programmers. Coconala’s marketplace is growing rapidly, not just because of the pandemic but because more and more Japanese are interested in gig-style work to supplement their income. The digitalization of the service economy is likely to follow the shift to e-commerce for the trading of physical goods.
Although the portfolio has a long-standing underweight position in banks, we continue to find interesting investment opportunities in other areas of financial services. We participated in the widely anticipated IPO of WealthNavi, which we discussed earlier, and we believe the company will benefit from the secular trends of “deposits to investments” and continue to enhance its dominant market position through its franchise strategy with key financial institutions.
Another IPO in which the fund participated was that of Visional (TSE:4194), a human resources technology company with the potential to disrupt the traditional recruiting market in Japan. Its BizReach platform for professionals seeking jobs is likely to enjoy a strong cyclical recovery as Japan moves past the pandemic, and its high profitability and cash generation should power investments in more early-stage projects, notably the HRMOS cloud-based talent management system.
We locked in some profits from Fast Retailing (TSE:9983), the operator of Uniqlo apparel, after it posted strong performance. We still like the name for its growth and potential, especially in China and the U.S., and it is expected to remain a core portfolio holding.
SMS, Japan’s leader in recruitment services and classified media for nurses and workers in the eldercare market, is a quality growth company that has performed well. However, we sold some of our position because the risk/reward trade-off seemed less attractive. However, SMS, a longtime holding, remains a core position given its favorable long-term structural opportunity in an attractive industry.
What is portfolio management’s outlook?
We believe the expected global economic recovery in 2021, together with the vaccine rollout, will provide a cyclical tailwind for Japan, one of the most cyclical and open markets in the world. It is, therefore, likely to benefit from the global recovery.
This cyclical, low-quality rally may prove a headwind for our quality growth bias in the short term, but these rallies are often short and sharp. We continue to believe that our quality growth approach is the best way to generate above-average risk-adjusted returns in Japan over our longer-term investment horizon.
The coronavirus pandemic has expedited the business model transformation and growth outlook of many of the high-quality growth companies in which we invest, particularly in the small-cap space.
Our view remains that structural reform is a positive feature of Japan’s economy, and the pace of change continues to exceed expectations.
RISKS OF INTERNATIONAL INVESTING
Funds that invest overseas generally carry more risk than funds that invest strictly in U.S. assets. Funds investing in a single country or limited geographic region tend to be riskier than more diversified funds. Risks can result from varying stages of economic and political development; differing regulatory environments, trading days, and accounting standards; and higher transaction costs of non-U.S. markets. Non-U.S. investments are also subject to currency risk, or a decline in the value of a foreign currency versus the U.S. dollar, which reduces the dollar value of securities denominated in that currency.
BENCHMARK INFORMATION
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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.
