For the first half of 2022, the Matthews Japan Fund (Trades, Portfolio) returned -29.15% (Investor Class) and -29.10% (Institutional Class), while its benchmark, the MSCI Japan Index, returned -20.10% over the same period. For the quarter ending June 30, 2022, the Fund returned -15.50% (Investor Class) and -15.46% (Institutional Class), while the benchmark returned -14.60%.
Market Environment:
Japanese equity markets for the first half of 2022 were dominated by two of the largest moves in decades. Japan’s currency hit 135 yen to the U.S. dollar toward the end of the second quarter, a level last seen in early 2002, and the biggest move between the currencies since the early nineties. Multiple rate hikes by the U.S. Federal Reserve and the accommodative stance of the Bank of Japan is resulting in a widening of the U.S.-Japan bond yield spread. Ongoing high energy prices are also adding pressure on the yen as Japan’s energy self-sufficiency ratio remains one of the lowest among Organisation for Economic Co-operation and Development (OECD) countries. As a result of the weakening yen, Japanese equity markets traded in-line with global developed market peers in U.S. dollar terms despite outperforming in local currency terms.
Secondly, the velocity of the widening of the spread between the performance of value stocks and growth stocks was the fastest in two decades. In the first quarter the spread was 1,556 basis points (15.56%), and in the second quarter it widened by another 730 basis points (7.30%). While this performance gap between value and growth can be seen across the world, it is especially large in Japan. In the first quarter it was more about rising rates resulting in equity multiple-compression of growth names while the second quarter was dominated by fears that multiple rate hikes to contain inflation will result in the world economy falling into a recession.
Performance Contributors and Detractors:
The first six months of the year were an amplified version of first three months of 2021 as our focus on high-quality growth continued to endure a surge in U.S. 10-year bond yields. From a sector perspective, stock selections in the key areas of information technology and industrials were the largest detractors to the relative performance of the portfolio in the first half. Industrials was notably impacted due to its inclusion of commodity price-sensitive trading companies and cyclical-transport enterprises—businesses that have been challenged by surging fuel costs and supply-chain disruption. On the other hand, our overweight and stock selection in consumer staples was the largest contributor to relative performance in the first six months.
From a market cap point of view, our overweight in small cap stocks—those under $3 billion—was also a detractor to performance in the first half. Our underweight and stock selection in mega cap, and overweight and stock selection in mid-cap stocks were also large detractors.
Turning to individual securities, Shin-Etsu Chemical (TSE:4063, Financial) and Tokyo Electron (TSE:8035, Financial) were among the biggest detractors in the first six months. Shin-Etsu Chemical is a top global provider of electronic materials (Silicon Wafers) and PVC (Polyvinyl Chloride) but its trading multiple has compressed sharply amid signs of a slowdown in U.S. housing starts. Tokyo Electron, the largest semiconductor production equipment provider in Japan, has been impacted over concerns over declining demand in consumer electronics and increasing semiconductor inventory.
On the positive side, pharmaceutical company Daiichi Sankyo (TSE:4568, Financial) was a top contributor, after posting a positive outcome of the DESTINY-Breast04 (DB04) trial for anticancer agent Enhertu, as announced by the American Society of Clinical Oncology (ASCO) in June. P&C insurance company Tokio Marine Holdings (TSE:8766, Financial) was also a top contributor in the period. March 2022 full-year results and March 2023 guidance delivered on our investment thesis. We view the stock as offering a mid-teens dividend compound annual growth rate (CAGR) coupled with earnings-per-share (EPS) growth driven by both earnings and buybacks.
Notable Portfolio Changes:
One significant adjustment within our portfolio is the increase in defensive sectors such as consumer staples. While we still see economic growth recovery as the world reopens from the pandemic, ongoing uncertainty over the war in Ukraine, coupled with inflation risks and a rising interest-rate environment, warrant a more balanced approach towards growth in our view. We have also taken down our portfolio weighting in cyclical growth areas as the Global Manufacturing PMI is starting to peak out and rate hikes to manage inflation pose risks for a recession.
In the second quarter, we re-initiated a position in Tokio Marine Holdings. We have always viewed the company as a prudent capital allocator, with its lucrative domestic P&C business among the three top players that control 90% of the car insurance market. The company is also expanding its footprint to overseas specialty M&A insurance.
We initiated a position in Mazda Motor (TSE:7261, Financial) as our research suggests that 2022 is a key launch year for firm’s new generation products and the company is at a turning point in profitability.
We also added Toho (TSE:9602, Financial), a producer and distributor of motion pictures in Japan, as we remain optimistic about earnings recovery of its movie theater division and in the longer term, we highly rate Toho’s untapped potential in monetizing its key IP assets.
In order to make positions for new names we exited AGC (TSE:5201, Financial), Kadokawa (TSE;9468), Koito Manufacturing (TSE:7276, Financial), Morinaga Milk Industry (TSE:2264), NTT Data (TSE:9613), Persol Holdings (TSE;2181), Raksul (TSE:4384) and Sumitomo Bakelite (TSE:4203).
Outlook:
The first half of 2022 turned out to be a much worse external environment for high-quality growth strategies even compared to first three months of 2021. The velocity of the widening of growth-value spreads has made it challenging to adapt our strategy quickly. While extremely loose monetary policy from all major central banks has come to an end and the Federal Reserve has officially started to tighten, the long-value/short-growth trade has now fully unwound back to pre-pandemic levels and some growth names valuations are well below pre-pandemic levels. That said, full-year earnings results in May showed Japanese growth stocks continued to improve their margins and strengthen cashflow generation abilities.
So while we are taking a more balanced approach towards stages of growth and valuation levels we believe the earnings capability of Japanese companies has improved meaningfully over the past economic cycle. This has been helped by productivity improvements, better corporate governance, innovation and a higher focus on capital efficiency.
Japan has yet to open up its borders like other developed countries have as they emerged from the pandemic but once it does that will provide a tailwind for the economy. As the Federal Reserve continues to tighten and tries to engineer a soft landing for the world’s biggest economy there will be challenging times ahead. But we believe Japan’s own loose domestic monetary environment, together with the strong fundamentals and profitability of its corporates, will provide healthy investment opportunities.
View the Fund’s Top 10 holdings as of June 30, 2022. Current and future holdings are subject to change and risk.
Average Annual Total Returns - MJFOX as of 06/30/2022
| 1YR | 3YR | 5YR | 10YR | SINCE INCEPTION | INCEPTION DATE |
|---|---|---|---|---|---|
| -26.32% | -0.01% | 1.07% | 7.22% | 5.08% | 12/31/1998 |
All performance quoted is past performance and is no guarantee of future results. Investment return and principal value will fluctuate with changing market conditions so that shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the return figures quoted. Returns would have been lower if certain of the Fund's fees and expenses had not been waived. Please see the Fund's most recent month-end performance.
