For the third quarter ending September 30, 2022, the Matthews Japan Fund (Trades, Portfolio) returned -8.05% (Investor Class) and -8.09% (Institutional Class), while its benchmark, the MSCI Japan Index returned -7.52%.
Market Environment:
Japan equity markets year to date offer an extremely different picture depending on which currencies investments are based on. The yen hit 135 to the U.S. dollar toward the end of the second quarter in June, a level last seen in early 2002. This past quarter has seen further weakness. After Federal Reserve Chair Jerome Powell’s hawkish speech on monetary policy and price stability in late August, the yen slid to 145 to the dollar, the weakest since 1998.
Multiple rate hikes by the Fed in tandem with the accommodative stance of the Bank of Japan has resulted in the widening of the U.S.-Japan bond-yield spread. Additional pressure on the yen has come from ongoing high energy prices. Japan's energy self-sufficiency ratio ranks among the lowest of Organisation for Economic Co-operation and Development (OECD) countries and the country’s current electricity generation is heavily dependent on U.S.-dollar denominated imports of natural resources. In simple terms, the yen’s slide has meant that in local currency terms, Japan equities have outperformed peers while in U.S dollar terms they are trading in line.
The other trend to have impacted the Japanese equity markets has been the continued significant spread between the performance of value stocks and growth stocks. While the spread narrowed somewhat in the third quarter, the year-to-date performance gap stands at 1,960 basis points (19.6%), one of the largest in the world.
Performance Contributors and Detractors:
From a market capitalization perspective, the biggest detractor to relative performance in the third quarter was the Fund’s stock selection in mid-cap stocks. The biggest contributor was the Fund’s underweight and stock selection in mega cap, which like large caps tend to be in the export sector and have exposure to global manufacturing cycles which are currently experiencing a slowdown. From a sector perspective, allocations in the cyclical areas of industrials and materials were among the largest detractors. Our stock selections in consumer discretionary were also a drag on the portfolio. On the other hand, our overweight and stock selection in consumer staples and health care were the largest contributors to relative performance.
Turning to individual securities, entertainment conglomerate Sony Group (TSE:6758, Financial) was the largest detractor. While its first quarter earnings reported in August surpassed consensus estimates, its mainstay PlayStation game business was weak and led to a downward revision of fiscal-year guidance for the segment. While we remain constructive on Sony we believe challenges in the gaming business will make it difficult for the share price to perform in the near term. JSR (TSE:4185, Financial), an electronic material manufacturer, was also a big detractor. It announced a downward revision to its earnings guidance as a result of slower than expected ramp-up of its highly anticipated health care business, as well as a weaker topline in display materials. Our conversation with management suggests issues in the health care businesses are transitory and display business revenue may bottom out next quarter. JSR still trades below its intrinsic value and we believe that a re-rating could accelerate as JSR’s health-care profit contribution increases in the later part of this fiscal year.
Conversely, seasoning producer and biopharmaceutical services company Ajinomoto (TSE:2802, Financial) was the largest contributor during the quarter. The company reported robust results in the June quarter, driven by price increases which negated the impact of higher raw material costs. We believe Ajinomoto is in the middle of a turnaround story, moving away from commodity businesses and allocating incremental capital into higher return segments, such as pharmaceutical services and electronic materials. Pharma company Daiichi Sankyo (TSE:4568, Financial) continued to be a top contributor after achieving a positive outcome in the DESTINY-Breast04 (DB04) trial for anticancer agent Enhertu that was announced in June. A favorable court ruling in a dispute with a competitor in August was also major positive news.
Notable Portfolio Changes:
During the quarter we continued to balance our portfolio to brace for the ongoing slowdown in the global economy. We increased exposure to defensive sectors such as consumer staples while taking down our portfolio weighting in cyclical growth areas. The bright spot is in the domestic sector where the Japanese government has finally started to move toward reopening of the economy. In this context, we re-initiated a position in Kyoritsu Maintenance (TSE:9616, Financial). The company's hotel operation adapted during COVID and improved its revenue per available room (RevPar) metric without relying heavily on a recovery in inbound tourist demand. Going forward, we believe the company has a potential to achieve higher earnings level than pre-COVID levels.
We also initiated a position in JGC (TSE:1963, Financial), a plant engineering company. We view its order outlook as remaining strong over the medium term given that the changes in natural gas procurement in Europe and other parts of the world will support plant demand for the company. Liquefied Natural Gas (LNG) has been an area starved of capital for a while which has resulted in the current market tightness. It has become more relevant as a transition fuel and we believe JGC is in a good position to capture this opportunity. In order to make positions for new names we exited CyberAgent (TSE:4751, Financial), Dai-ichi Life (TSE:8750, Financial), Food & Life Companies (TSE:3563, Financial), TDK (TSE:6762, Financial) and Toyota Industries (TSE:6201, Financial).
Outlook:
Extremely loose monetary policy from all major central banks has clearly reversed and the Fed is ever more hawkish to contain inflation. As we are still witnessing something of a mean reversion of growth underperformance in Japan and are taking a more balanced approach towards multiple stages of growth and valuation levels, we believe the earnings capability of Japanese companies has improved meaningfully over the past economic cycle. In addition, after more than two and a half years of various levels of border closures due to COVID, Japan will fully reopen for individual travel in October and in our view this will position the domestic economy for a boost.
For the past decade, Japan equities as an asset class has been one of the best performing international markets in U.S. dollar terms, despite lack of GDP growth, equity multiple expansion, and constant depreciation of the currency. With the yen at a 24-year low to the dollar, the earnings capabilities of Japanese companies in good shape and the country once again open for tourism, we believe a unique window has opened for investors looking to add long-term exposure to the market.
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.
