For the first half of 2023, the Matthews Japan Fund (Trades, Portfolio) returned 13.42% (Investor Class) and 13.46% (Institutional Class), while its benchmark, the MSCI Japan Index, returned 13.24% over the same period. For the quarter ending June 30, 2023, the Fund returned 4.90% (Investor Class) and 4.89% (Institutional Class), while the benchmark returned 6.45%.
Market Environment:
Japan equity markets posted double digit returns for the first half of 2023, along with other developed markets, outpacing emerging markets. Japanese stocks continued their march higher during the second quarter as government policy and activist pressure pushed undervalued companies to increase their payout and buy-back ratios. Hopes for China reopening waned quickly but the U.S. Federal Reserve’s pace of rate hike slowing down amid inflation rates starting to peak out spurred a general risk-on environment. The Japanese yen traded in a range bound for the first three months of the year but in second quarter, as U.S. 10-year bond yield rose towards 4%, and the Japanese yen weakened towards 145 yen.
Japan enjoys several tailwinds for the first time in years including a positive earnings cycle driven by moderate inflation, meaningful wage gains and policy driven reforms which are pushing companies to increase their corporate value via capital efficiencies and shareholder payouts. In addition, the recovery in inbound tourism plus the fact that Japan lacks the geopolitical headwinds of China is creating positive foreign inflows into Japan.
Performance Contributors and Detractors:
In the first half, strong stock selections were able to overcome the detraction from allocation effect versus the benchmark index. From a sector perspective, our stock selection in information technology and consumer staples were the two largest contributors to relative performance year to date. On the other hand, the portfolio’s underweight and stock selection in industrials was the biggest detractor.
At the holdings level, semiconductor company Renesas Electronics (TSE:6723, Financial), was the largest contributor to investment results. Shares reacted positively after earnings results in February, with progress being made in inventory adjustments showed the company’s solid execution during downturns. We continue to see Renesas constructively as its valuation level still remains compelling even after the strong performance year to date, and potential for the company to improve shareholder returns. Electronic materials and chemical product company Shin-Etsu Chemical (TSE:4063, Financial) was another top contributor. The company continued to impress the market with solid execution capability during economic downturns and inventory adjustment period in both semiconductor wafers and polyvinyl chllloride (PVC) demand. Over the long term, we remain bullish on the semiconductor market as well as the wafer market where Shin-Etsu is a solid global leader with pricing power.
On the other hand, debt guarantor eGuarantee (TSE:8771, Financial) was the largest detractor year to date. The company’s shares weakened as small-cap growth companies faced unfavorable style movements in markets, but eGuarantee is poised to benefit from rise in bankruptcies as COVID-related relief funds have started to expire. eGuarantee is in the business of guaranteeing various types of credit that arise between companies doing business with each other. The credit guarantee business is a niche market, but it is a growing market in which eGuarantee is the leader. Furniture retailer Nitori (TSE:9843, Financial) was also a major detractor to investment results. The company has high exposure to currency rates, as they manufacture furnitures overseas while the majority of their retail operations are in Japan. Yen weakness resumed especially in the second quarter, which pushed down the company’s own efforts to raise price and introduce new products that can adapt to current currency environment.
Notable Portfolio Changes:
During the second quarter, we initiated a position in credit card company Credit Saison (TSE:8253, Financial). The company, in our view, could offer double digit profit growth coupled with increased shareholder return potential. While total card membership number are not growing, revolving loan total has turned positive year over year (YoY) post COVID and cashing loan has started to bottom out. Credit Saison’s India subsidiary (Kisetsu Saison Finance India) is growing above expectations, and starting to contribute to earnings.
We have also re-initiated Toyota Motor (TSE:7203, Financial) after a year of hiatus. The stock has underperformed the overall market over the past year due to production constraints stemming from semiconductor shortage, but the shortage has been largely resolved while the company has been quietly increasing its market share in Europe and Chinese markets with its hybrid vehicles.
To fund these positions, we exited Daikin Industries (TSE:6367, Financial), IHI (TSE:7013, Financial), Lasertec (TSE:6920, Financial), Mitsubishi UFJ Financial Group (TSE:8306, Financial), Nippon Telegraph & Telephone (TSE:9342), and SMS Company (TSE:2175, Financial).
Outlook:
While the market seems ready for the Fed to pivot its interest-rate policy and for inflation to peak out, we believe the Fed is hesitant to prematurely remove its hawkish policies to contain inflation. With this backdrop, we don’t see a sudden reversal of growth underperformance in Japan anytime soon, although we also think that we have seen the worst in terms of style shift. We continue to prefer taking a more balanced approach towards multiple stages of growth and valuation levels. For the year of 2023, companies’ earnings growth and cash flow-generation ability will be ever more important as financial estimates for Japanese corporates have started to be revised down.
Over the long term, we continue to believe the earnings capability of Japanese companies has improved meaningfully over the past economic cycle. Last year, the Japanese equity market outperformed both developed markets (MSCI World) and emerging markets (MSCI Emerging Market) in U.S. dollar terms. With the yen at a near quarter-century-low to the dollar, Japanese companies are in good health and, importantly, the country is firmly open for tourism. We continue to believe this is the time for investors to add a 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.
