For the year ending December 31, 2013, the Matthews Japan Fund (Trades, Portfolio) returned 34.03% while its benchmark, the MSCI Japan Index, returned 27.35%. For the fourth quarter of the year, the Fund returned 0.28% versus 2.31% for the Index.
2013 was a positive year for Japan investors with the MSCI Japan Index gaining 54.80% in local currency terms, marking its highest annual return since 1986. The Index ended the year at its highs, regaining levels not seen since June 2008. The primary driver of the rally was “Abenomics,” the economic policies advocated by Prime Minister Shinzo Abe, supported by the Bank of Japan’s accommodative monetary policies and a weakening of the yen, which declined -17.6%.
While Abenomics has no shortage of critics, there are emerging signs that Japan is moving toward its ultimate goal of battling deflation, at least for the time being. Its consumer price index, excluding food and energy, advanced 0.6% year-on-year in November, showing the biggest rise in prices since 1998. As the effects of currency hedging by import companies wear off, we expect prices to increase further over the next several quarters. Meanwhile, job creation has been robust while the unemployment rate remains low and has contributed to an increase in total wages paid. However, growth in average wages per worker remains negative, and given the consumption tax hike in April, wages will eventually need to rise in order to maintain an inflationary environment.
The Fund has not employed an active hedging strategy. In hindsight, we underestimated the sheer impact of the yen’s devaluation from a rate of sub-80 yen to the U.S. dollar to 105 yen at the end of 2013. However, given the yen’s current levels, we believe the incremental return on a currency hedge is not attractive enough to account for the additional volatility and risk. Though we do expect the yen to continue weakening over the course of the year, we believe the pace should be more gradual and the impact on U.S. dollar returns should be smaller going forward. We believe there is sufficient room to add value through good stock selection and portfolio construction in order to counter the dilutive effects of a weaker currency.
In our investment process we aim to identify Japanese companies with the ability to grow their businesses through various economic cycles. Stock selection is the primary avenue through which we seek to add value. Attribution analysis shows that overall stock selection accounted for all of the outperformance for the year while sector allocation had a slight negative effect.
By sector, our holdings in financials made the largest absolute contribution to returns for the year. ORIX (IX), Japan’s largest non-bank financial company, appreciated substantially as valuations re-rated on the back of strong business performance. ORIX was among the Fund’s top holdings for both the year and the fourth quarter. In addition, real estate leasing company Hulic also performed well for the year, reflecting improving sentiment toward real estate in Tokyo. Our bank holdings, such as Mitsubishi UFJ Financial Group and Sumitomo Mitsui Financial Group, also contributed positively to returns. We continue to favor the financials sector, and more specifically the banks, given the potential to capitalize on overseas growth opportunities while valuation levels remain attractive.
SoftBank (TSE:9984), a telecommunications Internet conglomerate, was the top contributor to performance for the year. Led by its founder Masayoshi Son, the company made headlines with its acquisition of U.S. telecom carrier Sprint. We believe SoftBank has the potential to transform Sprint into a viable competitor against AT&T and Verizon Wireless over the long term. SoftBank also benefited from the rapid growth of Chinese e-commerce company Alibaba Group in which SoftBank holds roughly a 37% stake. We believe the value of this investment could rise even further as Alibaba secures its position as the dominant leader in China’s e-commerce industry.
Amongst our small-cap holdings, medical equipment company Asahi Intecc (TSE:7747) was another top contributor to returns. The firm reorganized its distribution channels in Japan and Europe, which has resulted in increased market share and revenue growth. They recently launched several new products in adjacent categories and we expect sales from these new products to contribute to growth over the next few years.
On the other hand, our holdings in the materials sector performed poorly during the year. Electronic material and components manufacturer Nitto Denko (TSE:6988) missed consensus earnings estimates due to weaker than expected orders for their specialty films used in displays such as TVs and smartphones. Specialty chemical company Shin-Etsu Chemical (TSE:4063) also underperformed due to oversupply in silicon wafers and lower prices for its mainstay PVC business. However, we deem these issues to be cyclical in nature and continue to hold our positions.
Our position in data center operator Bit-isle (JAS:3811) had the largest negative effect on performance over the year. Bit-isle’s business has been indirectly affected by a struggling mobile game company that had been one of their main customers. Although it will take some time to make up for this revenue elsewhere, demand for data center capacity itself continues to grow thanks to the increase in Internet data traffic. We believe the stock has been punished excessively and valuations now look quite attractive compared to other Internet-related businesses. Hence, we have been slowly adding to our position.
We are encouraged by the ongoing fundamental improvements in the Japanese economy. The outlook for corporate earnings is strong and domestic loan growth has been accelerating. Additionally, higher U.S. interest rates prompted by the U.S. Federal Reserve’s tapering of bond purchases is likely to further weaken the yen. Although we believe Japan’s consumption tax hike planned for April should pose significant challenges for growth over the following several quarters, we expect the Bank of Japan to implement further quantitative easing should the economy falter. In such an environment, we believe select Japanese companies could potentially experience more growth in both global and domestic markets. Finding such individual opportunities remains core to our strategy.
The views and opinions in this commentary were current as of December 31, 2013. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the Fund’s future investment intent.
Statements of fact are from sources considered reliable, but neither the Funds nor the Investment Advisor makes any representation or guarantee as to their completeness or accuracy.
As of 12/31/2013, the securities mentioned comprised the Matthews Japan Fund (Trades, Portfolio) in the following percentages: Current and future portfolio holdings are subject to risk. ORIX Corp., 4.1%, Hulic Co., Ltd., 1.1%, Mitsubishi UFJ Financial Group, Inc., 3.6%, Sumitomo Mitsui Financial Group, Inc., 2.4%, Nitto Denko Corp., 1.2%, Shin-Etsu Chemical Co., Ltd., 1.2%, SoftBank Corp., 3.6%, Asahi Intecc Co., Ltd., 1.8%, and Bit-isle, Inc., 1.3%. The Fund held no positions in AT&T Inc., Sprint Nextel, Inc. or Verizon Communications, Inc. Current and future portfolio holdings are subject to risk.
Performance and distribution figures discussed in any of the Manager Commentaries reflect that of the Investor Class Shares.