The views and opinions in this report were current as of October 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 fore - cast of the fund's future investment intent. The report is certified under the Sarbanes-Oxley Act, which requires mutual funds and other public companies to affirm that, to the best of their knowledge, the information in their financial reports is fairly and accurately stated in all material respects.
Fellow Shareholders Japanese stocks recorded very strong gains in our fiscal year ended October 31, 2013. The government's economic reform program, otherwise known as "Abenomics," helped jump-start the Japanese economy early in 2013 by bringing to an end the pattern of falling prices and by boosting the competitiveness of Japanese goods in world markets. Stocks were volatile in the latter half of our reporting period, however, as investors worried if the government would be able to carry out difficult structural reforms. We are happy to report that your fund recorded a very strong gain in this environment and outperformed its peer group average. We also remain bullish about the future, although we wish to remind investors to focus on the long term and to remain aware of the risks that lie ahead.
The Japan Fund recorded a gain of 34.23% in its fiscal year ended October 31, 2013, with the large majority of the return coming in the first half of its fiscal year. As shown in the Performance Comparison table, the fund outperformed its benchmarks.
Market and Economic Environment
Prime Minister Shinzo Abe's bold economic experiment dubbed Abenomics—and its "three arrows" of aggressive monetary easing, temporary fiscal stimulus, and structural reform—has been aimed at ending Japan's 20 years of deflation, or cycle of declining wages and prices. As evidenced by the currency and Japanese equity markets, the reaction to Abenomics has been dramatic. Since the Lower House election just over one year ago, which set the stage for Abe's victory in national elections in December, the TOPIX Index has risen 68.49% in local currency terms (from the low of November 14, 2012, to October 31, 2013). The returns in U.S. dollar terms have been muted by the weakness of the yen but remain impressive relative to other markets in Asia and elsewhere over the period. Over the last six months, however, the gains have been more modest, reflecting a period of consolidation for the yen but also a perceived lack of progress on the "third arrow" of structural reform.
Although not part of the official lexicon, Abenomics also includes a "fourth arrow" of fiscal consolidation, which is designed to address Japan's alarming levels of government debt. The government has added an additional 5 trillion yen of fiscal stimulus in order to offset the increase in the consumption tax from 5% to 8%, which will take effect in April 2014. Consumers and businesses are acting rationally by buying ahead of the tax increase, but as spending is brought forward, growth may accelerate deceptively in the next two quarters before falling into negative territory for the first half of fiscal 2014. Thus, a major test for Abenomics will be the rate of growth one year from now as the economy recovers from the slump following the tax increase. The economy's success will partly depend on the degree to which companies are able and willing to increase base wages, which have been falling in nominal terms for the last seven years. With deflation now over, higher taxes and increased costs for imported food and energy mean that consumers are seeing a decline in real living standards for the first time in over a decade. However, Japanese corporations are reluctant to raise what they consider to be fixed costs given the lifetime employment arrangements of many employees. Instead, they are attempting to accommodate employees through overtime payments and bonuses, and by hiring temporary workers on contract.
A further test will be the degree of resolve that the prime minister is able to muster over structural reform. Mr. Abe's Liberal Democratic Party (LDP) regained control of the Upper House in July and now faces no parliamentary opposition of any significance to his legislative program. The LDP is far from united on many of Abe's policy proposals, however, and the bureaucracy is unlikely to give
up on or allow radical changes to important areas of regulatory control and oversight. As a result, structural reforms have seen mixed success. Progress is being made in agricultural reform, which will support Japan's role in the Trans-Pacific Partnership, a free-trade area encompassing 10 other nations, including the U.S. On the other hand, negotiations with the Ministry of Health, Labor, and Welfare over the online sale of nonprescription drugs, which resulted in 23 drugs being banned from online transactions despite a Supreme Court ruling to the contrary, illustrate the obduracy of the bureaucracy and the historically limited role that Japanese politicians have had in setting policy.
Long-term investors in Japan have seen many false dawns since the market peak in 1989 and are justifiably cautious about an asset class that has consistently not only underperformed but has also lost money. This time promises to be different, however, as the policy measures are unprecedented. By the end of next year, the Bank of Japan's balance sheet could reach 60% of gross domestic product (GDP), approximately three times the current comparable level at the U.S. Federal Reserve. This should ensure a period of significant weakness for the yen, providing a tailwind for corporate profits and stock prices for at least the next year—although it could also have a powerful deflationary impact on the rest of the world.
In U.S. dollar terms, the 33.59% return of Japan's TOPIX Index over our fiscal year surpassed that of almost all other major markets and was substantially better than that of the overall international equity index. Telecommunication services, financials, consumer discretionary, and utilities were among the better-performing sectors, while consumer staples stocks lagged and energy shares recorded a modest loss.
Pportfolio Review and Strategy
Our strategy focuses on high-quality companies with capable managements and strong long-term growth potential. During the period, we maintained our thematic investment approach while making sure that the portfolio remained broadly diversified across sectors—with a few exceptions, such as utilities, where we have no exposure. We seek companies with superior cash flows that are either reinvested at similar or higher rates of return or distributed to shareholders in the form of dividends or stock buybacks. We have tended to avoid not only overly indebted firms and those with large unfunded pension liabilities, but also companies that have accumulated excessive amounts of cash on their balance sheets, unconcerned about the negative effect on return on equity.
It is significant that the Nikkei newspaper and the Japan Exchange Group, which operates the Tokyo Stock Exchange, have jointly announced a new stock index, the Nikkei 400, which includes return on equity as a criterion for inclusion. If, as is expected, the Government Pension Fund adopts this index as its benchmark, we believe that more attention will be paid to shareholder returns. This should not only benefit our strategy but also help attract more longer- term investors and perhaps even assets from the very large allocation to passive indexation among domestic corporate pension funds. We have maintained a balance in the portfolio between companies that are more dependent on overseas demand—and therefore a weaker yen—and the more domestically oriented sectors, which should bene - fit from the Bank of Japan's efforts to end deflation. Among the former, we are overweight relative to the benchmark in autos, where Japan retains a competitive advantage globally, but underweight in consumer electronics, chemicals, and machinery, where competition is stronger. Within domestic sectors, we are overweight real estate, retail, telecommunications, and services. Apart from utilities, our largest domestic industry underweights are in banks and transportation.
We will continue to keep between one-quarter and one-third of the portfolio in smaller Japanese companies, as we find more opportunities for growth in this area than in larger, more export-focused businesses. We believe that investing in quality growth stocks at reasonable prices is the right strategy for investing in Japan. Although the substantial undervaluation of Japanese equities is now behind us, we believe there are plenty of opportunities for stock picking. As is often the case in the first part of a market recovery, larger-capitalization stocks outperformed smaller-caps, and value-oriented shares led their growth counterparts, both of which weighed on your fund's relative performance in the period. Our favorable stock selection more than compensated, however, allowing us to outperform our peer group.
Our approach has led us to emphasize the following sectors and industries:
Health care. Japan's aging society is a demographic tailwind for many areas of health care and medical services. We have invested in a wide range of companies, including generic pharmaceutical providers such as Sawai Pharmaceutical, medical staff provider SMS, clinical testing company Miraca Holdings, and dental tool manufacturer Nakanishi. (Please refer to the portfolio of investments for a detailed list of holdings and the amount each represents in the portfolio.)
Niche consumer stocks. We have added a number of unique companies that give the portfolio exposure to domestic consumer growth opportunities. These include Start Today, an online fashion retailer; FamilyMart, a convenience store chain; Pola Orbis Holdings, Japan's fourth-largest cosmetic company; and eyewear retailer Jin.
Internet. We believe the Internet offers Japanese companies many opportunities for cost savings as broadband and mobile data services become more common. We own Japan's leading Internet portal, Yahoo! Japan, as well as Internet advertising specialist CyberAgent. In addition, through our holding in SoftBank, we have indirect investments in a number of Chinese Internet firms that are not traded publicly.
Industrial electronics. As both developed and emerging countries invest more in public infrastructure—including power plants, rail, and communications networks—Japanese expertise in this area is becoming highly valued. The fund has holdings in Mitsubishi Electric and Hitachi. Among the leading contributors to results during the period were Honda Motor and Toyota Motor, real estate management and development firms Mitsui Fudosan and Tokyo Tatemono, diversified financial services provider ORIX, and SoftBank. Major detractors included Ain Pharmaciez and Endo Lighting, both of which we eliminated from the portfolio, and industrial conglomerate Toshiba.
Following a 68.49% rally in the TOPIX, an end to deflation, a recovery in the property market, and a growing wealth effect, rising expectations are attracting overseas investor flows into the Japanese equity market. Should domestic asset prices continue to rise, we believe this early trend will gather momentum and support many of the tenets of the bull case for further Japanese equity strength: improved earnings, improved sentiment, rising wages, wealth, and spending.
All three of Mr. Abe's arrows must find their mark for Japan to become a durable, multiyear investment story. Investing in Japan continues to involve unique economic, corporate, and political factors—issues requiring a degree of comfort and, more importantly, a deep understanding from investors who have largely ignored this market in recent years. The magnitude of any future returns will depend not only on policy efficacy, but also on external growth factors, especially in Europe and the U.S. While the recent rally in Japan is justified by what were excessively cheap valuations and subsequent earnings revisions, progress in addressing the economy's structural challenges is necessary before investors are likely to commit for the long term.
Better prospects for Japanese firms have clearly been reflected in the market, moving valuations away from extremes, particularly for exporters. While the market remains relatively inexpensive, extreme undervaluation is no longer the main argument for investing in Japanese stocks. Instead, the question is now the sustainability and momentum of structural reform to move Japan forward. The Abe-led LDP has successfully broken the recent tradition of policy inertia and has jump-started markets with the magnitude of its monetary stimulus and its broader intentions. The early signs are promising. Profits are growing rapidly due to yen weakness, while GDP estimates see growth of 2% to 3% during the next few quarters. Temporarily, at least, Japan has the characteristics of a growth market.
We should remind shareholders that failure or disappointment at any stage will likely result in reversals in the weakening trend in the yen and in the rising pattern of Japanese stocks. Risks are meaningful and include the potential for an inflation cycle with no wage growth, as well as rising bond yields to compensate investors for inflation expectations, which would affect the government's funding costs. Corporate inertia with respect to governance changes could also set in if profits begin to rise.
Yet these words of caution should not cloak our bullishness. As we noted in our last letter, our expectations for meaningful change in Japan are higher than at any stage in the past decade, and if policy proves effective, we believe that Japanese stocks have material upside potential in the coming years. Valuations for Japanese equities remain attractive; the earnings potential of Japan is increasing; and, as improvement continues, we believe that investors will, once again, return to Japan in proportion to its weight in the global economy. Such a trend could provide further upside to rival previous market rallies. We would repeat our observation that profound changes are at work in Japan—and real change often brings real opportunity.
M. Campbell Gunn
Portfolio manager and chairman of the fund's Investment Advisory Committee
November 18, 2013
The committee chairman has day-to-day responsibility for managing the portfolio and works with committee members in developing and executing the fund's investment program