Dear Shareholder
Global markets recovered from a tumultuous start to deliver solid results for your fund’s fiscal year, the 12-month period ended October 31, 2019. The U.S. Federal Reserve switched course and joined other dovish central banks around the world to support markets following a sharp sell-off in December. This action, combined with better-than-feared corporate earnings, helped propel many equity indices during the year to double-digit gains. The S&P 500 Index reached an all-time high, and Europe’s Stoxx 600 Index was trading near a record close at the end of the period. Growth stocks in the U.S. were the strongest performers, but nearly all developed markets and most emerging markets also delivered strong gains.
The U.S. dollar finished with mixed results versus other currencies during the 12-month reporting period. A relatively strong greenback versus the euro weighed on returns for U.S. investors in European securities, for example, while a stronger yen boosted the returns of Japanese stocks in U.S. dollar terms.
During the period, investors faced worries about the U.S.-China trade dispute, Brexit, and a slowdown in global manufacturing. However, stocks were resilient, and the worst-case geopolitical scenarios failed to play out. Trade rhetoric has become more conciliatory and negotiators have made modest progress; the UK received another Brexit extension until January 31 to work out the terms of its departure from the European Union; and our economists believe that some manufacturing indicators, while still weak, appear poised for a recovery.
The actions by the Federal Reserve and other central banks to stimulate economic growth played a key role in sustaining market sentiment during the period. As evidence of slowing global growth began to mount, the Fed signaled early in the year that it would take steps to sustain the economic expansion, and central bank policymakers followed through with quarter-percentage-point rate cuts in July, September, and October and took steps to maintain liquidity in short-term lending markets.
The European Central Bank (ECB) also acted to address flagging growth. The ECB lowered its benchmark deposit rate deeper into negative territory and announced that it plans to buy €20 billion of bonds per month starting in November 2019 as it restarts its quantitative easing program.
Falling yields fueled a strong rally in the bond market and also aided equity results as companies benefited from lower borrowing costs and investors sought higher returns. Dividend-paying stocks in sectors such as real estate outperformed as investors searched for higher-income opportunities.
The yield on the 30-year Treasury bond hit a record low in August, falling below the 2% mark for the first time, and the benchmark 10-year Treasury note’s yield dipped to its lowest level since 2016. Despite being at or near record lows, Treasuries offered higher yields than bonds in many foreign markets, especially in Europe and Japan, where government bond yields were often in negative territory. (Bond prices and yields move in opposite directions.)
Looking ahead to 2020, we remain optimistic that the U.S. will avoid a recession in the new year, but we believe that further progress in U.S.-China trade talks will be a key factor in sustaining positive market sentiment. A reduction in trade barriers could help corporate earnings rebound and provide a lift to the manufacturing sector.
In the months ahead, our team of portfolio managers, analysts, and economists will be following the trade talks and the U.S. presidential elections, along with other developments that could affect market performance. Our teams in London and Hong Kong have provided us with important insights into Brexit and the protests in the Chinese territory over the past 12 months. We expect twists and turns along the way with each of these events, but we believe our approach to fundamental research around the globe will continue to add value in the year ahead.
Thank you for your continued confidence in T. Rowe Price.
Sincerely,
Robert Sharps
Group Chief Investment Officer
Management’s Discussion of Fund Performance
INVESTMENT OBJECTIVE
The fund seeks long-term growth of capital through investments in common stocks of companies located (or with primary operations) in Japan.
FUND COMMENTARY
How did the fund perform in the past 12 months?
The Japan Fund returned 10.97% in the 12-month period ended October 31, 2019. As shown in the Performance Comparison table, the fund outperformed its benchmark, the TOPIX Index Net, and the Lipper Japanese Funds Average. (Returns for I Class shares varied slightly, reflecting a different fee structure. Past performance cannot guarantee future results.)
Effective June 1, 2019, the TOPIX Index Net replaced the TOPIX Index as the fund’s primary benchmark. The new index assumes the reinvestment of dividends after the deduction of withholding taxes applicable to the country where the dividend is paid; as such, the returns of the new benchmark are more representative of the returns experienced by investors in foreign issuers.
What factors influenced the fund’s performance?
The biggest contributor to relative returns was the avoidance of the banking sector, while stock selection and overweight holdings in the machinery sector also boosted performance. In contrast, stock selection in the automobiles and transportation equipment and foods sectors held back relative returns.
The fund’s longstanding avoidance of banks was once again a source of relative strength. Banks face the headwind of low interest rates, and rife competition is squeezing margins. Furthermore, with continued negative interest rates on excess holdings, we believe that the outlook for banking will remain challenging for the foreseeable future.
The machinery sector was an area of strength. We believe our holdings in this sector constitute world-class companies that are exposed to robust industry growth trends, especially those holdings levered to innovative technology and factory automation. Top contributors to relative returns included an overweight position in Miura (TSE:6005, Financial). The manufacturer of boilers and ballasts has a strong domestic presence and cash flow generation, while it also benefits from vast growth potential in China. An overweight holding in Daikin Industries (TSE:6367, Financial) also added to relative performance. The air conditioner producer for both commercial and residential use was boosted by the growing penetration of its products across Asia and rising demand for higher-quality air conditioners globally. (Please refer to the fund’s portfolio of investments for a complete list of holdings and the amount each represents in the portfolio.)
Conversely, stock selection in the automobiles and transportation equipment sector was weak. Suzuki Motor (TSE:7269, Financial) underperformed as returns from its India business disappointed given a sluggish economic growth backdrop and subdued consumer demand. Performance has been strong over the long term, however, and our investment thesis remains intact.
The foods sector was an area of further weakness, with our holding in Coca-Cola Bottlers Japan (TSE:2579, Financial)as the biggest detractor. The beverage producer and bottler has come through a difficult period following the flooding of its Hongo plant in 2018. The subsequent supply chain disruptions led to a series of restructuring initiatives and management changes, all set against a backdrop of subdued market share. An overweight position in food company Ezaki Glico (TSE:2206, Financial) also detracted as weather effects and the impact on volumes of a price hike in China held back returns. While we have maintained both of these positions given their longer-term prospects, we did eliminate Japan Tobacco (TSE:2914), which has continued to underperform on market share losses amid the challenges of shifting away from nontraditional tobacco products.
How is the fund positioned?
The IT and services segment remained the fund’s largest allocation in both absolute and relative terms. We have a significant overweight in machinery, where Japan has many leading companies that are expanding globally.
Banks remains our largest underweight by a significant margin with no holdings in the sector. Intense competition means that there is an almost unlimited supply of loans at very low rates. Demand is improving for these loans, but margins remain very low given the backdrop of negative Japanese government bond yields.
We prefer investments where we see the potential for margin improvement, robust earnings growth, and an attractive dividend yield. In addition, we are also investing in companies that we believe stand to benefit from structural changes in Japan’s economy, such as the shift to digital payments, changing consumer preferences, the aging population, and the tightening labor market. The majority of the changes to the portfolio continued to be the result of stock-specific investment themes rather than a reflection of a shift in our industry views.
We added a position in Kyowa Kirin (TSE:4151). The pharmaceuticals and biochemicals company is a transformational product story, driven by the regulatory approval of three antibodies. We believe that market participants are underestimating the growth that will be derived from the company’s innovation, providing us with a compelling entry point.
We established a position in Hamamatsu Photonics (TSE:6965), a global leader in products that work with emitting or detecting particles of light. We believe that earnings will grow as the semiconductor cycle strengthens in 2020 and, longer term, as its addressable market increases.
We sold our holding in Zozo (TSE:3092), which operates Japan’s leading online fashion apparel site, ZOZOTOWN. This was prompted by the partial takeover of Zozo by Yahoo! Japan and the strong outperformance that followed. We believe that the company may become less innovative after the deal, while minority shareholders will eventually be taken out.
We sold our position in the third-largest listed tobacco company, Japan Tobacco, which has a 17% global share excluding China. Market share in Japan is 61%, but we have grown increasingly concerned about the threat of heat-not-burn products to their market share and, in particular, the IQOS product from rival Philip Morris. This, and the increasing scrutiny of ethical and responsible investors, is likely to limit the potential for multiple expansion.
What is portfolio management’s outlook?
The Shinzo Abe-led Liberal Democratic Party has successfully broken the long-held tradition of policy inertia via its attempts to jump-start the economy and equity markets with the magnitude of its policy intent. Abe is also attempting to deal with the economy’s structural challenges: Corporate tax rates have been lowered, an enhanced corporate governance code has been implemented, while initiatives to encourage married women and foreign workers into the labor force have also been announced.
Against this backdrop of change, an increasing number of Japanese companies are defying skeptics by transforming business practices and governance standards. We believe this can help corporate profit growth and generate improving shareholder returns. The volume of shareholder buybacks is increasing, while merger and acquisition activity also shows promise.
We believe that the valuation case for Japan still holds and that Japanese corporate earnings growth is likely to exceed global peers. This view underlies many of our preferred stock ideas today.
Our long-held view that the Bank of Japan’s policy decisions would weaken the yen over time has softened given the backdrop of an increasingly unpredictable currency outlook. We continue to believe the outlook for the currency is one of uncertainty and volatility.
We are cognizant of, and concerned about, the escalation of the trade war rhetoric that is coming from the U.S. and China. We continue to hope that sanctions and trade war concerns will subside, but our quality bias within the portfolio should hold us in good stead should events jeopardize the supportive growth environment.
The views expressed reflect the opinions of T. Rowe Price as of the date of this report and are subject to change based on changes in market, economic, or other conditions. These views are not intended to be a forecast of future events and are no guarantee of future results.
Also check out:
