For the year ending December 31, 2019, the Matthews Japan Fund (Trades, Portfolio) returned 26.08% (Investor Class), while its benchmark, the MSCI Japan Index, returned 20.07%. For the fourth quarter of the year, the Fund returned 8.62% (Investor Class), versus 7.67% for the Index.
Market Environment:
Japanese equities rose strongly in the fourth quarter, as global manufacturing activity formed a bottom and climbed out of contraction amid a tepid macroeconomic environment.
2019 started strongly for equity markets as the U.S. Federal Reserve's pause on rate increases improved investor sentiment and Japan equity valuations came back from their lowest levels since the start of the Abenomics era. In May, trade frictions between the U.S. and China intensified, with tariff hikes and a temporary U.S. ban on Huawei products dampening shares of export companies and the technology sector in particular. As bond yields increased worldwide in summer, global investors started to increase their weighting to Japan for early-cycle exposure.
The larger macro environment did not indicate a full-fledged recovery, but started to form a bottom and return to a growth trend. Global manufacturing PMI for December came in at 50.1, the second-straight month of an above-50 reading after six months of sub-50, indicating a contraction of manufacturing activity. The Bank of Japan's Tankan Survey for December 2019 showed further deterioration in the manufacturing sector while productivity-enhancement investments in software and IT services remained strong. Domestic consumption remained sluggish as the consumption tax increased to 10% from 8% as scheduled in October 2019.
Performance Contributors and Detractors:
For 2019 as a whole, quality and growth factors worked well in general, except for a few months during late August to mid-November when we saw a reversal in value factors.
With regard to market cap, 2019 saw mega cap (over US$25 billion) and large cap (US$10 billion to US$25 billion) outperform small and mid cap (under US$10 billion). As small and midsize companies make up roughly half of the portfolio, the allocation effect was a negative drag but the Fund was able to overcome and generate outperformance via stock selection.
From a sector perspective, our three key overweight sectors—information technology, industrials and health care—all contributed positively to performance. Our focus on productivity improvement through software, IT services and automation helped capture attractive returns within the sector amid the cyclical downturn.
Turning to individual securities, Lasertec (TSE:6920, Financial) was the top contributor to Fund performance for both the fourth quarter and full-year 2019. Leading-edge development in areas such as extreme ultraviolet (EUV) picked up momentum, benefiting the company that makes EUV mask blank inspection systems and EUV mask-defect inspection systems.
Media and technology conglomerate Sony (SNE, Financial) also contributed to performance in the fourth quarter. We meaningfully increased our weight in the company in the first quarter of 2019 when Sony shares were pressured in a semiconductor downturn and a potential competitive threat in Google's announcement of Stadia games. In the end, Sony succeeded to further increase its dominant market share in complementary metal oxide semiconductor (CMOS) sensors and also produced robust cash flow from its PlayStation business.
The largest detractor from performance for 2019 was dollar-shop retailer Seria (TSE:2782, Financial). Seria long enjoyed much higher operating margins than its peers. Competition intensified, however, while the overall retail environment remained sluggish. As a result, the company's same-store sales struggled to maintain positive growth.
Baby-product company Pigeon (TSE:7956, Financial) also was a major detractor to performance for the fourth quarter and the full year. The company revised down its full-year guidance in December due to a decline in inbound sales and an unfavorable Japanese yen—Chinese renminbi exchange rate. We agree with the company's view of per-baby consumption driving growth in China, overcoming the birth-rate decline, but we continue to monitor and evaluate its execution abilities.
Notable Portfolio Changes:
Our portfolio actions in 2019 were in two phases. For the first half, we reduced our exposure to cyclical companies and shifted to defensive growth. For the second half, we took profits in companies that performed well, but traded at the higher end of the valuation range, to increase our exposure to cyclical growth companies.
Regarding new holdings, we initiated a position in electronic-component maker TDK (TSE:6762, Financial). The company's recent driver of earnings was the batteries business, where it commanded a leadership position in high-end smartphone batteries and continued to expand market share despite sluggish overall smartphone-unit growth. As the 5G era approaches, we believe TDK's economic moat of higher density per area, design and safety capabilities will increase its value proposition.
We also initiated a position in marine-boat engine and motorcycle manufacturer Yamaha Motor (TSE:7272, Financial). The company is a global leader in marine engines amid a structural shift to outboard motors and increased appetite for more-powerful engines in Europe and the U.S. Its stock price halved due to market-share losses and a sluggish macro environment in the motorcycle business, both in emerging markets and in Europe. While the timing of its turnaround remained uncertain, the company took action in each market and we concluded shares were undervalued given the company's overall ability to generate free cash flow.
To fund these positions, we exited Z Holdings, Sysmex, Persol, Misumi and Mercari.
Outlook:
Throughout 2019, we maintained our constructive stance on Japan equities, given valuation levels were at the lower end of the range in the Abenomics era and our view that the current macro downturn will be a six- to nine-month month contraction rather than a multiyear, prolonged recession.
We believe there will be a mid-cycle recovery phase in 2020 after Global Manufacturing PMI contracted for the six months from May 2019 to October 2019. In this environment, we think Japanese equities will trade around the midpoint of the past seven-year historical range of 11.5X to 15.5X price-to-earnings ratio (P/E) based on forward 12 months consensus earnings. After a strong rebound since late August 2019, the MSCI Japan Index was already trading at 14X forward 12 months consensus P/E. As a result, we think earnings growth will be a driver of total returns in 2020.
While Japanese corporate earnings tend to be procyclical, with higher earnings volatility than developed-market peers, we continue to believe the earnings capability of Japanese companies has improved meaningfully over the past economic cycle, driven by better corporate governance and a higher focus on capital efficiency. We saw a record level of share buybacks in 2019, which will be an important earnings-per-share growth and return-on-equity improvement driver in a relatively muted macro growth environment.
We continue to be optimistic about the alpha-generation opportunities within Japanese equities as multiyear structural trends such as productivity growth, health care, technology and material science innovation—where Japanese corporations excel versus global peers—remain intact.
As of 12/31/2019, the securities mentioned comprised the Matthews Japan Fund (Trades, Portfolio) in the following percentages: Lasertec Corp. 3.0%; Sony Corp. 4.0%; Seria Co., Ltd. 0.1%; Pigeon Corp. 0.9%; TDK Corp. 2.0%; Yamaha Motor Co., Ltd. 1.7%. The Fund held no positions in Google (Alphabet Inc.); Z Holdings Corp.; Sysmex Corp.; Persol Holdings Co., Ltd.; Misumi Group Inc.; or Mercari, Inc. Current and future portfolio holdings are subject to change and risk.
The views and opinions in this commentary were as of the report date, subject to change and may not reflect current views. 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. It should not be assumed that any investment will be profitable or will equal the performance of any securities or any sectors mentioned herein. The information does not constitute a recommendation to buy or sell any securities mentioned.
The information contained herein has been derived from sources believed to be reliable and accurate at the time of compilation, but no representation or warranty (express or implied) is made as to the accuracy or completeness of any of this information. Neither the funds nor the Investment Advisor accept any liability for losses either direct or consequential caused by the use of this information.
