For the quarter ending March 31, 2020, the Matthews Japan Fund (Trades, Portfolio) returned -15.34% (Investor Class), while its benchmark, the MSCI Japan Index, returned -16.63%.
Market Environment:
During the quarter, Japanese equities went through two distinct phases of performance. In January and February, Japanese equities experienced steeper declines than those of other developed economies in anticipation of the global manufacturing cycle reaching a low point. Following strong performance in the final four months of 2019, there may have been an element of profit taking in the January and February sell off. In addition, Japan was an early focal point in coronavirus news coverage, dampening sentiment for Japanese equities.
However, Japan's markets held up relatively well in March as Europe and the U.S. faced an acceleration of COVID-19 cases. Valuations for Japanese equities were at the low end of their 10-year historical range and many Japanese corporations had strong balance sheets and significant cash on hand. Japan's central bank announced plans to double exchange-traded funds (ETF) purchases in an effort to calm markets, which also supported the relative performance of Japanese equities compared to other developed markets. Reflecting monetary easing efforts around the globe, Japan's central bank is committed to providing liquidity.
Performance Contributors and Detractors:
On a relative basis, the Fund held up better than its benchmark in the quarter. Mega-cap stocks (those over US$25 billion in market cap) outperformed small- and mid-cap stocks (those under US$10 billion) in the reporting period. Although small and midsize companies make up nearly half of the Fund's portfolio, the portfolio management team was able to overcome the underweight of mega caps via strong stock selection.
From a sector perspective, the Fund's long-term underweight in the financials sector was the largest positive contributor to performance among all sectors. In addition, the information technology and industrial sectors contributed positively to the relative performance. The health care sector detracted from relative performance, as some of the portfolio's higher valuation medical technology stocks suffered during a risk-off market environment.
Turning to individual securities, our new position in Santen Pharmaceutical (TSE:4536, Financial), a dominant player in the Japanese ophthalmic market, contributed to Fund performance. The company is growing its presence in the global ophthalmic space with solid growth in its China business through a recent acquisition. We built the position in Santen Pharmaceutical amid share price weakness in February and early March.
Biopharmaceutical and drug discovery platform company PeptiDream (TSE:4587, Financial) was a detractor from performance for the quarter. While the company continues to collaborate with drug makers and licenses its drug discovery technologies the underperformance was mostly from multiple contraction from a very high range.
Notable Portfolio Changes:
We took advantage of the current market correction to enhance the quality of the portfolio, making several changes in the quarter and reducing our total number of portfolio holdings to 50. New positions include high-quality companies that have been on our watch list whose stock prices lowered to our desired entry point and companies that can potentially grow even amid challenging macro conditions. At the same time, we decided to exit some more cyclical areas such as auto parts, staffing services and consumer discretionary companies.
New positions include conglomerate Fujifilm Holdings (TSE:4901, Financial). The company's printer division is viewed by market participants as having lackluster prospects; however we expect that the dissolution of Fujifilm's joint venture with Xerox could work in Fujifilm's favor. We also like Fujifilm's Med-tech portfolio covering endoscopy, in vitro diagnostic devices and ultrasonic devices, as well as its growth in its contract development and manufacturing organization (CDMO) business, which are attractive, cash-flow generative businesses. We also initiated a position in Shin-Etsu Chemical Co. (TSE:4063, Financial), a leading manufacturer of semiconductor wafers and polyvinyl chloride (PVC). While basic materials are affected by economic downturns, we believe the company's low cost base and sound balance sheet provides resilience.
To fund these positions, we exited twelve positions, including Denso Corp, Nifco Inc. and KOSE Corp.
Outlook:
As the trajectory of COVID-19 evolves, we remain cautious about the overall economy and epidemic's impact on larger ticket items such as cars and new home sales. If the recession goes on longer than we expect, companies with ample liquidity and cash reserves may have better prospects for survival. We made portfolio changes in the quarter with these considerations in mind.
While risks remain, Japanese equities may be attractively positioned relative to other developed markets. As previously noted, valuations have come down to the low end of their 10-year historical range. In contrast, European equities are trading at a nearly 40% premium to Japanese equities in terms of price-to-book ratio (PBR), despite comparable return on equity (ROE) levels. In addition, Japanese- listed companies have a record US$4.8 trillion of cash on their balance sheets. This cushion provides security in a tumultuous credit markets and upcoming recessionary environment. Finally, monetary policy remains constructive. The Bank of Japan in March announced an update of ETF purchase program from US$60 billion annual pace to having an option to increase to US$120 billion.
From a structural point of view, 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. Multi-year trends such as productivity growth, health care, technology and material science innovation—where Japanese corporations excel versus global peers—remain intact. Against this backdrop, we are optimistic about opportunities for generating long-term alpha within Japanese equities.
As of 3/31/20, the securities mentioned comprised the Matthews Japan Fund (Trades, Portfolio) in the following percentages: Santen Pharmaceutical Co., 1.5%; PeptiDream, Inc., 2.2%; Fujifilm Holdings Corp, 1.1%; Shin-Etsu Chemical Co, Ltd. 1.3%. The Fund held no positions in Denso Corp., Nifco Inc. and KOSE Corp. Current and future holdings are subject to 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.
