Dear Shareholder,
Global markets experienced extraordinary volatility during the first half of your fund’s fiscal year, the six-month period ended April 30, 2020, as the spread of the coronavirus led to the shutdown of significant portions of most major economies. After reaching record highs, stocks recorded their steepest declines since the global financial crisis a decade ago, while demand for safe-haven securities sent Treasury yields to all-time lows.
As a result of the improving trade situation between the U.S. and China and central bank stimulus, the outlook for 2020 appeared promising. However, market sentiment began to shift in January amid news of the coronavirus outbreak in China’s Hubei province.
Although the effect was initially muted, with the S&P 500 Index advancing to a record high on February 19, stocks began falling amid reports of major outbreaks in South Korea, Iran, and Italy and scattered infections in dozens of other countries. The major indexes continued their slide as cases mounted in the U.S. and New York City became the epicenter of the pandemic.
The economic toll of the virus became evident as governments throughout the world issued stay-at-home orders to contain the virus, and some sectors, such as travel, restaurants, and shopping malls, came to a virtual halt. In the last six weeks of the period, over 30 million Americans—almost one-fifth of the workforce—filed unemployment claims.
In response to the rapid contraction in economic activity, global central banks took firmly accommodative steps, and many governments around the world passed emergency spending packages. In the U.S., the Federal Reserve cut its short-term lending rate to near zero and began purchasing government and corporate bonds to stimulate the economy and supply liquidity in the fixed income market. The federal government also provided trillions in fiscal support in the form of direct payments to many Americans, expanded unemployment insurance, and subsidies to sectors such as transportation and health care that had been directly impacted by the pandemic.
Boosted by the support, market volatility calmed somewhat by the end of March, and most sectors recouped some of their losses with a strong rally that started in late March and continued throughout April.
Global equity returns for the six-month period were broadly negative, but U.S. large-cap growth stocks finished with positive results. Sector returns were mixed. Energy shares fared the worst as a supply glut and shrinking demand briefly sent the price of oil into negative territory. Health care and information technology shares were the strongest performers.
As a result of the drop in yields, U.S. Treasuries were the top performers in the fixed income universe. Other U.S. investment-grade bonds were also generally positive, but municipal debt was pressured as state and local governments grappled with the loss of tax revenue and mounting expenses as a result of the pandemic. Riskier fixed income sectors such as high yield and emerging markets bonds tumbled during the March sell-off but regained some ground in April.
Looking ahead, the range of possible economic outcomes is especially broad as a result of the unprecedented nature of this crisis—simply stated, we are in uncharted territory. Volatility is likely as investors react to both hopeful and disappointing news in the fight against the virus. We are early in the journey toward recovery, and there is certainly a possibility we could give back some of April’s gains.
In the meantime, our team of investment professionals is focusing on what the postcrisis world will look like. Certain consumer behaviors have been altered, and it is also possible that this crisis will accelerate trends that were already in place. In particular, the pandemic seems to have given a boost to the digitization of the economy, or the shift to online purchases for a widening array of goods and services.
Your fund’s portfolio manager will be carefully monitoring developments, and I believe that our disciplined fundamental research and strategic investing approach will continue to serve our shareholders well in this uncertain environment.
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 six months?
The Japan Fund returned -2.27% in the six-month period ended April 30, 2020. 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; therefore, 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?
Stock selection was the primary driver of outperformance, while sector allocation also contributed positively. Our overweight and stock selection in the IT and services sector added the most to relative returns. Stock selection and an overweight in the pharmaceutical sector also generated a strong contribution. Stock selection in the automobiles and transportation equipment and real estate sector detracted from relative returns, although underweight allocations to both areas contributed.
In the IT and services sector, our overweight position in SoftBank (TSE:9984, Financial) contributed the most to relative performance. The telecommunications and internet conglomerate suffered sharp losses amid the coronavirus panic of the first quarter as investors grew skeptical about the outlook for its technology holdings, including office-sharing firm WeWork and ride-hailer Uber. Shares recouped their losses in April, however, as the company continued to sell assets and buy back stock to reduce the discount at which it trades relative to the value of its assets. (Please refer to the fund’s portfolio of investments for a complete list of holdings and the amount each represents in the portfolio.)
Elsewhere in the sector, Sansan (TSE:4443, Financial), a provider of business card management services, registered strong gains. While the company struggled to generate sales as a result of the trend away from face-to-face meetings due to the coronavirus, it reported solid quarterly earnings in April. Sentiment benefited from expectations for a reacceleration in activity in the second half of the year as the productivity of new salespeople ramps up.
In the pharmaceutical sector, the top contributing holding was Chugai Pharmaceutical (TSE:4519, Financial). Its shares received a boost from news that an antibody developed by the pharmaceutical company would be part of a clinical trial to treat severe pneumonia linked to COVID-19, the disease caused by the coronavirus. The company released solid first-quarter results, with its key drugs Hemlibra and Tecentriq ahead of expectations on market sales and with costs remaining well controlled.
Suzuki Motor (TSE:7269, Financial) was among the largest relative performance detractors. The carmaker’s Indian subsidiary Maruti Suzuki has faced near-term cyclical challenges as its operations have been temporarily halted due to the coronavirus. Nevertheless, we retain our conviction in the stock, given Suzuki Motor’s solid balance sheet and long-term growth potential in India.
In the real estate segment, Hoshino Resorts REIT (TSE:3287, Financial) hurt relative returns. The real estate investment trust (REIT), which invests in hotels and traditional Japanese inns, fell sharply due to the disruption to domestic travel and uncertainty about the prospects for its operations.
How is the fund positioned?
The IT and services segment remained the fund’s largest allocation in both absolute and relative terms. We also have an overweight in machinery, where Japan has many leading companies that are expanding globally. Banks remained our largest underweight, with no holdings in the sector. Intense competition means that there is an almost unlimited supply of loans at low rates. Demand is improving for these loans, but margins remain low given the backdrop of negative Japanese government bonds 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 Fancl (TSE:4921), a cosmetics and nutritional supplements manufacturer. The brand is mainly marketed through direct sales and mail order, and also sold in retail stores. Overseas sales are small but increasing, while tourist sales provide scope for growth. The coronavirus pandemic resulted in a large sell-off and provided an opportunity to buy the stock, which we previously viewed as richly valued. The company’s long-term growth outlook and margin expansion potential underpin our investment thesis.
We also established a position in Oriental Land Company (TSE:4661), the operator of Tokyo Disney Resort. The stock plunged during the coronavirus crisis and the resultant impact on tourism. We believe the stock trades at an attractive valuation, based on the value of its real estate and earnings growth potential. Near-term volatility provided an attractive entry point with our long-term investment horizon.
Conversely, we exited our position in Fujifilm (TSE:4901). The company generates strong and stable cash flow from its imaging (camera, photo, and film), medical equipment, and pharmaceuticals businesses. The stock rallied strongly on news that China was having some success treating symptoms of COVID-19 with Fujifilm’s drug, but the company’s drug is off-patent and generics exist. The outperformance was marked, and we sold our shares into this strength.
What is portfolio management’s outlook?
Japanese equities sold off with global markets in the first quarter of 2020 as the coronavirus pandemic spread. Japan fared better than most other developed markets, however, and appears to have avoided the worst of the coronavirus so far, with fewer reported cases and disruption.
The focus now is on the depth of the global economic recession and the duration of the social restrictions to control the coronavirus. Encouragingly, policy stimulus has been swift and decisive. The Bank of Japan announced it would expand monetary stimulus with quantitative easing measures, including doubling the annual target of exchange-traded fund purchases, expanding commercial paper and real estate investment trust buying programs, and establishing a new lending facility.
The government plans a spending package equivalent to 15% of gross domestic product to help cope with the fallout from the coronavirus and has debated much larger stimulus efforts. These measures should help soften the recession and buy time for companies and consumers facing near-term cash flow pressures. Corporate Japan is cash rich, which is providing the local market with some respite as investors are generally concerned about balance sheet risk.
Against this uncertain backdrop, 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.
Japan is exposed to the global economic cycle. However, we believe there is significant potential upside when the coronavirus pandemic stops getting worse. Japanese companies are net cash on the balance sheet, and many of the holdings within the portfolio are exposed themes that are likely to be expedited by the pandemic.
We anticipate that long-term investment opportunities will be provided by an acceleration in the trends that we are already seeing, such as the shift from offline to online in the form of e-commerce and factory automation. We also see opportunities in companies with exposure to China, where the economy appears to be reopening.
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.
