For the quarter ending September 30, 2021, the Matthews Japan Fund (Trades, Portfolio) returned 5.37% (Investor Class) and 5.40% (Institutional Class), while its benchmark, the MSCI Japan Index, returned 4.70%.
Market Environment:
Japan equity markets continued to lag global peers earlier in the third quarter, as the county’s vaccination ratio fell behind the U.S. and Europe’s developed markets, and its state of emergency continued. In addition, Prime Minister Yoshihide Suga's approval rating, despite his efforts to secure the vaccine supply, continued to decline amid rising COVID cases during the summer.
However, as the vaccination ratio rose to a level comparable to the U.S. and Europe, and with the resignation of Prime Minister Suga in early September, the Japanese stock market saw a brief but strong rally and some reversal in global investor fow toward the end of the quarter.
Fumio Kishida has been named as Suga’s replacement as President of the Liberal Democratic Party and is serving as the incumbent Prime Minister until the next general election on October 31. Prime Minister Kishida is considered to be a consensus choice, and no ma or economic policy changes are expected.
Performance Contributors and Detractors:
The Matthews Japan Fund (Trades, Portfolio) is a quality core growth portfolio with focus on high return on assets and invested capital, cash fow generation and medium term (3 months) earnings momentum. Consequently, our portfolio companies naturally tend to trade at a premium valuation to the overall market average and are vulnerable to a sudden change in equity risk premiums. his happened during the rst quarter amid a rapid rise in bond yields, resulting in a di cult quarter for the portfolio. Since then, the Fund has outperformed the benchmark in the second and third quarters of the year, amid an ongoing performance gap between growth and value.
Sector wise, the portfolio changes we have implemented in health care and industrials contributed the most to the Fund’s relative performance for the quarter. On the other hand, the information technology sector, which previously was the largest overweight sector, continued to be a drag despite our efforts in reducing weightings as we took profits from growth companies trading at elevated valuations.
Turning to individual securities, leading human resources and media marketing solution provider Recruit Holdings (TSE:6098, Financial) was the Fund’s top contributor as the company has been a beneficiary of the reopening of Japan’s economic activity. Recruit’s HR Technology companies (Indeed Inc., and Glassdoor, Inc.), its crown jewels, guided for 40-50% topline growth for the current fiscal year.
Technology conglomerate Sony Group (SONY, Financial) also was a major contributor. In an era where content such as motion pictures, music and games are consumed via digital downloads, Sony’s value as a key intellectual property (IP) holder has increased in our view. Sony's current management has been proactive in securing IP assets via merger and acquisition (M&A) as well, which we view as a prudent allocation decision in incremental capital investment.
On the other hand, the largest detractor from performance was Softbank Group (TSE:9984, Financial), a telecom and venture capital firm. Softbank’s share price struggled amid stagnant performance of initial public offerings (IPOs) and the general risk off mode in China weighed on sentiment as the roup invests in key growth companies in the country.
Biopharmaceutical and drug discovery platform company PeptiDream (TSE:4587, Financial) also detracted from performance during the quarter. While the company continues to collaborate with drug makers and licenses the drug discovery technologies as well as in house development, PeptiDream’s underperformance continued to stem from multiple contractions from a very high range.
Notable Portfolio Changes:
Looking ahead, our base case scenario is that the global economy will continue its path to recovery toward pre COVID levels and the bond yields to normalize. Therefore, we have continued to shift our portfolio during the quarter toward a cyclical earnings recovery, increasing our exposure to cyclical growth companies as economic activity started to bottom out and improve.
During the quarter, we participated in an IPO, Simplex Holdings (TSE:4373, Financial), an I solutions and service management company. Japan’s workforce is starting to peak out and is expected to accelerate over the next 10 years. It remains to be one of the lowest labor productivity countries among OECD (Organisation for Economic Co-Operation and Development) and enabling technology to improve e ciency is imminent. Japanese corporates now have record amounts of cash on balance sheets and we believe Simplex is poised to be a beneficiary of the digital transformation of Japanese corporates, many of which lack internal resources.
We also initiated a position in Mitsui High-Tec (TSE:6966, Financial), a manufacturer of "motor core," which is a key component of a powertrain motor in electric vehicles (EVs). Comprising approximately 300 to 500 layers of electrical steel sheet to create stator/rotor, the company commands around 70% of global market share. We believe the tightening of environmental regulations bodes well for EV penetration, and we chose to invest in a niche, but key, EV component maker. The company has a deep moat in material science, which is hard to replicate with only a large scale investment.
To fund these positions and other new names, we exited seven positions including Sumitomo Mitsui Financial Group (SMFG, Financial), Marui Group (TSE:8252, Financial) and Fanuc Corp. (TSE:6954, Financial).
Outlook:
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 fficiency. Multiyear trends such as productivity growth, health care, technology and material science innovation where Japanese corporations have historically excelled versus global peers not only remains intact, but we think the pace of change will accelerate as this COVID-19 situation became the stress test on the healthcare system and costs, as well as labor productivity issues in white collar obs as more people work remotely.
For many years, Japanese equities have not been considered a place to invest, but rather a place to trade in and out of. Investors tend to buy Japan when things bottom out and improve, then get out when things start to peak. However, the dynamic has meaningfully changed since 2010 as Japanese corporates have been generating improving levels of profits in each bottom of the cycle. 2020 showed another resiliency of Japanese corporate profits. We believe the Japanese Equity market fundamentals have turned from pure value to cyclical growth, and many global investors are still skeptical of this change. We will continue to look for investment opportunities in high quality companies that are able to execute well. At the same time we will also seek for opportunities in cyclical areas that have a potential to achieve high growth via lower and easier competition.
As of September 30, 2021, the securities mentioned comprised the Matthews Japan Fund (Trades, Portfolio) in the following percentages: Recruit Holdings Co. Ltd. 1.52%; Sony Corp. 3.24%; Softbank Group Corp. 1.45%; PeptiDream Inc.
2.07%; Simplex Holdings, Inc., 0.7%; and Mitsui High- Tec., 0.9%. The Fund held no positions in Sumitomo Mitsui
Financial Group, Marui Group, or Fanuc Corp.
Current and future portfolio holdings are subject to change and risk.
All performance quoted is past performance and is no guarantee of future results. Investment return and principal
value will fuctuate with changing market conditions so that shares, when redeemed, may be worth more or less than
their original cost. Current performance may be lower or higher than the return fgures quoted. Returns would have
been lower if certain of the Fund's fees and expenses had not been waived. Please see the Fund's most recent
month-end performance.
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.
The views and opinions in the commentary were as of the report date, subject to change and may not refect current
views. They are not guarantees of performance or investment results and should not be taken as investment advice.
Investment decisions refect 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 proftable 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.
