For the year ending December 31, 2021, the Matthews Japan Fund (Trades, Portfolio) returned -1.92% (Investor Class) and -1.83% (Institutional Class), while its benchmark, the MSCI Japan Index, returned 2.04% over the same period. For the fourth quarter of the year, the Fund returned -1.30% (Investor Class) and -1.28% (Institutional Class), while the benchmark returned -3.94%.
Market Environment:
Japan’s equity markets lagged their global developed-market peers in 2021. While the U.S. and Europe enjoyed rising economic activity as their vaccination ratio increased, Japan initially lagged in the start of its vaccination efforts, and continued its state of emergency status even after its vaccination ratio surpassed most developed market countries. As a result, Japan’s domestic GDP growth remained at recessionary levels throughout 2021. During the year, Japan growth stocks were not able to reverse the performance gap created by the growth-to-value reversal rally which happened in early 2021.
Performance Contributors and Detractors:
From a sector perspective, stock selection in the information technology sector was the largest drag on relative performance. On the other hand, our holdings in the materials and consumer staples sectors were the top contributors to relative performance.
Turning to individual securities, the largest detractor from absolute performance was Softbank Group (TSE:9984, Financial), a telecom and venture capital firm. Softbank’s share price struggled amid stagnant performance of its IPOs. Additionally, global investors’ general risk-off stance with respect to China in 2021 weighed on sentiment as the Group has investments in key Chinese growth companies.
Electronic component maker TDK (TSE:6762, Financial) was also a detractor. While the company continues to be a dominant supplier of small- to mid-sized batteries via its core lithium polymer battery manufacturer subsidiary Amperex Technology, TDK’s near-term earnings were slowing down due to weaker-than-expected demand for personal computers and smartphones. TDK’s increased investment in its mid-size battery expansion was also viewed likely to weigh on margins.
On the other hand, leading HR and media marketing solutions provider Recruit Holdings (TSE:6098, Financial) was the largest contributor to absolute return during the year. The company has been a beneficiary of the reopening of economic activity, and its crown jewel HR Technology companies (Indeed, Inc. and Glassdoor, Inc.) guided for 40%-50% topline growth for the current fiscal year, buoying the company’s stock price during the period.
Technology conglomerate Sony Group (SONY, Financial) was another major contributor to performance. In the current era where many key media types such as motion pictures, music and games are consumed via digital downloads, Sony’s value as a key Intellectual Property (IP) holder has significantly increased in our view. Sony's current management is being proactive in securing IP assets via mergers and acquisitions as well, which we view as a prudent allocation decision in incremental capital investment.
Notable Portfolio Changes:
Our portfolio actions during the year were a continuation of efforts to increase our exposure to cyclical growth companies as economic activity started to bottom out and improve. We initiated a position in Toyota Motor Corp. (TM, Financial) early in 2021, our first allocation since early 2017. The company is viewed as a laggard in the shift to electric vehicles (EVs), and has underperformed global original equipment manufacturer (OEM) peers over the past year. However, we believe Toyota is ahead of peers in terms of vehicle electrification technology, and we anticipate the company will launch key EV models going forward. In May, the company announced it expects to sell approximately 8 million EVs on a global basis by 2030, of which 2 million will be battery-powered EVs and fuel cell EVs, which was later increased to 3.5 million units.
While our significant underweight to the consumer staples sector was a contributor to relative performance in 2021, we have started to increase our weight in this area given that current valuations have become attractive as a result of the stagnant consumption environment in Japan over the past year. In the fourth quarter of 2021, we initiated a position in Seven & i Holdings Co. (TSE:3382, Financial), which owns 7-Eleven convenience stores in both the U.S. and Japan, as well as Japanese supermarket chain Ito-Yokado. We believe its acquisition of U.S. gas station chain Speedway has ample room for synergies and can be a future growth driver of the company’s overall profits.
To fund these positions and other new names, we exited NIDEC Corp., Pan Pacific International Holdings, Nitori Holdings Co., PeptiDream Inc., TDK Corp., Tokyo Century Corp., freee KK, and Hikari Tsushin Inc. during the fourth quarter.
Outlook:
After a very favorable environment for growth stocks in 2019 and 2020, during 2021 Japanese equities experienced a strong growth-to-value reversal, with global central banks starting to tighten their loose monetary policies. The Bank of Japan, which has financed large ETF purchases over the past four to five years, has significantly pulled back the pace of purchases. Matthews Japan Fund (Trades, Portfolio) is a quality core growth portfolio with focus on high return on assets and invested capital, cash flow generation and medium term (36months) earnings momentum. As a result, our portfolio companies naturally tend to trade at a premium valuation to overall market average, and is vulnerable to a sudden change in equity risk, which tends to happen during a rapid rise in bond yields. Nearly all of our underperformance versus the benchmark during the year happened in a matter of six weeks, when the U.S. 10-year bond yield moved from 1.0% to 1.6% during the period. Since then, the Fund has outperformed the benchmark for the remaining nine months, amid the ongoing performance gap between growth and value.
Looking ahead to 2022, our base-case scenario remains that the global economy will continue its path to recovery towards pre-COVID levels and bond yields to normalize. Therefore, we have continued to shift our portfolio towards a cyclical earnings recovery.
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. Multiyear trends such as productivity growth, health care, technology and materials 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 the COVID-19 situation became the stress test on the health care system and costs, as well as labor productivity issues in white collar jobs as more people work remotely. In our opinion, this creates opportunities for attractive alpha generation through bottom-up, active stock selection.
As of December 31, 2021, the securities mentioned comprised the Matthews Japan Fund (Trades, Portfolio) in the following percentages: SoftBank Group Corp., 1.4%; Recruit Holdings, 3.2%; Sony Group Corp., 5.6%; Toyota Motor Corp., 4.3%; and Seven and i Holdings Co., 1.5%. The Fund held no positions in: Amperex Technology, Indeed, Inc., Glassdoor, Inc., 7-Eleven, Inc., Ito-Yokado Co., Speedway, NIDEC Corp., Pan Pacific International Holdings, Nitori Holdings Co., PeptiDream, Inc., TDK Corp., Tokyo Century, freee KK, and Hikari Tsushin.
Current and future 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 fluctuate 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 figures 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.
