For the year ending December 31, 2022, the Matthews Japan Fund (Trades, Portfolio) returned -27.85% (Investor Class) and -27.84% (Institutional Class), while its benchmark, the MSCI Japan Index, returned -16.31% over the same period. For the fourth quarter, the Fund returned 10.76% (Investor Class) and 10.74% (Institutional Class), while the benchmark returned 13.26%.
Market Environment:
Japan equity markets in 2022 delivered very different performances depending on the currency and style of investment used. Taking currency first, the Japanese yen weakened to 150 to the U.S. dollar in October, a level last seen in 1998. Multiple rate hikes by the U.S. Federal Reserve in tandem with the accommodative stance of the Bank of Japan resulted in the widening of the U.S.-Japan bond-yield spread. For investors, the yen’s decline meant that in local currency terms Japanese equities outperformed developed markets while in U.S. dollar terms they traded more in line. The other trend to have impacted Japanese equity markets was the continued significant spread between performance of value stocks and growth stocks. The one-year performance gap between value stocks and growth stocks in 2022 ended at 2,260 basis points (22.26%), the largest in international equity markets. The Matthews Japan Fund (Trades, Portfolio) is a quality core growth portfolio and the widening of the growth-value spread has been a challenge.
Performance Contributors and Detractors:
From a sector perspective, our stock selection in consumer staples was the largest contributor to relative performance in 2022. Stock selection in real estate was also a contributor though its impact was mitigated by our underweight in the sector. On the other hand, stock selection in industrials was the biggest detractor while our selections in financials, materials and information technology (IT) were also detractors.
At the holdings level, Daiichi Sankyo (TSE:4568, Financial), a pharmaceutical company, was the largest contributor to the investment results. We view the company as evolving into specialty pharma company focused on oncology and based on their proprietary antibody-drug conjugate (ADC) platform. The success of Daiichi Sankyo's first ADC—Enhertu, an anticancer agent for breast cancer—coupled with a favorable court ruling in a dispute with a competitor regarding ADC technology in August drove the strong performance in the year.
P&C insurance company Tokio Marine Holdings (TSE:8766, Financial) was the second-largest contributor to performance. We regard the company as a prudent allocator of capital with a mid-teens dividend compound annual growth rate (CAGR) coupled with earnings-per-share (EPS) growth that is driven by both earnings and buybacks.
Game developer Capcom (TSE:9697, Financial) was also a positive contributor. Owner of key intellectual property (IP), such as “Monster Hunter” and “Resident Evil”, the company pledges to deliver stable and continuous double-digit growth. Given the uncertainty in macro situations, Capcom’s has resulted in equity outperformance.
Technology conglomerate Sony Group (SONY, Financial) was the largest detractor last year. After approaching an all-time high in January, performance has struggled due to weakness in the mainstay PlayStation game business. While we remain constructive on Sony's management capability and its competitive position in games, music and image sensors, the weakness in their highest return-on-invested-capital (ROIC) business segment makes it difficult for the share price to perform.
Recruit (TSE:6098, Financial), a leading HR and media marketing solution provider was the second-largest detractor. The company benefited from the reopening of economic activity in 2021 with their crown jewel HR Tech segment but growth slowed due to the peaking out of global economic activity.
JSR (TSE:4185, Financial), an electronic material manufacturer, was also a detractor. The company’s recent earnings were below expectations due to the slower-than-expected commercial production ramp of its highly-anticipated Contract Development and Manufacturing (CDMO) for bio-pharma products, as well as the weaker topline in display materials segment. Despite the near-term weakness, our conversation with the management suggests that the issues in the health-care businesses are transitory and the display business topline will bottom out. We still calculate that JSR trades below its intrinsic value and believe that a re-rating would accelerate as JSR’s health-care profit contribution increases in the later part of this fiscal year.
Notable Portfolio Changes:
During the fourth quarter, we re-initiated furniture and household goods retailer Nitori Holdings (TSE:9843, Financial). We exited the name in 2021 due to the negative impact from a weaker yen and tough year-on-year after COVID lockdowns had pushed up their home fashion goods demand in 2020. After a year, both consensus earnings and valuation levels came down enough to warrant a review, especially as cost pressures and the weakness of the Japanese yen have started to peak out, in our view. The long-term thesis remains unchanged. Nitori is the last man standing in the furniture retail space in Japan and has achieved 35 consecutive years of earnings growth. The company’s track record in cost adjustment is also impressive.
We also initiated a position in Sumitomo Mitsui Financial Group (SMFG, Financial) in anticipation of potential changes in Japan’s monetary policy. The Bank of Japan revised its yield curve control (YCC) targets at its December 20 monetary policy meeting. While the move came as a surprise to the market including us, we had discussed the possibility of this happening. As current BoJ Governor Haruhiko Kuroda's term expires in the Spring, increasing news flow around the upcoming change in leadership will drive expectations for a change in the bank’s negative interest rate policy and steps toward monetary policy normalization.
To fund these positions, we have exited Toyota Motor (TM, Financial), Suntory Beverage (TSE:2587, Financial) and Food, SMC, Septeni Holdings, Roland, Ono Pharmaceutical, Mazda Motor, Kyoritsu Maintenance, Japan Steel Works, GMO Payment Gateway and Direct Marketing Mix.
Outlook:
While the market seems ready for the Fed to pivot with its interest-rate policy and for inflation to peak out, we believe the Fed is hesitant to prematurely remove its hawkish policies to contain inflation. With this backdrop, we don’t see a reversal of growth underperformance in Japan anytime soon and are taking a more balanced approach towards multiple stages of growth and valuation levels. For the year of 2023, earnings growth and cash flow-generation ability will be ever more important as financial estimates for Japanese corporates have started to be revised down.
Looking long term, we continue to believe the earnings capability of Japanese companies has improved meaningfully over the past economic cycle. Last year, the Japanese equity market outperformed both developed markets (MSCI World) and emerging markets (MSCI Emerging Market) in U.S. dollar terms. With the yen at a near quarter-century-low to the dollar, Japanese companies are in good health and, importantly, the country is firmly open for tourism. We believe this is the time for investors to add a long-term exposure to the market.
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.
