For the quarter ending September 30, 2023, the Matthews Japan Fund (Trades, Portfolio) returned -3.91% (Investor Class) and -3.90% (Institutional Class), while its benchmark, the MSCI Japan Index, returned -1.45%.
Market Environment:
Japan equity markets continued to post healthy total returns in the last quarter. One key tailwind was government policy and activist pressure that pushed undervalued companies to increase their payout and buyback ratios. In the period, hopes waned over the Federal Reserve's interest rate strategy amid inflation rates starting to peak out as the central bank increasingly telegraphed a ‘higher for longer' approach which spurred a risk-off move across global markets. As the strategy gained traction, so the U.S. dollar strengthened and Japan's currency weakened, dropping to 150 yen to the dollar. Overall, however, Japan equities continue to enjoy several areas of support, primarily from a positive earnings cycle driven by moderate inflation, meaningful wage gains and policy-driven corporate reforms. In addition, a recovery in inbound tourism and absence of the geopolitical headwinds China is facing is creating positive inflows into the country.
Performance Contributors and Detractors:
The third quarter saw a marked shift toward value investing from growth investing–the MSCI Japan Value Index outperformed the MSCI Japan Growth Index by 14.49% in the period. This shift hurt sentiment toward many of the sectors and stocks we hold in the portfolio which is in the main growth orientated. Consequently, from a sector perspective, stock selection in industrials and consumer staples were the two largest contributors to relative performance during the quarter. On the other hand, the portfolio's stock selection in financials and health care were the two single biggest detractors from relative performance. An overweight and stock selection in information technology (IT) combined to make the sector the biggest drag on the portfolio.
At the holdings level, Toyota Tsusho (TSE:8015, Financial), the trading arm of Toyota Motor (TM, Financial), was the top contributor to total and relative returns. The company delivered strong quarter results and we think it will be sustained in the quarters ahead, helped by production momentum within its business units and continued growth of the auto industry in emerging markets, especially in Africa. The company is also part of ongoing discussions at Toyota Motor over the group's stance toward improvement shareholder returns. The company's dividend payout ratio of 25% lags other peers as well as that of its parent company.
Athletic apparel and shoe company Asics (TSE:7936, Financial) was another top performer. Its June quarter results were a clean beat and the company raised full-year guidance above consensus. We like Asics' execution capability. They are making progress in improving profitability by reducing low gross-profit margin (GPM) products and in improving sales channel mix.
On the other hand, semiconductor company Renesas Electronics (TSE:6723, Financial) was one of the bottom performers and the biggest detractor to relative returns. The stock faced profit taking after a strong year-to-date performance as the company delivered positive results with progress being made in inventory adjustments, which showed the management's solid execution during downturns. We continue to see Renesas constructively as its valuation remains compelling.
Factory automation business Keyence (TSE:6861, Financial) was also a detractor. While the company continues to outpace peers in terms of underlying results and execution capability, the company trades at a premium valuation and has one of the highest price-to-earnings (P/E) ratios among Japan mega cap names. It experienced huge growth factor underperformance in September.
Notable Portfolio Changes:
During the third quarter we initiated a position in ZOZO (TSE:3092, Financial), an online fashion and accessories platform. The company has shown solid execution capability with gross merchandise value (GMV) growth still a respectable high-single digits and with higher profit growth. Valuation was at a 10-year low at the timing of our investment and looks attractive for a company that in our view has cashflow generation capable of supporting an above-benchmark average dividend yield with mid-high teens dividend growth while continuing to invest for its own growth.
Department store operator Isetan Mitsukoshi (TSE:3099, Financial) is another new holding. We see multiple areas of growth both from cyclical and structural changes, such as monthly sales momentum driven by inbound tourists and the rise of the dual-income young ‘power couple' in the metropolitan Tokyo area. Management is also starting to take bolder actions in its capital policy plans.
To fund these new positions, we exited Takeda Pharmaceutical (TAK, Financial), Taisei (TSE:1801, Financial), Simplex (TSE:4373, Financial), Shift (TSE:3697, Financial), Olympus (TSE:7733, Financial), NTN (TSE:6472), JGC (TSE:1963), HOYA (TSE:7741) and Fast Retailing (TSE:9983).
Outlook:
Strong underlying U.S. employment data suggests that the Fed's ‘higher for longer' rate strategy will remain in place at least for the near term. While there are downsides to this, higher rates and a strong U.S. dollar do offer a tailwind for Japanese exports. And while a value investing bias across large areas of the Japan equity market is a headwind for quality growth strategies, we also believe our investment philosophy of investing in positive margin slopes generates incremental returns over the long term.
As for the long term, we believe the earnings capability of Japanese companies has improved meaningfully. Last year, the Japanese equity market outperformed both developed markets (MSCI World) and emerging markets (MSCI Emerging Markets) in U.S. dollar terms. With the yen at a near quarter-century-low to the dollar, inflationary growth seemingly bedding in and corporate reforms gaining traction, we think the case for Japan is becoming easier to make.
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.
