For the year ending December 31, 2023, the Matthews Japan Fund (Trades, Portfolio) returned 17.99% (Investor Class) and 18.08% (Institutional Class), while its benchmark, the MSCI Japan Index, returned 20.77% over the same period. For the fourth quarter, the Fund returned 8.25% (Investor Class) and 8.29% (Institutional Class), while the benchmark returned 8.22%.
Market Environment
Japan equity markets posted healthy total returns in 2023, along with other developed markets, outpacing emerging markets. Japanese stocks' outperformance was mainly driven by resilient earnings growth amid a tepid global macro economy. Valuation levels also moved up from the low end to the midpoint of the past 10-year historical range, helped by government policy and activist pressure which pushed undervalued companies to increase their payouts and buybacks.
The direction of interest rates and risk premiums in 2023 was largely driven by hopes for the U.S. Federal Reserve's pace of rate hike slowing down. The discussion of rates being ‘higher for longer,' spurred a risk-off move across global markets for the third quarter, and U.S. 10-year bond yields reached 5% in October for the first time in 2008. Sentiment improved toward the end of the year as investors responded to evidence of softening in global growth and an easing in inflationary pressures. For the full year, the MSCI Japan Value Index outpaced the MSCI Japan Growth Index by 661 basis points (6.61%), reflecting the general rise in interest rates.
The Japanese yen generally traded in a range bound for the first six months of the year but in the third quarter, as U.S. 10-year bond yields rose, the currency weakened back to its 27-year low of 150 yen to the U.S. dollar.
Performance
The portfolio's overweight to small caps relative to the benchmark resulted in the majority of the detraction while positive stock selection in all market cap spectrums offset the allocation effect. From a sector perspective, stock selection in materials and consumer staples were the two largest contributors to relative performance while stock selection in financials and industrials were the biggest detractors.
At the holdings level, Shin-Etsu Chemical (TSE:4063, Financial) and Renesas Electronics (TSE:6723, Financial) were the top two contributors to both the Fund's total and relative returns. The share price of semiconductor company Renesas Electronics faced some profit taking in the third quarter, but we continue to view positively the company's ongoing progress in inventory adjustments as it shows the company's solid execution during downturns. We continue to see Renesas constructively as its valuation level remains compelling.
Polyvinyl chloride and semiconductor wafer manufacturer Shin-Etsu Chemical's main businesses faced a downturn through the housing and semiconductor cycle, but the company once again displayed its capability to maneuver slowdowns, maintaining its high-capacity utilization rate and adhering to long-term agreements with key customers.
The largest detractor to the portfolio's relative returns was Tokyo Electron (TSE:8035, Financial), a semiconductor production equipment company that we did not own until mid-December of 2023. However, as the portfolio level, we were able to benefit from overweighting semiconductor-related sectors. Debt guarantor eGuarantee (TSE:8771, Financial) was the second-largest detractor to investment results. Although the company continues to execute and generate strong earnings growth, COVID-related relief funds that saved many institutions from bankruptcy led to a slower-than-expected rise in bankruptcy numbers in Japan. We have already exited from this position.
Notable Changes
During the December quarter, we made three major changes to the portfolio. First, with foreign investor flows turning positive for the first time in five years, we shifted our portfolio's average market cap upwards. Second, we reduced multiple positions that worked as a “value play” within the portfolio, especially names where the majority of the returns were from pure re-ratings. Third, as the global purchase manufacturing index (PMI) stayed below 50 for the full 12 months of 2023, we started to look for names whose fundamentals are set to bottom out as we look toward 2024 and beyond. We took advantage of the market correction in October to initiate some cyclical growth names.
We initiated a position in real estate developer Mitsui Fudosan (TSE:8801, Financial). We believe the company will continue to produce steady mid-single digit growth from vacancy rates peaking out in central Tokyo. We also look forward to its new management's stance towards achieving optimal return on equity through asset sales.
We have also re-initiated a position in medical device manufacturer Terumo (TSE:4543, Financial). After meeting with the management team, we have built a conviction that multiple headwinds such rising raw materials and logistics and manufacturing cost inflation have started to peak out. Terumo has also taken numerous steps, from shifting its manufacturing locations to raising prices. We initiated our position when the company's valuation level was in the lower end of its 10-year range.
To fund these positions, we exited several holdings including Amvis (TSE:7071, Financial), Asahi Intecc (TSE:7747, Financial), Bandai Namco (TSE:7832, Financial), Baycurrent Consulting (TSE:6532, Financial), Denso (TSE:6902, Financial), Dip (TSE:2379, Financial) and eGuarantee.
Outlook
After a strong finish to the close of 2023, the MSCI Japan Index is trading at 14.7 x forward 12 months price-to-earnings ratio and 1.42 x price-to-book ratio with a 2.24% dividend yield. Valuations have risen compared to 2022 year-end but still look sensible in an international context. Along with the long-term trend of corporate Japan achieving better through-the-cycle margins, recent activist investor activity is working as a clear catalyst for the corporate sector to further enhance shareholder returns via dividends and share buybacks.
Over the long term, we continue to believe the earnings capability of Japanese companies has improved meaningfully over the past economic cycle. As of year-end 2023, the Japanese equity market outperformed both the MSCI EAFE Index and the MSCI Emerging Markets Index in U.S. dollar terms. In other words, ‘not owning Japan' is no longer a formula for outperformance for global investors. With the yen at a near quarter-century-low to the dollar, Japanese companies are in good health and domestically, a full year of reopening has resulted in record spending despite tourist numbers still below pre-COVID levels. We continue to believe there is a major perception and positioning gap of the Japanese equity market as an asset class in the global market context.
Overall, Japan continues to enjoy several tailwinds including a positive earnings cycle driven by moderate inflation, meaningful wage gains and policy driven reforms which are pushing companies to increase their corporate value via capital efficiencies and shareholder payouts. In addition, the recovery in inbound tourism plus the fact that Japan lacks the geopolitical headwinds of China is creating positive foreign inflows. 2023 saw an inflow of 3.2 trillion yen from foreign investors. While this is not small, it is only a fraction of the of the 11.8 trillion yen foreign investor outflow in the previous five-year period (2018-2022).
Our strategy continues to focus on investing in companies that can grow earnings through a relentless effort to achieve positive margin slope (long-term improvement in corporate margin levels). We are strong believers that these companies will be able to generate incremental returns over the long term. In sub-industries, we continue to be constructive in areas such as semiconductors, automation, software, healthcare service and technology, as well as global intellectual property (IP) owners.
View the Fund's Top 10 holdings as of December 31, 2023. Current and future holdings are subject to change and risk.
Average Annual Total Returns - MJFOX as of 12/31/2023
| 1YR | 3YR | 5YR | 10YR | SINCE INCEPTION | INCEPTION DATE |
|---|---|---|---|---|---|
| 17.99% | -5.84% | 6.45% | 5.55% | 5.54% | 12/31/1998 |
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.
