Environment
Japanese stocks posted strong gains in local currency terms over the quarter but lost ground in U.S. dollar terms due to a significantly weaker yen. In the first half of the quarter, good corporate earnings and a number of stock buybacks helped support stocks, as did reports that the country's public pension fund may raise its weighting in domestic equities. Later in the period, markets got a more unexpected lift from weaker economic data, which raised expectations of further stimulus and monetary easing and drove the yen significantly lower. Export-oriented stocks, such as automakers and manufacturers of machinery and electric appliances, posted particularly strong gains. The weakest-performing sectors over the quarter included banks, real estate, and financial services excluding banks.
Performance
The Japan Fund returned −3.69% in the quarter compared with −2.27% for the TOPIX Index and −0.71% for the Lipper Japanese Funds Average. For the 12 months ended September 30, 2014, the fund returned −0.60% versus 1.37% for the TOPIX Index and 2.60% for the Lipper Japanese Funds Average. The fund's average annual total returns were −0.60%, 7.56%, and 3.25% for the 1-, 5-, and 10-year periods, respectively, as of September 30, 2014. The fund's expense ratio was 1.06% as of its fiscal year ended October 31, 2013.
Portfolio Highlights
We maintained IT and services as the portfolio's largest overweight, with significant positions in communications firms. We remain overweight in the nonbank financial sector, where fundamentals and valuations remain attractive, and firms are poised to benefit from growing credit card penetration as well as the recovery in cash advances. Banks remain our largest underweight by a significant margin, however, as robust competition has driven an almost unlimited supply of loans at very low rates.
Outlook
We believe Japan is capable of leaving its lost decades behind, but we are mindful that the recovery will take place over many years and is likely to feature bouts of significant market volatility. In the meantime, we see evidence of a cultural shift within Japanese corporations that is creating opportunities for investors, as more companies are transforming business practices and improving governance standards. The number of shareholder buybacks is increasing, while merger and acquisition activity is slowly emerging. Current valuations remain well below precrisis levels and should continue to provide medium-term support. Japan has the potential to deliver the strongest revenue growth and earnings growth of any major country this year, with profit margins having significant room to expand if the global economy remains on track.
