Period ended September 30, 2016
For the quarter ending September 30, 2016, the Matthews Japan Fund (Trades, Portfolio) returned 3.42% (Investor Class), while its benchmark, the MSCI Japan Index, returned 8.76%.
Market Environment:
All eyes were on the Bank of Japan (BOJ) as it announced in July that the central bank will conduct a comprehensive review of its controversial negative interest rate policy while also doubling its purchases of equity exchange-traded funds (ETFs). This sparked an array of top down-driven speculation resulting in significant performance differences by sector and market capitalization. In general, investors shifted from defensive quality, growth names and from small caps into large caps in previously beaten down sectors like commodities, financials and autos.
In late September, the Bank of Japan announced its new monetary policy structure “Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control.” The aim is to control the supply of Japanese government bonds (JGBs) so that 10-year JGB yields will remain more or less around zero percent, resulting in a steeper yield curve. The BOJ also tweaked its equity ETF purchases to acquire more of the broader-based Tokyo Stock Price index ETFs rather than the Nikkei 225 index ETFs. These actions sparked a reversal of some of the shifts we saw earlier in the quarter. Most noticeably, small-cap stocks outperformed significantly in the last two weeks of the quarter.
Performance Contributors and Detractors:
During the quarter, both sector allocation and stock selection contributed negatively to relative performance. In general, the Fund’s underperformance was concentrated in our mid- and small-cap holdings. Stock selection in the consumer discretionary sector had the largest negative impact on a relative basis as core holdings, such as retailer Ryohin Keikaku and fashion e-commerce company Start Today, underperformed. Additionally, our lack of meaningful exposure to automotive-related companies also detracted from performance as these names rebounded. This was followed by underperformance in the financials sector due to our limited exposure to banks, securities brokerages and life insurance companies, which rallied off their post-Brexit lows.
On the other hand, our stock selection in the industrials sector provided some relief. Industrial motor company Mabuchi Motor (TSE:6592, Financial) rallied as it delivered better-than-expected earnings and announced a new large order from a global customer. Construction and mining equipment company Komatsu (TSE:6301, Financial) also performed well as equipment demand started to show signs of bottoming. Komatsu also acquired U.S. mining equipment company Joy Global, which we believe to be accretive to earnings going forward.
Notable Portfolio Changes:
During the quarter, we added several new names, including Suzuki Motor (TSE:7269, Financial). Suzuki is a medium-sized automobile manufacturer that specializes in small cars, and has a significant presence in India through its subsidiary Maruti Suzuki. Its India business, including royalties received, accounts for the vast majority of Suzuki’s net profits. The research into this idea involved extensive discussions with our India team, which has in-depth knowledge of the local market. We believe India’s automobile market has significant room for growth as rising income levels result in higher vehicle ownership.
To fund the purchase of Suzuki, we exited our position in internet service company Kakaku.com (TSE:2371, Financial). Kakaku.com management has done a great job growing its restaurant information service Tabelog over the past several years, building it into the most dominant restaurant information app in Japan. However, growth at Tabelog has started to slow, weighed by new competition, while the company has struggled to find new avenues for growth. Compared to the slowing growth outlook, valuations remained elevated and hence, we decided to exit the position.
Outlook:
Now that the BOJ has completed its review of its negative interest rate policy, we look forward to returning to a more rational, fundamentally driven market. As a whole, we remain cautious on the outlook for Japanese equities, but we are quite upbeat about our portfolio holdings. In particular, growth in Asia is showing nascent signs of recovery with fiscal measures finally coming through in China. With currencies stabilizing in most of emerging Asia, consumption and capital spending seem to be bottoming out. It will take at least several quarters for this to be reflected in earnings figures but we expect our portfolio holdings, particularly those with high exposure to Asia, to grow earnings much faster than the overall market. We believe that a selective and patient approach to Japanese equities will benefit investors over the long term.
The views and opinions in this commentary were current as of September 30, 2016. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the Fund’s future investment intent.
Statements of fact are from sources considered reliable, but neither the Funds nor the Investment Advisor makes any representation or guarantee as to their completeness or accuracy.
As of 9/30/2016, the securities mentioned comprised the Matthews Japan Fund (Trades, Portfolio) in the following percentages: Ryohin Keikaku Co., Ltd. 2.1%, Start Today Co., Ltd. 2.4%, Mabuchi Motor Co., Ltd. 2.5%, Komatsu, Ltd. 2.4%,and Suzuki Motor Corp 1.5%.The Fund has no holdings in Maruti Suzuki or Kakaku.com. Current and future portfolio holdings are subject to risk.
