For the quarter ending September 30, 2018, the Matthews Japan Fund (Trades, Portfolio) returned 0.17% (Investor Class) while its benchmark, the MSCI Japan Index, returned 3.82%.
Market Environment:
Japan's equity markets traded within a tight range for most of the third quarter followed by a strong rally into the quarter end. Market sentiment around the deepening trade spat between the U.S. and China resulted in a compression of valuation multiples despite better-than-expected earnings reported by Japanese listed companies. Overseas investors remained net sellers of Japanese equities during the quarter, though the pace of selling subsided.
Meanwhile, Japan's economy delivered solid annualized growth, at a rate of 3% in the second quarter of 2018, driven by robust private sector capital expenditure. This comes on the heels of a slight contraction during the previous quarter and provides comfort that domestic economic conditions remain healthy. Strong demand conditions, rising wages and labor shortages are prodding companies to reinvest in their business to enhance productivity. Steady job creation combined with rising wages is leading to an increase in total employment income, supporting domestic consumption.
Performance Contributors and Detractors:
During the quarter, the Fund underperformed the benchmark as both sector allocation and stock selection detracted from returns. The largest detractor was the consumer discretionary sector as fashion e-commerce company Zozo (TSE:3092, Financial) (formerly known as Start Today) slumped as it failed to meet heightened expectations for its private-brand apparel business. We had trimmed our position, but not enough, as valuations became expensive. Dollar-store operator Seria (TSE:2782, Financial) also struggled amid weak sales delivery and higher costs. Holdings in the health care sector also detracted from performance. Hematology equipment company Sysmex (TSE:6869, Financial), a core long-term holding for the Fund, missed quarterly consensus estimates as some order deliveries were pushed out to future quarters. Japan Lifeline, a manufacturer and wholesaler of cardiovascular equipment, declined following weak quarterly earnings that resulted from reimbursement price cuts and increased expenses in preparation for new product launches.
On the other hand, our telecom holding SoftBank performed well. SoftBank traded at a significant discount to estimated net asset value, and transparency should rise as it gears up to list its domestic mobile telecom business. Marketing media and HR technology company Recruit Holdings also contributed positively on the back of the rapid growth of job search engine business Indeed. Indeed continues to drive revenue growth as it expands into non-U.S. markets, including Japan.
The largest negative contribution came from real estate tech company Tateru (TSE:1435), which was a recent addition to the portfolio. During the quarter, Tateru disclosed that one of its employees had intentionally falsified loan application documents in order to obtain an apartment loan for a customer. Although the stock declined significantly following the disclosure, we immediately exited the position.
Notable Portfolio Changes:
We did not initiate any new positions in the portfolio during the third quarter. We did, however, exit our long-held position in mining and construction equipment company Komatsu (TSE:6301, Financial). We expect sales momentum in its construction equipment business in China will likely weaken going forward due to the slower-than-expected progress of infrastructure projects. At the same time, profit margins for its mining equipment have improved substantially and we believe further improvements have already been priced in.
We also exited robotic gear company Harmonic Drive Systems (TSE:6324, Financial). This was another long-term holding for the Fund that had contributed significantly over the years. We believe orders for robotics reached a cyclical peak last year and expect growth momentum to slow going forward. Additionally, we saw new participants in the robotics gears industry and were concerned that increased competition might erode the company's future pricing power.
Outlook:
We are turning slightly more optimistic regarding the outlook for the Japanese economy. Robust job creation combined with a structural labor shortage is translating to faster growth of employment income. This, combined with an expected expansion of fiscal spending, may allow Japan to better cope with the consumption tax hike scheduled for 2019. Additionally, based on our bottom-up research, it seems consumer prices are actually rising faster than what the government's consumer price index statistics suggest as companies adjust pricing to account for higher wages. This is prompting aggressive investment into automation and IT systems, which we believe will serve to enhance productivity and improve margins in the future.
However, we remain cognizant of the external risks for Japan's economic growth and equity markets. Higher U.S. dollar interest rates and a tighter dollar supply are raising funding costs in many emerging economies and leading to a softening of demand. With our emphasis on growth in the region, we are starting to feel the impact through our portfolio companies. We are actively revisiting the investment thesis for our Asia-exposed businesses and will continue to focus our research on identifying unique bottom-up opportunities that we believe will add value over the long term.
As of 09/30/2018, the securities mentioned comprised the Matthews Japan Fund (Trades, Portfolio) in the following percentages: Start Today Co., Ltd. 1.0%; Seria Co., Ltd. 1.0%; Sysmex Corp. 2.3%; Japan Lifeline Co., Ltd. 1.1%; SoftBank Group Corp. 2.9%; and Recruit Holdings Co., Ltd. 2.6%; The Fund held no positions in TATERU, Inc.; Komatsu, Ltd. or Harmonic Drive Systems, Inc. Current and future portfolio holdings are subject to risk.
Average Annual Total Returns - Investor Class (9/30/2018)
1-year 8.52%
3-year 13.95%
5-year 9.60%
10-year 9.64%
Inception (12/31/98) 6.61%
Gross Expense Ratio
0.95%
After fee waiver and expense reimbursement: 0.94% 1
1 Matthews has contractually agreed to waive a portion of its advisory fee and administrative and shareholder services fee if the Fund's average daily net assets are over $3 billion, as follows: for every $2.5 billion average daily net assets of the Fund that are over $3 billion, the advisory fee rate and the administrative and shareholder services fee rate for the Fund with respect to such excess average daily net assets will be each reduced by 0.01%, in each case without reducing such fee rate below 0.00%. Any amount waived by Matthews pursuant to this agreement may not be recouped by Matthews. This agreement will remain in place until April 30, 2019 and may be terminated (i) at any time by the Trust on behalf of the Fund or by the Board of Trustees upon 60 days› prior written notice to Matthews; or (ii) by Matthews at the annual expiration date of the agreement upon 60 days› prior written notice to the Trust, in each case without payment of any penalty.
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.
The views and opinions in this commentary were as of the report date, subject to change and may not reflect current views. 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. It should not be assumed that any investment will be profitable or will equal the performance of any securities or any sectors mentioned herein. The information does not constitute a recommendation to buy or sell any securities mentioned.
The information contained herein has been derived from sources believed to be reliable and accurate at the time of compilation, but no representation or warranty (express or implied) is made as to the accuracy or completeness of any of this information. Neither the funds nor the Investment Advisor accept any liability for losses either direct or consequential caused by the use of this information.
