For the year ending December 31, 2018, the Matthews Japan Fund (Trades, Portfolio) returned -20.18% (Investor Class) while its benchmark, the MSCI Japan Index, returned -12.58%. For the fourth quarter of the year, the Fund returned -20.38% (Investor Class), versus -14.20% for the Index.
Market Environment:
2018 was a rough and volatile year for Japan's equity markets. Fears over worsening U.S.—China trade troubles combined with continued tightening by the U.S. Federal Reserve, which triggered a U.S. yield curve inversion, cast a shadow on investor sentiment—particularly toward the last quarter of the year. The impact of the trade war negatively impacted consensus earnings expectations, and led to a compression in multiples in sectors where growth expectations had been relatively high. Investor flows exacerbated conditions as overseas investors, who are typically geared toward quality names, pulled more than US$53 billion out of Japanese cash equities. An even larger amount was also pulled out of Japanese index futures. Additionally, steepening losses among the margin trading accounts of retail investors toward the end of the year strained the performance of small-cap stocks relative to their larger-cap peers.
Meanwhile, Japan's macroeconomic growth slowed during the year, in line with our expectations. GDP growth, in fact, turned negative in the first and third quarters, though the latter was largely due to one-off natural disasters. Business investment into production capacity expansion, enhancement and IT systems remained a driver of growth. Some cracks began to show, however, as corporate managers hesitated to invest more given the uncertain external environment. At the same time, consumption remained sluggish despite rising employment and wages.
Performance Contributors and Detractors:
The Fund severely underperformed its benchmark for both the full year and fourth quarter periods due to poor stock selection in the industrials and consumer staples sectors. For the full year, holdings in the consumer discretionary sector also posed a drag on performance. Additionally, our small- and mid-cap positions underperformed relative to their large-cap peers. Due to the acute correction, retail investors accumulated large losses in margin trading accounts, prompting margin calls that exacerbated the downside in small-cap stocks. The Fund is positioned as a quality growth-oriented portfolio but the selling activity we observed during the quarter was indiscriminant of quality or growth. Companies with valuation levels higher than market averages were sold off regardless of fundamentals that may justify those higher multiples. We believe the market is pricing in the possibility of a recession in 2019 after seeing the yield curve inversion in the U.S.
Our industrials sector holdings detracted the most from relative performance. Staffing companies such as Persol Holdings, TechnoPro Holdings, Recruit Holdings and Outsourcing were sold off as the market priced in a significant deceleration in future growth despite continued delivery of solid results amid Japan's labor shortages. We believe shares of these companies have been widely held by overseas investors for their quality and cash flow generation capability but were sold as investor funds flowed out of Japan.
The portfolio's consumer staples sector holdings also detracted from relative performance for the year. Firms with exposure to China, such as baby product company Pigeon, cosmetics company Kose and toiletry company Kao have been experiencing slower revenue growth in China amid softer consumption and emerging competition with local brands.
Meanwhile, our underweight position in the financials sector helped our relative returns. Our core holding non-life insurer Tokio Marine Holdings and non-bank financial service company Orix managed to outperform the broad sector while banks underperformed due to the flattening yield curve.
Notable Portfolio Changes:
During the fourth quarter, we added NTT (Nippon Telegraph & Telephone) (NTT, Financial), the state-owned fixed line telecom company that also owns a majority stake in the largest wireless service provider NTT DoCoMo. We had been wary of engaging in Japan's telecom sector due to intense pressure from the government to lower mobile tariffs. This culminated in the announcement by NTT DoCoMo in late October that it would sharply lower its mobile phone fees in 2019, resulting in a correction of share prices in the telecom sector. We began adding NTT after this event as we believed the negative impact from tariff cuts will not be as severe as touted while we also expected declining capital intensity and a reduction in working capital combined with the rollout of 5G services would lead to a gradual expansion in the future returns on invested capital.
During the quarter, we also added Sony (SNE, Financial). The company has gone through a substantial restructuring over the past decade, shifting its revenue away from consumer electronics, and toward recurring revenue businesses primarily in games and media. Sony's gaming platform PlayStation Plus boasts over 34 million paying members globally while its music publishing business, which recently added EMI Music Publishing, benefits from the proliferation of various music streaming offerings. As the proportion of recurring revenue business increases, we believe there is room for Sony to be rerated in line with other media companies, rather than as a consumer electronics company.
To fund these positions, we sold out of several technology and industrial holdings including industrial conglomerate Hitachi, automotive components company Mabuchi Motor and electronic materials company Nitto Denko. For Hitachi after meeting with senior management, we decided it would be prudent to exit the holding for the time being until there is more clarity surrounding its U.K. nuclear plant project. Mabuchi Motor was negatively affected by slowing car sales in China and the U.S. We believe Nitto Denko's optoelectronics business will likely face severe erosion in profitability with the saturation of smartphone sales volume while its health care business faces some obstacles following the cancellation of a major order.
Outlook:
We are cautiously optimistic on the outlook for Japanese equities. We expect earnings growth for Japanese companies to slow and possibly turn negative for the fiscal year starting April 2019 given slowing growth in the U.S. and China—Japan's two most important trade partners. Japanese corporate earnings tend to be pro-cyclical with higher earnings volatility than developed-market peers. A stronger yen, which can develop in an environment of “flight to safety,” may also be a source of earnings volatility for export-oriented businesses. As a result of the large correction in the recent quarter, however, valuations have already come down quite significantly. The MSCI Japan Index's price-to-book ratio has declined to 1.1X—nearing the trough level in the era of Prime Minister Shinzo Abe. A handful of stocks that we've been monitoring closely are approaching the levels at which we would feel comfortable investing in over the mid to long term.
We believe the earnings capability of Japanese companies has improved meaningfully over the past economic cycle due to better governance and a higher focus on capital efficiency. While earnings growth may be challenging amid a potential economic downturn, tougher times may also reinvigorate Japan Inc.'s resolve to further strengthen and enhance productivity. We believe a patient and constructive approach to Japan can reward investors over the long term.
As of 12/31/2018, the securities mentioned comprised the Matthews Japan Fund (Trades, Portfolio) in the following percentages: Persol Holdings Co., Ltd. 1.4%; TechnoPro Holdings, Inc. 1.0%; Recruit Holdings Co., Ltd. 2.1%; Outsourcing, Inc. 0.9%; Pigeon Corp. 1.7%; Kose Corp. 3.0%; Kao Corp. 1.8%; Tokio Marine Holdings, Inc. 3.7%; ORIX Corp. 2.7%; Nippon Telegraph & Telephone Corp. 3.4% and Sony Corp. 2.2%. The Fund held no positions in Hitachi, Ltd.; Mabuchi Motor Co., Ltd.; Nitto Denko Corp. or NTT DoCoMo, Inc. Current and future portfolio holdings are subject to risk.
Average Annual Total Returns - Investor Class (12/31/2018)
1-year -20.18%
3-year 2.18%
5-year 4.66%
10-year 8.27%
Inception (12/31/98) 5.31%
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.
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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.
