Period ended March 31, 2019
For the quarter ending March 31, 2019, the Matthews Japan Fund (Trades, Portfolio) returned 12.68% (Investor Class), outperforming its benchmark, the MSCI Japan Index, which returned 6.85%.
Market Environment:
Japanese equities posted solid gains in the quarter, up from one of their lowest levels of valuations since the start of the Abenomics era in late 2012. Along with other central banks worldwide, the U.S. Federal Reserve's recent pause in rate hikes seems to have improved sentiment. At the same time, the larger macro environment both globally and in Japan remains mixed, with exports slowing and the earnings forecast for Japanese companies still in a downward trend. The Bank of Japan's most recent Tankan Survey (announced April 1) saw business conditions for large manufacturers erode, mainly caused by export sectors such as semiconductors and semiconductor capital equipment. Domestic consumption remained sluggish, with monthly retail sales mainly driven by weather-related factors.
Performance Contributors and Detractors:
The Fund's outperformance during the quarter was driven by strong stock selection among smaller and midsize companies, which make up roughly half of the portfolio. While smaller companies outperformed larger companies across the board during the reporting period, stock selection—more so than market cap allocation—primarily drove returns.
From a sector perspective, stock selections in information technology (IT), industrials and communication services were positive contributors to performance. Although we remain cautious on the cyclicality of the semiconductor industry and industrial production, our emphasis on companies that enhance productivity via IT services or automation within these sectors helped us capture attractive returns. Meanwhile, our holdings in the consumer staples, utilities and consumer discretionary sectors mildly detracted from performance, as retail spending remained tepid during the quarter.
Turning to individual securities, telecom and venture capital firm SoftBank (TSE:9984, Financial) was the largest contributor to performance. SoftBank's share price rose following the announcement of a massive 600 billion yen (US$5.5 billion) stock buyback. The recent IPO of transportation network company Lyft in the U.S. and other unicorn companies going public also spurred interest in pre-IPO companies that SoftBank and its Vision Fund currently hold.
Lasertec (TSE:6929, Financial), a semiconductor equipment test and measurement company, also contributed to performance during the quarter, despite weak capital expenditure among semiconductor manufacturers. Leading-edge development in areas such as extreme ultraviolet (EUV) technologies has gained momentum, benefiting Lasertec, which makes related inspection systems.
The largest detractor from performance was natural seasoning and flavoring producer Ariake Japan (TSE:2815, Financial). The company announced plans late last year to sell its stake in its U.S. business, which had been a driver of profit growth in recent years. The company intends to channel the resources to other regions, especially in Asia. We continue to monitor the position and evaluate its growth prospects and its execution abilities.
Sony (SNE, Financial) also was a detractor. Most recent quarterly results showed some slowdown in its core game business after a very strong first half. Additionally, late in the quarter Google announced plans to launch a new cloud game service, which spurred concerns of potential competition to Sony's PlayStation game platform. Although details are still limited regarding cloud game service, we think Sony's strategy of closely working with developers to help deliver a superior gaming experience to users using their consoles still has an edge.
Notable Portfolio Changes:
During the quarter, we reduced our exposure to cyclical stocks, taking advantage of the market rally in January. We reallocated the proceeds to higher-quality companies that were sold off toward the end of last year, which were trading at the bottom of the range despite their ability to grow in a slower macro environment. We continue to keep an eye out, however, for high-quality growth companies in cyclical sectors as these periods test management capabilities to maneuver downturns.
During the quarter, we sold five positions: Minebea Mitsumi, ZOZO, Shin-Etsu Chemical, CKD and Mitsui & Co. In general, we added the proceeds from these sales to our current high-conviction holdings.
Outlook:
While Japanese equities experienced healthy gains in the first quarter, the macro environment remains relatively muted. Underlying fundamentals are sluggish, in terms of both export and domestic consumption, although corporate inventory levels have declined quickly in the past six months. Some Japanese businesses sell products and services in China, where the economy has slowed a bit. On a positive note, the Chinese policymakers, who were in a monetary tightening cycle last year, have shifted their policy to a relatively accommodative stance, although we do not expect any kind of a large stimulus. The MSCI Japan Index's price-to-book is now 1.24X, up from the lows of 1.16X level at the end of 2018, but still in the lower end of the range.
While Japanese corporate earnings tend to be procyclical with higher earnings volatility than developed-market peers, we continue to believe the earnings capability of Japanese companies has improved meaningfully over the past economic cycle, driven by better corporate governance and a higher focus on capital efficiency. Year to date we have already seen many companies announce large-scale share buybacks, which will be an important earnings per share (EPS) growth and return on equity (ROE) improvement driver in a relatively muted macro growth environment.
As of 3/31/2019, the securities mentioned comprised the Matthews Japan Fund (Trades, Portfolio) in the following percentages: SoftBank Group Corp. 2.4%; Lasertec Corp. 2.0%; Ariake Japan Co., Ltd. 1.4%, Sony Corp. 1.8%. The Fund held no positions in Lyft, Inc.; Alphabet Inc. (Google); Minebea Mitsumi, Inc.; ZOZO, Inc.; Shin-Etsu Chemical Co., Ltd.; CKD Corp.; or Mitsui & Co., Ltd. Current and future holdings are subject to risk.
Average Annual Total Returns - Investor Class (3/31/2019)
1-year -14.52%
3-year 6.26%
5-year 7.67%
10-year 11.76%
Inception (12/31/98) 5.87%
Gross Expense Ratio
0.91%
After fee waiver and expense reimbursement:
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.
