Investing in "Growth in Disguise" Japanese Companies

What is the status of the reopening of tourism in Japan?

Japan has just begun to slowly reopen to overseas tourists following the closing of the border due to the Covid-19 omicron variant. Importantly, the government is taking the necessary steps to gradually ease border restrictions, allowing more tourists to visit and exempting testing for vaccinated visitors. 

Tourism into Japan remains well below the 2019 figure of 30 million people, yet we believe once the border fully reopens, there will be a large influx of tourists due to the currency depreciation and Japan’s reputation for high-quality services and hospitality.

With regards to the Hennessy Japan Fund, the portfolio has little-to-no direct exposure that benefits from tourism. Yet we believe new holding ORIX Corp. could be an indirect beneficiary. ORIX is Japan’s largest non-bank comprehensive financial services company. Originally a leasing company, ORIX has diversified into a broad range of businesses including aircraft leasing, property development, asset management, banking, life insurance, private equity, venture capital, renewable energy investment, and airport concession. Many parts of its business, including aircraft leasing and airport concession, could benefit from increased tourism.

What effect has the Japanese Yen depreciation had on exporters?

Many Japanese exporters have benefited from the Yen depreciation. However, investors have not rewarded these exporters equally as execution capability makes a difference in the current market.

For example, Daikin, a global leader in heating and air conditioning products and systems, and Kubota, a tractor and heavy equipment manufacturer, are both global manufacturers with comparable profit margins. 

When they reported earnings in the second quarter, both expressed similar headwinds, including higher raw material costs, supply chain disruptions, and the pandemic-related lockdowns in China. Yet both companies raised their full-year guidance due to the weak currency.

Still, their stock prices reacted differently. Kubota’s stock declined when it announced a decline in operating profit but Daikin’s price rose as it was able to offset the decrease in profit with price hikes. 

Many exporters can only prosper in a weak currency environment. We continue to focus on select exporters who have the ability to grow independent of currency fluctuations. While Kubota had a weak quarter, when compared to other manufacturers, we believe the company remains well-positioned to continue its growth. 

How do current valuations in Japan compare to the U.S.?

Japanese companies look attractively priced compared to U.S. companies, with the Tokyo Stock Price Index trading at 12.2x 2022 estimated earnings as of September 6, 2022, compared to 17.3x for the S&P 500® Index.

The lower valuation can be attributed to Japan’s lower return on equity (ROE), which reached a high of 10% in 2017 but has stayed below that number. We believe Japan will see a significant improvement in ROEs driven by an accommodative monetary policy and Japan’s improving corporate governance and rising awareness of capital efficiency. 

Would you please discuss new holding Tokio Marine?

We recently added Tokio Marine, Japan’s largest general insurance group with a solid track record in the domestic market and an expanding overseas business. 

At the time of purchase, the stock was trading at what we believe to be a low valuation compared to the overall Japanese market. The reason for the below-market-average valuation is due to the market’s misperception of the insurance industry, in our opinion. Insurance businesses are generally regarded as mundane and mature in Japan. While this is true to some extent, the industry as a whole has been growing faster than Japan’s GDP and now is an oligopoly due to industry consolidation. Furthermore, its sizable overseas underwriting businesses are driving the overall net premium growth rate to mid-single digits. 

Tokio Marine is one of three mega-insurance groups in Japan that are attractive due to the following:

1.  After years of consolidation, they control nearly 90% of the domestic underwriting business, allowing them to generate abundant cash flows. 

2.  They own “strategic equity holdings” worth tens of billions of dollars, which used to be the target of shareholder criticism as under-utilized assets but now are being wisely utilized to create shareholder value.

We believe great businesses sometimes hide in plain sight. For example, with portfolio holding Unicharm Corp. we have found the baby diaper business and other baby care products business attractive due to their relatively strong pricing power and brand equity for Japan-made premium products. Tokio Marine is yet another portfolio example of a great business hiding in plain sight.

What makes Tokio Marine a “growth in disguise” company?

A “growth in disguise” company has growth prospects that are as compelling as the Fund’s other portfolio holdings but the stock is valued at what we believe to be a low price to earnings (P/E) multiple.

We consider Tokio Marine to be a “growth stock in disguise” business. Tokio Marine’s compounded annual growth rate (CAGR) could be comparable to other portfolio holdings, yet the sources of return differ. Many of the Fund’s holdings do not engage in share buybacks nor offer dividends, and therefore the future investment return relies solely on earnings growth—aside from valuation multiple expansion. 

For stocks with share buybacks and dividend yields, the total investment return equals the sum of aggregate profit growth, incremental increase in earnings per share driven by share buybacks, and dividend yield. In the case of Tokio Marine Holdings, this total investment return should fall within a range between high single digits to over 10%.

Holdings Sony Group and Hitachi also fit this “growth stock in disguise” category. When purchased, Sony Group was valued at 13x forward P/E in 2019/2020 and Hitachi was valued at 10x forward P/E last year.

Looking ahead to the rest of 2022, would you please provide an outlook for the Fund?

Despite Japan’s macroeconomic challenges of inflationary pressures and an aging and shrinking population, we believe it’s important to focus on individual market-leading companies that are well run and globally competitive. 

From a portfolio perspective, many of the Fund’s holdings can be broadly grouped into two types of companies: 

1.  High-quality companies whose competitive strengths are rooted in manufacturing excellence. We continue to view manufacturing excellence to be Japan’s durable competitive advantage, and our holdings have excellent track records of navigating past recessions. We believe they have the ability to weather inflationary headwinds over time.

2.  Businesses whose compelling economics are in intangible assets. These companies require little capital to grow and have high returns on capital and high operating leverage, providing potential growth regardless of an inflationary environment.