Market Commentary and Fund Performance

Performance data quoted represents past performance; past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the fund may be lower or higher than the performance quoted. Performance data current to the most recent month end, and standardized performance can be obtained by viewing the fact sheet or by clicking here.

Fund Performance Review

In November 2024, the TOPIX increased 0.90%.

The first half of the month saw fluctuations. Following the U.S. presidential election on November 5, the reports that former President Donald Trump took the lead in the election led to a significant rise in the Nikkei 225, nearing JPY40,000 ($259.66) on November 7.

However, when U.S. President-elect Trump’s plan to appoint a hardliner against China to his administration was reported, increased caution towards the incoming administration’s policy for tougher tariffs put pressure on semiconductor-related stocks, and the stock market began to decline. Nevertheless, on November 14, following the Federal Reserve Chairman Jerome Powell’s comments that the central bank of the U.S. does not need to be “in a hurry” to lower interest rates, export-related stocks were bought as the yen weakened, and semiconductor-related stocks rebounded, halting the stock market’s daily declines.

In the second half of the month, the Japanese stock market fluctuated within a narrow range, with investors continuing to be affected by uncertainty over the future of U.S. monetary policy and trends in U.S. semiconductor stocks. In addition, the market continued to soften in response to the announcement by U.S. President-elect Trump of tariff measures against China, Mexico, and Canada, resulting in an overall decline by the end of the previous month.

This month, the Fund returned 4.64% (HJPIX), outperforming its benchmark, the Russell/Nomura Total Market™ Index, which returned 1.00%.

The month’s positive performers among the Global Industry Classification Standard (GICS) sectors included shares of Financials, Consumer Staples, and Consumer Discretionary while Information Technology, Industrials, and Health Care detracted from the Fund’s performance.

Among the best performers were our investments in Seven & i Holdings Co., Ltd., a Japanese diversified retail group and operator of Seven-Eleven convenience stores, Sompo Holdings, Inc., one of the three largest general insurance company in Japan and Recruit Holdings Co., Ltd., Japan’s unique Human Resources (HR) and media company and the owner of U.S.-based online job advertisement subsidiary “Indeed.”

As for the laggards, Mitsubishi Corporation, the largest trading company in Japan, Rohto Pharmaceutical Co., Ltd., a leading skincare cosmetics and over-the-counter (OTC) ophthalmic medicines producer and Hitachi, Ltd., one of Japan’s oldest electric equipment & heavy industrial machinery manufacturers.

Year 2024 in Review

We are now entering the final month of the year. We would like to take this opportunity to reflect on the recent changes in the market trend and discuss the outlook for 2025 (and beyond).

For the first half of this year, the Japanese market was characterized by a strong rally, up 18% through to the end of June, with the index repeatedly renewing 33-year highs. The market celebrated Japan’s new era after finally breaking through the previous peak marked back in 1989. This rally gained strength after a confluence of events in the early part of 2023.

First, the Tokyo Stock Exchange’s initiative of “naming and shaming companies with less than 1x price to book ratio (P/B),” announced in March 2023, instilled a sense of urgency in corporate boardrooms to improve returns on capital. Around the same time, Japan started to witness an acceleration of shareholder campaigns led by both overseas and home-grown activist firms. More than a dozen underperforming companies have become the poster children of Japan’s renewed shareholder activism, with the Fund holding Seven & i Holdings among them.

In late April 2023, Warren Buffett of Berkshire Hathaway garnered attention when he made a surprise visit to Japan to meet with the management teams of the five Japanese general trading companies he is invested in. To our knowledge, these investments were the first that the legendary investor has made in a Japanese public company.¹ In media interviews, he praised how far Corporate Japan had come and how it had become an attractive investment destination. Additionally, the second iteration of the government-sponsored Nippon Individual Savings Account program (NISA), introduced in January 2024, helped rekindle interest in Japanese stocks among retail investors.

Japan’s corporate governance reforms have been progressing since 2014/2015 with the introduction of the stewardship code and the corporate governance code. Nevertheless, global investors didn’t take notice of the gradual, steady improvements in the capital efficiency of Japanese businesses until the events we highlighted above finally caught the world’s attention. Since then, the market has gone on a tear.

However, the tide turned in August this year. The month started with an unprecedented market sell-off that saw stock prices fall beyond the 1987 Black Monday, throwing cold water on the upbeat stock markets. The trigger was the sudden unwinding of speculative short positions in the Japanese yen (JPY), known as carry trades, which had been a factor behind the currency’s depreciation. The unwinding caused a surge in JPY and a massive downturn in stocks, putting Japanese markets in a bad light. Many global allocators became wary of the extreme volatility following this event, alienating some consequently.

The tumultuous August was followed by a Liberal Democratic Party (ruling party) leader election in September. The newly elected Shigeru Ishiba unintentionally rocked the boat when he revealed his agenda, in which he toyed with the idea of potential financial income tax hikes. He was also said to be slightly more hawkish than other candidates, as he believed the years-long ultra-low rates created too many side effects. On seeing the negative market reaction, he quickly dialed back on both.

Around the same time in China, whose economy has been struggling with signs of deflation emerging, the central bank, People’s Bank of China, announced a much-needed large-scale stimulus package. The Chinese stock market roared back as a result. This altered the flows of global investment capital. Traders took profits from India and Japan, two of the best-performing markets, and shifted to China.

The end of October saw Japan’s lower house election. The ruling coalition party failed to win the majority seats in a surprise defeat. This raised concerns that new legislative bills going forward will take longer to pass in Parliament, stifling structural reforms and even diverting attention from other important political agendas, such as building a sound diplomatic relationship with the new U.S. president. Then, in November, the U.S. presidential election took place. The Trump and “Red Sweep” once again cast a cloud over the fate of Japanese companies. All these factors contributed to the softening of investors’ interest in Japan, in our view.

Is the case for Japan really over?

With 2025 just around the corner, one of the most important question on global investors’ minds should be is, “Is the case for Japan really over?” Here, our short and decisive answer is: Far from it.

It is easy to brush aside our bullishness because we are a long-only portfolio manager dedicated to this market (after all, it is in our interest to make a case for Japan). However, many readers would recall that Portfolio Manager Masa Takeda has been rather pessimistic about the Japanese economy through most of his investing career during the 2000s and 2010s, citing numerous structural challenges surrounding the country, such as deflation and rising government debt levels. Particularly, the country’s shrinking and ageing demographics have been the biggest drawback.

This is why the Fund seeks Japanese companies with an international footprint. Thanks to their global exposure, many of our portfolio companies have grown their businesses, which in turn have increased their intrinsic value and their share prices (long-term compounders like Keyence and Fast Retailing), irrespective of the domestic economic conditions.

Today Japan’s investment landscape has arguably shifted to a more positive one. The biggest catalyst has been the improving corporate governance standards, which started in 2014/2015 but only gained recognition in the last two years. Corporate Japan is finally embracing the capitalistic ethos focusing on capital efficiency, which was almost ignored before.

This makes Japan’s entire market a much more conducive investment environment. Our observation is that what was initially spearheaded by the government in a top-down manner has now turned into more spontaneous actions. These actions are being taken by the listed companies from the ground up. Therefore, the key message we want to convey is this: We believe Japan’s corporate governance reforms will continue to progress regardless of economic or political changes going forward.

How should we think about the Japanese political landscape?

While Japan’s ongoing capitalist reforms are likely to remain on track, questions about Japan’s future political leadership remain.

Fundamentally, all political parties (both the ruling and the opposition) share the same common interests: ending deflation, boosting the economy, and keeping inflation from running too hot, with varying degrees of commitment. This suggests that economic growth is prioritized, with the public debt problem to be addressed later.

While stimulative measures could lead to upward pressure on long-term interest rates and higher inflation, requiring more careful economic and fiscal planning, we believe this is the only prescription that works for Japan at this juncture. To this end, it is encouraging that we have a reform-minded government that is pro-growth and pro-business, and a central bank that is also pro-growth and pro-inflation today. This is a very different dynamic from the late 2000s.

Trump Administration

We are also frequently asked about the incoming Trump administration and its impact on Japan. Here, we will paraphrase the question and discuss the impact on our portfolio instead.

The implications of the Trump policies are not straightforward. On the one hand, his proposed tax cuts will likely benefit those operating in the U.S. Our major holdings, such as Seven & i Holdings, ORIX, Hitachi, Recruit Holdings, Sony Group, Shin-Etsu Chemical, and Tokio Marine Holdings, all come to mind as potential beneficiaries.

These companies derive a significant portion of their global revenues from the U.S. Better yet, they either produce their goods locally (e.g., Shin-Etsu’s PVC business) or are in the non-manufacturing sectors (Seven & i, Recruit, Tokio Marine, etc.). This may insulate them from the potential tariff burdens. Even for those that will be subject to the new tariffs, the impact should be limited. For example, Keyence, one of our longest holdings, excels in developing differentiated factory automation sensors. These are highly value-added products, which enable industrial customers to save costs by eliminating the need for humans. As such, its customers will likely continue to find their offerings valuable.

Elsewhere, the Trump administration’s plans around de-carbonization, semiconductor trade policy, and defence policy are all still “sketchy.” We expect there will be both positive and negative implications from each of these policies as the details become clearer. At this stage, we feel our portfolio is well-positioned to withstand these risks.

Lastly, we should also keep an eye on the widening U.S. budget deficit and its long-term consequences. The ever-worsening fiscal situation may eventually weigh on the health of the American economy as well as on equity valuations.

Investment outlook for 2025 and beyond

We are optimistic about the expected returns of Japanese equities over the next several years, assuming a benign economic and currency environment continues.

We anticipate Corporate Japan as a whole can continue to produce solid earnings growth in the mid-single digits. This growth should be partly organic, potentially 3-5%, and partly driven by mild inflation of around 2%. While the former has been achieved by Japanese companies for many decades, the latter has emerged as a new tailwind only recently. As inflation in Japan is expected to stay higher for longer, we can now look to additional growth from continuous price increases to keep up with inflation. This could not be counted on under the past deflationary environment.

After years of anaemic price inflation, our view is that the Japanese economy can absorb inflation-offsetting price hikes. The ongoing nationwide wage hike efforts can help keep the economy from slumping into stagflation. Nominal profit growth is what matters to investors.

Share buybacks and dividends are also sources of returns just as important as earnings growth albeit often underappreciated by the market. They are crucial in improving Japan’s overall return on equity (ROE). According to financial market data tracker I-N Information Systems, Japanese companies paid out 20tn yen ($129.8bn) in dividends in FY2023.² When compared to the average monthly market capitalization of the Tokyo Stock Exchange of 871tn yen³ ($5.7tn), the ex-post dividend yield comes out to 2.3%.

In the same vein, share repurchases were conducted on the order of 9.4tn yen ($61.0bn) in total for the same period, which was roughly 1.1% of the total market cap. Not all repurchased shares are cancelled, but an increasing number of companies are doing so for the sake of better capital efficiency.⁴

That’s about a 3.4% total cash return yield. Many listed Japanese companies boast cash-rich balance sheets and too much equity. As of the end of FY2023, the aggregate cash balance amounted to a record 114tn yen ($739.3bn) and a capital ratio of 42%, both of which were all-time highs.⁵ It seems safe to assume that Japanese companies can augment shareholder returns to sustain the current yield even as share prices continue to advance.

Expansion of valuation multiples can also provide a boost to share prices. Despite the positive changes in the quality of earnings, where ROE has improved from mid-single digits to almost 10% since the start of Abenomics at the end of 2012 through August 2024, the market has not yet awarded higher valuations.

Whereas the price to earnings (P/E) ratio for the TOPIX Index was 14x as of September 30, 2024, we could see a range of 15x to 18x. Some skeptics may argue that a P/E ratio of 15x is not exactly cheap when other countries are trading at lower valuations (e.g., South Korea, China, Hong Kong). However, when you consider Japan’s unique circumstances, one can see why our valuation arguments become compelling, or at least not overvalued:

•    The real interest rate in Japan is still negative and therefore lower than in other low P/E countries

•    Cash-rich balance sheets serve as a margin of safety and make ex-cash P/E appear cheaper

•    The country’s improving capital efficiency is still in the early phase

•    The geopolitical neutrality of Japan makes it a safe choice for global investing

Putting it all together, we can summarize the return components as follows:

•    +3.0-5.0% organic earnings per share (EPS) growth through sales volume growth and improving sales mix

•    +2.0% additional growth in EPS to reflect sustainable inflation

•    +3.0% from total capital return yield, of which +2.0%from dividends and +1.0% from share buybacks

•    +4.0-6.0% from the change in valuation multiples

•    Therefore, a 10+% compound annual return can be estimated for the next several years.

Another viewpoint worth highlighting is the supply and demand dynamics of Japanese stocks. Japan may not be a high-growth economy anymore, but there is abundant surplus wealth of over 2,200tn yen ($15tn) in household financial assets. As a country of savers, Japan has kept roughly half of this in bank savings with near-zero interest for decades. However, with inflation being the new norm, households are faced with the continued erosion of their purchasing power. If Japanese consumers can show economically rational behaviour, the shift from savings to investments should accelerate from here. While the early movers have thus far allocated to offshore equities (mainly U.S. stocks), the next big move may come to the Japanese stock market. Considering the total market size of the Japanese stock market at 1,000tn yen ($7tn), only a modest shift in asset allocation toward Japanese equity can move the needle in a big way.

Lastly, a word on the shift in market appreciation patterns. Since the early 2000s, when Portfolio Manager Masa Takeda started his career as a portfolio manager (he was an analyst from 1999 to 2003), the Japanese stock market has been primarily driven by a few select outliers like Fast Retailing and Keyence, which have outstanding business models that earn extraordinarily high returns on capital. Due to a dearth of attractive investment opportunities, these stocks often traded at multiples way above the market average, which was justified under Japan’s ultra-low-interest rate regime back then. However, this narrative may have changed. As Japan enters a new era of sustainable inflation and normalized interest rates, together with a strong commitment to improving the perennially low ROE, we can now expect a large number of listed companies in the bottom half of the market in terms of capital efficiency to drive up the entire market. This could be a very powerful force.

In closing

Japanese stocks may have been just part of the yen trade in the past, where risk-on sentiment meant shorting JPY and buying stocks, and risk-off indicated the opposite. However, in our opinion, this is not the right approach to investing in Japan. Nor is it wise to trade to market based on short-term economic outlooks, in our view. Rather, it is about participating in changing corporate governance standards that lead to better returns on capital of Japanese listed companies. This is a long-term structural story.

We believe the sharp falls in stock prices caused by the unwinding of JPY/USD carry trades are not due to a deterioration of business fundamentals. Thus, this often creates mispricing of securities where their prices deviate significantly downward from their intrinsic value.

For fundamental bottom-up investors like us, it becomes a buying opportunity. During the August turmoil, we played to our strength by doubling on our high-conviction ideas. As such, the Fund’s YTD return (HJPIX) of 20.82% at the end of July, just before the sell-off, has subsequently extended to 22.17% at the end of November.

We believe Japan is a market where an active manager can still beat the index consistently. Japan is culturally very different compared to the U.S. and Europe. Many foreigners note a lack of meritocracy in corporate culture, a sense of egalitarianism, and homogeneity, where Japanese people tend to think alike. This makes it challenging for foreign investors to fully understand the local market dynamics, leading to inefficiencies in the Japanese stock markets. We believe that local active managers like us can continue to add value here.

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