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 June, the Fund returned 2.34% (HJPIX), outperforming its benchmark, the Russell/Nomura Total Market™ Index, which returned -0.72%.

The month’s positive performers among the Global Industry Classification Standard (GICS) sectors included shares of Financials, Materials and Industrials, while Information Technology and Communication Services detracted from the Fund’s performance.

Among the best performers were our investments in Hitachi, Ltd., one of Japan’s oldest electric equipment and heavy industrial machinery manufacturers, Tokio Marine Holdings, Inc., Japan’s largest general insurance company with arguably the best underwriting track record and successful overseas expansion, and Rohto Pharmaceutical, a leading skincare cosmetics and over-the-counter (OTC) ophthalmic medicines producer.

As for the laggards, Socionext Inc., a fabless semiconductor vendor involved in the development, design and sales of custom SoC (system on a chip), Seven & i Holdings Co., Ltd., a Japanese diversified retail group and operator of 7-11 convenience stores, and Mitsubishi Corporation, the largest trading company in Japan were detracted.

Our investment mantra is to “Invest in a great business with exceptional management at an attractive price,” focusing on companies with high returns on capital and sustainable above-average growth. While we aspire to invest like Warren Buffett, adapting this strategy to Japanese stocks requires a deep understanding of Japan’s distinct culture. Unlike the West, Japan’s business practices and social norms can significantly influence investment outcomes. In this month’s commentary, we will discuss our views on these unique cultural factors that often puzzle non-Japanese investors.

The good and bad aspects of Homogeneity and Egalitarianism—Japanese people are largely homogeneous and egalitarian.

Let us consider the “homogeneity” among Japanese people. As predominantly a single ethnic group, Japanese people are expected to intuitively understand each other’s intentions in society. This cultural norm leads to a business environment with fewer standardized procedures, creating challenges for foreign workers either accustomed to more explicit guidelines or not accustomed these the cultural patterns of Japan.

Japan is also very much an egalitarian society often dubbed “socialist capitalism.” This poses challenges to adopting a merit-based work culture. Despite the emerging “job-focused employment,” many companies still adhere to lifetime employment and seniority-based pay. In Japan, the annual spring wage negotiation season called “Shunto” focuses on uniform “base salary” increases, which are applied to all employees. This significantly raises personnel costs and has contributed to stagnant real wage growth since the 1989 collapse of the bubble economy. While Japan’s employment system has its merits, we believe embracing meritocracy is long overdue. History suggests that economies with merit-based wages tend to flourish more.

The good news is that recent trends show some Japanese companies are adopting Western salary practices. For instance, Renesas Electronics, one of our portfolio companies, recently delayed annual pay raises by six months globally, citing an uncertain business outlook. In a Nikkei interview, CEO Shibata said, “Base salary increases are hardly heard of outside of Japan. (In the West) It is unthinkable to implement wage increases in a soft business environment.” We highly regard Mr. Shibata’s leadership and management skills in addition to Renesas’ competitiveness in the analogue semiconductor chip/MCU (Micro Controller Unit) business and cheap valuation. Similarly, Sony Group, another portfolio holding, announced in February that it would cut 8% of its workforce at a subsidiary that operates its game business. The subsidiary may have been based abroad, but the decision has been made and based from their Tokyo headquarters which is a move in the right direction. Furthermore, in May, Indeed, a subsidiary of Recruit Holdings, also held in our portfolio, announced a layoff of about 1,000 staff (the second such reduction since 2023).

Until just a decade ago, most Japanese companies did not reduce their workforce until their earnings deteriorated significantly. However, it is worth noting that all three companies are reigning in costs at a time when their profits are at a record high. This marks a departure from Japan’s lifetime employment and seniority systems, aligning with Western practices of adjusting the workforce based on financial performance. These proactive measures by Japanese firms represent a significant shift in their approach to cost management, which should eventually lead to the full-on adoption of a merit-based pay system.

Drawbacks of Homogeneity and Egalitarianism

However, these Japanese characters hinder change and can become a drag on businesses and the economy in various places.

•    The career path system for salaried workers in Japan favors a “generalist” approach, which is seen to ensure equal treatment for all employees. As such, it is uncommon for an employee to be placed in the same department or role for a long time as there are periodic job rotations. A drawback of this system is that, for example, in overseas assignments, personnel changes typically occur every three to five years. As a Japanese living abroad in Hong Kong, Masa Takeda often hears gripes from local friends that it is hard to build long-term trust with Japanese expats, who are likely to return to Japan in a few years (and will be replaced by a new Japanese representative).

•    Japan’s generalist system often impedes the cultivation of specialized skills among workers. In the fund industry, for instance, most domestic firms are tied to major financial groups like Nomura, Daiwa, and Mitsui Sumitomo. As these large institutions typically engage in job rotations, there have been cases where portfolio managers and analysts spend a few years before returning to the parent group or moving to a different role (although Japan is increasingly fostering specialists dedicated to building lifelong careers in their fields today). This practice hinders the development of professionals who can compete on a global scale (In contrast, SPARX adopts a specialist approach, focusing on internal talent development for long-term careers in the field).

•    The “nemawashi” practice in Japanese companies—informal consensus-building before formal meetings—also has drawbacks. This traditional practice shows that Japanese corporate culture emphasizes harmony amongst all attendants to reach key business decisions in a unanimous agreement. However, the extensive time and cost involved in individually explaining proposals to executive members and gathering consensus can delay decision-making. In a January 4 interview with the Nikkei, the chairperson of the Thai conglomerate Saha Group was critical of Japanese companies, saying “They follow the traditional step-by-step approach and are slow to make decisions. They are not suitable for today’s world where the speed of innovation is fast.”

•    Ride-sharing service is poised for legalization in Japan this year after considerable debate. Bureaucrats have been notably cautious, reflecting a cultural aversion to deregulation that might disadvantage any societal group. Japan has the mentality that avoids moving forward until all potential drawbacks are completely removed. This cautiousness could also impede the (unlikely) adoption of immigration policies, which, despite being a potential solution to Japan’s declining population, would likely face a protracted and complex implementation process.

•    Mr. Sagara, the representative director of Ono Pharmaceutical at that time, criticized Japan’s drug price review system highlighting its unfairness towards innovative drugs. He was quoted in the Nikkei (March 27, 2024) as saying, “It’s inevitable that the price of drugs will drop as sales increase, but it’s unreasonable for prices to be lowered for unrelated drugs. The Japanese system is unfair.” Japan’s universal health insurance system was originally designed to make treatments affordable to all people in need. However, it is now financially strained and ironically causing “drug lag”—the delay in making new drugs available in Japan compared to other countries. Multinational drug companies avoid the Japanese market due to rapid price cuts post-launch, leading to a lack of access to the latest treatments for Japanese patients. This undermines the system’s goal to provide affordable care to all.

How Homogeneity and Egalitarianism may affect the economy going forward

Given these dispositions, it would be interesting to see how Japan will deal with “zombie companies.” These are (mostly small) uncompetitive businesses kept afloat by extremely low interest rates, which is partly the reason behind excess capacity in the economy and the prolonged deflation. As interest rates rise, many of these businesses may falter. But if Japan remains too lenient and continues to bail them out, that would be problematic. We believe that the phasing out of “zombie companies” is essential to ensure the end of deflation. Although it may be painful, it is a hurdle that Japan must overcome.

In a Nikkei interview (April 14, 2024) with Ken Saito, Minister of Economy, Trade, and Industry, he said, “Until now, the industrial policy for small and medium-sized enterprises has been based on the idea of strong large enterprises protecting and supporting the weak ones. Small companies like startups that are trying to grow rapidly were never the main focus.” This seems to us that the government suggests a shift away from Japan’s “convoy system” of economic policy. Though Mr. Saito did not explicitly advocate for the outright elimination of zombie companies, we believe the government and the Bank of Japan (BOJ) must normalize the monetary policy and strategically phase out these companies. Such actions could signal a significant and positive change in Japan’s economy, embracing the adage “no pain, no gain.”

“The nail that sticks out gets hammered down.”

Japan’s commitment to egalitarianism protects the socially vulnerable, yet the culture also discourages individual standout success as the Japanese proverb “the nail that sticks out gets hammered down” aptly illustrates. For example, the government is currently working to set up “Special Zones for Financial and Asset Management Businesses” to attract skilled workers from overseas as well as domestically, which is part of the initiatives to drive the shift of household financial assets from “savings” to “investment.” To make Japan appealing, it will not be enough to just improve the living infrastructure for foreigners who work in the industry and their families. Japan may need to consider lowering its tax rates to compete with major financial centers like Singapore, Hong Kong, and Dubai. However, Japan’s high tax rates, which include income tax, dividend tax, capital gains tax, and inheritance tax, could be a deterrent. From the perspective of ordinary Japanese people who bear a heavy tax burden, the preferential tax rates that could be introduced in the special zone to attract global talent may not be easily accepted. There seem to be various hurdles to nurturing an internationally competitive financial centre in Japan.

Homogeneity and Egalitarianism is not all bad

So far, we have mainly discussed the negative aspects brought about by the homogeneity and egalitarianism of Japanese people. Now let us look at situations where these characteristics can be leveraged as strengths.

•    One such example is the recent progress on corporate governance reforms, which has been a driving force behind the Japanese stock market rally. Since the Tokyo Stock Exchange’s initiative to “name and shame” the listed companies with a price to book ratio (P/B) below 1x was announced, the atmosphere of “We need to do it because others are doing it,” and “It’s embarrassing and disgraceful if our company is the only one not improving to a P/B of 1” seems to have been created among listed companies. The movement may have been slow at the beginning, but it is rapidly evolving into a major trend, driven by growing peer pressure. This is a good example of how the homogeneity of Japanese people is having a positive effect on the situation.

•    As urged by the government, currently Japan is experiencing nationwide wage increases even amid an ongoing issue with low labor productivity. We discussed in the September 2023 letter that wage growth ideally should be achieved through increased labor productivity as raising wages without this can harm profitability. While not ideal, we would like to believe that this could boost employee morale and, in turn, productivity. The nationwide effort to tackle the productivity problem should gather pace as everyone starts to feel the pressure and behave the same way.

•    The shift from savings to investment in household financial assets, spurred by the new Nippon Individual Savings Account (NISA), has been significant since the year’s start. This shift, reflecting a uniform mindset, could redirect a meaningful portion of the 2,000+tn yen ($15tn) worth of household assets into investments, potentially revitalizing Japan’s economy.

Japan seems to have finally emerged from deflation. Inflation, which is shunned in other countries, is perceived positively in Japan as the “end of decades-long deflation.” While rate hikes to curb inflation are seen as a headwind to the economy abroad, they are regarded as a “normalization” of interest rates in Japan and are benefiting sectors like financials, which have been hindered by persistently low rates. As mentioned in the November 2023 letter, these conditions are unique to Japanese stocks.

That said, we cannot declare victory just yet. We still do not know if real wage growth poised to turn positive this year will be sufficient to stimulate the Japanese consumers, who have spent most of their lives under deflation. Therefore, the next thing we want to confirm is whether this will change the mindset of the households. Would people act rationally in the face of inflation? In other words, unlike in a deflationary era where holding off on purchases today means the price will be lower tomorrow, prices constantly rise under inflation, so the rational thing to do is to spend money actively for purchases. Inflation also erodes the value of currency, so instead of keeping money in bank savings, astute people think about investing to preserve their purchasing power. Said differently, the “velocity” of money must pick up from here.

If Japanese people are reluctant to spend money due to pessimism about the future caused by Japan’s structural problems such as declining birth rates and ageing demographics, the economy will not revive to its full potential. It remains to be seen whether people can envision a hopeful future. As exemplified by the term “one hundred million middle class” coined in the 1970s, which refers to the consciousness of the majority of Japanese people who consider themselves middle class, and the “formation of a thick middle layer” proposed by the current Prime Minister Kishida, the strength of Japanese people’s “homogeneity” is being tested for change in Japan. For now, we are cautiously optimistic.

The good and bad aspects of Japan’s meticulous manufacturing culture “Monozukuri”

Superb craftsmanship and persistent work ethic.

Japanese workers are known for their superior artisanry. Few would object that the phrases “Made in Japan” and “Monozukuri” have connotations of being high-quality, value-added products.

The country’s manufacturing process is often attributed to its studious ethos and dexterity. Many expressions are used to describe this strength in Japanese such as “TAKUMI no WAZA (artisanal skills)” and “Anmokuchi (tacit knowledge)” which refer to personal craft knowledge (i.e material and hand-making knowledge) that cannot be easily manualized, and “Suriawase-Gijutsu” meaning manufacturing that is carried out in close coordination with trading partners (think the “Keiretsu” system). Since the inception of the Fund, we have often selected stocks with a focus on Japan’s manufacturing excellence, which we believe is one of the most reliable and sustainable competitive advantages that Japanese businesses possess versus global peers.

The same studious ethos extends to the realm of research and development (R&D). It is this same pursuit of excellence, dedication to perfection, continuous improvement and meticulousness that propel Japanese companies to the forefront of innovation. For example, in speciality chemicals, many of the breakthrough discoveries are often a serendipity that can only come true through countless trials and errors in lab experiments. Fundamental R&D activities in material science are hardly glamorous but Japanese people are well-suited to this. The fact that many Nobel Prizes in chemistry have been won by Japanese scientists attests to this view.

Willingness to embrace the daunting trial and error period means Japanese companies are more likely to commit to loss-making, long gestation projects than Western (and Chinese) companies who tend to focus on short-term results. Such Japanese companies are not well received in the stock market. However, thanks to their “grit,” it is often the case that once it achieves commercialization, the accumulation of know-how has advanced to the point where it is virtually impossible for others to catch up, creating significant barriers to entry. This competitive advantage is evident in some of our portfolio holdings, such as Shin-Etsu Chemical (the world’s largest in silicon wafers manufacturing), Sony Group (dominant market share in CMOS image sensors), and Tokyo Electron (monopoly in the coater/developer semiconductor equipment).

Where the manufacturing-centric culture becomes a disadvantage.

On the other hand, there are times when the Japanese virtue of attention to detail in product quality can work to their disadvantage. The term “Galapagos phenomenon¹“ coined in Japan, and commonly used in business studies, refers to Japanese products designed specifically to meet the high standards demanded by domestic consumers. It describes products that have evolved with a focus on a single market or culture, resulting in distinct features compared to the rest of the world and are therefore unsuccessful overseas. One notable example of the Galapagos phenomenon is the 3G mobile phones during the 2000s known as “Gala-kei.” The Japanese-designed handsets had numerous specialized features that were widely adopted in Japan but as the global mobile phone industry evolved, Japanese phones diverged significantly from their international counterparts. In a way, the word “Galapagos” mocks the manufacturing strategy of Japanese companies.

Also, Japanese companies have a problem of not monetizing well even when making good products. Insufficient pricing leads to low returns on capital. As discussed in our September 2023 commentary, Japanese manufacturers generally have a high level of labor productivity on a production volume basis, which has been well-demonstrated by Japanese automakers like Toyota and Honda. On the other hand, labor productivity in dollar terms remains low internationally.² As can be seen from the fact that the prices of Japanese products and services remain low by global standards (part of which is due to deflation and a weak yen), they have not been appropriately priced, and sufficient profit margins have not been secured as a result. Japanese companies need to actively review their pricing strategies and proceed with price increases that match the value of their products, which in turn should improve Japan’s return on equity (ROE) further and solve the “P/B less than 1” issue.

Japan’s recent product quality rigging scandals are caused by an obsession with excessive quality standards.

One controversial issue is the recent series of safety testing misconduct at Japanese manufacturers (Toyota, Honda, Nissan, Suzuki, Mazda, Mitsubishi Motors, Yamaha Motors, Hino, Daihatsu, Toyota Industries, Mitsubishi Electric, etc.), undermining their renowned manufacturing reputations. Here, we suspect that the root cause of the problem lies in the cultural obsession with excessive quality. In other words, the original safety and quality standards were met at an extraordinarily high level internationally, and the fatigue of the production site to maintain them led to the falsification of inspection results. Of course, violations of laws and regulations are not permissible, but there may be some causal relationship with the over-emphasis on product quality. To support this view, no serious consumer damage has been reported to date in the product models that were the subject of the quality inspection falsifications. As such, we are more forgiving of these companies than the media would have liked us to be.

The pressure faced by Japanese workers having to comply with high-quality standards characterize Japan’s fixation on norms and a strong emphasis on principle over practicality. This can be seen in other examples:

•    Anecdotes about closing accounts at stores, where if the amount is off by even one cent, the store cannot be closed until the irregularity is corrected. This reflects the broader cultural value placed on accuracy, which is thought to be embedded in Japanese moral standards. In other foreign cultures, we observe that people would consider the practicality of tracking down the whereabouts of one cent and think more rationally, taking different approaches to the problem. A similar comparison can be made in railway services between Japan and overseas, where the former is known for its impeccable on-time operations. Japanese people tend to prioritize principles and take situations seriously regardless of the magnitude of the error or rule violation. This is both a good and inefficient aspect.

•    The reason English proficiency among Japanese people significantly lags globally is that school lessons focus too much on grammar (and that English lessons start late, at age 13), which results in reluctance to use English in practical settings. Many Japanese people strive for perfection such that few are willing to communicate confidently if it is imperfect. More efforts are needed to reform English education in Japan.

The good and bad aspects of the Japanese spirit of perseverance

The third distinctive characteristic of the Japanese people is a tendency not to value pragmatism as a virtue. The belief that “what is gained through hardship has value” is deeply ingrained in the culture, which means enduring pain and suffering is encouraged in the face of obstacles. These cultural traits can be observed in many different places.

For instance:

•    The anti-diabetes drugs Ozempic and Manjaro (GLP-1 receptor agonists), which have been a hot topic recently, were swiftly approved overseas for use in weight loss treatments. However, in Japan, the same prescriptions have not been approved by the Medical Association or the Diabetes Society. According to a hearing we conducted with a Japanese specialist doctor in diabetes, the reason for this decision is that they do not approve of “losing weight too easily.” The notion that weight loss should be achieved through a rigorous diet regimen still prevails.

•    In Japan, only 9% of childbirths involve “painless” procedures with epidural, with natural birth still being the norm. In contrast, about 70%in the U.S. and 80% in France choose “painless” delivery. Despite being a highly medically advanced country, the reason for the low rate of painless childbirth in Japan seems to be a societal belief that women should endure pain during childbirth to be a respected mother.

•    In the case of gastroscopy during health check-ups, while anaesthesia is used in Western countries to alleviate patient discomfort, it is typical in Japan for patients to endure the pain and discomfort during the procedure.

•    In the U.S., the pandemic has changed people’s work styles. Many companies continue to allow remote work even after reopening to save commuting time and boost productivity. In contrast, most employees in Japan have been asked to return to the office following reopening. This cultural difference is interestingly apparent in the real estate market today, with the U.S. office building market continuing to be sluggish, while in Japan, the office market is recovering noticeably, which is reflected in the strong year to date (YTD) share price performance of real estate companies.

•    In Asian and Middle Eastern countries, it is common for middle-class households (and above) to have domestic helpers. Employing helpers makes it easier for both spouses to work. In contrast, Japan does not have such a system despite its proximity to local labor markets. Making housework a heavy burden for dual-income households. Again, there seems to be a social consensus that housework should be done by oneself.

These are just a few of the numerous examples we can think of. It is also believed that this cultural norm is influencing the slow adoption of new technology to increase the efficiency of office workers. To improve Japan’s perennially low white-collar productivity, it is imperative to drastically change our way of thinking and the long-standing social norms.

We believe Japan’s uniqueness makes it suitable for active management

The Japanese culture is unique, both positively and negatively, especially when viewed from a Western perspective. Additionally, there is the language barrier. It is because of all these factors and years of experience we believe that a successful approach to investing in Japanese stocks requires a deep understanding of these unique characteristics. Furthermore, in the Japanese stock market where foreign investors’ participation rate is high, analyzing these unique aspects of Japan from a Western capitalist lens can provide a significant competitive advantage in stock selection (Don’t get us wrong, we are not saying Western capitalism is the best form of capitalism but there is a lot that Japan should emulate).

In the world of investment, active investing has long been losing ground to low-cost passive investing (i.e. ETFs). However, we believe there is still plenty of room for active managers to thrive in Japan. One reason could be Japan’s uniqueness. According to data compiled by Morningstar Japan at the end of January this year, the percentage of Japanese active large-cap equity funds that outperformed the TOPIX over 10 years was 31.6%. For periods of 3 years and 5 years, the percentages were 31.6% and 39.7%, respectively.³ These figures are significantly higher than those for U.S. active managers, where the proportion is much less than 10%.⁴ Simply put, Japan is still very much an inefficient market. The reason we strongly recommend investing in Japanese stocks through active management rather than passive is precisely because of this.

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