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 May, the Fund returned 4.21% (HJPIX), outperforming its benchmark, the Russell/Nomura Total Market™ Index, which returned 1.10%.

The month’s positive performers among the Global Industry Classification Standard (GICS) sectors included shares of Financials, Industrial, and Health Care while Materials, Consumer Staples, 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, 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,” and MS&AD Insurance Group Holdings, one of the leading non-life insurance company in Japan.

As for the laggards, Mitsubishi Corporation, the largest trading company in Japan, Nissan Chemical Corporation, a manufacturer of liquid crystal alignment films and pesticide, and Rohto Pharmaceutical Co., Ltd., a leading skincare cosmetics and over-the-counter (OTC) ophthalmic medicines producer.

It has been over a year since the Tokyo Stock Exchange (TSE) announced its request for “Action to Implement Management that is Conscious of Cost of Capital and Stock Price” in March of last year. This was aimed at companies whose stock prices are at a price to book ratio (P/B) below 1x, a situation affecting over 40% of all listed companies as of March 31, 2023. The TSE intended to prompt these companies to increase their corporate value, thereby generating a sustained rise in stock prices and enhancing the appeal of the Japanese stock market to investors. The TSE particularly emphasizes the importance of corporate management having more awareness of capital efficiency, which for many decades has been less focused than in Western capitalism.

Interestingly, while it may seem that this initiative is only targeting companies with a low P/B, the TSE’s true intention is to encourage all listed companies to carry out management duties that are more conscious of the cost of capital and profitability based on the balance sheet. Last year’s quasi-directive from the stock exchange is merely a starting point for broader market reform.

Last November, we had the opportunity to discuss this issue with Japan Exchange Group, the owner and operator of the Japanese bourse, which also happens to be one of the Fund’s portfolio companies. The topic of discussion was how to raise more management awareness around capitalistic metrics such as return on equity (ROE), ROIC (return on invested capital), and ROCE (return on capital employed) not only at companies with a P/B below 1x but also at companies with a P/B above 1x. In the meeting, the executive officer of investor relations admitted that the latter part remains a big challenge in Japan and we could not agree more. Companies with a P/B above 1x are often high-quality profitable businesses whose ROE exceeds their cost of equity. However, even among these blue-chip Japanese companies, some are not optimizing their capital allocation. In our view, difficult problems lie beneath these companies.

Let us look at Keyence, one of our long-term holdings since the late 2000s. It is an ultra-high-margin company with a fortress-like balance sheet. Its historical growth rate—net income rose nearly six-fold from FY2007 to FY2023 or 11.7% compounded annual growth rate (CAGR)—and returns on capital (ROC) have been among the best in Japan.

The fact that Keyence has accumulated total equity of 2.8tn yen ($17.8bn) (all is the result of hard-earned profits from its factory automation (FA) sensor business) against total assets of 2.96tn yen ($18.8bn) is due to the lack of thoughtful shareholder return policy. However, despite its bloated capital base, its ROE of 14% comfortably exceeds that of the average Japanese company, not to mention its own cost of equity. The company’s extraordinary business performance has also increased its market capitalization significantly over the past 15 years, handsomely outstripping the aggregate amount of retained earnings, and making it difficult for minority shareholders to lodge a complaint about its management performance. As can be seen from the astonishing figure of a real ROCE¹ of 111% excluding surplus cash and cash equivalents, it is obvious that if Keyence decides to “right-size” its shareholders’ capital through share buybacks, it can substantially improve its ROE (36% on 1tn ($6.3bn) yen of equity, 73% on 500bn yen ($3.2bn), and 146% on 250bn yen ($1.6bn)) without sacrificing its financial soundness.²

The reason Keyence’s ROE is underwhelming is that it is holding a large amount of surplus funds (cash and deposits, marketable securities, investment securities, etc.) on its balance sheet way more than necessary to maintain its growth. Sure enough, management has delivered earnings performance and share price returns that are required of listed companies but much more could be done. When viewed from the perspective of the entire Japanese economic system, the firm’s capital allocation is simply not desirable. Hoarding cash means that idle capital is not necessarily being supplied to areas where they are needed,³ resulting in a sub-optimal distribution of economic resources. Investors who strive to maximize returns would like to demand more payouts in the form of dividends or share buybacks and shift the proceeds to areas with good prospective returns (though management will likely counter “We have delivered satisfactory returns to our shareholders so leave us alone”). Understandably, individual companies like Keyence do not have much incentive to act for the sake of the well-being of the overall economy.

Worse yet, Keyence is known for its consistently high stock prices due to its long-standing reputation as a high-growth company, and there seems to be an extremely low likelihood of being targeted by corporate raiders. Under Japanese corporate law, a shareholder can put forth a shareholder’s proposal to influence the management policies at an AGM (annual general meeting) if they own 1% of the shares. However, the reality is that it is difficult for a single institutional investor to become a major shareholder due to the high financial hurdle as the company’s market capitalization itself is that of a mega-cap stock in Japan (since our initial investment in the late 2000s, the company’s market cap rose from number 80 to number 3 on the leader board, now worth 17tn ($108bn) yen). Even if shareholders were to collectively pressure the company to criticize its capital allocation policy, it seems unlikely to get every investor on the same page as Keyence has been rewarding shareholders through stock price appreciation over many years. One could even argue that the company has already done its part to contribute to the TSE’s goal of “enhancing the appeal of the market” through earnings growth and its market-beating stock price appreciation.

As for the corporate governance structure, Keyence adopts an auditor system with three external directors rather than the more ideal “Corporation with Nominating Committee, etc.” system. Their external directors include a certified public accountant from an audit firm, a lawyer from a law firm, and a university professor, giving the impression that these people were hired for cosmetic reasons.

According to its annual report (“YUHO”), the method of determining the management remuneration is linked solely to the amount of operating profit, and it does not consider capital efficiency metrics or stock price performance as evaluation items. It is no surprise that there is little incentive on the part of management to enhance the shareholder return policy to cater to the interest of general shareholders. As such, it is doubtful that telling such companies to “embrace the importance of ROE” and “to that end, increase dividends and buybacks” will have any impact at all.

What can be done?

In our view, there is a need to tie financial indicators such as ROE/ROIC/ROCE, as well as stock price performance more to management remuneration (although this is not without its drawbacks). In this regard, the concept of capital efficiency is ingrained much more deeply in Western corporate culture. Even if it is not explicitly stated, the willingness to increase capital efficiency is naturally cultivated as an individual goal for pursuit, and the idea is often embedded in the remuneration (if any of the readers have a different take on this, please correct us). For this reason, we doubt if something like the “Correcting the P/B less than 1x” movement led by a stock exchange could even happen in Western capitalist countries in the first place. It should not be something that the government or the stock exchange interferes with.

However, in a country like Japan, where a different corporate culture from the West dominates, government policy intervention may be helpful. Who knows, giving tax incentives for incremental gains on returns on capital as new legislation might work well in this endeavour. Likewise, we believe that corporate managers in Japan should take initiative-taking steps to improve capital efficiency through remuneration incentives. As discussed in our October 2023 commentary, management compensation at large Japanese companies is reported to be only one-fifth of that in the U.K. and less than one-twentieth of that in the U.S.⁴ Even more egregious is that there are often large differences in compensation between Japanese and non-Japanese executives within the same company. Earning only a fraction of the fellow non-Japanese directors just because you are a Japanese national seems utterly absurd to us. This situation needs to be rectified by establishing a more equitable and globally competitive compensation structure, which in turn should lead to Japanese C-suite executives not only taking more appropriate risks to grow the business but also proactively striving to maximize the capital efficiency of the business.

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