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 August, the Fund returned 3.05% (HJPIX), outperforming its reference index, the Russell/Nomura Total Market™ Index, which returned 1.15%.

The month’s positive performers among the Global Industry Classification Standard (GICS) sectors included shares of Consumer Staples, Consumer Discretionary, and Industrials while Financials, Information Technology, and Communication Services 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, Hitachi, Ltd., one of Japan’s oldest electric equipment & heavy industrial machinery manufacturers, and FAST Retailing Co., Ltd., the operator of “UNIQLO” brand casual wear stores.

As for the laggards, Tokyo Electron Limited, one of the world’s largest manufacturer of semiconductor production equipment, Mitsubishi UFJ Financial Group, Inc., one of Japan’s largest financial groups and Daikin Industries, Ltd., the leading global manufacturer of commercial-use air conditioners.

This month, we would like to address some of the recent frequently asked questions we receive from our domestic and international investors both institutional and retail.

1) Thoughts on the August turmoil in the Japanese stock market

The month of August started with an unprecedented market sell-off that saw stock prices fall beyond the 1987 Black Monday. 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 has caused a JPY surge and a massive downturn in Japanese stocks.

Carry trades are widely employed by speculative traders, where JPY is used as a funding currency to invest in higher-yielding risk assets. The strategy is essentially a bet against the Interest Rate Parity theory, and as such it is only profitable if the theory does not hold over the investment horizon. The risk is that the funding currency, in this case, JPY may appreciate significantly against the currency of the investment, which would reduce a trader’s profit or even lead to a loss.

Because there are so many speculative positions involved, it is widely known that the return distribution of the carry trades does not follow a normal distribution but instead, it is characterized by negative skewness and fat tail risks (excess kurtosis). This means that the probability of a large loss is higher than what is implied under a normal distribution. Once the prevailing trend assumed in the carry trade reverses, speculators rush for the exit, causing panic selling.¹ To sum up, when the market is in a “risk-on” mode, it begets JPY depreciation (JPY shorting) and stock market appreciation (long equities), and when a risk-off mode sets in, the opposite happens.

The sharp falls in stock prices caused by the above mechanism are not due to the deterioration of business fundamentals. Thus, it often leads to securities mispricing where their prices deviate significantly downward from their intrinsic value. Therefore, for fundamental bottom-up investors like us, it becomes a buying opportunity.

Of course, caution is warranted as there can be negative repercussions on corporate fundamentals through the market turmoil. For instance, a JPY appreciation could reduce export competitiveness, or a stock market crash could dampen consumer sentiment which, in turn, affects the real economy.

On the positive side, Japanese companies that have once again fallen below 1x price to book ratio (P/B) after the sell-off are anticipated to accelerate share buybacks. This is a driver that could not be relied upon before last year’s Tokyo Stock Exchange announced the “name and shame” companies below 1x P/B.

The future is full of uncertainty, so it is unclear whether there will be a second dip in the weeks/months ahead.² However, because JPY continues to be the only major currency with negative real interest rates currently, which creates interest rate differentials with other currencies, we are biased towards the continued relative weakness of JPY. In other words, we think that JPY’s status as the funding currency for carry trades will remain unchanged. For this reason, it is unlikely that JPY will strengthen against the U.S. dollar (USD) as it did in 1995 and 2009-2012 when the exchange rate shot through 80 JPY/USD.

2) What are some of the downside risks for Japanese equities from here on?

Last month’s sell-off threw cold water on the upbeat Japanese stock market that had rallied since the beginning of the year. However, as long as the progress of corporate governance reforms by Japanese companies, consistency in domestic inflation, normalization of interest rates, increase in inbound tourists to Japan, expansion of inbound foreign direct investments in industries such as semiconductors, and outlook for a positive turnaround in real wage growth do not falter, the market should move towards its all-time highs in due course.

Valuation-wise, Japanese stocks traded at 17x price to earnings ratio (P/E) just before the market crash and it is currently at 16x. This is below the levels before the start of the government-led corporate governance reforms under the Abenomics policy. While the quality of Japanese companies has greatly improved, the valuation multiples have yet to reflect this. We expect the re-rating of market valuation to continue to be a tailwind.

On the other hand, the potential Japanese market risks we could think of from here on are as follows:

1.    Stagflation in Japan

2.    Potential deterioration of Bank of Japan’s (BOJ) financial condition

3.    Potential Japanese government bond (JGB) downgrading

4.    The severe recession in the U.S. leading to aggressive rate cuts and JPY appreciation

5.    The U.S. reckless fiscal spending and ballooning budget deficits contributing to a rise in long-term interest rates

6.    Geopolitical conflicts or major natural disasters causing significant damage to the Japanese and global economies

On 1, we are reasonably optimistic that Japan’s real wage growth is likely to turn positive soon thanks to a second straight year of +3% year over year (YoY) base salary hikes nationwide. While this is likely to continue, the trend is still fragile. Nikkei reported that the real wage increased YoY in June for the first time in 27 months, but there are still lingering concerns that it may fall back into negative territory with the expected termination of government energy subsidies. If the country fails to pull off “good inflation,” then Japan’s much-awaited inflation will turn into just another stagflation.

Regarding 2, it will be most likely just a headline risk, and investors should not be spooked by this. The risk refers to the acceleration of rising JGB yields resulting in an asset-liability mismatch for the BOJ’s balance sheet, and its shareholders’ equity turning negative. After years of unprecedented quantitative monetary easing, BOJ’s JGB holdings amount to nearly JPY 600tn ($4.3tn), about the size of the country’s gross domestic product (GDP). Given that the shareholders’ equity of BOJ is around JPY 12.8tn ($90.9bn) (calculated as the sum of “total net assets” and “provision for possible losses on bonds transactions” as of March 2024), mathematically if market rates are to keep rising, unrealized losses on these JGBs would widen, potentially exacerbating BOJ’s financial condition to a point its equity falling below zero. Or the interest payments on the bank reserves could exceed the interest income from JGBs and dividend income from its exchange traded fund (ETF) holdings, resulting in a negative spread. When such things are reported in the media, it may trigger a selloff in Japanese stocks, JGBs, and JPY.

However, this should not be a cause for concern because in practice, the BOJ, as the central bank of Japan, will likely never become insolvent as it can print money in JPY. We believe it is nothing like Greece during the 2010 Euro debt crisis.

Sure enough, there may be some side effects such as JPY’s weakening, accelerating inflation or rising long yields, but the economic activities will continue to carry on. Of course, reckless fiscal finance is a problem. If the creditworthiness of the nation’s debt or JPY is in question, undesirable situations may occur. However, if speculative short selling of JGBs puts downward pressure on bond prices, the over JPY 500tn ($3.6tn) of bank reserves sitting at BOJ’s deposit account can be expected to return to the JGB market, helping to put a lid on long-term rate spike.

On the other hand, 3 is a most likely real risk. In a situation where no progress on the Japanese government’s primary balance surplus goal is expected, JGBs, which are currently rated single A plus, could be eventually downgraded to below investment grade. There will be far-reaching repercussions for this scenario.

For instance, the sovereign ceiling³ could severely affect Japanese companies’ businesses. If the cost of raising dollar funds rises significantly or it becomes difficult to raise dollar funds itself, it could cause significant disruption to the business. Judging from the recent comments of officials at S&P Global Ratings and Fitch Ratings, the probability seems extremely low at this point.⁴ Particularly, business risks are high for Japanese banks that rely on the interbank markets for USD funding and other Japanese companies that operate overseas by borrowing from Japanese banks. As for the other risks 4-6, these are widely covered in the media, therefore we will not comment further as we have no valuable additional insights at this time.

3) Recent developments at Seven & i Holdings, one of our top portfolio companies:

We have been continuously buying shares of Seven & i Holdings, the world’s largest convenience store operator, since initiating the position in 2022 and now it is one of our top holdings. However, it does not mean that we are approving of the company’s financial performance. It has been far from satisfactory with same-store sales continuing to stagnate in both Japan and the U.S. Low-income consumers are feeling the pinch as sticky inflation has been eroding their purchasing power. Thus, our buying is a contrarian move.

As explained in our 2021 September letter, investing in a stock for which most people are still sceptical or negative is uncomfortable psychologically. This is especially true as the future expectations implied by the stock market are often correct. However, as the opinion of the majority is already reflected in the stock price making it difficult to make a large profit, we believe that being uncomfortable in an unpopular trade is a necessary condition for successful investment.

The convenience store business is inherently an attractive retail business that generates high returns on capital and ample cash flow underpinned by stable demand given that it sells essential goods. The company’s long record of accomplishment as a pioneer in this field also gives us a sense of “safe and sound business.”

To address the ongoing challenges, the management is implementing the right strategies to bolster sales at existing stores in the U.S., in our opinion. Convenience stores in the U.S. are often attached to gas stations, and many customers shop there while filling up their tanks. These stores often lack cleanliness and even can make customers feel unsafe at times. There is a lack of incentive for customers to willingly shop at these convenience stores. Recognizing these issues, the company is aggressively renovating its existing stores: involving simple face-lifts such as changing the store signage, installing new bathrooms, redrawing lane markings in the parking spaces, etc.

It is also expanding its product lineup focusing on fresh food. Here, Seven & i is partnering with Warabeya, a supplier for Seven-Eleven Japan, rolling out commissaries to make a wide range of food offerings (i.e. sandwiches, burritos, hotdogs, rice balls, ramen, etc).

While the appearances of Japanese and American convenience stores are vastly different, observing American tourists impressed by the cleanliness and variety of SKUs at Japanese stores makes me bullish that if the company successfully apply the Japanese strategies to the U.S., it could significantly open growth opportunities. The Japanese model should resonate with American consumers.

The company is also transferring its operational know-how such as “Tanpin Kanri  (Item-by-Item Management)” from Japan. This system traces the movement of each merchandise item and collects extensive demographic data based on who is buying what, at what time of day, under what weather conditions, etc. to improve the accuracy of the next order placement for re-stocking. This also helps each store localize its assortment to the needs of customers. You can find more details in this video: 7-Eleven Is Reinventing Its $17 billion Food Business to Be More Japanese | WSJ The Economics Of.⁵

We are also keenly watching its Japan operations. Japan’s CVS industry is dominated by three players with Seven-Eleven being the long-term market leader. It is already a mature market but a strong cash cow. Though same-store sales performance has been sluggish here as well, we are sanguine about the company’s prospects. Considering the company’s long-standing track record as an industry pioneer, we believe management will eventually be able to turn around sales.

Another reason we maintain high conviction is that there appears to be limited downside risk at the current stock price levels measured by P/E, EV/EBITDA and free cash flow (FCF) yield, which were discussed in detail in the 2023 June letter. The updated figures are: 10.7x forward FY2024 earnings (vs. TOPIX 14.3x), 6.7x on EV/EVTDA (vs. Canada’s Alimentation Couche Tard at 11.5x) and 10+% on FCF yield. In other words, there is a good margin of safety.

The company needs to improve a lot. One area we have taken issue with is the company’s disclosure stance towards management remuneration. Recently, it was learned that Joseph DePinto, a director and executive officer of the company and CEO of its U.S. subsidiary 7-Eleven Inc., had been paid JPY 7.7bn ($54.7mn) according to its annual filing, far above the amount indicated in the proxy statement for the annual general meeting (AGM), which was held on May 28, 2024. In the document, the company’s directors’ compensation framework is explained such that the upper limit of officer compensation is a total of JPY 1bn ($7.1mn) for the 15 directors combined (plus, up to JPY 400mn ($2.8mn) worth of share-based compensation). The difference arises as the proxy statement is only required to disclose the total compensation amount at the parent-holding company level while the disclosure in the annual filing encompasses management remuneration on a consolidated basis. This created controversies because the annual filing was only released one day after the AGM. In Mr. DePinto’s case, almost all his compensation came from the U.S. subsidiary thus it did not need to be included in the proxy statement. Although there was no violation of any rules, we felt uncomfortable with the firm’s disclosure attitude and its timing.

Unlike our other investment cases, we have been privately voicing our opinion in a bid to exert influence on management. The scope of discussion spans all the arguments we have presented in our letters thus far. Because we own nearly 2% of the company today, they are willing to engage and listen to us. To be clear, we adopt a non-confrontational strategy so our approach is based on having a constructive dialogue. Hopefully, our contrarianism and patience for this investment will deliver fat returns in the end.

As a postscript, on August 19, Seven & i released a press release stating that the company had received an acquisition offer from Canada’s Alimentation Couche-Tard, the global operator of Circle K convenience store chain. The talks are still in incredibly early stages, and we do not have the faintest idea whether this deal will go through. The offer is currently being reviewed by an independent committee set up internally within Seven & i.

We are indifferent about the potential outcome of the deal talks. As much as we would like to see quick results from our investment, this one has an extremely long growth runway if Seven & i can run it well globally. If anything, what is important about this event is that the world has come to know that Seven & i has value for strategic buyers. Even if Couche-Tard is unsuccessful, there will be someone else who would be interested. That should put a solid floor on the share price.

Since last year’s proxy battle with Value Act, the company has come under close public scrutiny, and whatever action they choose to take in response to the acquisition offer this time, management will be held accountable. It is not difficult to imagine that there is huge pressure on management to “behave well” for the good of the shareholders. If the deal falls through, management has no choice but to speed up the ongoing strategic initiatives to grow the intrinsic value of the business fast. The sense of urgency was virtually non-existent before, but we are quite certain it is now firmly installed in the company, and that will be good enough for the time being.

4) The portfolio appears heavily weighted in Seven & i Holdings and ORIX

Our Fund currently has a high allocation to Seven & i, as explained above, and to ORIX, which we discussed extensively last month. However, we do not believe that the Fund portfolio is as skewed towards these two stocks as the fact sheet may suggest.

That is if we consolidate together semiconductor-related businesses (four names such as Shin-Etsu Chemical) and insurance names (Tokio Marine, MS&AD, SOMPO), the active weight of each basket is about the same as the top two names, which means that the portfolio is more evenly diversified. These exposures in aggregate (Seven & i, ORIX, semiconductor, insurance) account for about half of the portfolio, with the rest made up of 18 stocks (for a total fund holdings of 27 as of August 30, 2024). Looking at the portfolio this way may not be completely appropriate in terms of risk management, but it provides a useful perspective.

The order of preference for portfolio holdings is determined by the balance between the size of the expected upside if the stock price is to rise and the significance of the downside risk if it is to drop. In our risk-return framework, we consider the expected return to be determined as a function of potential future upside that we can currently estimate and the conviction level. This probability requires a subjective judgement and varies by investor; hence we refer to it as just “conviction level.”

The same can be said for the downside risk. Theoretically, the maximum downside of a stock price is 100% when the company defaults. However, the probability of the stock becoming worthless varies greatly depending on the business. Also, the risk of the stock price falling from the current price due to earnings performance varies and is subject to your perspective.

No matter how large the expected return (as a function of upside and conviction level) is deemed to be, if the downside risk is equally large, the order of preference within the portfolio will not be very high (i.e. we do not assign a large weighting). In a nutshell, the sizing is determined based on the risk-return profile. As of today, among all the portfolio names, Seven & i and ORIX are the most attractive in terms of risk-return profile to us (which suggests that these are not necessarily the stocks with the biggest upside potential).

5) Implications of Japan’s mega-earthquake risk for the insurance sector

Our Fund has been invested in all three listed mega-insurance groups since the spring of 2022. The rationale for this investment has been explained in previous letters.

2023 August commentary

A key concern regarding the shares of these insurance groups is the impact on the companies’ financials in the event of a mega-earthquake in Japan, which is prone to such disasters.

The Japanese government has previously said the next magnitude 8-9 megaquake along the Nankai Trough had a roughly 70% probability of striking within the next 30 years. The Nankai Trough is the 800km undersea trough between two known tectonic plates, which runs from Shizuoka (west of Tokyo) to the southern tip of Kyushu Island. It is known that a powerful earthquake with 8-9 magnitude has occurred in this region every one to two hundred years.⁶

Last month on August 8, a magnitude 7.1 earthquake shook this region. Earthquake prediction is extremely difficult, however the occurrence of one earthquake usually raises the likelihood of another. Thus, while there were no major casualties or damages this time, it did heighten the alert level for Japan’s long-anticipated mega-quake. The Japan Meteorological Association (JMA) has warned the residents in quake zones to take general precautions, the first-ever warning issued under new rules drawn up after the 2011 Great Eastern Japan Earthquake.

So how much should we worry about our investments in insurers?

The good news is that domestic property and casualty (P&C) insurers do not take on the earthquake insurance risk for personal properties, and it is entirely borne by the Japanese government. The private-sector insurers only underwrite earthquake insurance for commercial lines with the risk being carefully managed using reinsurance.  The bottom line is, that while a significant earnings decline for the quake-hit year is inevitable, it is highly likely that the insurers’ financials will remain sound.

According to the three insurers, even if a major 8-9 magnitude earthquake struck today, plus a super-size typhoon equivalent to the “Isewan Typhoon” (struck in 1959, considered the worst in history) and financial crisis occurring all in the same fiscal year, the companies would likely still break even. This means that the risk of a significant impairment of shareholders’ equity is extremely low.

For example, Tokio Marine Nichido, Tokyo Marine Holdings’ domestic insurance arm, has JPY 166.4bn⁷ ($1.2bn) provisioned for catastrophe loss reserve, which is small enough to be fully absorbed by the current year’s adjusted net income.

If these disasters did occur today, there would likely be at least short-term knee-jerk negative reactions on shares of the insurers. Not only will there be a temporary surge in incurred losses, but also there will be a sharp drop in dividend income from policy shareholdings, a significant decline in the market value of the equity portfolio (which is currently in the multi-year process of complete sales), and an event-driven surge of JPY, which will hurt their overseas operations.

As such, it will be inevitable that their ESR (Economic Solvency Ratio), a measure of the financial soundness of an insurance company, will fall significantly. 

However, we believe Japanese insurance companies have the financial strength and profitability to keep their finances from being impaired. Once the fiscal year is put behind, they will likely recover.

The Japanese insurers have been through numerous natural disasters with a sharp increase in insurance losses at times, yet their share prices have continued to reach all-time highs. We do not think that there is need to worry excessively as each insurance company is prepared sufficiently, precisely it is because Japan is an earthquake-prone country.

6) Why don’t we invest in real estate stocks as an inflation hedge?

The regular readers of our letters probably remember that our base-case macroeconomic scenario since 2022 has been “higher for longer inflation” and “the normalization of interest rates” in Japan. At this juncture, we do not see the need to revise these assumptions.

We have been long arguing the attractiveness of businesses that are resistant to inflation (strong pricing, differentiated products, brand image, etc) and, more recently, the businesses that benefit from rising interest rates.

Inflation also calls for investments in shares of asset-rich companies that benefit from rising asset values. Specifically, real estate companies come to mind as well as asset-rich companies with non-core property holdings, whose share prices are heavily discounted relative to their property market values. However, our Fund does not invest in these types of companies including the major real estate developers for the following reasons:

The real estate business is inherently capital-intensive and hard to differentiate other than geographical advantages.

When focusing on asset value, the location of the owned real estate is crucial, but it is not easy to identify places that will continue to endure as “prime locations” in the future. For example, the intrinsic value of office properties has been brought into question by the pandemic, and it is still unclear as to whether people’s work style has permanently changed. It is often difficult to judge whether a residential location will continue to be valuable if an unexpected land redevelopment project pops up or climatic changes undermine the area. Speaking specifically of Japan, the shrinking demographic trend itself poses a long-term headwind for the real estate market, in our view.

If there are abundant unrealized gains, it would be ideal to monetize them at some point and return them to shareholders, but this is not realistic for companies with a buy-and-hold landlord business model. It is hard to imagine a major developer selling all its office buildings in prime downtown locations to crystalize its unrealized gains.

Major Japanese property developers have return on equity (ROE), dividend yields, and the number of share buybacks relative to their market cap that are inferior to those of non-life insurers (Tokio Marine, MS&AD, Sompo), mega banks (MUFG), and trading companies (Mitsubishi Corp) that we own now.

Major developers tend to have low levels of free cash flow (relative to operating cash flow) due to their growth capital needs of investing in domestic land re-development projects and acquisition of overseas real estate. Hence, they lack the capacity for consistent dividend hikes and share buybacks compared to our other holdings (non-life insurers and banks).

Even if the value of real estate rises due to inflation-induced rent increases, if real interest rates rise, the value could conversely be impaired (assuming the rent increases at the same rate as inflation, the cap rate will rise along with the real interest rate, which will hurt their valuation).

Generally, we are less attracted to asset-rich stocks with unrealized gains on assets held outside of their main businesses or unrealized gains on assets that are unlikely to be ever sold in the future. On the other hand, from the perspective of hidden asset value, ORIX is a company whose main business model encompasses the process of identifying investment opportunities executing investments and ultimately exiting them. We find businesses like ORIX more appealing, where the unrealized gains on held assets are regularly realized through capital recycling.

7) On how to approach investing in investment conglomerate companies

Finally, let us explain our approach to investing in shares of conglomerate-type investment companies. In Japan, some of the representative names include trading companies (Mitsubishi Corp. and the like), SoftBank Group, and ORIX.

The target investments of these companies range from outright acquisitions of businesses to investments in real assets such as renewable energy and real estate, investments in publicly traded securities as well as private equity, and other types of financial assets.

Among these, investment companies that mainly invest in listed stocks are most likely to be subject to a conglomerate discount. This is because for ordinary investors, listed stocks can be easily bought on the public market without going through the investment company.⁸

When investing through an investment company, not only does the sale of shares in the investee company result in capital gains tax that effectively accrues to the investment company’s shareholders, but the income tax paid by the company itself also burdens them, resulting in double taxation. In addition, corporate overhead such as the cost for the personnel of the investment company who execute the investment will also be incurred. It is more economical to directly assemble their optimal investment portfolio for ordinary shareholders. For these reasons, the majority of publicly traded investment company stocks are valued below the total market value of the investee’s shares. The only reason to invest in such an investment company would be if one believes that the stock selection skill of the company is far superior to his own.

Among the names mentioned above, SoftBank Group (SBG) is arguably the most subject to conglomerate discounts in our view. This is because the company holds a wide array of listed stocks, including the shares of the UK chip design and intellectual property holding company ARM, which returned to the public market last year, the listed telecom subsidiary SoftBank Corp., and the major U.S. telecom carrier T-Mobile. According to the company’s presentation slides, the proportion of listed shares is 82% of the entire portfolio (including those investments in the Vision Fund that have gone public) as of June this year.

However, the conglomerate discount of SBG is somewhat unjustifiably large to me. The current market capitalization of SBG is approximately JPY 12tn ($85.2bn). In contrast, the net asset value of the company when the stock holdings are valued at market value is JPY 24.9tn ($176.8bn) as of August 6,⁹ more than half of which is attributable to ARM (the value of shares held by SBG is about JPY 14tn ($99.4 bn),¹⁰ exceeding SBG’s market cap). ARM is 90% owned and consolidated by SBG, giving it the ability to influence its management. In other words, investing in SBG shares is effectively equivalent to investing in ARM shares. Moreover, an additional benefit, which cannot be enjoyed by other investors buying ARM shares directly, is that the Vision Fund (SVF1, SVF2, LatAm Fund), which is appraised at JPY 8tn ($56.8bn), can be obtained practically for free.¹¹

For these reasons, we re-entered a small position in SBG shares in June of this year.

Click here for a full listing of Holdings.