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.

Market Commentary and Fund Performance for July 2024

In July 2024, the Nikkei Stock Average decreased by 1.22%. The significant volatility characterized the Japanese stock market. The market remained firm in the first half of the month, continuing the positive trend from the previous month. U.S. employment data showed signs of easing in the tight labor supply-demand balance, and predictions that the Federal Reserve would cut interest rates by year-end increased, leading to lower long-term interest rates and a rally in U.S. high-tech stocks. In Japan, semiconductor-related stocks underpinned the market, and the Nikkei Stock Average hit all-time highs on consecutive days, reaching the JPY 42,000 ($281.86) mark on July 11. However, the Japanese stock market turned downward due to a weaker-than-expected U.S. consumer price index, profit-taking in U.S. high-tech stocks, and a stronger yen against the dollar.

In the second half of the month, the decline accelerated further. Reports indicated that Trump had the upper hand in the U.S. presidential election, fueling concerns about America-first policies, including escalating the U.S.–China conflict and correcting the strong dollar. These concerns triggered increased selling of semiconductor-related stocks, impacting Japanese equities. Moreover, the Bank of Japan’s (BoJ) additional interest rate hike and the Fed’s rate cut speculation triggered an unwinding of the yen carry trade, with the dollar temporarily hitting the JPY 151 ($1.01) level and widespread selling in the Japanese stock market. The Nikkei Stock Average plummeted to below JPY 38,000 ($255.04). On July 31, the BoJ decided to raise its policy rate to around 0.25% at its monetary policy meeting and revealed plans to reduce its purchases of government bonds. When it was reported that the U.S. government would exclude Japan and other countries from semiconductor export restrictions to China, semiconductor-related stocks rebounded. The Japanese stock market closed July trading lower than where it began despite reducing the overall decline. As a result, the benchmark for the Fund, the Russell/Nomura Small Cap™ Index returned 7.58%, while the Fund’s performance returned 7.04% (HJSIX), underperforming its benchmark.

This month’s positive contributors to the Fund’s performance included Kyudenko Corporation and Musashi Seimitsu Industry Co., Ltd. Kyudenko’s share price rose amid rising expectations that the firm would outperform corporate projections after it announced increased revenue and improved profit margins in its Q1 earnings call. Musashi Seimitsu’s share price climbed on higher expectations of earnings growth from its new business in hybrid supercapacitors, which could contribute to reducing the power consumption of artificial intelligence (AI) servers.

Conversely, the stocks negatively impacting the Fund’s performance included Daihen Corporation and Tokyo Ohka Kogyo Co., Ltd. Share prices for Daihen and Tokyo Ohka Kogyo declined as semiconductor-related stocks fell across the board due to concerns over reports that the U.S. would tighten regulations on semiconductors to China. This month, we did not make any new investments.

In July, the foreign exchange and stock markets fluctuated widely against the backdrop of speculation about the monetary policies of Japan and the U.S. and growing uncertainty surrounding the U.S. presidential election. At the end of July, the BoJ decided to raise its policy interest rate to 0.25%, but the difference in monetary policy between Japan and the U.S. has caused the yen to appreciate, leading to volatility in the Japanese stock market. On the other hand, the Japanese economy has seen a steady increase in wages, and the economic and price situation is considered to be on firm footing. The ongoing yen depreciation and weak domestic consumption have been weighing on the small- and mid-cap markets, which are mainly driven by domestic demand. However, the focus on small- and mid-cap stocks should increase as corporate performance recovers. We will continue unearthing investment opportunities the market has ignored through bottom-up research.

Outlook

Semiconductor stocks are in a temporary correction phase. The U.S. administration’s tightening of export restrictions on China and Trump’s negative comments toward defending Taiwan have contributed to the deterioration of investor sentiment. We have been downgrading the Fund’s weighting of semiconductor equipment stocks, believing that the rising stock prices have factored in near-term earnings growth. However, in June, we began investing in a new specialty chemical company that manufactures chemicals used in semiconductor production. Although the demand for semiconductor equipment is becoming increasingly uncertain due to rising geopolitical risks and other factors, demand for semiconductor components and consumables should continue growing steadily. Demand for parts and materials is linked to the increase in semiconductor production, because demand is expected to grow in line with operating the high volume of production equipment delivered over the past several years. In addition, there is expected to be an increase in the added value of components due to miniaturization’s progress.

The new portfolio company has a wide range of business domains, from high-tech components to healthcare, but each business specializes in products with unique characteristics and boasts high market share, profitability, and capital efficiency. In recent years, however, its share price has remained low due to stagnant performance caused by demand fluctuations during the COVID-19 pandemic, prior investments, and deteriorating semiconductor market conditions.

However, through our interviews with the firm, we have concluded that its deteriorating performance will likely be a temporary factor. The new semiconductor components that fuel high expectations for the company are highly competitive and can achieve better performance growth than before during the demand recovery phase. The firm has already completed capital investments in semiconductor components to meet immediate demand. While that was the reason for the recent deterioration in business performance, it is also highly likely to see renewed growth in business performance because its profit margin is expected to improve as depreciation expenses decline.

In the healthcare business, there are concerns about a decline in royalty income due to the expiration of patents on some flagship products. However, the company sells bulk pharmaceuticals in addition to the royalty income, so the risk of a rapid decline in sales is limited. Preparations for the next pipeline are also progressing, so its performance will likely remain stable. In addition, it is worth noting that the company is actively returning excess capital to shareholders to maintain high capital efficiency. Despite not explicitly stating that it has done so, it has adopted a progressive dividend policy, which should be sufficient to limit the stock’s price floor.

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