Commentary

Japan Strategy

September 30, 2022

THE MARKET ENVIRONMENT

Major global markets continued to experience pressure and volatility in the third quarter as investors reacted to prevailing challenges facing economies across the world. Efforts by central banks to reign in elevated inflation by tightening financial conditions were at the forefront of financial discourse with investors reducing exposure to assets, such as equities, as interest rates climb at aggressive paces. In the U.S., the Federal Reserve raised its benchmark interest rate by 75 basis points in July and again in August to 3.00–3.25%. Importantly, rhetoric following each decision was noticeably hawkish as Fed Chair Jerome Powell looked to emphasize the Federal Open Market Committee’s commitment to regaining price stability with further rate hikes, even at the expense of economic hardship. The Bank of England, Bank of Canada and European Central Bank all increased their respective benchmark rates in September by 50, 75 and 75 basis points, respectively. China and Japan’s central banks opted for more accommodative policies. Major currencies including the pound, yen, euro, Australian dollar and Swiss franc all depreciated against the dollar throughout the quarter.

Late in the quarter, newly elected U.K. Prime Minister Liz Truss created some volatility in markets when she announced plans for an unfunded tax cut totaling GBP 45 billion per year in hopes of easing citizens financial burdens and spurring economic growth. The 30-year yield for a U.K. government bond jumped nearly 150 basis points in under a week to nearly 5% before settling at around 3.8%. The Bank of England reacted by purchasing gilts to stabilize the market and delayed its planned quantitative tightening program of selling gilts.

While we do not overlook the negative impacts the war in Ukraine, tightening financial conditions, energy crisis and volatile currencies will continue to have, we remain cognizant that a company’s value is derived from its longer term cash flows discounted back to the present day. As share prices fall across the board, we rely on our disciplined approach to identify exceptional businesses overpenalized by share price activity. In our view, risk is not synonymous with owning equities during times of market turmoil. Rather, we believe owning companies that meet our rigorous criteria at discounted levels offers an attractive opportunity on a risk to reward basis.

THE PORTFOLIO

Top Performers:
BIPROGY released fiscal first-quarter results that included a 4% increase in sales, which matched our estimates precisely. Sales advanced due to very strong growth in the system services segment (+20%), which was offset somewhat by small negative growth in the other segments. Furthermore, the company’s sales and operating profit surpassed market expectations. While operating profit and the profit margin lagged our forecasts, we recognize that BIPROGY’s first quarter is generally its weakest of the year, and we do not find the shortfall concerning. Notably, order growth of 18% from a year earlier was also stronger than the market projected driven by robust order increases in the system services (+28%) and outsourcing (+22%) segments. The nearly JPY 70 billion of orders procured in the first quarter is the highest level the company has seen in multiple years, and we believe this establishes the basis for solid performance going forward.

Kansai Paint issued fiscal first-quarter results that included recurring operating profit of JPY 13.2 billion, which reflected a 14% advance from the prior year. Notably, operating profit was nearly double market forecasts of JPY 6.8 billion. The outperformance was mainly driven by business in India (where operating profit was about JPY 2.1 billion stronger than had been projected) and by positive currency effects in Japan and Africa. Upward product price revisions in Japan and India helped results as Kansai achieved a company-wide raw material cost pass-through rate of 110% in its first quarter. In addition, demand in India has been recovering with year-over-year increases in sales volumes for decorative coatings (+18%), automotive coatings (+46%) and industrial coatings (+32%). Management expects that second-quarter results should also benefit from ongoing resilient demand and higher selling prices. We think the company is in a good position to grow its business moving forward.

WingArc1st’s fiscal first-quarter results included revenue, operating profit and adjusted earnings that accelerated 21.4%, 37.2% and 30.2% year-over-year, respectively. In addition, diluted earnings per share advanced 42% from the same period last year to JPY 42.05. Revenue was aided particularly by positive performance in the business document solutions and data empowerment segments. Encouragingly, sales of on-premise software licenses rebounded from depressed levels due to the impact of Covid-19. Guidance for the remainder of the year was unchanged. Given that WingArc1st’s products help customers automate, utilize data more efficiently and digitize their businesses, we think the company is well positioned to benefit as corporate Japan’s progress toward digitalization aligns with the rest of the world.

Bottom Performers:
Komatsu’s fiscal first-quarter results were quite strong, in our assessment. First-quarter attributable net income rose by an impressive 97% year-over-year. Concurrently, net sales advanced 18%, operating profit climbed 52% and the operating profit margin expanded 270 basis points to finish beyond our estimates. Negative factors, such as Covid-19-related lockdowns in China, supply constraints and raw materials price increases, were largely offset by management implementing higher selling prices and currency benefits from the weaker yen. In addition, volumes were healthy in more profitable mining regions, like Southeast Asia and Latin America. However, the company’s share price fell later in the quarter when news surfaced that an analyst from a prominent market research firm downgraded the company and that Komatsu sold four mining equipment production facilities in China. Management expressed that the sales would have only a minimal effect on forthcoming results as China is a relatively small market for Komatsu’s mining equipment. We believe the company’s fundamentals remain solid and that this investment can deliver shareholder rewards into the future.

Toyota Motor reported a disappointing set of first-quarter results. Volumes were down 6%, which the company attributed to supply chain constraints preventing its ability to meet strong customer demand. The semiconductor shortage specifically had a disproportionate impact on electric and luxury vehicles, which had a negative impact on sales mix. Encouragingly, management commented that the semiconductor shortage was improving modestly. Costs grew significantly with raw material costs growing to YEN 315 billion, over 30% of the year-ago period’s operating profit. Management plans to provide more support to suppliers to strengthen its overall supply chain and revise the scope of production plans from one month to three months, which gives suppliers better visibility. Looking forward, management maintained their production and vehicle sales targets for the full year.

JSR’s first-quarter results proved disappointing to investors as its share price fell following the release. Sales climbed 13.3% year-over-year, but core operating profit declined 50.2% year-over-year, which we attribute to a slowdown in display materials, higher costs in the life sciences segment, and delays in automotive production hindering results from the plastics segments. We will continue to closely monitor results but despite these pressures, we continue to believe JSR has a strong management team with a track record of creating innovative products. In addition, we find it has advantageous market positions across most of its business lines.

During the quarter, we added Fujitsu and PERSOL HOLDINGS to the portfolio. There were no final sales.

Past performance is no guarantee of future results.

The MSCI Japan Index (Net) is designed to measure the performance of the Japanese equity market. The index includes large- and mid-cap stocks and covers approximately 85% of the free float-adjusted market capitalization in Japan. This benchmark calculates reinvested dividends net of withholding taxes. This index is unmanaged and investors cannot invest directly in this index.

The specific securities identified and described in this report do not represent all the securities purchased, sold, or recommended to advisory clients. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time one receives this report or that securities sold have not been repurchased. It should not be assumed that any of the securities, transactions, or holdings discussed herein were or will prove to be profitable. Holdings are representative of Harris Associates L.P.’s Japan Unhedged composite as of 09/30/2022.

Certain comments herein are based on current expectations and are considered “forward-looking statements”. These forward looking statements reflect assumptions and analyses made by the portfolio managers and Harris Associates L.P. based on their experience and perception of historical trends, current conditions, expected future developments, and other factors they believe are relevant. Actual future results are subject to a number of investment and other risks and may prove to be different from expectations. Readers are cautioned not to place undue reliance on the forward-looking statements.

The information, data, analyses, and opinions presented herein (including current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) are for informational purposes only and represent the investments and views of the portfolio managers and Harris Associates L.P. as of the date written and are subject to change without notice. This content is not a recommendation of or an offer to buy or sell a security and is not warranted to be correct, complete or accurate.