Commentary

Japan Strategy

December 31, 2019

THE MARKET ENVIRONMENT
The fourth quarter of 2019 brought a steady recovery in global markets following the volatility that afflicted indexes around the world earlier in the year. As was the case last year, 2019 featured extreme price movements as the latest news, including trade talks, Brexit, European Union political instability and even a political conflict between South Korea and Japan dating back to World War II, influenced stock prices. As an example, while global markets started the year off strong, a few tweets that fueled trade war fears in May sent indexes around the world tumbling. August also saw more measurable declines until markets began to recover and rebound based, in part, on more positive geopolitical headlines.

Other fears that weighed on markets were the possibility of a Jeremy Corbyn victory in the U.K. general election and continued uncertainty surrounding Brexit. With a large, historical victory by the Conservative Party in the U.K., investors’ fears of a Corbyn-led socialist-style government were alleviated for the medium term. Instead, Prime Minister Boris Johnson’s government acted quickly to move its Brexit bill through Parliament in an attempt to ensure a smooth exit from the European Union.

Meanwhile, China and the U.S. de-escalated their trade dispute with an agreement of a “phase-one” trade deal in the fourth quarter. These events boosted global equity market sentiment toward the end of 2019 and entering into 2020. These developments also provided more solid foundations for businesses to make capital allocation and investment decisions going forward as the news pushed key U.S. indexes to all-time high levels. In fact, all 11 GICS sectors in the S&P 500 Index gained value in 2019 and produced double-digit returns for the year. In China, the Shanghai Composite increased 22% for the year, while Japan’s Nikkei 225 Index finished 18% higher in 2019.

Despite the recovery in 2019, we still believe our investment approach offers good upside potential. In fact, our investment philosophy and team have been consistent throughout our history. We continue to look for opportunities to achieve higher returns by estimating business value and buying at a discount. We utilize this strategy with the goal of long-term outperformance for the benefit of our shareholders.

THE PORTFOLIO
Top Performers:
Sundrug issued fiscal first-half results that were decent, by our measure, and reflected a recovery from uncharacteristically weak 2018 fiscal year earnings that were impacted mainly by matters outside of the company’s control. Consolidated operating profit was up 15% from a year earlier as both newly targeted sales promotions attracted new customers and increased demand helped boost results. The company opened 16 new stores in the period, which was short of the goal to open 23. To accelerate the pace of new store openings, management plans to grow the number of development staff from 15 to 45 by the end of the fiscal year. In addition, Sundrug recently appointed Hiroshi Sadakata to president, replacing Kimiya Akao who passed away in 2018. Sadakata was previously the head of Direx where he successfully turned the loss-making business into an enterprise that generated a 4% operating profit margin. His main objectives include accelerating the pace of new store openings and expanding automation in stores to offset worker shortages and labor inflation.

Investors responded favorably to communication services company Hakuhodo DY Holdings’ fiscal first-half earnings report. Revenue growth finished 70 basis points higher than management’s guidance. Later, we met with the new holding company president Masayuki Mizushima. Mizushima worked his way up through the company over the past few decades, developed a solid record in managing the firm’s largest clients and seemed comfortable in his new role. In addition to discussing Hakuhodo’s purchase of the large minority of its digital agency D.A. Consortium, which we think will afford both cost and revenue synergies, we reviewed the company’s new three-year plan to achieve 7% per annum revenue growth via organic growth as well as from mergers and acquisitions. The plan also targets an operating profit margin over 20% and a return on equity over 15%. Overall, we find that Hakuhodo continues to outperform its peers and seems to have realistic objectives based on what it has accomplished in the past.

Olympus’s fiscal first-half earnings results included a second-quarter acceleration of growth in the core medical business and the expansion of medical segment margins to 28.4%. The company also announced its medium-term plans, including ambitious profit and return targets, in our view. The plan includes: 6% topline growth over the next three years in the endoscopy business; the transfer of the therapeutic headquarters to Boston along with plans to achieve an 8% topline compound annual growth rate over the next three years; guidance for operating profit margins over 20% by fiscal year 2023; expectations for free cash flow to grow 20%, return on invested capital of 20%+ and earnings per share growth over 25%; and more regular assessment of businesses within Olympus’s portfolio. We appreciate the company’s intent to achieve these goals in three years instead of the traditional five years allotted in a medium-term plan as it increases the sense of urgency, in our estimation.

Bottom Performers:
Investors proved disappointed with Sugi Holdings’ third-quarter earnings report, which caused the company’s share price to finish lower for the fourth quarter. Accelerated store openings increased selling, general and administrative expenses and weighed on margins. However, we believe topline results were healthy with third-quarter sales growing at nearly 13%, driven by these new store openings, increased pre-buying in September ahead of the consumption tax increase and continued strength in the core pharmacy dispensing operations. We met with President Katsunori Suguira in December and found him to be knowledgeable, confident and able to clearly communicate Sugi’s strategy for the future. Our investment thesis for the company remains intact.

There were no new purchases or final sales during the quarter.

Past performance is no guarantee of future results.