THE MARKET ENVIRONMENT
Japanese financial markets experienced volatility throughout the fourth quarter of 2022. Equity indexes rose sharply throughout October and November before backpedaling in December and ending the period roughly flat. Japan’s core inflation reached a 41-year high in November of 3.7% year-over-year. The Bank of Japan continued its accommodative policy stance on interest rates, but surprised markets by doubling the amount of fluctuation from zero it would allow on 10-year bonds from 0.25% to 0.50%. The central bank said the reason was to enhance the sustainability of monetary easing, but many investors speculated it to be a sign of a potential exit from its decade-long stimulus policy. As a result, the Yen appreciated against other currencies and Japanese government bonds fell. The Bank of Japan ran unscheduled purchases of government bonds following the announcement in an effort to control the spike in yields.
While we recognize the challenge facing investors with the current state of financial markets, we believe that the lower and more widely dispersed valuations in the market today have allowed us to redeploy capital into increasingly attractive investments. We are optimistic that these decisions will sow the seeds of future outperformance. As always, we remain focused on building a high conviction portfolio of undervalued businesses which we believe will provide both a margin of safety and the potential for attractive risk-adjusted returns over the long-term.
THE PORTFOLIO
Top Performers:
Fiscal first-half results from Sumitomo Mitsui Financial included a year-over-year net revenue increase of 14%. Net profit and ordinary profit both rose 15%, while ordinary income grew 48%, which led to earnings per share of JPY 383.23 that were 15% higher than in the prior year. The company’s customer segments drove profit growth, particularly the wholesale and global business units. Expanded corporate lending in Japan and overseas boosted interest income, and a weaker yen value also helped results. Management raised full-year guidance for net income and earnings per share to figures in excess of market expectations. Furthermore, the company’s share price climbed significantly in mid-December upon surprising news that Prime Minister Fumio Kishida in conjunction with the Bank of Japan decided to revise the country’s monetary easing policy and 2% inflation target. This action will allow for a more flexible monetary policy and rising interest rates, which the market believes will help boost earnings at banks.
Komatsu reported a strong set of first-half results, in our view. In the core construction and mining segment, sales in the second quarter increased 34% year-over-year compared to an increase of 20% in the first quarter. In our estimation, currency effects were a tailwind and added about 16% to topline growth in the first half. However, we appreciate that pricing was also a positive factor with average selling prices up around 3.5%. We believe there is room for further upside from pricing. Operating profit margin for the second quarter was 13.8% versus 12.2% in the first quarter. Incremental margins were above 20% as operating costs and raw material costs were higher. Management increased full-year guidance by 15% for revenue and 27% for operating profit margin, driven by foreign currency adjustments, expectations for stronger volumes in mining, better price realization in the second half, and improved product mix. Management also noted it is seeing a better situation in logistics, which was a material drag on performance last year. The company said it has not seen any deceleration in demand for mining equipment and expects decent growth in construction equipment on energy and infrastructure demand in the U.S.
Sumitomo Mitsui Trust released fiscal first-half results that included ordinary income of JPY 825 billion, which reflected an increase of 18.4% from last year. However, ordinary profit of JPY 145 billion and net income of JPY 104 billion declined from a year ago by 4.6% and 6.3%, respectively. Even so, management issued full-year net income guidance of JPY 190 billion (+12.4%), and the company’s share price rose following the release. Management also increased the shareholder dividend payment for fiscal year 2023 by 18% to JPY 200 per share. In December, Sumitomo Mitsui Trust’s share price soared alongside prices of other Japan-based banks, such as Sumitomo Mitsui Financial. Price advances were prompted by an announcement that Prime Minister Fumio Kishida in conjunction with the Bank of Japan decided to revise the country’s monetary easing policy and 2% inflation target. Here too, though we are not certain about the benefits Sumitomo Mitsui Trust will garner, market sentiment has turned decidedly positive for Japan’s financials.
Bottom Performers:
Kansai Paint’s fiscal first-half results included net sales of almost JPY 251 billion, which reflected a 23.3% increase from the same period last year. In addition, ordinary income rose 1.3% to JPY 21 billion and net income advanced 7.7% to slightly more than JPY 12 billion, while operating income fell 6.4% to about JPY 16 billion. Furthermore, management raised fiscal full-year guidance across the board. Management attributed the guidance upgrade to recently implemented price increases, positive currency effects and ongoing robust improvements in the automotive coatings segment. Also, during the quarter we spoke with President MORI Kunishi who said he is focused on strengthening the company’s management foundation and improving capital efficiency. In addition, he added the adjusted earnings margin and return on equity as key performance indicators. We came away confident in our thesis and investment.
Fiscal second-quarter results from Olympus included revenue of nearly JPY 225 billion and operating profit of slightly more than JPY 49 billion. However, revenue and operating profit undershot market expectations by 6% and 10%, respectively. Furthermore, attributable profit fell 4% year-over-year in the second quarter, and it appears these factors unnerved investors and pressured the company’s share price. Even so, attributable profit for the quarter reached almost JPY 42 billion, which outpaced market forecasts by 5%. For the full fiscal first half, revenue climbed by 15.8% from a year earlier to JPY 417.06 billion, and Olympus realized a record high operating profit that rose 32.5% to JPY 93.6 billion. Attributable profit also advanced by 7% to JPY 66.8 billion. In addition, management announced a new share repurchase program wherein the company will spend JPY 50 billion to buy back 21 million shares by the end of the year. In December, the company completed its acquisition of Odin Vision, a start-up operation that provides cloud-based artificial intelligence applications for endoscopies. Olympus expects this acquisition will expand its digital strategy and enable data-driven insights to enhance patient care. We are hopeful that the integration of this firm can boost the intrinsic value of Olympus and provide additional shareholder benefits.
Fiscal first-half results from Hirose Electric revealed revenue increased 19.6% year-over-year to JPY 94.7 billion, while operating profit and net profit advanced by 37% and almost 40%. This progress prompted the company to increase full-year guidance for revenue and net profit. Hirose also raised the shareholder dividend by over 37% to JPY 220 per share. Despite these positive developments, the company’s share price fell for the quarter. We recently met with members of Hirose’s management team and reviewed the company’s performance. Management has seen a shift from growth in its consumer and smartphone connectors business, which was driven by strong PC and mobile demand, to the industrial and auto segments. The industrial segment acceleration is being driven mainly by factory automation equipment as end-market demand continues to rise as well as from new product introductions by Hirose. Notably, there is a six-month industrial order backlog, and this segment produces the largest margins. In the auto segment, as a result of significant research and development investments in 2018 and 2019, the company is now able to produce and sell connectors for electric vehicles and advanced driver assistance systems. The auto segment realized 22% revenue growth in the first half, and management foresees ongoing revenue growth and margin expansion in this segment. In our view, this company’s operational efficiency can continue to benefit stakeholders moving forward.
There were no new purchases or final sales during the quarter.
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 12/31/2022.
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.
