Commentary

Japan Strategy

December 31, 2021

THE MARKET ENVIRONMENT

Major global markets finished largely higher in the fourth quarter in spite of a variety of macroeconomic concerns that ranged from inflation fears to supply chain disruptions along with yet another Covid-19 variant that took hold in the final three months of the year. As previously announced, the Federal Reserve slowed its pace of asset purchases in November. The tapering came as the rate of inflation in the U.S. quickened to 6.8% versus the year-ago period. The Fed’s dot plot now calls for three rate hikes each in 2022 and 2023. The Bank of Japan and European Central Bank echoed similar sentiments as they also left interest rates unchanged, while the Bank of England raised its main interest rate from 0.1% to 0.25% following a surge in U.K. inflation to a 10-year high of 5.1% annual growth in November.

Meanwhile, as the world attempted to return to normal from the depths of the global pandemic, energy suppliers rushed to ramp up production to meet growing demand. However, a supply shortage and bottlenecks at major U.S. ports sent U.S. oil prices in excess of $85 per barrel for the first time since 2014. Natural gas prices also spiked around the world, forcing the suspension of operations at factories in Europe and China. A shortage of semiconductors, in particular, significantly impaired worldwide automobile production. Simultaneously, the new and highly contagious Omicron variant of Covid-19 spread in the fourth quarter as countries across Europe implemented restrictions once again to combat the spread of the disease.

Although stock prices surged higher in many places across the globe, we are still finding pockets of value in the market. Once restrictions lift, we think pent-up demand and savings will drive business growth in places like Europe. That said, the world is learning how to live with the ever-changing risk of Covid-19, much like how investors must continuously monitor potential risk, potential return and the quality of the businesses when making investment decisions. We think our long-term investment horizon positions us well to observe and capitalize on these considerations.

THE PORTFOLIO

Top Performers:
Investors responded favorably to first-half earnings results from Nihon Unisys, including improved operating profits due to a better business mix and selling, general and administrative cost controls. Though the company’s first-half orders were up only 1%, system service and support services grew orders strongly at 20% and 10%, respectively, which should help support margins growing forward and is central to our investment thesis. The overall backlog also improved 8% versus the year prior, improving the probability that the company can meet its full-year revenue guidance despite its soft first half. In addition, gross profit margins expanded 100 basis points year-over-year as Nihon Unisys increasingly uses its scarce resources for higher end projects.

TIS Inc. reported strong fiscal second-quarter results, beating consensus expectations on operating profits, which grew 29% year-over-year. Orders continued to grow by double digits while margins improved as well, signaling both strong growth and improved efficiency. Other areas of note included order backlogs increasing by 14.5% and management’s increase in guidance for full-year operating profit, which was ahead of consensus forecasts. We appreciate the strong set of results from the company, and believe it is operating in a way that will be beneficial to shareholders in the future as well.

Meitec’s share price appreciated throughout the quarter following a fiscal-year second-quarter earnings report released in October. First-half net sales increased 8.1% year-over-year and operating profit grew by 9.4% year-over-year. The company’s guidance for the full year included an 11% increase in sales year-over-year and a 20% increase in operating profit year-over-year, both of which exceeded market expectations. Meitec also announced plans for a share repurchase of up to JPY 3.4 billion (or about 2% of shares outstanding) and full-year dividend per share guidance of JPY 185.5. We appreciate Meitec’s capital-light business model and reputation for high-quality service and excellent engineers. In addition, management has proven to be focused on shareholder value, returning 100% of free cash flow to shareholders through either buybacks or dividends and decreasing the number of outstanding shares by 25% over the past 12 years.

Bottom Performers:
Sugi Holdings delivered weak nine-month results and lowered full-year guidance, implying that fourth-quarter sales growth will decelerate to 3-4%. The company also guided to a JPY 6 billion impairment charge on obsolete inventory and impairment of select stores. The lowered guidance is attributable to a steeper than expected decline in Covid-19 products (masks and cleaning products), which were coming off a high base, and management overestimated in terms of sales growth. In addition, a shortage of building materials stunted the company’s net new store openings. However, we believe Sugi Holdings is positioned to benefit from the growing role of drugstores in dispensing prescriptions. In addition, we think the company can grow organically using internally generated cash flow as the drugstore market is not yet saturated and the company has significant store opening opportunities in suburban markets. We also appreciate its history of strong capital allocation, including investing in new stores with impressive unit economics and opportunistically expanding its store network through cheap acquisitions.

Sundrug’s first-half earnings report revealed quarterly and first half operating profit down 7% and 9% year-over-year, respectively. However, first-half operating profit and sales both surpassed previous guidance from management. The company opened 25 stores in the first half and believes it is on track to achieve its goal of 84 new stores for the full year. Management left full-year guidance unchanged. We like Sundrug’s competitive position as the drug store industry consolidates from its current highly fragmented dynamic. Based on our analysis, the company generates healthy free cash flow and delivers strong returns on capital and equity. Its lean cost structure and efficient operations allow it to pass savings on to the customers in the form of competitive prices. Finally, we appreciate that management has a reputation for a high focus on profitability and a strong track record on acquisitions.

Kansai Paint’s share price finished lower for the fourth quarter. However, investors responded favorably to the company’s fiscal second-quarter earnings report. Overall recurring profits reached JPY 9.2 billion billion, though management reduced its full-year guidance for the metric given higher input costs. We believe management has successfully kept costs under control while simultaneously expanding outside the company’s home market. Over half of operating profit comes from emerging markets, including in India and South Africa where Kansai holds the leading market position.

During the quarter, we added WingArc1st 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 12/31/21.

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.