Commentary

Japan Strategy

June 30, 2020

THE MARKET ENVIRONMENT
Major global markets finished higher for the second quarter, despite pockets of volatility dispersed throughout the reporting period. Businesses continued to grapple with the effects of the coronavirus pandemic on economic activity in the second quarter. In the U.K., gross domestic product sank 20.4% in April following a 5.8% decline in March. In Germany, industrial output dropped a record 17.9% in April after an 8.9% descent in March. In June, the International Monetary Fund (IMF) lowered its previous forecast for a 3.0% global economic contraction to a 4.9% global economic contraction for full-year 2020. The IMF also anticipates that the Japanese economy will shrink 5.8% in 2020, which is in excess of the 5.4% contraction the country experienced in 2009.

By the end of June, confirmed global coronavirus cases topped 10 million and global deaths from the virus surpassed the grim 500,000 mark. The U.S. accounted for over 25% of both global cases and deaths, with more than 35 states experiencing an increase in new cases by the end of June. Daily cases in the country eclipsed the 40,000 mark multiple times during the second quarter. Brazil trailed only the U.S. in both cases and deaths at more than 1.3 million and 55,000, respectively.

Meanwhile, heightened recognition of racial inequities and injustices prompted large-scale protests (and, in several cases, riots) to break out around the world. Surging protest activity that lasted weeks interrupted newly reopened businesses just emerging from pandemic-induced shutdowns, which led to further market volatility. The widespread call for change caused many organizations to publicly implement practices to fight racism, emphasize diversity, and eliminate offensive images, symbols and product brand names.

As is the case in any period of volatility, we find that the price of a business is an important aspect of what makes a stock attractive. Investing in a business at a fraction of what we think its underlying value is presents an opportunity to create value for our shareholders. In times like these, we look for high-quality companies with over-penalized share prices as investors disregard strong balance sheets and free cash flow and instead base investment decisions on market sentiment.

THE PORTFOLIO
Top Performers:
Sugi Holdings issued first-quarter results, including revenue, operating profit and profit margin, that all outpaced our estimates and were aligned with market expectations. Like-for-like sales advanced 8.5% in the core Sugi Pharmacy segment and household goods were particularly strong with sales up 27%, helped by consumers stockpiling toilet paper and other items. While prescription drugs performed well in absolute terms (revenue rose 12%), prescription volumes were down during the quarter, owing to reduced doctor-patient interactions to dispense the necessary physical prescriptions. The company opened 32 net new stores during the quarter, which puts Sugi ahead of management’s full-year target for 100 openings. The strength of the company’s first-quarter performance was not surprising to us because it benefited from consumer spending related to the pandemic. However, we anticipate that results will normalize as the effects of the coronavirus recede.

Komatsu’s share price, which was helped by a general advance of Japan’s equity market, rose for the second quarter. The company’s fiscal full-year results released in May included year-over-year declines of revenue and operating profit of 11% and 41%, respectively. Results were weaker than our estimates and were driven by effects from the coronavirus and negative currency impacts primarily in the fourth quarter, where revenue fell 13% and operating profit decreased by JPY 10 billion. By segment, full-year mining revenue was down 9% as revenues from original equipment plunged 19% and parts/service fell nearly -5%. Likewise, construction revenues were down 12% (original equipment -13% and parts -4%). Management did not issue guidance for the current fiscal year. However, the company has been preparing for a tough future operating environment by cutting fixed costs, increasing liquidity and reducing inventories to maximize cash flow. While we have lowered some of our near-term valuation metrics for Komatsu, our investment thesis remains unchanged.

Fiscal full-year results from Olympus included total revenue growth (excluding currency effects) of 4% and operating profit nearly tripled from a year earlier. Management attributed these strong results to the medical segment, which achieved record high revenue for three consecutive years, and to a significant reduction in selling, general and administrative expenses that drove the operating profit advance. Conversely, revenue and operating profit declined in the imaging division, though the profit decline narrowed from the prior year. While overall results were largely in line with market expectations, total revenue and operating profit fell short of management’s targets, owing to coronavirus effects in the fiscal fourth quarter. Later, investors responded favorably to news Olympus sold its imaging business in June to Japan Industrial Partners. We believe management has performed well in recent times by selling non-core assets, restructuring the business, growing the medical segment and strengthening the balance sheet. In addition, we like that the company has made progress to reduce costs, improve efficiency and globalize the management team and its board of directors.

Bottom Performers:
Sumitomo Mitsui Trust, the only detractor for the quarter, released fiscal full-year results that reflected year-over-year declines in net income, ordinary profit and earnings per share. While these metrics fell short of market forecasts, we were pleased that the company’s performance largely met our estimates. Sumitomo Mitsui Trust’s capital ratio is sufficient and in line with our forecasts as its common equity Tier 1 ratio is 11% post Basel III reforms (9.8% excluding unrealized gains), which exceeds the target of 10%. In addition, management issued a new medium-term plan that incorporates the impacts from the coronavirus. The company estimates that the pandemic will lead to a 2.3% decrease in Japan’s 2020 gross domestic product (GDP) and global GDP will fall by 2.7%, with expectations for a recovery in 2021. As a consequence, management sees net income of JPY 400 billion in fiscal-year 2020 (a reduction of nearly half of original expectations) due to higher credit costs and lower revenue. We have considered these factors and continue to believe that Sumitomo Mitsui Trust is well positioned to reward long-term investors.

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

Past performance is no guarantee of future results.