Commentary

Japan Strategy

December 31, 2020

THE MARKET ENVIRONMENT

Similar to the year 2016, 2020 was a year of extremes driven by exogenous factors ranging from the Covid-19 pandemic to Brexit negotiations with elections in between. Most recently, markets reacted favorably to events in the fourth quarter, particularly the approval and emergency use authorization of multiple vaccines aimed at preventing the spread of Covid-19.

Meanwhile, the U.K. and European Union negotiated arduously in the quarter, finally accomplishing an agreement that eliminated the possibility of a hard Brexit outcome. In the U.S., the four-year presidential election cycle produced a more balanced outcome than many had expected. The market proved relieved at both the elimination of uncertainty and the lower probability of big changes. Later in the fourth quarter, President Trump signed the country’s long-debated second economic relief bill into law, sending direct payments to some individuals and families as well as further extending unemployment benefits.

These events propelled equity prices higher across the globe for a strong finish to a year that had earlier experienced a bear market. Ultimately, the Nikkei 225 Index soared to a 30-year high in Japan, the German DAX Index surged to a record figure, and both the Dow Jones Industrial Average and S&P 500 Index closed out the year at record levels.

This year amounted to a volatile 12 months for investors. Though traumatic and difficult to tolerate, we recognize that market instability can unearth investment opportunities for those who are patient and willing to weather the storm. In times when others chase performance or lose conviction based on news headlines and irrational reactions, we remain alert to subsequent opportunities caused by short-term investors to build positions in quality companies that are trading at large discounts to our perception of their intrinsic value. This discipline is deeply embedded in our philosophy and process.

THE PORTFOLIO

Top Performers:
Komatsu’s fiscal second-quarter results showed improved operations as operating profit exceeded consensus estimates by 14%. Sales in the construction and mining segment improved from -25% in the first quarter to -19% in the second quarter. Geographically, revenue results in China (+14%) and Australia (+10%) drove improvement, and the company increased full-year projections in key markets, such as China, North America and Japan, due to a recovery in these markets. Margins also improved to 6.7% in the second quarter from 5.9% in the first quarter. In addition, the company raised its guidance for full-year sales and operating profit by 3% and 16%, respectively. While the short-term operating environment remains challenging, Komatsu is trading at a discount to our perception of its intrinsic value.

Toyota Motor posted a strong sequential recovery in its fiscal second quarter, including a 55% increase in automotive sales quarter-over-quarter. Operating profit (JPY 520 billion vs. JPY 317 billion) also handily bested consensus estimates. On a sequential basis, much of the improvement in Japan was driven by exports, especially a recovering U.S. market and Lexus sales in the U.S. Toyota cut JPY 165 billion in costs during the second quarter to more than offset a JPY 120 billion currency headwind and management announced a special interim dividend of JPY 5 per share. The company also increased full-year guidance for sales by 8% and for operating profit by 160%. In December, investors responded favorably to news Toyota produced a solid-state electric vehicle battery that recharges in 10 minutes. The solid-state battery will more than double the distance range of an electric vehicle using a lithium-ion battery, and Toyota intends to unveil a prototype vehicle utilizing this technology in 2021. We appreciate the company’s long history of quality and brand equity in the U.S. In addition, we think Toyota is one of the best operationally run auto companies in the world and like that it has steadily taken market share in North America and Europe over the past 20-30 years.

Despite no fundamental changes, Kansai Paint finished higher in the fourth quarter. In November, the company held a strategy briefing to provide an update on its medium-term plans, including adjusted earnings margins in excess of 18% and return on equity of more than 13% by 2025. Kansai plans to maintain its focus on investment in its businesses rather than executing share repurchases with a concentrated effort in India as a growth area for construction-use paint. The company sees scope to boost its market share in Japan, which it thinks will lead to a JPY 10 billion boost to adjusted earnings when coupled with cost cuts. Kansai also intends to boost profits in Africa via expansion into central Africa and trimming costs in that continent as well.

Bottom Performers:
Despite no fundamental changes, Sugi Holdings finished lower in the fourth quarter. The company posted solid nine-month results in December, in our view, as margins exceeded both management’s guidance and consensus expectations. Third-quarter topline grew 7% and same-store-sales (SSS) growth reached 4.7%, driven by a 7% increase in prescription drugs on an SSS basis. In addition, over-the-counter drugs, food and homewares sales were up 11%, 9% and 11%, respectively. Gross profit margins expanded 130 basis points in the third quarter, though selling, general and administrative costs were up nearly 12% for the nine-month period due to the aggressive hiring of pharmacists, opening new stores and rental increases. Moreover, Covid-19 accelerated the shift to Sugi’s local neighborhood stores in lieu of others located near hospitals, resulting in new customers, higher traffic numbers and higher prescription drug sales. Sugi opened 84 net new stores year-to-date, putting the company on pace to meet its full-year target for about 100 new stores. We believe the company is a solid investment that will reward shareholders into the future.

Early in the reporting period, Cosmos Pharmaceutical delivered its fiscal first-quarter earnings report, which included a 52% increase in operating profits year-over-year. In addition, September’s same-store-sales fell by just 2.5% year-over-year, despite a tough comp. However, sales growth slowed from September to October. Later, the company’s November same-store-sales grew 7.8% year-over-year and average all-store growth between September and November amounted to over 9% year-over-year. Overall, we appreciate that Cosmos and the industry as a whole are benefitting from an aging society, increasing rate of drugs dispensed outside hospitals, market share gains from traditional supermarkets and general merchandise stores, and drug store consolidation.

Investors were disappointed with NGK SPARK PLUG’s release of its fiscal second-quarter results and update on its long-term plans in November. During the release, the company outlined an investment of JPY 200 billion in new businesses over the next 10 years. However, these businesses will not be profitable by 2030. Demand for NGK’s spark plugs and sensors is strong at present, and the company is expecting sales of JPY 450 billion in 2030 in this space and sales of JPY 750 billion overall. NGK also expects operating profit margins of 15% or higher, return on invested capital of 10% or higher, and return on equity of 12% or more in 2030. The company looks to shift its business mix toward precious metal plugs and all-area sensors while reducing capital expenditures. We continue to believe the valuation for NGK remains attractive, offering a compelling reason to own.

During the quarter, we initiated positions in TechnoPro Holdings and TIS Inc. We eliminated Sumitomo Mitsui Trust from the portfolio.

Past performance is no guarantee of future results.

The Nikkei Stock Average (Nikkei 225) is a price-weighted average of 225 Japanese companies listed in the First Section of the Tokyo Stock Exchange. Constituents are selected based on liquidity and industry representation. This index is unmanaged and investors cannot invest directly in this index.

The Deutsche Boerse AG German Stock index is an equity index that measures the share performance of the 30 largest German companies in terms of exchange turnover and market capitalization, and is thus an established indicator for the performance of the German economy as a whole. This index is unmanaged and investors cannot invest directly in this index.

The Dow Jones Industrial Average is a price-weighted measure of 30 U.S. blue-chip companies. The index covers all industries except transportation and utilities. This index is unmanaged and investors cannot invest directly in this index.

The S&P 500 Total Return Index is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. It is a widely recognized index of broad, U.S. equity market performance. Returns reflect the reinvestment of dividends. 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 12/31/20.

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.