Commentary

Japan Strategy

September 30, 2020

THE MARKET ENVIRONMENT

During the third quarter, global markets continued to contend with the economic ramifications of Covid-19 as worldwide fatalities surpassed the grim 1 million mark. In August, the U.S. Federal Reserve announced a policy change that indicated it would not necessarily increase interest rates upon an improvement in unemployment figures, even if inflation is above the group’s traditional 2% target. At its September meeting, the Fed maintained near zero interest rates and publicized intentions to keep them at this level through 2023. Meanwhile, both the S&P 500 Index and the NASDAQ Index closed near peak levels in the quarter. Ultimately, the Fed raised its forecast for full-year 2020 gross domestic product (GDP) from a 6.5% contraction to a 3.7% contraction.

Similarly, both the European Central Bank and the Bank of Japan opted to keep interest rates steady in September. In Japan, the Nikkei 500 Index reached a record high, while industrial profits in China increased 20% in July and 19% in August. Conversely, the U.K. moved into a technical recession following a roughly 20% contraction in GDP in the second quarter, the largest on record, which followed an approximately 3% contraction in the first quarter. As of the end of the third quarter, the country had yet to secure a Brexit trade deal with the European Union. Furthermore, continued Covid-19 concerns and Saudi Arabia’s plans to cut oil prices translated to a decline in both West Texas Intermediate crude and Brent crude to less than $40 per barrel.

On the vaccine front, China indicated a Covid-19 vaccine may be ready for public consumption as early as November. Meanwhile, a leading vaccine candidate from the University of Oxford and AstraZeneca was halted again in September when a participant in its trial became ill. On the other hand, Johnson & Johnson’s vaccine candidate moved into Phase 3 of its clinical trials, the first single-dose vaccine in the U.S. to do so.

In our view, there is a lot of value in the market today. Though the near-term macro outlook may be mixed, positive vaccine developments or further signs of economic recovery from the initial shock of Covid-19 could improve market sentiment. In the meantime, we are finding good opportunities from a valuation perspective and think it is a ripe environment to be picking stocks.

THE PORTFOLIO

Top Performers:
As part of its fiscal first-quarter earnings results, JSR reported solid demand in its semiconductor materials division as sales increased 8% quarter-over-quarter. Management expects semiconductor materials demand will be unchanged in the second quarter. Although operating profits of JPY 2.4 billion in the first quarter fell short of analysts’ estimates, the company maintained its expectations for JPY 23 billion full-year operating profit. Management also anticipated a recovery in demand in the second quarter in its elastomers business. Later, JSR announced its withdrawal from the South Korean and Taiwanese markets for color resists and photosensitive spacers, the closure of a JSR Micro Taiwan plant, and the reduction of personnel at two JSR Micro Korea plants. Costs associated with these moves translated to the company’s reduction of its forecast for fiscal-year operating profit to JPY 20 billion from JPY 23 billion. In our view, the company’s strong management team has a track record of creating innovative products and it possesses strong market positions across most of its business lines.

Kansai Paint’s fiscal first-quarter earnings report proved to be a relief for investors as recurring profit reached JPY 5.2 billion and bested market expectations, despite the challenging operating environment. The company expects full-year recurring profit of JPY 21.0 billion. Kansai’s cost-cutting efforts in Africa contributed to the recurring profits result and it intends to improve asset efficiency throughout the company. Overall, we believe the paint industry is attractive, characterized by technological barriers to entry, strong customer relationships and moderate/low capital requirements.

Sundrug’s fiscal first-quarter results included consolidated sales that increased 3% from the previous year and consolidated operating profits that rose 12%. Both outperformed market forecasts. Results were helped by effective cost containment, especially with regard to selling, general and administrative expenses, and higher consumer spending owing to the Covid-19 pandemic. In addition, stores have re-opened quicker than management anticipated as only 10 of more than 1,100 total stores remained closed at the end of June. Sundrug’s stronger than predicted performance caused some market analysts to increase earnings and profit targets as well as expected share price for the company. We believe the company still has a good amount of upside potential that can provide shareholder rewards into the future.

Bottom Performers:
Oracle Japan’s fiscal first-quarter operating profit and sales results fell short of market expectations as the effects of Covid-19 weighed on results. However, management anticipates improvements in the second quarter. In the meantime, we appreciate that Oracle Japan benefits from Oracle Corporation as the former spends very little on research and development and mergers and acquisitions, yet is a beneficiary of both the financial firepower and intellectual capital of the latter. In addition, we believe Oracle Japan’s business is very sticky with high switching costs and a good recurring revenue stream.

OTSUKA delivered a disappointing second-quarter earnings report. As an office services and products provider, the prevalence of working from home negatively impacted the company’s results. Although the company lowered its full-year sales guidance, it maintained its expectations for operating profit. Moreover, OTSUKA believes its business bottomed out in May. We appreciate that maintenance and office supplies account for about 40% of sales, which traditionally provide stable income streams and recurring revenue. In addition, we like the company’s health economics as a capital-light business with strong free cash flow conversion.

The share price of Sumitomo Mitsui Trust fell after the company released fiscal first-quarter 2020 results at the end of July. The company realized declines in ordinary income, ordinary profit and net income per share of 13.7%, 33.8% and 32.5%, respectively, from the same quarter last year. However, management’s commentary that accompanied fiscal full-year 2019 results that were released in June warned that current-year performance would reflect ongoing impacts to the business from Covid-19. We continue to believe that Sumitomo offers a compelling investment opportunity for long-term shareholders.

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

Past performance is no guarantee of future results.

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 NASDAQ Composite Index is a broad-based market-capitalization weighted index of all common type stocks on the NASDAQ Stock Market, including common stocks, American depositary receipts, ordinary shares, shares of beneficial interest or limited partnership interests, and tracking stocks. The index includes all NASDAQ listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds (ETFs) or debentures. This index is unmanaged and investors cannot invest directly in this index.

The Nikkei 500 Stock Average is a price-weighted average of 500 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 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 09/30/20.

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.