THE MARKET ENVIRONMENT
Japanese equity markets were mixed in the third quarter as the TOPIX Index returned 2.45% and the Nikkei 225 Index returned -3.27%. Year-to-date, the indexes have returned 25.70% and 24.45%, respectively. The Japanese yen lost value against the U.S. dollar during the quarter, ending the period at approximately 149.23 USD/JPY.
Japan’s gross domestic product grew at 6% in the second quarter, surpassing consensus expectations, which called for 2.9%. Inflation came in at 3.2% in August, down from 3.3% in June and July; while core inflation remained steady at 3.1%. The prospect of Japan exiting deflation is a significant development and one that has investment implications in our portfolio. Specifically, we look for businesses that have pricing power over the medium and long term and where the competitive environment allows for greater flexibility in pricing.
Unemployment in the country remains low and was 2.7% in August. The Bank of Japan adjusted its accommodative monetary policy as it increased the band for purchases of its benchmark 10-year government bond to 100 basis points, an increase from the prior 50 basis point range. While in the short term the Bank of Japan is likely to continue an accommodative policy, we believe the change in the band represents a meaningful step in long-term normalization of interest rates in the country. This is an area we are watching closely as it is directly impacts our holdings in financial companies, like Sumitomo Mitsui Financial Group and Sumitomo Mitsui Trust. While very accommodative policy may be the case in the short term, over the medium and long term we continue to believe the hyper accommodative policy by the Bank of Japan is unsustainable.
We continue to be positive about the portfolio where, for a few exceptions, fundamentals have performed in line to better than our expectations. Due to the weak yen, generally speaking, export-oriented companies have benefitted more than domestic-oriented companies. As a result, valuation levels for domestic-oriented businesses are more attractive today and this is where the portfolio is overweight.
THE PORTFOLIO
Top Performers:
Financials firm Sumitomo Mitsui Financial was a top contributor. The company reported fiscal first-quarter ordinary income 2.27 trillion yen versus 1.33 trillion yen the prior year and reiterated full-year guidance. We expect the company to continue to report strong earnings and benefit from a higher interest rate environment. In our view, Sumitomo Mitsui Financial is the best run Japanese megabank in terms of prudent lending, and it has an impressive return on equity relative to the three largest banks historically. We also appreciate that the company has a strong balance sheet, which adds to our confidence in this investment.
Toyota Motor was a contributor during the reporting period. The Japan-headquartered consumer discretionary company announced plans in July to produce 2.68 million units between August and October 2023, increasing production by 11% year-over-year. The company remains confident that it can achieve its targets in fiscal-year 2023 as current trends in the U.S. auto business remain strong and demand continues to outstrip production. We believe Southeast Asia remains an important and profitable region for Toyota, and current trends in the market remain healthy with demand higher than production levels. We are monitoring this market over the midterm as Chinese original equipment manufacturers penetrate the market with low prices for electric vehicles (EV). Earlier in 2023, former CEO Akio Toyoda stepped down to become chairman. He was replaced by Koji Sato, the previous head of Lexus, to accelerate the development and transition to EV. Since Sato’s start as CEO, Toyota hosted a battery investor day where it outlined several new strategies to accelerate technological development as well as a sped-up design and production timeline for its battery electric vehicles series.
Sumitomo Mitsui Trust, a financials firm, was a top contributor for the quarter. Sumitomo Mitsui Trust reported first-quarter ordinary income of 548 billion yen versus 394 billion yen a year ago. Despite the challenging operating environment, we like that Sumitomo’s focus is on its fee-based business, such as trusts, asset management and real estate. In our view, this makes the business quality higher than the megabanks, which are more dependent on net interest income. We also believe Sumitomo is positioned to benefit from improved gross domestic product, credit growth and higher asset prices. Moreover, we think the company has one of the best management teams of the Japanese banks that focuses on the right things, including retaining cost efficiency and increasing fees, among others.
Bottom Performers:
Olympus was a detractor during the reporting period. The Japan-headquartered health care company’s share price fell following its fiscal first-quarter results, which revealed sales that were short of consensus estimates. We find that much of the miss can be attributed to supply chain-related headwinds, such as suspended shipments and shortages as well as lower hospital spend due to macro conditions and budget reductions. We do not believe these will have a material impact on the business over the medium to long term and, in our view, the decline in share price was more significant than the decline in underlying intrinsic value. We continue to appreciate the job management has done as it undergoes a transformation through reducing costs, improving efficiency, and globalizing the management team and board. We also believe management has done well strengthening the balance sheet and growing the medical business, both helping to provide a path toward creating shareholder value over the long term.
Sugi Holdings was a detractor during the reporting period. The Japan-headquartered consumer staples company reported first half of 2023 results in line with consensus expectations. First-half sales were up 10% driven by continued demand for cosmetics, hayfever medicine, higher prices and larger customer basket sizes, which translated into higher gross profit margins by 40 basis points. However, the market seemed to anticipate slower earnings momentum heading into the second half of the year due to a decline in demand from Covid-19-related merchandise and higher expenses. In our estimation, the prescription drug business was the weakest part of the report, with gross profit margins falling by 60 basis points, mainly driven by the National Health Insurance price revisions and changes to the technical scheme that were announced in 2022. We are monitoring the situation and plan to speak with management about full-year projections given the deceleration from the first quarter to the second quarter. We continue to believe Sugi Holdings is an attractive investment for patient investors, such as ourselves.
Japan-headquartered technology company Fujitsu was a detractor during the third quarter. While the company’s stock remained flat despite the Japanese market performing well, we believe the weak share price performance can be attributed to underperformance outside of the company’s core technology businesses. However, we think corporate Japan is behind the rest of the world in digitizing businesses. As a result, we expect to see a multi-year tailwind of information technology spending in Japan. During the quarter Fujitsu did not repurchase any shares but is still committed to repurchase YEN 150 billion worth of shares this year, equal to about 4% of its market capitalization. We appreciate Fujitsu’s progressive management team when it comes to governance and shareholder returns and believe that our long-term thesis remains intact.
During the quarter, we eliminated Oracle Japan from the portfolio. There were no new purchases.
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 09/30/2023.
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.
