Commentary

Japan Strategy

March 31, 2020

THE MARKET ENVIRONMENT
At the start of 2020, it appeared market activity would continue in familiar fashion and would largely support global benchmark levels achieved from prior bull market advances. However, by mid-January, developments concerning the coronavirus came to light. What began in late 2019 as an outbreak localized to China spread swiftly and by mid-March, the World Health Organization officially deemed the coronavirus a global pandemic. Equity markets declined precipitously in conjunction with increasingly dire news about the accelerating rate of illness.

The virus quickly disrupted economic activity across geographies and sectors from large global enterprises to Main Street businesses. Significant travel restrictions, the shutdown of typical group gathering activities and orders by officials in many countries for citizens to stay home upended daily life. Even the 2020 Olympic Games were postponed. Unemployment began to rise, with the U.S. seeing a record three million jobless claims filed in a one-week period and the United Nations estimated that virus-prompted job losses could exceed 25 million worldwide. To stem the economic impact, policymakers around the world enacted significant economic stimulus measures and leaders of industrial nations vowed to work in tandem to support the global economy. Though some funding levels have already reached trillions, economists expect that even more stimulus may be necessary.

Over our decades of experience, we have witnessed other market-rattling crises, each uniquely different from each other. No one knows how this particular issue will be resolved as there is not enough data today to reach specific conclusions. Yet please be assured that our framework for dealing with exogenous risks like this is to attempt to determine the impact on business value rather than extrapolate near-term costs in perpetuity. In our assessment, equity share price declines have reached levels that are in excess of the actual value declines of businesses we hold. One proactive action we adopt under adverse circumstances is to rebalance our client portfolios. We take advantage of lower equity prices to increase share weightings of companies that, according to our estimates, have become even more undervalued. Although the current situation is changing rapidly, as long-term investors, we focus on rational decision-making and avoid making emotionally driven investing choices. Our investment team remains on vigilant watch for appropriate opportunities today that we believe can yield shareholder rewards over our typical five- to seven-year holding timeframe.

THE PORTFOLIO
Top Performers:
OTSUKA’s share price jumped during the quarter upon release of its fourth-quarter earnings report. Net sales for the quarter and for the fiscal year outpaced market expectations, increasing 13% and 17% year over year, respectively. The SI (system integration) business segment, which develops and sells packaged software and provides sales and technology support for network-related equipment, was the largest contributor, accounting for over 65% of net fourth-quarter sales. In addition to net sales, operating profits also improved, increasing 14% in the fourth quarter year over year. We continue to be impressed with the company’s fundamental performance and believe OTSUKA’s strong operations provide an attractive investment opportunity.

The share price of Cosmos Pharmaceutical rose after it was added to the strategy early in the first quarter. The company’s fiscal second-quarter consolidated sales rose 11% year over year, while operating profit declined 7%, owing to sales promotions that included discounted pricing. However, for the fiscal first half, though operating profit was lower than a year earlier, it met management’s guidance. Cosmos utilizes a unique business model with stores that are larger than those of its competitors and a product mix of food and prices that are among the lowest in the industry. We find the drug store industry in Japan appealing, in part, owing to demographics in the country and the rising trend of drugs being dispensed outside of hospitals. We especially like that Cosmos is currently growing revenues on an organic basis at a faster rate than peers. Overall, we believe the valuation for this high-quality company with a large market share is attractive, offering a compelling reason to own.

Before we added SMC to the strategy in the first quarter, manufacturing plants in Beijing were shut down, owing to effects from the coronavirus pandemic. China is an important market for the company as customers in this region generate the second-largest amount of the company’s revenue. Operations at Beijing plants have restarted earlier than expected, which appeared to reassure investors. We like SMC because pneumatic equipment industry growth looks promising as businesses face an increasing need to automate to reduce labor costs and enhance product quality. Higher penetration of automation in the emerging world could also foster greater growth. The company currently possesses about 35% of the global market share for pneumatic equipment and 65% share in Japan, which makes it the dominant competitor in its industry. Importantly, SMC has gained market share globally over the past 5 to 10 years. We think this trend can likely continue, owing to the company’s competitive advantages, which we believe include unmatched scale and breadth of product, inventory availability, and a strong service network.

Bottom Performers:
Hakuhodo DY Holdings released third-quarter results and reported JPY 18.4 billion in adjusted earnings (excluding Mercari) in line with market estimates of JPY 17-18 billion. Third-quarter domestic billings increased 0.6% year over year, which reflected a slowdown from the billing growth in the second quarter. We believe the slowdown in domestic billings was a result of a softer advertising market in Japan following the consumption tax increase along with slower digital advertising sales. Third-quarter digital ad sales increased 6% year over year, a decline from the 13% year-over-year increase in the second quarter. Hakuhodo’s management team did not make any changes to full-year guidance, and we continue to believe the company offers a compelling investment opportunity.

Komatsu issued fiscal nine-month results that were weak, as we had expected. Revenue declined 9.5%, compared with the year-ago period, and operating profit fell 30%, mainly driven by results in the third quarter. Equipment sales were down in all regions except Europe, and Southeast Asia and China continued to generate the weakest equipment sales. Business in Indonesia again worsened as volumes fell 39% in the third quarter, which prompted a 34% decline for the nine-month period. As a result, management further reduced full-year volume expectations for Southeast Asia by 5% to a range of -20% to -25%. In addition, volumes in China were approximately 10% lower in the third quarter due to economic uncertainty from the trade war along with market share gains by domestic manufacturers. Based on these result as well as business disruptions and fallout from the coronavirus pandemic, we lowered our near-term revenue estimates for some of Komatsu’s operating segments. However, we left our long-term valuation projections unchanged.

Sumitomo Mitsui Financial reported fiscal nine-month results that reflected declines in net income, ordinary income and ordinary profit from the prior year period. Earnings per share dropped nearly 3% to JPY 443.33 compared with JPY 455.88 last year. However, market commentary from certain analysts noted some positive core profit trends. While Sumitomo Mitsui’s consolidated gross profit fell for the period, core profit (composed of net interest income plus fee income, excluding the impact of reorganization costs) increased year over year, owing to a rebound in fee income from individuals and loan yields that remained steady. Furthermore, fee income in the retail segment improved quarter over quarter from a recovery in the investment products business and solid results for Sumitomo Mitsui Card. In addition, the international segment benefited from overseas loans that grew 7% from a year earlier. While we acknowledge that this company still has challenges to overcome, we are hopeful that forward progress will continue.

During the quarter, we initiated new positions in Cosmos Pharmaceutical and SMC. We eliminated NSK and Toyota Industries from the portfolio.

Past performance is no guarantee of future results.