Commentary

Japan Strategy

June 30, 2021

THE MARKET ENVIRONMENT

Despite experiencing some volatility in June, major global markets finished largely higher for the second quarter. In April, inflation in the U.S. accelerated at the fastest rate in more than 10 years as the Consumer Price Index rose 4.2% year-over-year and 0.8% month-over-month. Core inflation (stripping out food and energy prices) in May rose at the fastest pace since 1992, up 3.8% versus the year-ago period, while concerns for supply shortages drove national gasoline prices in excess of $3 per gallon for the first time in over five years. In June, oil prices reached their highest point in more than two years, and markets responded unfavorably to the U.S. Federal Reserve’s heightened expectations for inflation in 2021. While the Fed noted that inflationary pressures are “transitory,” it also now foresees two interest rate hikes in 2023. This compares to its forecast in March for zero rate hikes until at least 2024. However, Chairman Jerome Powell made assurances later in June that the Fed would not be coerced into raising interest rates on inflationary fears alone.

On the Covid-19 front, total global cases surpassed 180 million and global deaths approached 4 million. By the end of the second quarter, more than 800 million people reached full vaccination, representing about 10% of the global population. The overall increased distribution of Covid-19 vaccines and the additional stimulus in the U.S. contributed to the International Monetary Fund’s (IMF) decision to increase its outlook for global economic expansion for 2021 from 5.5% to 6.0%. The IMF also now expects 8.4%, 4.4% and 3.3% economic growth in China, the eurozone and Japan, respectively, as well as 6.4% economic expansion in the U.S in 2021.

In our view, there is still value to be had in value investing. We are finding a large gap in valuations when comparing growth and value stocks, and believe value stocks remain attractive on both an absolute and relative basis. Though conditions are ripe for value stocks to recognize upside potential, we also acknowledge that the backdrop of the market could change at any time as evidenced most recently by Covid-19. As such, we aim to invest in companies with strong balance sheets and management teams that can remain successful no matter the macroeconomic backdrop.

THE PORTFOLIO

Top Performers:
Toyota Motor issued fiscal full-year results with total revenue of JPY 27.22 trillion, net income of JPY 2.28 trillion and earnings per share of JPY 794.67, which all surpassed market expectations. However, results for the full year were mixed compared with our estimates. Auto volumes declined 15% from the prior year, which matched our expectations. Total revenue fell 10%, which was somewhat better than we had projected, while operating profit decreased 20%, which was slightly worse than our forecasts. Even so, we were heartened that Toyota’s performance strengthened in the fourth quarter as year-over-year volumes rose 5%, revenue advanced 13% and operating profit grew an impressive 59%, which illustrated to us that its business is poised for a post-pandemic rebound. Furthermore, although full-year volumes fell in the U.S., Europe and Asia (including Japan), volumes grew 30% in China and operating profit climbed 79% as business in the country remains robust. In addition, Toyota continued to gain U.S. market share in 2020 partly due to enhanced sales of SUVs and trucks. The company has been shifting its product mix to these higher margin vehicles in the key U.S. region where it had lagged the market just a few years ago. Lastly, management announced a new JPY 250 billion share repurchase program and increased the shareholder dividend payment by 9% to JPY 240 per share.

The share price of OTSUKA CORP was volatile during the quarter, particularly prior to the company issuing fiscal first-quarter results at the end of April. Net revenue advanced 6.7% from the prior year to JPY 239.35 million and operating profit rose 3.4% year-over-year to JPY 16.6 billion, which exceeded market forecasts. Results were driven by robust sales growth from cross-selling and system maintenance, which worked to offset Covid-19 effects and a decline in copier maintenance. Concurrently, OTSUKA’s gross margin fell from 20.6% a year ago to 19.7% in the first quarter, impacted by sales volumes that more than doubled for low gross margin client devices, including personal computers and tablets. However, the company has shifted focus to higher margin digital transformational projects at small- to mid-sized enterprises, which we think can work to expand margins and increase cross-selling opportunities going forward.

The share price of TIS Inc jumped upon release of fiscal full-year results in May. Revenue rose 1.1% from a year ago and operating profit grew 2%, which were slightly above our estimates. Similar to prior quarterly performance, revenue strength in TIS’ Service IT and business process outsourcing segments was offset by weakness in Industrial IT and Financial IT. We were pleased that the full-year gross profit margin expanded by 150 basis points due to improved product mix, a greater number of value-added projects involving its digital experience platforms and lower loss-making contracts. Although sales, general and administrative costs rose 11%, much of the increase came from investments into future software products. In addition, software development orders grew 5% in the fourth quarter, which was the first advance for these orders in four quarters, and total orders grew 8.5%, which reversed a loss of 2.8% in the fiscal first half. Order activity is a metric investors watch closely, and recent positive trends point to better forward progress. Lastly, we recently met with new President Yasushi Okamoto. We found him to be transparent and pragmatic and think he is well equipped to be an effective leader for the company.

Bottom Performers:
The share price of Komatsu dropped primarily in June prompted by a negative note from a prominent market analyst, which downgraded the company’s rating. The note cited weakening demand in China while at the same time competition from the country is increasing. However, Komatsu has been preparing for a tough future operating environment by cutting fixed costs, increasing liquidity and reducing inventories to maximize cash flow. Earlier in the quarter, the company released fiscal full-year 2020 results that included year-over-year declines of both revenue (-11%) and operating profit (-33%), which were not as severe as we had estimated. Komatsu’s performance strengthened in the fourth quarter as revenue rose 10% and operating profit was up nearly 40%, which marked the first operating profit advance achieved over the past eight quarters. Geographically, most markets posted positive fourth-quarter revenue growth except for Japan and the U.S. The important Indonesian market, which generates high margins for Komatsu, is recovering and the company is projecting low- to mid-double-digit volume growth in 2021 after two consecutive years of declines. Management noted that order activity has been robust and within the past few months order activity approached 2018 levels. While near-term challenges will likely remain for Komatsu, we think management can successfully build on recent progress.

Oracle Japan’s share price fell precipitously in June upon the release of fiscal full-year results. The company’s total revenue fell 1.3% from the prior year. Revenues were particularly weak in the cloud and on-premise license business, which dropped 14.2% year-over-year. Management stated that Japan’s extended state of emergency due to Covid-19 was the main driver of the deterioration in this business. Hardware systems (-1.6%) and services (-1%) also saw revenue declines. In addition, while operating income and net income both advanced roughly 3%, the increases were far smaller than the approximate 10% growth realized a year ago. We expect that Oracle Japan will likely see ongoing near-term challenges owing to conditions in Japan imposed by the pandemic. However, we believe that the company has the wherewithal to navigate these difficulties successfully. TechnoPro Holdings released fiscal third-quarter results that included revenue growth of 0.7% year-over-year, which was better than we had anticipated. Furthermore, total operating profit rose 7.2% (core +3.3%) and the core operating profit margin exceeded our estimates by nearly 200 basis points.

Overall, TechnoPro’s results were slightly ahead of our full-year estimates. The company’s utilization rate reached 96.2% during the quarter, up significantly from the 89.8% at the outset of Covid-19 last year. Management believes the improvement in utilization will carry through to year-end. Accordingly, TechnoPro incrementally raised revenue guidance by 1.6% and operating profit guidance by 5.9%, which implies the operating profit margin will expand to 11.3%. Cash flows for the full fiscal nine-month period grew 30% from the same period last year and management increased the per share dividend payment from JPY 111 to JPY 122. Despite these positive developments, the market appeared unimpressed and TechnoPro’s share price declined for the second quarter.

During the quarter, we added Nihon Unisys to the portfolio. There were no final sales.

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 06/30/21.

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.