THE MARKET ENVIRONMENT
Major global markets finished lower for the first quarter as Russia’s invasion of Ukraine prompted unease among investors. In particular, major U.S. stock benchmarks delivered their worst quarterly performance since the onset of the Covid-19 pandemic. Throughout the first quarter, countries responded with sanctions on Russia in a nearly unified condemnation of the invasion. In China, concerns that its ties to Russia could result in sanctions from the U.S. pressured share prices in the country. However, a meeting of China’s State Council late in the first quarter effectively alleviated unease regarding its economic climate given the body’s pledge to support economic growth and stability.
Meanwhile, supply concerns stemming from the conflict sent prices of WTI crude oil in excess of $120 per barrel. In response, U.S. President Joe Biden announced the release of 1 million barrels of oil a day for the next six months from the U.S. Strategic Petroleum Reserves. In addition, OPEC confirmed its intent to increase production by more than 400,000 barrels per day.
As expected, the U.S. Federal Reserve raised interest rates by a quarter point in March for the first time since 2018. The Fed also struck a more hawkish tone than at its previous meeting. It now projects a total of seven rate hikes in 2022, an increase over the three projected rate increases in 2022 from its December meeting. In the following days, Fed Chairman Jerome Powell indicated that inflationary concerns further fueled by the crisis in Ukraine that led to a 7.9% increase in the consumer price index in February could lead to a more than one quarter of a percentage point hike at upcoming meetings. In the U.K., the Bank of England increased interest rates by another 25 basis points for its third rate hike since December. President of the European Central Bank Christine Lagarde pointed to a slower pace of rate hikes, despite a 5.9% inflation reading in February and a 7.5% inflation reading in March in the region.
As we have mentioned in time of previous crises, such as Brexit and the global financial crisis, we do not believe that share price movement reflects the long-term underlying value or quality of the businesses in which we invest. Our focus remains firmly on refining our value assessments as material, fundamental information flows from our companies and not on short-term, sentiment-driven share price movements. In our estimation, volatility is not synonymous with risk. Rather, it is an asset that can be utilized to optimize portfolio positioning for success over the long term.
Komatsu delivered good fiscal third-quarter earnings results in January as sales and operating profit bested consensus estimates by 9% and 19%, respectively. Later, the company’s share price advanced on expectations for increased demand for coal mining equipment due to the conflict in Ukraine. In March, PT United Tractors (Indonesian heavy equipment distributor) indicated that Komatsu’s construction equipment sales volume improved over 160% year-over-year in February. We appreciate Komatsu’s strong market position in the construction and mining equipment industry and think it is undervalued relative to our perception of its intrinsic value.
Toyota Motor released its nine-month results during the quarter, which were mixed, in our view. The shortage of semiconductors and other Covid-19-related headwinds persisted and caused third-quarter sales to retreat nearly 6%. Outlook for production was also impacted as the company lowered its full-year vehicle production target for the second time this year for Toyota and Lexus by 500,000 units to 8.5 million. Despite the weaker volumes and revenues in the third quarter, margins continue to show strength. Automotive margins increased by 10 basis points from the second quarter to 8.5% and reached 10.1% when including the finance business. A silver lining of the supply shortage has been the company’s ability to optimize product mix toward higher margin vehicles, such as SUVs, trucks and Lexus cars. Management slightly lowered guidance for full-year revenue from JPY 30 trillion to JPY 29.5 trillion but maintained their full-year operating profit target of JPY 2.8 trillion.
We added Nakanishi in the final days of the quarter and its share price advanced slightly for our holding period, making it a top contributor for the quarter. We appreciate Nakanishi’s strong global market position in dental handpieces, which we view as a niche business with attractive economics. We believe Nakanishi has an advantage relative to peers with its micromotor and ultrasound technologies, allowing for handpieces that offer both high-quality speed and torque. Of the more than 15,000 parts that go into its handpieces, the company produces approximately 85% in-house, including some of the most critical and value-added components. This results in products that are lighter, shorter, more precise and designed with craftsmanship while maintaining a leading cost position. We view the aging global population as a tailwind for the industry offering structural growth, which Nakanishi has outpaced in recent years due to market share gains and product expansion.
We spoke with management at Sugi Holdings in January as it finalized its long-term plan and came away optimistic on its trajectory. The company is focused on opening new stores in areas where the locations have an adequate population and it sees an opportunity for a drug dispensing store, has a strong brand reputation and lower competition. This will result in a lower quantity of new store openings, approximately 100 a year, 20 of which will be pure pharmacies. We believe this new mindset will attract higher quality stores that offer adequate return potential and a higher probability of success. The company later released a report on its February sales. Same-store sales within the pharmacy business declined 4.4% year-over-year, partially attributable to a 1.2% decline in customer traffic and a 3.2% decline in average spend. The Japan business also saw sales decline by 5.6%. Sugi opened 12 new stores in February while one closed, with the company’s total store count reaching 1,483. We appreciate the company’s progress in opening new stores and continue to view this as a growth opportunity due to the unsaturated market and the company’s ability to utilize its internally generated cash flow.
Nine-month results from Hakuhodo DY Holdings showed performance generally better than consensus estimates, however, management revised financial targets for its mid-term plan. The current plan runs through 2023 and management is now targeting 7% topline growth until 2023 and adjusted earnings of at least JPY 65 billion with 15% margins in the final year of the plan. This is materially below both our expectations and consensus estimates for 2023. The reason for the decline is management’s intent to invest heavily upfront in digital transformation efforts. Multiple points of emphasis from the earnings presentation include software, data analytic capability, market insights and other technology capabilities. We met with management in March and came away disappointed as we were unable to gain an understanding of how Hakuhodo plans to increase spending to change its long-term financial outlook. We lowered our estimates of the company’s intrinsic value but continue to believe it remains undervalued by the market.
OTSUKA CORP’s fiscal year 2021 fell short of investors’ expectations and pressured the company’s share price. We recognize that the past two years have been challenging for OSTUKA on three fronts: 1) the company’s proclivity for in-person sales, 2) its increased exposure to small- and medium-sized enterprises in which business confidence is weak, and 3) as more people work from home, less office supplies are required. OTSTUKA anticipated another difficult year in 2022, targeting just 1% revenue growth. Despite the challenging operating environment, we continue to believe the company is well managed with a current growth rate that is hampered by cyclical issues and our investment thesis for OTSUKA remains intact.
During the quarter, we added NAKANISHI 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 03/31/22.
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