For the first half of 2019, the Matthews Japan Fund (Trades, Portfolio) returned 13.76% (Investor Class), while its benchmark, the MSCI Japan Index, returned 7.97% over the same period. For the quarter ending June 30, 2019, the Fund returned 0.96% (Investor Class), while its benchmark returned 1.05%.
Japanese equities posted solid gains in the first half, even as global markets experienced swings in sentiment. Early this year, the U.S. Federal Reserve's pause in rate hikes improved investor sentiment and Japan equity valuations came back from their lowest levels since the start of the Abenomics era. In May, however, trade friction between U.S. and China intensified, with tariff hikes and a temporary U.S. ban of Huawei products dampening export companies and the technology sector in particular.
The larger macro environment, meanwhile, continues to slow. Global manufacturing PMI for May came in at 49.8, its lowest level since October 2012. A reading of below 50 indicates a contraction of manufacturing activity. The Bank of Japan's most recent Tankan Survey (announced July 1) showed further deterioration in the outlook among respondents within the manufacturing sector, reflecting the weakness of exports, especially among semiconductor-related products. Domestic consumption remained sluggish, and we expect this will continue with Japan's consumption tax increasing in October to 10% from the current 8%.
Performance Contributors and Detractors:
The Fund's outperformance during the first six months of the year was driven by strong stock selection among smaller and midsize companies, which make up roughly half of the portfolio. While index returns were largely driven by large-cap companies performing better than small caps, we were able to overcome the overall trend with stock selection. From a sector perspective, stock selection in information technology (IT), industrials and health care were positive contributors to performance. Our focus on productivity improvement through software, IT services and automation and helped us capture attractive returns within the sector, despite the cyclical downturn in semiconductors and sluggish industrial production. Our holdings in the consumer discretionary sector, meanwhile, detracted from performance.
Turning to individual securities, Net One Systems was a strong contributor in the first half. The company is transforming from a hardware-centric business model to one that is maintenance- and service-oriented, experiencing margin expansion along the way. Telecom and venture capital firm SoftBank (TSE:9434) also contributed to performance. SoftBank's share price rose following the announcement of a massive 600 billion yen (US$5.5 billion) stock buyback. The recent IPO of transportation network company Uber in the U.S. and other unicorn companies going public also spurred interest in other pre-IPO companies that SoftBank and its Vision Fund currently hold.
The largest detractor from performance was dollar-shop retailer Seria. Seria has long enjoyed much higher operating margins than its peers. Competition has intensified, however, while the overall retail environment remain sluggish. Home fashion goods retailer Ryohin Keikaku also was a detractor to performance, after the company reported fiscal year earnings below the guidance that was revised down only three months earlier. Although we believe in the long-term brand equity of the firm's marquee products, we continue to monitor and evaluate its growth prospects and execution abilities.
Notable Portfolio Changes:
During the half, we continued to reduce our exposure to cyclical stocks, taking advantage of the market rally in January. We reallocated the proceeds to higher-quality companies that were sold off toward the end of last year, which were trading at the lower end of their price range despite their ability to grow in a slower macro environment. We also conducted research on high-quality growth companies in cyclical sectors, but we still think it would be premature to build a substantial position in these sectors.
Regarding new positions, we initiated a position in Yahoo Japan (TSE:4689). The company in May announced a corporate structure change resulting in Altaba and SoftBank Group selling out and Yahoo Japan coming under the umbrella of SoftBank's domestic telecom business. The company can now focus on online ads and e-commerce, two bright spots of growth in Japan. We also initiated a position in SBI Holdings (TSE:8473), the largest online broker and second-largest among all brokerages in Japan. Unlike its competitors where a majority of assets under management are held by clients in their 60s and 70s, SBI Holding's core demographics are customers in their 30s and 40s, which is set to grow given that Japan pensions are no longer sufficient to support retirement life. And we initiated a position in Shionogi, a pharmaceutical company focused on small molecule drugs in infectious disease areas. During the quarter, we exited two positions--ORIX and Suzuki Motor--and found more compelling investment themes elsewhere.
While Japanese equities experienced healthy gains in the first quarter, the macro environment remained muted and second-quarter broad market equity returns were mixed. Underlying fundamentals are still on a downward path, and developments surrounding trade frictions remain unpredictable. We do not expect any dramatic outcomes or resolution of current issues. On a positive note, corporate inventory levels have declined quickly in the past six months. Recent earnings results showed an earnings decline in many sectors but absolute profit levels remain higher than during past downturns.
Additionally, given earnings growth no longer drives return-on-equity improvement, share buybacks by Japanese companies are at a record level, with many companies using their cash holdings to bolster equity performance. While valuations have risen a bit, they remain near the low end of their historical range. The MSCI Japan Index's price-to-book ratio is now 1.20X, up from the lows of a 1.16X level at the end of 2018. While Japanese corporate earnings tend to be procyclical with higher earnings volatility than developed-market peers, we continue to believe the earnings capability of Japanese companies has improved meaningfully over the past economic cycle, driven by better corporate governance and a higher focus on capital efficiency.
As of June 30, 2019, the securities mentioned comprised the Matthews Japan Fund (Trades, Portfolio) in the following percentages: Net One Systems Co., Ltd. 2.9%; Softbank Group Corp. 2.7%; Seria Co., Ltd. 1.3%; Ryohin Keikaku Co., Ltd. 0.5%; Yahoo Japan Corp. 1.5%; SBI Holdings Inc., 1.2%; Shionogi & Co., Ltd. 1.6%. The Fund held no positions in Uber Technologies, Inc.; Altaba Inc.; ORIX Corp.; or Suzuki Motor Corp. Current and future portfolio holdings are subject to risk.
Average Annual Total Returns - Investor Class (6/30/2019)
Inception (12/31/98) 5.85%
Gross Expense Ratio
After fee waiver and expense reimbursement:
All performance quoted is past performance and is no guarantee of future results. Investment return and principal value will fluctuate with changing market conditions so that shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the return figures quoted. Returns would have been lower if certain of the Fund's fees and expenses had not been waived. Please see the Fund's most recent month-end performance.
The views and opinions in this commentary were as of the report date, subject to change and may not reflect current views. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the Fund's future investment intent. It should not be assumed that any investment will be profitable or will equal the performance of any securities or any sectors mentioned herein. The information does not constitute a recommendation to buy or sell any securities mentioned.
The information contained herein has been derived from sources believed to be reliable and accurate at the time of compilation, but no representation or warranty (express or implied) is made as to the accuracy or completeness of any of this information. Neither the funds nor the Investment Advisor accept any liability for losses either direct or consequential caused by the use of this information.
This article first appeared on GuruFocus.
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