Fellow Shareholders
Japanese stocks offered good gains over the past six months, but the broad Topix benchmark was roughly flat over the fund’s fiscal year ended October 31, 2014.
A pronounced decline in the yen versus the U.S. dollar over the period had important but contradictory effects on returns for U.S. investors, as it boosted the profit and competitive outlooks for many Japanese firms but reduced returns in dollar terms. We are pleased to report that our fund fared a bit better than its index in this environment, and we continue to see longer-term opportunities for shareholders despite what we expect will be ongoing volatility.
The Japan Fund returned 6.44% in the second half of its fiscal year ended October 31, 2014, a gain that pulled the fund into positive territory for the fiscal year as a whole. As shown in the Performance Comparison table, the fund fared better than its benchmarks. A balanced concentration on domestically focused firms versus exporters weighed on returns relative to its Lipper peer group average, however.
MARKET ANd ECONOMIC ENVIRONMENT
The Japanese economy cooled significantly in the second half of our fiscal year, with the primary culprit being an increase in the consump- tion tax right before the period began. The impact of the tax hike was initially deceptive, however, as it boosted purchasing even more than expected in the months before. Indeed, data showed that the Japanese
economy expanded at a faster rate than expected in the first quarter of 2014 and at its fastest quarterly pace in almost three years. Consumer confidence improved for the first time in six months in May, while producer prices rose at the fastest annual rate since October 2008.
Investor sentiment was further helped by encouraging economic data from China, a key export market for Japan’s manufacturers, and the Federal Reserve’s commitment to maintaining an accommodative policy stance. Good corporate earnings and a number of share buybacks helped support stocks, as did reports that the country’s public pension fund may raise its weighting in domestic equities.
Data later in the period revealed that the economy had slowed considerably in the middle of the year as the increased consumption tax took hold. The slowdown failed to undermine investor confidence, however, as it raised expectations of further stimulus and monetary easing and drove the yen significantly lower versus the U.S. dollar. Export-oriented stocks, such as automakers and manufacturers of machinery and electric appliances, posted particularly strong gains as their competitive positions improved. Confirmation on the last day of the reporting period that the government’s massive pension fund was doubling its equity weighting was coordinated with news that the Bank of Japan was dramatically increasing the scope of its quantitative easing. The joint announcement led to the market’s best daily gain in several years and helped end the period on a strong note.
PORTFOLIO REVIEW AND STRATEGY
The fund’s modest gain over its fiscal year reflected in part the boost that Japanese exporters received from the falling yen and the better prospects for shipments to China. Mitsubishi Electric (TSE:6503, Financial), an industrial electronics company with a focus on factory automation and power semiconductors, was a top contributor to results. The company has benefited from increased capital spending, particularly in the Chinese smartphone industry. The weak yen also boosted some materials holdings. Hitachi Metals (TSE:5486, Financial), a supplier of specialty steel and metal products, saw its competitive position improve because of the falling yen. Investors also welcomed their acquisition of a North American iron casting supplier. (Please refer to the portfolio of investments for a detailed list of holdings and the amount each represents in the portfolio.)
We saw very good results from several of our technology investments, as well. Murata Manufacturing, which makes passive electronic components, was our second-largest overall contributor despite being newly added to the fund. Electronic equipment provider Hitachi was another very strong contributor thanks to cost cutting. We maintained
IT and services as the fund’s largest overweight relative to the benchmark, with significant positions in communications firms, including SoftBank (TSE:9984, Financial), NTT DoCoMo (DCM, Financial), and Nippon Telegraph & Telephone (NTT, Financial), our leading contributor for the year. We are bullish on the industry, specifically the scope for improving earnings fundamentals, while valuations also look attractive. Internet firm Yahoo! Japan was a notable detractor among technology names as the company has had trouble monetizing its strong posi- tion in the growing field of mobile advertising.
The fund remains balanced between exporters and firms focused on domestic demand, however, and the economic weakness that provoked the decline in the yen took a toll on the latter. Retailers were particularly weak. Auto dealer group VT Holdings (TSE:7593, Financial) performed poorly in the third quarter after reporting a significant decline in operating income, and the country’s largest retailer by sales volume, Aeon, also fell after reporting a sharp decline in profits. Household durables firm Iida Group Holdings was also particularly weak, as was “Hello Kitty” licenser Sanrio, which we discussed in our last letter.
Domestically focused financials firms were the fund’s biggest overall detractor. While nonbank financials’ poor performance has reflected the weak economy and falling interest rate margins, we remain overweight in the sector, which we think will benefit from growing credit card penetration as well as a recovery in cash advances. We added to Credit Saison (TSE:8253), which should benefit from these underlying trends. With a cheap valuation, the stock should also receive a boost from potential relaxation of lending laws and further industry consolidation. Conversely, banks remain our largest underweight by a significant margin as competition within the sector remains rife. The intense competition means that there is an almost unlimited supply of loans at very low rates. While demand is improving for these loans, they are being offered at no premium to Japanese government bonds in some instances. While net interest margin compression is easing, this benefit is being lost as banks try to gain market share. Our three bank holdings, Mitsubishi UFJ Financial, Sumitomo Mitsui Trust Holdings, and Sumitomo Mitsui Financial, all performed poorly.
In our last letter, we noted the opportunities for long-term investors that we perceived in the cultural shift taking place within Japanese corporations; one opportunity in particular was the chance that banks and other Japanese firms will become more responsive to the needs of shareholders. Recent results in this area have been mixed, but we are keeping our eye on situations where management teams are poised
to engage in stock buybacks or increased payouts to shareholders in the form of dividends. An increasing receptivity to returning cash to shareholders drove our recent investment in Mabuchi Motor, a manufacturer of electric motors, parts, and equipment that is particu- larly dominant in the market for automotive door locks and mirrors. Cash represented roughly 40% of the firm’s market capitalization at the time of our purchase, and we also liked the company’s plans to expand its businesses where it has less penetration, such as power windows and seats.
OUTLOOK
In our last letter, we described in some detail our view of the progress Japan is making toward escaping its “lost decades” of stagnant growth and falling prices. In general, we remain optimistic that Prime Minister Shinzo Abe and his government have successfully broken with the past by taking decisive action to boost consumer and business confi- dence along with inflation expectations. The dramatic and unexpected decision by the Bank of Japan on October 31 to boost its bond-buying program by 60%—on the same day that the Government Pension Investment Fund simultaneously announced a large increase in its equity purchases—was another example of the bold steps that have reinvigorated the economy since Prime Minister Abe took office.
The last six months brought more muted evidence on progress in
the difficult structural reform efforts, however—the remaining “third arrow” of the government’s reform plan. We were glad to see the announcement of the government’s “New Growth Strategy,” which included a reduction in corporate tax rates below 30%, along with an enhanced corporate governance code and initiatives to draw married women and foreign workers into the labor force. The new TOPIX 400 Index, which selectively lists companies that demonstrate a focus on profitability gains and are sensitized to tackle governance issues, is also encouraging. Evidence that more of the country’s wealth will flow back into consumption is slight, however, as real wage gains remain elusive. While nominal wages are increasing alongside bonuses and overtime pay, disposable incomes are under pressure as they fail to keep pace with inflation.
Since our reporting period ended, the government has released data showing a more pronounced slowdown in the Japanese economy than originally thought. As a result, the government has announced a delay in a further increase in the consumption tax, as well as new elections that may weaken the hand of Prime Minister Abe as he pursues reform. In short, the economic environment in Japan has become yet more uncertain. Nevertheless, we remain encouraged by the changes taking place at the corporate level, including the newfound focus on return on equity, improvements in corporate governance, and generally improving returns for shareholders. Even as the macroeconomic environment ebbs and flows, we are optimistic that the new face of corporate Japan will continue to offer opportunities to investors.
Respectfully submitted,
Archibald Ciganer
Portfolio manager and chairman of the fund’s Investment Advisory Committee
November 18, 2014
The committee chairman has day-to-day responsibility for managing the portfolio and works with committee members in developing and executing the fund’s investment program.
Risks of International Investing
Funds that invest overseas generally carry more risk than funds that invest strictly in U.S. assets. Funds investing in a single country or limited geographic region tend to be riskier than more diversified funds. Risks can result from varying stages of economic and political development; differing regulatory environments, trading days, and accounting standards; and higher transaction costs of non-U.S. markets. Non-U.S. investments are also subject to currency risk, or a decline in the value of a foreign currency versus the U.S. dollar, which reduces the dollar value of securities denominated in that currency.
Glossary
Lipper averages: The averages of available mutual fund performance returns for specified time periods in categories defined by Lipper Inc.
TOPIX Index: Tracks the performance of larger companies on the Tokyo Stock Exchange. TOPIX Small Index: Tracks the performance of smaller shares within the TOPIX Index.
