Period ended 30 September 2019
For the quarter ending 30 September 2019, the Matthews Japan Fund returned 1.45%, while its benchmark, the MSCI Japan Index, returned 3.29%.
Japanese equities were positive in the quarter amid a rally by value stocks. As global macroeconomic conditions slowed, Japanese equities may have represented a flight to quality for some investors. Japan's value rally seemed to be sparked by mixed signals among market indicators, rather than by any notable shift in economic fundamentals during the quarter.
Early this year, the U.S. Federal Reserve's pause in rate increases improved investor sentiment and Japan equity valuations came back from their lowest levels since the start of the Abenomics era. In May, trade frictions between U.S. and China intensified, with tariffs and a temporary U.S. ban on Huawei products dampening export companies and the technology sector in particular. September saw a sudden rise in 10-year U.S. Treasury yields, however, even though the Fed cut target rates. This pick-up in bond yields briefly gave a false signal of a strong U.S. economy and spurred a market rally in Japan led by value stocks, as growth stocks declined.
Meanwhile, the larger macro environment continued to slow. Global manufacturing PMI for September came at 49.7, the fifth-consecutive month of a reading below 50, indicating a contraction of manufacturing activity. The Bank of Japan's most recent Tankan Survey (announced Oct. 1) showed further deterioration in the manufacturing sector, reflecting the weakness of exports. The bright spot is in the software/ IT service outlook where the fiscal 2019 spending plan looks for year-over-year 13.1% growth. 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 underperformance was primarily style-driven, as value stocks outperformed growth stocks in the quarter. All of the Fund's underperformance occurred over two days, Sept. 10 and 11, when a sudden shift in sentiment caused a sharp price drop in growth stocks. On both days, shares of many high-quality growth companies the Fund owns sold off while the sectors that were trading well below price-to-book ratios, such as regional banks, energy providers, steel and basic commodity chemical companies, rose rapidly.
From a sector perspective, our underweight position and stock selection in consumer discretionary, real estate and industrials sectors detracted from performance. Our holdings in information technology, meanwhile, continued to be positive contributors to performance. Our focus on productivity improvement through software, IT services and automation helped us capture attractive returns within the sector, despite the cyclical downturn in semiconductors and sluggish industrial production.
Turning to individual securities, telecom and venture-capital firm SoftBank was the largest individual detractor in the quarter. SoftBank's share price performed well in the first half of this year, and we took profits during the strength. SoftBank's Vision Fund includes ownership positions in Uber and WeWork. Stagnant performance of Uber's IPO and the canceled IPO of WeWork weighed on SoftBank's share price.
Staffing service company Persol was another detractor from performance. Over the long term, we see the company in a superior position to gain market share in a fragmented temporary-staffing industry in Japan, but weak first-quarter results for an overseas subsidiary caught markets by surprise and led to underperformance.
Lasertec, a semiconductor equipment test and measurement company, contributed to the Fund's performance during the quarter. Leading-edge development in areas such as extreme ultraviolet (EUV) technologies has picked up momentum, benefiting the company, which makes EUV mask blank inspection systems and EUV mask defect inspection systems.
Health care service company M3 also contributed to performance. Shares jumped after the Nikkei announced Sept. 4 that M3 will be incorporated into the Nikkei 225 index. Aside from index news, fundamentals remained solid. The company's most recent earnings saw its core medical platform business topline showing steady growth. We believe the company continues to revolutionize the inefficient health care market in Japan and overseas.
Notable Portfolio Changes:
During the third quarter, we increased our exposure to cyclical growth stocks, while taking profits of some high-valuation stocks that performed well year to date. Although global manufacturing activity was still in contraction, we saw some early indicators of improvement, especially in the semiconductor sector. Our view is that the current downturn is similar to the normal business cycle downturn seen in 2016, and not like 2002 or 2009 when we saw 12 to 18 months of contraction of manufacturing activity.
Regarding new positions, we initiated a position in entertainment company Nintendo. Shares of Nintendo and other game companies have long traded based on “console cycles,” but we believe the industry is rapidly changing in the wake of digital distribution and subscription-based services via online gaming. Nintendo, similar to Sony, is trying to move out of console cycles, and shifting to a more-stable profit stream based on monetizing its intellectual property in multiple media not limited to games. President Shuntaro Furukawa, appointed last year, is more open to collaborating with other parties.
In the cyclical sector, we increased our positions in dicing-blade manufacturer Disco and electronic components maker Murata Manufacturing. Disco commands a 70% global market share in dicing-blade equipment, to cut everything from wafers to LEDs to power semiconductors. The added value on a single wafer continues to increase and semiconductor companies prefer no mistakes during the back-end process. Disco works with end clients on new product development, which we find builds a compelling economic moat.
Murata Manufacturing, a global leader in multi-layer ceramic capacitors (MLCCs), has been a long-time holding in the Fund. We reduced our position in January amid deteriorating fundamentals in smartphone end markets, but we added back to our position by taking advantage of share price weakness during the summer. To fund these positions, we exited Fuso Chemical.
Growth stocks have meaningfully outperformed value stocks over the past decade, so we could see occasional periods where value stocks outperform growth. At present, global macroeconomic conditions remain somewhat muted. We believe markets would likely require a major catalyst, such as significant additional rate cuts by the Fed or a resolution of U.S.—China trade tensions, to experience a strong shift in investor sentiment. As always, we focus on companies that can grow with or without macro tailwinds.
Regarding valuations, the MSCI Japan Index's price-to-book ratio is now 1.21X, 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. Share buybacks by Japanese companies are pacing at a record level, with many companies opting to use cash holdings to bolster equity performance.
Looking ahead, we remain constructive on Japan equities and the quality of earnings. While earnings may slow, some early indicators, such as global semiconductor sales, have the potential to turn around. We continue to focus on earnings and the quality of fundamentals as the earnings capability of Japanese corporations has improved over recent years.