Period ended 31 March 2020
For the quarter ending 31 March 2020, the Matthews Japan Fund returned -17.10%, while its benchmark, the MSCI Japan Index, returned -16.63%.
During the quarter, Japanese equities went through two distinct phases of performance. In January and February, Japanese equities experienced steeper declines than those of other developed economies in anticipation of the global manufacturing cycle reaching a low point. Following strong performance in the final four months of 2019, there may have been an element of profit taking in the January and February sell off. In addition, Japan was an early focal point in coronavirus news coverage, dampening sentiment for Japanese equities.
However, Japan's markets held up relatively well in March as Europe and the U.S. faced an acceleration of COVID-19 cases. Valuations for Japanese equities were at the low end of their 10-year historical range and many Japanese corporations had relatively strong balance sheets and significant cash on hand. Japan's central bank announced plans to double exchange-traded funds (ETF) purchases in an effort to calm markets, which we believe also supported the relative performance of Japanese equities compared to other developed markets. Reflecting monetary easing efforts around the globe, Japan's central bank is committed to providing liquidity.
Performance Contributors and Detractors:
From a sector perspective, the health care sector detracted from relative performance, as some of the portfolio's higher valuation medical technology stocks suffered during a risk-off market environment. Biopharmaceutical and drug discovery platform company PeptiDream was a detractor from performance for the quarter. While the company continues to collaborate with drug makers and licenses its drug discovery technologies the underperformance was mostly from multiple contraction from a very high range.
On the other hand, the Fund's long-term underweight in the financials sector was a contributor to performance. In addition, our new position in Santen Pharmaceutical, a dominant player in the Japanese ophthalmic market, contributed to Fund performance. The company is growing its presence in the global ophthalmic space with solid growth in its China business through a recent acquisition. We built the position in Santen Pharmaceutical amid share price weakness in February and early March.
Notable Portfolio Changes:
We took advantage of the current market correction to enhance the quality of the portfolio, making several changes in the quarter and reducing our total number of portfolio holdings to 50. New positions include what we believe are high companies, ones that have been on our watch list whose stock prices lowered to our desired entry point and companies that can potentially grow even amid challenging macro conditions. At the same time, we decided to exit some more cyclical areas such as auto parts, staffing services and consumer discretionary companies.
New positions include conglomerate Fujifilm Holdings. The company's printer division is viewed by market participants as having lackluster prospects; however we expect that the dissolution of Fujifilm's joint venture with Xerox could work in Fujifilm's favor. We also like Fujifilm's Med-tech portfolio covering endoscopy, in vitro diagnostic devices and ultrasonic devices, as well as its growth in its contract development and manufacturing organization (CDMO) business, which are attractive, cash-flow generative businesses. We also initiated a position in Shin-Etsu Chemical Co., a leading manufacturer of semiconductor wafers and polyvinyl chloride (PVC). While basic materials are affected by economic downturns, we believe the company's low cost base and sound balance sheet provides resilience.
To fund these positions, we exited twelve positions, including Denso Corp, Nifco Inc. and KOSE Corp.
As the trajectory of COVID-19 evolves, we remain cautious about the overall economy and epidemic's impact on larger ticket items such as cars and new home sales. If the pending recession goes on longer than we expect, companies with ample liquidity and cash reserves may have better prospects for survival than those that do not. We made portfolio changes in the quarter with these considerations in mind.
While risks remain, Japanese equities may be attractively positioned relative to other developed markets. As previously noted, valuations have come down to the low end of their 10-year historical range. In contrast, European equities are trading at a nearly 40% premium to Japanese equities in terms of price-to-book ratio (PBR), despite comparable return on equity (ROE) levels. In addition, Japanese- listed companies have significant cash on their balance sheets. This cushion provides security in a tumultuous credit markets and expected recessionary environment. Finally, monetary policy remains constructive. The Bank of Japan in March announced an update of ETF purchase program to double its annual target.
From a structural point of view, 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. Multi-year trends such as productivity growth, health care, technology and material science innovation—where Japanese corporations excel versus global peers—remain intact. Against this backdrop, we are optimistic about opportunities for generating long-term alpha within Japanese equities.