Fund Overview
This Fund seeks to achieve long-term capital appreciation primarily through investment in equities of Japanese companies and secondarily through investment in equities of other Asian countries. The Fund employs a process that combines a bottom-up approach to individual security selection with a strategic asset allocation process. Security selection is based on an analysis of a company's valuations, earnings growth prospects and unique competitive advantages. The Fund is managed by a team of Portfolio Managers. The Asset Allocation Strategist, Iain Clark, oversees the management of the Fund and the allocation of the Fund's assets among countries, regions and sectors. Individual members of the team manage the Fund's investment in specific countries, regions and sectors.
Quarterly Commentary
Japanese economic data deteriorated, over the third quarter, with export activity slowing and industrial production contracting more sharply than had been generally expected. It appears that after six years of expansion, Japan may be headed for its first recession since 2001. Headline inflation eased and the core inflation measure (excluding fresh food and energy) fell to 0%. The economy remains structurally deflationary and, given the profile of weak growth and rising unemployment, is once again at risk of slipping into deflation. T he Tankan report reflected underlying weakness in the economy and noted that plans for investment have been cut back. Small and medium sized companies have reported difficulty in securing funds.
Stock market volatility has been incredible, where many stocks regularly moved more than 10% per day due to a combination of panic and forced selling. In the political arena, the big event over the quarter was the resignation of Prime Minister Fukada and the subsequent election of Aso from the Liberal Democratic Party.
Fund performance review
Over the period, the Fund (A shares at NAV) marginally outperformed the benchmark, MSCI Japan Index. On a sector basis the underweight position in Industrials and Materials was a positive factor as related share prices fell precipitously as concerns over global growth heightened. The overweight position in the Consumer Discretionary sector was also a positive factor. At stock level, Bridgestone (tires) was the largest contributor as analyst upgrades boosted the share price. Holdings in bank stocks Mitsubishi UFJ and Sumitomo Mitsui also had a positive contribution as Japanese Financial stocks were considered by many investors to be relatively sound. Mitsubishi UFJ further demonstrated its strong capital position by buying a stake in Morgan Stanley.
The worst performance in the Japanese market came from global cyclical stocks, including anything commodity-related such as Shipping, Trading Houses and Steel. Autos also performed badly, as sales declined sharply in US, Asia and Europe. We believe these companies will also face problems as their financing arms get hit by the credit crunch. Given that the Fund was not exposed to some of these poor-performing sectors, it could have performed better but was hit by a couple of specific stocks that fell heavily. Detractors to performance included Shinko Electric, Furukawa Sky and Leopalace21. The Asian portion of the portfolio, 2% of total Fund NAV, was also disappointing.
Investments
The violent share price moves created certain opportunities to buy on weakness or cut back holdings at advantageous prices. The Fund added to Mitsubishi UFJ (which we then reduced at profit), and reduced holdings in performers such as Furukawa Sky Aluminum and Bridgestone. However, we also increased the position in housing construction company Leopalace21, which continued to underperform.
There was one new holding over the period, in technology company Disco. This company makes machines for producing LED lights. It is generally expected that LED lights will take over from incandescent bulbs in the next 5 years around the house, as they last 10 times longer and use 85% less electricity. At the moment prices are too high, but production costs have been reduced rapidly.
In addition, the Fund also reduced its weight in defensives after strong performance, and invested the proceeds in stocks that have underperformed where the valuations are, in our opinion, too cheap. This latter group of stocks included SumitomoMitsui and Daiwa House, and an increase in Furukawa Sky-Aluminum.
Outlook
The market has been very, very volatile, which is highly likely to continue as the market adjusts for the implications of the global slowdown. Japan, which has habitually been closely associated with financial crises in the past, has been remarkably quiet on this front, even bucking the trend by taking stakes in prestigious Wall Street names such as Morgan Stanley. Some companies with capital to spare have found investment opportunities at apparent bargain prices. Continuation of such a trend may further strengthen Japan's hand as having been maligned for hoarding their wealth. Japanese corporations may find themselves center stage in a capital curtailed world, though this remains to be seen.