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2024 Q2 Portfolio Perspectives

by | Jul 29, 2024

Earlier this year, Japan’s Nikkei benchmark index hit a record high for the first time in 34 years. The last time the market hit a record high was in 1989, at the apex of Japan’s economic bubble and four years after the launch of our Canadian International Fund in 1985. At the time, Japan’s economy was fueled by rapidly inflating real estate and financial asset prices. When the Japan bubble burst in 1991, it was followed by a period of stagnation in Japan, now known as the Lost Decade.

This time around, there have been different factors which propelled the Japanese market to a new record high, many of which are long-term positives for investors. For example, Japan is seeing positive inflation for the first time in 25 years. While high inflation has been an issue for most global economies, Japan has faced the opposite challenge: chronic deflationary pressures. A return to modest inflation is expected to enable Japan to raise interest rates, stabilize its currency and create a virtuous cycle of corporate investment, wage growth and consumer spending that should benefit the overall Japanese economy.

Intriguingly, the Tokyo Stock Exchange itself has played an important role in spurring on the recent rally in Japanese equities. In March of 2023, the exchange challenged listed companies to disclose plans to improve capital management and enhance investor returns.  By year end, nearly half of the listed companies had detailed plans to improve returns, setting up 2024 as a record setting year for both share repurchases, and dividend increases. While Sprucegrove regularly communicates with our portfolio companies about the importance of strong balance sheets and using capital to reinvest back into their businesses, many Japanese companies have historically carried levels of cash well in excess of their capital needs hindering returns on capital.

Yet, these changes are not limited to share buybacks and dividends. There is a changing climate in Japan where corporate governance is concerned that appears genuine and sustainable. One important change has been the increasing gender diversity on company boards.  Ten years ago, women represented just 2.3% of board seats at TOPIX 500 companies in Japan.  Today, women account for 17% of board seats and the government is encouraging companies to raise that representation to at least 30% by 2030. Other notable changes include mandated electronic voting, disclosures in English, a reduction in cross-holdings between companies and an increasing separation of CEO and Chairman roles.  Improving corporate governance increases the long-term attractiveness of Japanese stocks as these companies increasingly gravitate to global standards and best practices.

Over the past two years, a meaningful part of the rally in the Japanese market has come from lower return, lower quality Financial and Industrial companies that do not meet our quality criteria.  As a result, despite the market reaching an all-time high, we continue to find opportunities to add to our Japanese holdings at attractive valuations.  Detailed below is a list of all of our Japanese holdings and more detailed descriptions of those we added to this quarter.  There are several common threads that run through these businesses.  We consider them to be leaders in their respective fields, they have generated above average returns without compromising their balance sheet strength and they are led by management teams that think long-term about opportunities to enhance their businesses without compromising their core strengths.

Sprucegrove International Equities – Japan Holdings

As At June 30, 2024

Company Sector Quality Value
Projected ROE (%) Historical ROE (%) Financial Leverage (x) Normalized P/E (x) Dividend Yield (%)
AIN Holdings Consumer Staples 12.0 10.3 1.8 12.9 1.3
Denso Consumer Disc. 9.0 8.2 2.6 14.6 2.2
FANUC Industrials 12.0 10.3 1.1 20.4 1.9
Kubota Industrials 11.0 12.0 2.5 10.4 2.1
Makita Industrials 10.0 8.7 1.2 13.5 1.3
Misumi Industrials 13.0 11.0 1.2 17.4 1.0
Nihon Kohden Health Care 12.0 11.0 1.3 17.9 2.6
Nitto Denko Materials 11.0 11.2 1.3 16.6 2.2
Omron Info. Tech 11.0 8.5 1.7 12.6 1.9
Seria Consumer Disc. 15.0 11.7 1.8 14.3 2.4
Toyota Motor Corp. Consumer Disc. 10.0 11.8 2.6 13.0 2.3
Average 11.5 11.0 1.6 14.9 1.9
MSCI JAPAN 7.9 2.4 19.8 2.0

Source: Sprucegrove, FactSet

Denso is the world’s second largest auto parts supplier with leading global market shares in most of its product categories such as thermal, powertrain, electrification, safety and electronics. This is due to its global scale, its long-standing relationship with Toyota, industry-leading investments in R&D and their ability to offer customers vertically integrated solutions.  Denso is also well positioned for the disruptions taking place within the automotive industry from vehicle electrification to advance driver/autonomous systems.  Management has a proven record of innovation and investing in future technologies. The balance sheet is strong with 2% net debt to equity.

Kubota is a leading manufacturer of agriculture and construction equipment. The company has leveraged its core competency of manufacturing small engines to expand into a wide range of equipment categories and geographic markets, from agriculture tractors in Asia to lawn mowers in North America. Kubota’s sizeable dealer network, product diversity and flexible manufacturing model has allowed the company to establish strong competitive positions.  Kubota is led by an experienced management team that has maintain its dominance in Asian farming while finding new applications and markets for its machinery internationally.  Kubota maintains a strong financial position with a net cash balance sheet.

Makita is one of the world’s largest manufacturers of battery-operated power tools and outdoor power equipment. The tools are geared toward professional users who value Makita’s quality, reliability and service excellence, which allows the company to charge a premium price for its products. Makita has ample opportunities to increase penetration of battery powered tools, which is expected to support demand for its high margin replacement batteries.  Management has consistently taken a very long-term view on the strategic direction of the business.  Makita maintains a strong financial position with a net cash balance sheet.

Misumi is a leading manufacturer and distributor of maintenance, repair, and operations products. Misumi’s unique combination of breadth, speed, and scale in Asia makes their model highly valued by customers and difficult to replicate. Misumi is well-positioned to benefit from growing investment in factory automation. Misumi is led by a capable management team that has focused on geographic expansion and continues to shift the business to e-commerce.  Misumi maintains a strong financial position with a net cash balance sheet.

Nihon Kohden is Japan’s leading manufacturer and distributor of high-quality medical equipment with leading market positions in EEGs, ECGs, Patient Monitors and Defibrillators.  The company has a long history of innovation dating back to its founding in 1951 and has often been the first in the world to introduce new technological advances.  Growth opportunities remain robust as the business expands the sale of its products in the U.S. where it has a strong foothold.  Management has a strong record of geographic expansion and improving profitability through product innovation. Nihon Kohden maintains a strong financial position with a net cash balance sheet.

Omron is a global leader in sensing and control components for industrial automation and healthcare sectors.  Omron is one of the only companies with expertise across this entire chain and has been increasingly leveraging this unique position to provide customers with packaged solutions.  It has the greatest product breadth across sensors, logic controllers, output devices, robots and safety components, giving Omron an advantage over its competitors.  The balance sheet is strong with 4% net debt to equity.  Management is disciplined, experienced and focused on the long-term success of the company.

Seria is the second largest and the most profitable chain of 100-yen stores in Japan. The company has consistently taken market share through its well-executed price leadership model, earning the company industry-leading profitability.  Seria is currently led by the founder’s nephew, Eiji Kawa, who has been instrumental in reinforcing the company’s competitive strengths which include inventory management, product mix optimization and strong supplier relationships.  Seria maintains a strong financial position with a net cash balance sheet.  Longer-term, Seria’s ambition is to double its store count from over 1,900 stores today.

[1] Source: Sprucegrove, MSCI, FactSet

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