Q: What makes investing in Japan unique? Why should U.S. investors consider it?

A: In many ways, Japan is still an inefficient market, where active managers can add value. The U.S. market is so competitive that about 90% of the active managers underperform after fees over five to 15 years. In Japan, about half of the active managers outperform the broader market, which shows that the Japanese market is still inefficient.

There are many reasons for the inefficiency. First, the Tokyo Stock Price Index, or TOPIX, is largely dominated by mature, low-growth or no-growth sleepy giants, ranging from traditional manufacturers to financials, utilities and telecoms. That’s a significant difference from the S&P 500 or the Nasdaq, where there are mega caps growing at 40% or 50% per year, such as Facebook, Google or Amazon.

There are many attractive long-term growth businesses in Japan, even in the large-cap space, but it is not a good strategy to invest in the entire index when seeking exposure. Since December 1989, Japan has had difficult times, so the retail investors are still myopic and don’t really know how to invest in an intelligent manner. The Japanese mom-and-pop retail investors are pretty much amateurs. The fund managers affiliated with big financial groups are often just part of the job rotation system. Until recently, there weren’t professional money managers at those institutions. That’s the second major reason for the inefficiency of the market.

At the same time, Japan has some of the most globally competitive enterprises. It has a lot to offer to global customers in terms of manufacturing, factory automation or consumer-related companies. The aging and shrinking labor population for decades has created a situation that helped nurture robotics and factory automation technology. Japan is still the global leader in the space with promising investable ideas.

Another noteworthy trend is that the middle-class consumers across Asia have strong aspirations for Japanese brands. For example, in cosmetics or personal care products, Japanese products have the image of high-quality, value-added, trouble-free products. Cosmetic companies like Shiseido or Kao have strong market and mind share among the middle-class consumers in emerging Asia. When U.S. investors gain exposure to Japan through these businesses, they benefit not only from the growth of the Japanese economy, but also from the growth of the global economy. They can buy stocks at reasonable valuation and with strong liquidity, corporate governance and wide moats.

Q: How is your firm different from other investors in the space?

A: At SPARX Asset Management, which is the subadvisor to the fund, we differ substantially from the mom-and-pop investors and from the institutions that lack professional fund management. We look at stock investing as owning a piece of the business. We deep dive into the long-term economic characteristics of the business. The company was established in 1989; I joined SPARX in 1999 and have been working as a portfolio manager since 2004.

For many foreigners, Japan is still a big black box. It is a mysterious country in certain ways; its corporate culture and labor practices are quite different. To identify the truly promising investment opportunities, one must understand the inner workings of the Japanese corporate landscape. Our presence on the ground in Japan gives us an edge over foreign players. Overall, we believe that Japan is an attractive place for active managers, where SPARX can thrive.

We also differ from the domestic institutions, which are quite rigid and bureaucratic. At SPARX, the fund managers have full discretion over their portfolios. When it comes to stock-picking, there is no consensus building. I am fully accountable for the investment decisions within the Hennessy Japan Fund and we run a concentrated portfolio of 23 names and active share of 86 percent. Most institutions are not at liberty to run such concentrated portfolio.

We have adopted the Warren Buffett approach of looking at the long-term economic characteristics of the business to identify companies with high returns on capital, sustainable and predictable long-term, above-average earnings growth, and strong cash flow. Those are the primary qualities that we seek in a potential investment.

Q: How do currency fluctuations affect your portfolio?

A: U.S. investors are dollar-based investors, who invest with global companies, including Japan-domiciled companies. If the yen depreciates, the dollar return on equity is reduced, but the international competitiveness of the companies improve. So, the investors are compensated for the currency depreciation. If the yen appreciates, the dollar return on the equity improves right away. The international competitiveness of the businesses is reduced but, over time, the high-quality companies that we look for can typically overcome the currency headwinds. In a nutshell, from the perspective of U.S. investors, our portfolio is naturally hedged.

Q: How has the investing landscape evolved in Japan over the last 30 years?

A: After the financial markets bubble burst in 1989, Japanese stocks have been down for many years and most old-school investors approach the Japanese stocks as value stocks only. They look for companies trading at price-to-book ratio of less than one, preferably 0.5 or 0.4. If at some point the business breaks even and the stock price recovers, investors have to sell the stock because the ROE is not compelling enough to warrant long-term ownership. That’s the traditional view on Japan for most investors, but they overlook what’s really happening underneath.

During the 1990s and 2000s, the share prices of some stocks doubled or tripled. For example, Fast Retailing, better known as Uniqlo, went public in the 1990s and today is one of the biggest constituents of the index. People often compare Uniqlo to H&M or Zara, but the core strength of the company is rather different. Uniqlo thinks of clothing not just in terms of fashion, but also in terms of functionality; there is craftsmanship involved.

Another example is Toyota and the car makers, which at one point conquered the world. I attribute their success to Japan’s studious ethos and craftsmanship. We don’t have companies likes Facebook or Google, but we have strong manufacturing excellence. Currently, we don’t own car companies in the portfolio, but I believe that the mentality of manufacturing excellence can produce globally competitive companies in different areas.

Skin care cosmetics is not just about slapping a brand or a label on the container; there is a lot of science involved. Uniqlo is approaching the business of clothing from a completely different angle. Overall, there is high-quality value proposition that Japanese companies are trying to deliver. If an investor focuses on these aspects, there are many investment opportunities in Japan.

We are also mindful of investing in companies with international growth potential. Japan’s economy is declining, so as a large-cap, long-only manager, we invest in companies that can withstand our long-term investment horizon. In our portfolio, we have stocks, which have been with us for more than 10 years. Japan is not a place of value investment; it is a great place for growth investors. It is significantly different from the U.S. and has attractive products in different areas.

Q: What are the key elements of your investment process?

A: Our firm wide investment philosophy is “Macro is the Aggregate of Micro” and everyone has a different approach. Basically, that is our bottom-up, stock-picking mantra.

Regarding my strategy, there are about 3,700 listed companies in Japan. From that pool, only 60 to 80 investable names through the years have met my strict investment criteria. I have a seven-item checklist, which includes simplicity of the business model, inherently safe and sound business, strong balance sheet, durable competitive advantage or a wide economic moat, high returns on capital, sustainable and predictable long-term earnings growth, cash flow generation and strong management. We evaluate each business based on this checklist.

My belief is that great companies are here to stay. They don’t and shouldn’t change overnight. I believe in proven, time-tested business models and track records, because only the proven track record allows to extrapolate into the future and to predict long-term earnings. We need to rely on the past and analyze the present environment. We evaluate if the business is still entrenched and whether there are threats approaching. If the company is still in a dominant position, we look at the future to see if there is predictable growth of the demand for its products or services.

That’s the typical process for creating our shortlist of 60 to 80 names and the shortlist has been quite stable. We look at hundreds of stocks each year; everyone at SPARX does the same thing. They visit companies and study them one by one. Through the decades of cumulative research experience, we know where the opportunities exist.

The next step is to wait because the great companies seldom trade at attractive valuations. We have to be patient and sometimes wait for five or 10 years or longer. However, even the highest-quality company can go through a free fall in the share price due to short-term earnings problems or a minor scandal in the management. We typically pounce when the opportunity presents itself.

The key is to patiently wait for the right opportunity and our patience sets us apart. Meanwhile, our seasoned holdings can compound capital for us. Our turnover typically is about 10% with 23 names in our portfolio. We don’t invest by themes and we don’t chase what’s driving the market. We don’t participate in high-flying stocks. We are down to earth, and we try to ignore the crowd.

Q: How do you gather information? What is your research process?

A: First and foremost, we do a lot of reading. Visiting companies is part of our investment process, but it’s not synonymous with bottom-up research. We do a lot of homework, which means reading and trying to understand the business, the history of the industry, the management philosophy and strategy. We look for durable information and how the company creates the moat and its management culture.

We don’t pay too much attention to temporary data like monthly retail sales, for example. This data quickly becomes obsolete. We ignore broker research and read industry periodicals, company annual reports, management interviews, books, Internet resources, etc. We build our knowledge not knowing when the information will become useful. At some point the dots start to connect and if the right opportunity arises, we pull the trigger.

Q: What is the disclosure policy in Japan and does it affect your portfolio?

A: Disclosure has changed a lot over the last 20 years. When I first came into this industry, disclosure was rather limited; many companies didn’t even have an IR department. At the time, some companies didn’t have consolidated financial statements.

Now Japan largely adopts IFRS or U.S. GAAP; most companies have IR departments and the disclosure level has gone up a lot. Nevertheless, some companies still release their financial results only in Japanese and that’s gives us an advantage over foreign investors. But, overall, the quality of information and the disclosure level have improved significantly over 20 years.

In the IT era, there is no information edge anymore, especially for large-cap managers like us. Everything is readily available through the Internet or by phone. We believe that our edge comes primarily from our ability to interpret the information thanks to our familiarity with Japan’s unique corporate culture and business practices.

The key elements are the analytical skill, the long-term investment horizon and the behavioral advantage. When the market is in a panic selling mode, we can take a contrarian approach. With the ease of collecting information, we don’t claim to have any information edge. The differentiator is our ability to interpret and translate that information into a winning investment.

Q: Could you highlight your research process with some specific examples?

A: One of our top holdings is Recruit Holdings Co., an Internet advertisement media platform company. It has job advertisement and media platforms that cater to the restaurant industry, the travel industry and property agents, who don’t have means to reach out to prospective consumers. It has its own proprietary online media that provides network effectiveness. A strong media platform attracts consumers, which brings more advertisers, etc. They create a virtual cycle and we like the business.

We delved into it in 2014, during its IPO. It was not a startup; it had been a private company for over half a century. When it went public, it released a standard prospectus, which contains financial history for the last five years. We couldn’t gain insights into how the business through its lifetime, so we turned to library resources to find books written by the late founder and former employees. We went to great lengths to understand the past earnings patterns, because that explains the economic characteristics of the business.

Initially, Recruit was a domestic company, but at the time of the IPO, the management intended to make acquisitions overseas to strengthen the revenue base. With no international track record, we were not fully convinced. We kept watching the name over the next two years to evaluate the management’s prowess around acquisitions. One of their successful purchases was Indeed, the world’s largest job search engine. Recruit acquired Indeed for $800 million at an early stage and the business has been growing by leaps and bounds. Based on our estimate, only this business is worth more than $10 billion today. When we saw signs of the successful strategy, we warmed up to the idea of buying Recruit for the portfolio.

We finally invested in December 2016, when the valuation was appropriate. The P/E multiple was north of 30, so the stock wasn’t cheap. However, Recruit was still reporting under JGAAP, where the management had to amortize goodwill, which is a non-cash expense. Because of Recruit’s strong appetite for acquisitions, it had large goodwill on the balance sheet, but we didn’t see any significant impairment risk. So, we made the adjustment to evaluate the true cash earning power. The reported net profit was $600 million, but the actual earnings number was $1.2 billion. After adjusting for the goodwill expense, the P/E multiple dropped down to 17 or 18, which was attractive for a company of this quality.

As a media, Recruit has inherently capital-light business model. Five years into the future, we are fairly confident in its cash flow generating abilities. The market and the investors are short-term oriented, but we always look at businesses from the long-term perspective. We felt that when the acquisition phase was over, the entire operating cash flow will drop down to free cash flow. The market was overlooking the earning potential due to accounting reasons and due to its reluctance to look forward.

Since December 2016, the stock has not only outperformed the index, but also produced strong absolute returns through 2019. It came down this year due to the pandemic turmoil, but it has been one of our most successful investments to date. Today Recruit is one of the largest market-cap companies with about $50 billion in market cap.

Q: Can you give us another example from a different industry?

A: Shimano, Inc. the bicycle parts maker, has global market share of 70% to 80% and a straightforward business model. The company has been around for more than half a century and has never been threatened by competition. For the most part, bicycles aren’t going to change in a big way. Shimano continues to be a dominant player with extremely high market share among top racers. That professional endorsement extends to consumers. Although it is a supplier of parts, Shimano is perceived as a consumer brand, and that brand is one of its moats. It has high margins, strong cash flow, high returns on capital, and strong balance sheet.

Although the coronavirus negatively impacts the demand for consumer discretionary brands, people under extreme stress change their behavior in unexpected ways. Some studies show that in times like this, consumers actually spend money on things that they never experienced before. Bicycles represent a good way to exercise and are an eco-friendly transport. That bodes well with the rising health consciousness. I believe that demand for bicycles will increase over the next 12 to 18 months. European governments are investing more in bicycle rows; China is also a promising market. Overall, there is a reasonably predictable demand growth for bicycles.

Another example is the factory automation company Keyence Corp, which develops sensors. Factory automation is one of the areas, where Japan is a global leader. Keyence’s team visits the factory of the customer to inspect the floor and to propose cost-saving solutions. For instance, a customized sensor can replace three workers along their inspection line. That sensor costs Keyence about $200 and the company sells it for $1,000. The added value comes from the consulting service and automated production is exactly what the post-coronavirus world needs.

Keyence is among the companies in Japan with highest operating margins. It has about $15 billion of cash and equivalents, or 30 months of sales. I don’t know any other company that is more prepared for enduring a recession or a depression. Despite the inefficient balance sheet, Keyence has been producing above-average returns on capital and growing market cap.

We have owned Shimano, Keyence and Recruit well before the coronavirus outbreak. Then we reassessed the portfolio to see if we could hold these names during the pandemic and in the post-coronavirus world, because consumers will change their behaviors. Some companies will prosper, while others will never return to their peak earnings. We did a deep analysis of our existing names and concluded that we can and should hold them through thick and thin.

Q: What is your portfolio construction strategy?

A: It is an all-cap strategy and our primary focus is the large-cap space. Japan offers a lot of growth opportunities in the large-cap space, so we don’t feel too constrained.

I believe that managing a concentrated portfolio is the only way to meaningfully outperform the benchmark over the long term. The risk associated with a concentrated portfolio is the unintended high exposure to certain sectors or names, so we always make sure that we have diversified underlying businesses. Our portfolio can be best described as concentrated with a diversified approach.

For example, among the top 10 holdings, we have companies in the areas of medical devices, factory automation, bicycle components, diapers, Internet media, ophthalmic medicine drugs, clothing retailers, etc. The earning patterns of these companies are not correlated with each other, so the underlying businesses are well diversified. We also make sure that the geographical exposure is spread out. We have companies geared mainly towards U.S. and Europe, other companies are more geared towards Asia, while some companies are truly global. We sustain a nearly equal geographic mix in terms of markets, but all the companies are domiciled in Japan.

We are also diversified from a valuation perspective. Some companies are trading at 30 times P/E because of their high-growth momentum, while other companies, due to misperception by the market, are trading at high single digit P/E multiples. We aim to mix all of these to build a truly all-weather type of portfolio. We always try to balance between non-cyclical, stable-growth companies, such as consumer stocks or healthcare, and moderately economically sensitive businesses, such as high-quality, well-capitalized industrials.

Due to the focus on all-weather type of portfolio, we typically do well in bear markets. For example, in 2018 we had the first bear market since 2011. In yen terms, the market fell by 17%, while we were down less than half that number. In 2016, the market finished almost flat in yen terms, while we were up by seven percent. Our goal is to minimize the downside in a bear market and maximize the upside in a bull market. I don’t claim to outperform every single year; we evaluate our performance on a three-to-five-year timeframe. Due to the structure of the market, we believe that our approach represents a timeless strategy.

Q: How do you define and manage risk?

A: Our biggest concern is the permanent loss of capital. We don’t worry about the gyrations of stock prices as long as the company remains well run and has its moat is intact. But we always look out for companies going through permanent changes in the business model or companies about to suffer a structural defect or erosion of the moat. For example, bookstores and physical retailers today have structural erosion of the moat.

Once we buy a new stock, we spend a lot of time maintaining our research. That means not just following the company, but also studying competitors or related industries globally. We look at Asian, European, U.S. companies; we examine historical case studies. I believe that it pays off to read and understand the past, to spend time on corporate failures or accounting scandals. We minimize the risk through accumulating knowledge and staying ahead of the curve.

We don’t worry too much about macro picture. We cannot entirely escape from it, but our strategy is to look for businesses that can grow organically, regardless of the macroeconomic conditions. In the end, we invest in individual companies and we minimize the business risk through rigorous screening and stress testing.