Despite all that’s happened on the global stage during December, the equity markets seemed fairly calm. Not only did we have 3 major central bank rate changes (the Fed, BoE, and BOJ) albeit disseminated well in advance, South Pacific risks continued to rise including the largest-ever Chinese military exercise after a record-breaking weapons sale by the US to Taipei as well as escalating tensions between China and Japan. Within this backdrop, December continued the trends from November in Japan with the N/T ratio contracting (though still at highly elevated levels compared to historics) and broad mean reversion after the strong beta-led drive in September and October.
 
In terms of both factor and sector exposure, we faced strong headwinds as both growth and quality underperformed (as noted in previous monthlies, our “value” definition is based on the margin-of-safety vs intrinsic value and not the traditional Fama-French value definition; we tend to own high PBR stocks due to high relative ROE/ROICs and long-term earnings and equity growth tends to be higher than peers). Furthermore, we have no exposure to the top 5 Topix-based sectors by December attribution. Our outperformance came almost entirely from mean reversion and our large underperformance early in the quarter had been 3/4th recovered in December.
 
Outside of marginal rebalances, we traded very little in December. As we look out to 2026, despite the continued geopolitical uncertainties, I have ever rising confidence regarding the long-term outlook of the companies within our portfolios. We remain highly overweight the Information Technology sector and expect to maintain that overweight, although I do plan on rebalancing some industries within this sector. And we will likely lean into our key long-term themes being led by acceleration of the decline in the working population such as labor tightness/wage inflation, economic dispersion (corporate and individual), and labor productivity such as automation and software services.
 
Finally, two administrative items that I’d like to mention. First, after discussions with our LPs, we will be changing our benchmark from MSCI Japan SMID to Topix Mid 400. The industry breakdown is extremely similar, but the average market cap is higher, coinciding with the rising average market cap of our portfolios. This has to do with the increasing volatility of the market as a whole, leading to a broader opportunity set across the market cap spectrum. However, we are still significantly tilted toward mid and small caps as compared to the market. Secondly, we have 2 new additions to our team, one research analyst and one trader, both seasoned veterans in their respective fields. We look forward to their contribution to our team and our partners.
 
The new year has already brought additional volatility in geopolitics. So far, the market appears to have shrugged off these uncertainties, and the Japanese indices continue to march to new highs, driven by large caps (with an added boost from news of a possible snap election which wasn’t expected until the fall). According to Bloomberg, consensus estimates are looking for an acceleration in EPS growth from 2025 both in the US and Japan. After 3 consecutive years of double-digit market growth, the odds that we get a fourth seem low. The last time that happened in Japan was during the 80s real estate bubble and, for the US, during the period leading up to the dot com crash. Of course, such statistics are meaningless, but I wouldn’t be surprised if we had a pull back this year. Of course, we don’t let such views dictate our portfolio construction, and we will continue to focus on our long-term investment thesis based on Japanese Quality.
 
We wish everyone a safe and fruitful 2026!

Masaki Gotoh​​​

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“To be human and to be adult means constantly to be in the grip of opposing emotions, to have daily to reconcile apparently conflicting tensions. I want this, but need that. I cherish this, but I adore its opposite too.” – Sir Stephen Fry, British actor, from the 2010 BAFTA speech.

 

Reconciliation. When it comes to fundamental investing, we are continually faced with the need to reconcile. This is because, as an investor, there are only three outcomes to an investment, either to buy, hold/do nothing, or sell/short. This is despite the infinite number of variables, both those currently observed (which may or may not be fact) and those that may come to pass in the future, that could potentially dictate how much a company should be worth vs what its current market value is as well as the infinite number of paths to get to that point (if ever) in the short, medium and/or long term. So not only must one attempt to decide which finite subset of variables matter during which time horizon but, of course, what the values of those variables might be. The more variables one assumes matter to the equation, the complexity and workload rise exponentially which does not necessarily mean greater accuracy. Conversely, fewer variables could lead to oversimplification, and the margin of error could be that much wider. The chosen investment horizon and the strategy one wishes to employ would obviously change which variables are of greater importance than others. While the variables themselves will be different for each individual investment, one develops a certain expertise in identifying which variables are important for the strategy being employed and, so, there is a learning curve involved. But it is still fairly idiosyncratic and extremely subjective.
 
As an investor, I had evolved, staring my career in equity derivatives during my sell side years, to a quants-driven strategy during my prop days with an investment horizon of ticks to days involving hundreds of positions, to equity long-short whose horizon was months to quarters and a portfolio with several dozen names on each side (my coverage being 1/3 of the whole), to engagement-based long-only and finally to a quality-based long-only, both of which looked at investments in terms of years and whose concentration was further tightened (in our flagship fund). The variables needed to be analyzed changed significantly throughout that period and each change required quite a bit of personal reconciliation. However, there was a common thread too. For example, there was always a value tilt although my definition of value had matured over time (in fact, I didn’t understand what “value” meant for quite a while and didn’t realize that there were differing definitions). There was also an underlying short-term mean reversion/long-term momentum factor in play regardless of strategy. And I always believed in a good balance of stock selection and portfolio management, though the priority of one vs the other also differed depending on portfolio concentration.
 
But recently, I was asked “why?”. After so many investor meetings throughout my career, I thought I’d heard all of the questions possible from an investor meeting. Admittedly, it’s been a while since someone threw me off balance. The question was interesting because I’ve asked the same question thousands and thousands of times when I meet companies. In fact, it’s the most important question we ask (which I’ve written about a few times in the past). “Why is this company the leader in their field?” “Why do they keep growing faster than its peers?” “Why are margins higher?” Then we have to ask ourselves, “Why is the stock down?” “Why are valuations contracting?” “Why will it recover?” The other questions like “How did they do all these things?” “What are the things they will do to improve?” or “When will it happen?” come later.
 
But thinking back, I can’t remember someone asking me “why?”. And so, I had to give it quite some thought. The conclusion I came to is lengthy, so I’ll leave that for a separate discussion. But thanks partly to a very long 4-session interview I had with another prospective investor a few years ago, I was able to rationalize the answer which is based on inherent personal biases and traits, upbringing, paths chosen, and experiences that shaped what became our investment philosophy. Along the way, there were many reconciliations that were faced. And while the underlying philosophy is fixed, reconciliation continues even now when we answer the “What” and the “How”.
 
As an example, I believe we pride ourselves in the deep research and the understanding we attempt to fulfill in order to assess the quality of a business. This requires a strong sense of “curiosity”, a trait that is developed not learned. In fact, I believe there is no such thing as being overly curious. However, my duty to our investors is to produce a commensurate risk-adjusted return. While I’d like to follow up every infinite variable if I could to satisfy our insatiable curiosity, it’d be impossible to do so and, frankly, quite foolish. As a former engineer, I’m also looking for improvement and efficiency. Therefore, I also want to reduce the number of variables and answer them as efficiently as possible. This is a conundrum and requires a balance of how deep we want to research vs how much is necessary to make a choice (and at what conviction level, i.e. weighting in the portfolio).
 
As a business owner in addition to a research analyst, I understand how a business operator would and should think. And so, I absolutely understand the long game. We’ve suggested that companies stop paying dividends and reinvest into their compounding business, contrary to the shareholder payout led activism that has grown exceedingly popular. We frequently suggest, following our labor shortage theme, that companies use their strong positioning to increase spending on labor and R&D even if that means slower short-term earnings growth, because that will enable future share gains and accelerate topline in future years. However, both suggestions, which may be positive for long-term value creation, will likely be short-term negative for the stock price, especially in Japan whose investors are obsessed with next year’s operating income rather than long term cash flow generation. How strongly do we want to provide suggestions that could cause near term underperformance, even if it’s the right call from a long-term strategic perspective?
 
Despite our models that look out 10 years, I believe active portfolio management is important in driving returns in Japan. This is because of my view that Japanese equity markets lack true long-term fundamental investors (and from the sell side fueling the short-termism). But if that is the case, a fair question might be why assess long-term sustainable competitive advantage which often has little to do with short term stock activity? As a stock analyst, I believe that it is these short-term market movements that provide opportunities, but that goes both ways and it also drives short term stock exuberance. However, as a business analyst, I also believe that corporate value is based on the long-term growth of a business that can continually outperform its peers. This too requires reconciliation.
 
From this exercise, what I’ve come to realize is that all strategies can and do coexist and they can all be profitable. As I’ve experienced many varieties, the philosophy that we’ve evolved to is based, ultimately, on what I enjoy doing and what I think will be rewarding for our partners, using our specific expertise as the method to achieve it. I like deep research because I like owning great businesses and that research provides conviction. But I also became more aware of the many reconciliations we face as we try to bridge long-term intrinsic value vs short-term stock price action. Thanks to this exercise, we have refined our process even further (which also became possible thanks to our team expansion). The “why” hasn’t changed although we continue to evolve the “how”.
 
However, one fact that has changed significantly after nearly three decades as a Japanese equity market participant is inflation expectations (further accelerated by our reflationary PM). This fact has also contributed to “how” we express the investment philosophy. Many of us probably have differing views on what that means and how to take advantage of it. For us, it means rising dispersion and the strong get stronger. Some believe this will drive the entire market to indefinite highs. But whatever your view, we can probably agree that Japan has structurally changed. And I’m terribly excited about it, more than I’ve ever been as a Japanese equity investor. “What’s going to happen?”, you may ask.
 
“Something wonderful.” – from 2010: The Year We Make Contact.
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