June was another factor driven month with small/mid-cap value strongly outperforming large-cap growth. For example, the MSCI Japan large growth index was down -5.5% while the MSCI Japan SMID value index was up +0.5%. Interestingly, this appeared to be an isolated phenomenon with the corresponding MSCI US and MSCI World indices returning similar magnitudes around -8% ~ -10%. I’m not sure as to why Japan was spared the carnage observed in the rest of the world. As of the end of June, Topix (price return) is only down -6.1% YTD (Growth -14.5%, Value +2.7%) while the S&P 500 (price return) is down -20.8% (Growth -28.3%, Value -12.4%) and MSCI World down -19.0% (Growth -27.6%, Value -9.8%). While I’d like to say that Japan is more resilient to the downturn, I suspect the true reason is merely mean reversion as Japanese growth stocks did not drive market returns as much as they had in the rest of the world during calendar 2021. However, this does relate to our thesis that because valuations were much more reasonable in Japan at the end of 2021 as compared to the rest of the world, there is also less room for valuation contraction should the tide turn. Even after this correction, Topix is currently trading at 12.1x forward earnings and 7.1x EBITDA as compared to 17.0x and 11.6x respectively for the S&P 500.

 

After a very difficult May, our portfolio fared slightly better this month with most of our names outperforming our benchmark. However, our top holding, Macromill, continued its underperformance and was down -10.7% for the month and -23.9% for the quarter (-13.6% YTD). We have had 3 meetings with the company in June alone and our conviction remains the same. Not only are we convinced that they will likely beat their own forecasts and consensus (what little consensus there is), they are still on pace to meet their midterm targets ending in Jun 2024 that amounts to a +17% CAGR to EBIT compared to last June. We have conservatively estimated only +13% CAGR due to increased labor costs as well as lower labor productivity from the excessively high demand for their digital marketing research services that is exceeding their capacity. As the company will most likely continue their stock buyback program, at least throughout the remaining 2 years of their midterm plan, EPS growth should be higher. Even if the stock were to maintain its current 12x earnings multiple, we see nearly 50% upside from EPS growth alone vs last June. They may, again, begin the new fiscal year starting this month with very conservative guidance. However, the company has, for the last 2 years since the new CEO took the helm, revised up in Q3 and ultimately had beaten that revised up figure (and we expect them to do the same this fiscal year when they announce next month). As such, despite the difficult stock action over the last two months and our large ownership of the company, we have continued to take our stake higher in the business.

 

While the first half of this year proved difficult, we are confident that many of our top holdings that have been a drag on performance will see underlying growth, regardless of the upcoming recession that we expect to become realized. We have largely eliminated our globally economic-sensitive companies and have added to names like Macromill and other businesses whose franchise is linked more closely with domestic growth as Japan continues to pull out of the post-pandemic malaise. Already, we are starting to see such signs through strong capex guidance as companies seek to rebuild after holding back investments for the last 2 years. While inflation, the weaker yen (which is now more of a hindrance than a benefit as most global manufacturers produce in their local markets), and higher labor cost will weigh on earnings growth, we expect that not only will the leaders of each field (which is where we invest) will be able to navigate this storm better through price hikes, higher margins, and stronger balance sheets, they will also be in a stronger position on the way out of the weakening economic cycle than when going in, thus expanding on their competitive advantage.

​

Masaki Gotoh

​

===

​

“God of peace, bring your peace to our violent world: peace in the hearts of all men and women and peace among the nations of the Earth.” – Pope Benedict XVI from his prayer at Ground Zero on Apr 20, 2008.

​

In Japan, July 7 is the Star Festival, or “Tanabata” in Japanese. According to folklore, this is the day that the two deities Orihime (represented by the star Vega) and Hikoboshi (the star Altair) separated by the Milky Way are allowed to meet once a year. It is now celebrated through brightly-colored festivals, often held in shopping malls and local towns between July and August. Children often celebrate the day by writing wishes on small streams of paper that is tied to a bamboo. We asked my older son, Leo, what he wishes for and he said to us, “world peace”. I was very surprised and actually a little proud of my son for being so selfless (my younger son said he wanted to be Son Goku from Dragon Ball). I didn’t ask why Leo wished that, but I do know that the recent violence from the news coming out of the US frightens him, not to mention the atrocities from the war in Ukraine. And, the next day, ex-PM Abe was assassinated.

 

Now, one must remember that there have been no mass shootings in Japan, compared to over 300 in the US just this year alone. For the decade between 2012 to 2021, there were a total of 205 incidents where a firearm was discharged in Japan, of which 153 were related to crime syndicate groups. While Abe’s assassin used a hand-made gun, it is very difficult to obtain a gun license in Japan (in my lifetime, I’ve only met two people who owned a firearm for hunting purposes). First, only shotguns and air rifles are permitted for sale and handguns are outlawed. To obtain a gun, one must take an all-day class, an official safety course, pass a written test, and hit at least 95% accuracy on the shooting-range test. The tests cover maintenance and inspection of the gun, methods to load and unload, shooting from various positions, and target practice for both stationary and moving objects. Then, one has to pass a mental health evaluation taking place at a hospital, a drug test, and a very rigorous background check including criminal records, personal debt, and interviews of friends and family. Once obtained, the owner must register it with the police with details as to where it is stored with the gun and ammunition locked in separate compartments. The gun must be inspected by the police once a year, ammunition inventory is checked to make sure that no shells or pellets are unaccounted for, and the owner must also retake the class and pass the exam every three years to renew the license. Only a maximum of three gun shops are allowed to operate in any prefecture, new magazines can only be purchased after trading in the empty one, and the gun must be surrendered by the living relatives if the gun owner dies. Needless to say, gun-related homicides are also extremely rare. Some conservatives who are anti-gun control may say that strict gun laws do not work, I believe that, while it is impossible to eliminate homicides, Japan has proven that a country can be much safer with strict gun laws.

​

This isn’t to say there are no massacres in Japan. There have been 11 massacres (resulting in the deaths of three or more indiscriminate persons) since the sarin attack in 1995, although none involved firearms. In the last 27 years, there were 5 cases of arson, 3 stabbings, 2 cases involving both vehicular homicide and stabbings, and 1 case of arsenic poisoning. There have been political assassinations, but it, too, is also very rare. They were actually fairly frequent leading up to World War II but, since then, there have only been three. Inejiro Asanuma, the leader of the Japan Socialist Party at the time, was stabbed by a short sword during a televised debate in 1960 by a far-right ultranationalist. In the same year, PM Nobusuke Kishi, Abe-san’s grandfather, was also a victim of a failed assassination attempt and survived. Koki Ishii, a DPJ Diet member, was stabbed to death in 2002 under suspicious circumstances by a member of the Yamaguchi-gumi Yakuza crime syndicate. And, Iccho Itoh, a mayor of Nagasaki, was shot in 2007, also by a member of the Yamaguchi-gumi. There has been no successful assassination attempt of a prime minister since pre-World War II.

 

I’m sure I don’t need to go over Abe-san’s incredible legacy here, but I’m probably not exaggerating to say that most everyone, at least in the finance industry, were strong supporters of Abe-san’s policies. As a nation, we became relevant again on the world stage and helped us become proud of our heritage, not to mention more economically and politically stable. He was strongly involved in world affairs, and I believe he had left his mark, not just in Japan but globally. Personally, I was also a strong proponent of many of his hawkish domestic policies. This isn’t because I have right-wing tendencies (in fact, I wrote in a previous monthly that, if anything, I probably lean left when it comes to social policies). However, I agreed with his desire to amend our pacifist constitution and increase defense spending, not so much because I feared a rise of China or North Korea, but because I felt Japan had become to rely too much on the US and, therefore, too complacent regarding world affairs. At the minimum, we should have the strength to defend ourselves against aggressors while maintaining the strong US-Japan alliance. However, this was highly unpopular in Japan and, if I recall correctly, less than 10% of the population supported that view. Ironically, consensus has reversed that view after the war in Ukraine. But, before the war, most of Japan were against him. Arguably, this is what also led to his political decline. While, officially, he left office due to health reasons, my conspiracy-theory belief is that he knew his approval rating was on a sharp decline driven by excessive media exposure to some minor scandals involving currying favors to friends and family. In order to maintain his political power, he voluntarily resigned before being forced out, allowing him to keep his hold on the LDP behind the scenes. Of course, I think it unfair that certain persons or organizations have favorable financial gains due to their proximity to the head of state. But I am also not an idealist. As a realist, I could forgive a little favoritism to keep a man like Abe-san in power as long as it doesn’t go too far. Nepotism is, in my view, a by-product of any democratic system. And the cases alleged to have involved Abe-san were, in my view, relatively minor. We eliminated a strong leader that had brought so much more to Japan for something which I felt to be relatively trivial. And he was no saint. His strong right-wing nationalist views kept tensions high with China, North Korea, and South Korea (although the foreign policy of South Korea at the time was to improve relations with China and North Korea at the expense of relations with the US, so a nationalist Japanese PM probably suited their purpose too). While I felt his nationalism was a little too far-right for my taste, we needed a strong leader to guide us out of a decade of political impotence and he was such a man. His legacy cannot be underestimated.

 

And I think this is what makes Abe-san’s assassination particularly tragic. The reason behind this attack is so outrageous that it, quite frankly, angers me. The country has lost a great person to something that seems so misguided. I suppose there can never be a “good” reason and we, of course, cannot condone any type of violence against another person. But the reason behind the assassination makes one feel even worse.

​

But setting aside our emotions, what does this mean for our business? I am no political analyst, and therefore I encourage everyone to take it with a grain of salt. But I believe the initial reaction of the market was correct when we first heard of the shooting last Friday. The market was strong during the AM session but lost most of its gains in the afternoon as more details of Abe-san’s assassination were available. In other words, I believe, on the margin, the effect was negative. The Liberal Democratic Party, who has held control of the government since its foundation almost continuously, is actually a mishmash of a variety conservative beliefs. Abe-san controlled the largest faction within the LDP. It has strong support of the Keidanren, the largest business federation in Japan. The faction actually follows more traditional classical economics and not necessarily the neoclassical policies that drove the administrations of both ex-PM Koizumi and ex-PM Abe, his successor. It tends to be more nationalistic than the other factions. They hold 94 of the 373 LDP members of parliament. The next largest factions, the Motegi faction and Aso faction who both hold 51 seats each, are more pro-China. Motegi is more Keynesian while Aso is more classical. Both tend to have support from farmers and blue-collar workers. Our current PM Kishida leads the 4th largest faction who has only 41 seats. The views of this faction tend to stand between that of the Abe faction and the Motegei and Aso factions. This faction tends to have the support of white-collar workers, the medical industry, and small businesses.

The death of Abe-san leaves a political void as there is no one of his stature to take over his faction. As such, I suspect that Kishida-san has more room to navigate. When Kishida-san took office, he initially tried to roll back some of the Abenomics policies with talk of wealth redistribution and tax hikes. He was later forced to dial back his comments after the market posted one of its longest losing streaks in more than a decade. He has since tried to communicate to the investment community that the markets had misunderstood him, and his “New Capitalism” announced later notably removed any mention of some of the controversial policies. Still, many in the business and financial community see him as more left-leaning despite his efforts to portray himself as market-friendly (e.g. during a speech in London, Kishida-san stressed as the only PM since World War II with experience working in the finance industry and stressed his commitment to a “robust economy supported by the animal spirits of the private sector,” tax cuts, and incentives to encourage citizens to move savings into asset management “to stimulate the market”). With the Abe faction standing much weaker, there is a risk that he may again pursue his more socialist agenda, especially since both his faction and Aso faction were critical of the neoliberalism of Koizumi/Abe. Also, his faction is more moderate when it comes to foreign affairs. With both Motegi and Aso factions being pro-China, there could be a shift in the North Asia geopolitical balance, especially with a more friendly South Korean government led by the new President Yoon Suk-yeol. For now, Kishida-san has stated that he will continue to work toward completing Abe-san’s unfinished goal of revising the pacifist constitution.

 

While I suspect Kishida-san doesn’t have the political power to push through his leftward agenda (Motegi and Aso may be less neoliberal, they are still liberal economists), Abe-san was definitely one counterweight that is probably no longer as heavy. Abe-san was the perfect US ally. Kishida-san may take a more balance approach in order to maintain power. I suspect we can safely assume that the period of massive monetary easing will almost certainly come to an end once BOJ governor Kuroda ends his term next April. Kuroda-san had extremely strong support from Abe-san and, if Abe-san were still alive, there was a much higher probability that Amemiya-san, Kuroda-san’s right-hand man, would lead the BOJ from next year. However, there is a good chance now that Nakaso-san, who has been critical of Abenomics, will become our new governor. While no governor can take an aggressive stance on quantitative tightening given our fragile economy sitting on top of a mountain of debt, the exit pace will likely be faster with Nakaso-san than Amemiya-san.

 

I was frankly surprised by the strong market response on Monday; I suppose an overwhelming win by the LDP in the upper house election this weekend is better than uncertainty, especially as most other parties are still less economically liberal (and outright disorganized) than the LDP. We have not, of course, changed our portfolio based on this tragedy, nor do we plan to. However, I do think that the death of Abe-san has greater economic implications than what the present Japanese media has expressed. Abe-san was arguably much more respected outside of Japan than within. But I, for one (and I suspect many in our industry), mourn his death. And I watch anxiously to see how the LDP may change in the coming months.

 

Abe-san, may you rest in peace. Your legacy will not be forgotten.

​​​