EDITED TRANSCRIPT
Lukasz de Pourbaix (LDP): Hello and welcome to Fidelity Sound Bites, Fidelity's monthly podcast where we talk about all things investments. My name is Lukasz de Pourbaix, and I'm pleased to host today Min Zeng, our Portfolio Manager for the Fidelity Japan Equities Fund. Welcome Min.
Min Zeng (MZ): Hi. Thank you very much for having me.
LDP: You're here for a few days in Australia and I like to get a feel for people’s background, how they've got into this industry. Y have a little anecdote on how you first got into investments and your first investment. Tell me about that.
MZ: Sure. I studied finance in undergraduate school at McGillin in Canada. With that, my first part-time job was at a buy-side firm in Montreal. It was called Jarislowsky Fraser. I was a junior analyst making financial models for Japanese companies for the more senior analysts. That was my first-hand experience. I thought it was very interesting just simply modelling the future of companies. Back then, I remember one of the analysts, Kimberly, and myself discussing that if you were going to be an equity analyst, the best company to be in, in this industry, is Fidelity. That was my first time I heard about this company. And the rest is kind of history. In terms of my first investment experience itself, I graduated in 2010/11, that kind of era. So, I went through the financial crisis while I was in university. At that time, I remember all the American companies, big American companies like General Motors, and Ford at the brink of bankruptcy. For my first investment, I was supposed to use the money, $900 (I think it was) for two textbooks for that semester. I told my parents somehow I didn't have enough, but I instead used that money to invest in GM when it was maybe I think (US)$1 or a (US)$1.80 or something like that. I just thought there was absolutely no way such a company like General Motors, of United States of America, can stay at this value for long. I did have the choice to choose between General Motors and Ford, I didn't really know how to choose. I just thought, okay, let me just eennie, meenie, minnie, mo. I ended up choosing. It was my first process. My investment, $900 in GM went to zero. Ford, I think, was a multi-bagger after that as it recovered. So, my first lesson was, well, if you're going to do that kind of investment analysis of the financials of the balance sheet of how long a company can survive through that those type of periods, that's going to make or break your investment. So that was my first experience.
LDP: That's a brilliant lesson. How'd you go with a semester with no textbooks?
MZ: My parents were relatively forgiving if it was money for education. I made up a good excuse to have more funding.
LDP: Very good. There's nothing like having skin in the game to teaching you about markets. So that's a great reflection. Japan's been a really interesting market over many years. For people that are listening that have maybe followed Japan to some degree, some of the key things that come to mind is deflation, it's slow growth, it's one of maybe companies not acting in the best interest of shareholders. Maybe that's a bit of a historical mindset, but I guess it feels like there's been a real shift in Japan for some time now in terms of some of those structural things. Can you run through maybe where we have been, but what are some of the really exciting changes that we're seeing now in the market that have taken hold?
MZ: I think to put it simply, the biggest change that's happened in Japan is inflation returning and the belief by corporates and consumers alike that this time it's probably here to stay. It's structural, not a one-off. That changes the way many companies think, consumers think, and how people and corporations take action. I think this corporate governance push has maybe more recently has gotten attention in Japan, given how the markets have moved. It's not something that just started this year or last year. It was actually almost a decade ago when our new, back then, Prime Minister Abe came in, and really drove the initial drive to introduce corporate governance codes, stewardship codes, improve corporate management structures, board structures. That process has been a decade long process. One thing that Japanese corporates are accused of being poor at is capital allocation and more specifically, too much cash holdings on the balance sheet. Despite the past decade of corporate governance improvement push, if you think Japan, you're under a deflation. What that means is if I have cash and I invested into a factory or some specific asset, the chances are that asset will deflate because the products that I'm selling, the prices are declining, volume may or may not be growing. Why would I spend that cash to invest in capacity and in CapEx or R&D? So that was a deflation was a very big reason. Even if company wanted to be good it's natural to not to accumulate cash. So, I think this time around, what's really changed is the combination of pushing companies to think better, but also the fact that inflation coming back gives companies a different outlook of the financial models. Prices, I can now raise my prices. That makes a big difference in my revenue forecast. That means I have new areas I can invest in that makes more sense than before. I am well aware now that by storing cash on the balance sheet under inflation, my cash is depleting, the value of it is depleting. So, I am urged by shareholders much more than before to either spend that on growth, CapEx, or return it to shareholders if I'm not using it appropriately. There's a much more natural push to deploy capital better. So those are the two, well, the number one change, I think, is inflation.
LDP: You mentioned the consumer as well. Have you observed a shift in consumer behaviour as a result of inflation picking up because again? Because, to your point, if you're in a deflationary environment, you probably hold off on a big purchase maybe because that product or item might become cheaper over time. Have you seen a tangible change in behaviour from consumers?
MZ: I think so far because we are still in that first phase where, for the positive inflation cycle to work, you need of course not just prices of things going up, but wages also rising and hopefully rising faster than the rate of inflation for people to actually believe I can spend more tomorrow. What's happened in Japan up until now is in the past few years, in past two years especially, there has been a much higher level of nominal wage growth, very much pushed by the government urging unions through their annual spring labour wage negotiation process to really push for 5% nominal wage growth. That 5% includes a 3% actual base salary increase, and about a 2% natural, as people get older, general slide upwards in terms of their career, so the real number is actually 3% even if they push for 5%. The problem so far is that the rate of inflation in Japan, with the currency weakening very substantially, the inflation has been a little bit higher than this 3%. That eventually, it's coming down now towards, I think, mid-2s. If inflation can settle finally at 2%, which is the government target, and wage growth can stay at 3%, then you finally get real wage growth and then the consumers can finally react. So, to your question, what's happening so far today is there's the first parts of that wheel beginning to turn. However, the consumption is only strong so far in the wealthiest cohorts. But the rest of the market, we're still seeing consumers trading down or reducing volume of consumption as prices are being raised so far.
LDP: I think when we were speaking, you mentioned there was a retailer clothing brand that you invested in that you've noticed this real ramp up in the consumer?
MZ: Trading down?
LDP: Yes.
MZ: Yes, so the Fidelity Japan Equities Fund does invest in a clothing retailer called Shimamura. This is a kind of boring business traditionally. It's domesticated, well, it's domiciled in Japan. There's not a lot of international growth potential. It does have clothing at a lower pricing point and consumers, as I mentioned, are trading down. So, the basic growth of the business is positive now, even though it's not that exciting. This is a company that's priced at 13 times price to earnings, which is relatively cheaper for retail business in Japan. But half of its market cap is in cash, net cash that it has accumulated over the years. So, it's very cheap and it can take action on that if it wants to. We are in the process of engaging with management to discuss what kind of actions they can take to really better, you know, achieve a much more ideal balance for their balance sheet.
LDP: I think one of the interesting developments that we've observed in the Japanese market is also the Tokyo Stock Exchange, I don't know what you want to call the list, the name and shame list, I guess. But it's about companies that are trading at below the 1% price to book level, which is a valuation indicator. Just elaborate on that, because it's an interesting development, but the psychology of, ‘you don't want to maybe be in that camp’ is also interesting. Can you talk through that?
MZ: This was a directive that somewhat surprisingly came out in March of 2023, where the stock market told basically companies trading below book value to really publish their view on ‘what is your cost of capital? What is the return on your business? Why is your return low? And what are you going to do to rectify that situation and disclose that to investors in public?’ The stock exchange at the beginning of January this year started to disclose a list of companies that actually began to disclose their plans and companies that haven't. It's quite a mechanical way to force companies to take action. It's almost a little bit of a high school approach. But Japanese management ad people are good at following rules. There's also a tendency to look at what your peers are doing and follow. So, when you are told to do something, companies diligently do what they are told, especially if your competitors are also taking action. So far, we've seen a very strong ramp up in companies that have been making these type of disclosures. From here, it really is about choosing the companies that can execute on their analysis and execute on their plan to rectify that situation. A lot of that comes from our ESG team as we engage and discuss with management there after they publish these thoughts and how quickly, how much they are committed to achieving those goals. And those can arrive at investment ideas for the Fund.
LDP: I think generally it's very fair. It feels like there's a real elevation of governance across the board as a result of this. It’s not an overnight thing, but you know, a number of years that that's occurred. If we talk about the Japanese market, we have seen certainly, over last couple of years, the Japanese market return speed be pretty strong. One could argue that we've seen this rally - have we? Is that it? Maybe Japanese equities are overpriced, all of those things can go through people's minds. What are we actually seeing though? What are you seeing on the ground in terms of where valuations are at? And also, where are the potential growth opportunities?
MZ: I think if you take a step back and look at the market as a whole as if it was like a stock, a single stock, usually stocks are driven by one, the earnings trajectory in the long term, it follows earnings and then there's a multiple that you know the market subscribes to that. Japan Inc in total, if we look at this past decade, the earnings per share growth of Japan Inc, that growth rate has been comparable, actually one of the highest growth rates in local currency terms versus all of the developed markets and the emerging markets. So, the EPS growth of Japan Inc has already been one of the highest. The market today, after the rise over the past few years, the multiple now is close to mid-cycle, something like 14 times forward PE, which is no longer very, very cheap if you compare it to somewhere like China. But it's still inexpensive when you compare it to markets like the United States. Of course, they are, industrial structural differences, sector weighting differences that really are good reasons for the market to be priced differently. But the message is that earnings growth has been one of the highest in global markets. PE is mid-cycle. From here then, the story is, can we believe that earnings per share growth of Japan can continue its past trajectory and even be better now that we are in inflation? Companies have more ability to raise prices and a sharper focus to improve their margins, driving EPS, and through improving margins, through better balance sheet management, raising the ROE of their overall businesses, can the market eventually deserve a re-rating further beyond its historical kind of mean level. So those are the two big, longer term drivers that are probably the strongest drivers for the market from there.
LDP: To your point, it feels like we're mid-cycle, so a bit of runway to go?
MZ: Yes.
LDP: If we look at some of the opportunities and maybe a couple of interesting stocks that you're looking at currently, one that comes to mind is Sumitomo Forestry that I know we've spoken about it previously. It may be familiar to some Australians as well, in terms of housing and construction development. Tell us about that company and why you find it such an interesting investment opportunity.
MZ: Sumitomo Forestry, even though there's forestry in the name, the main business really doesn't have anything to do with forests. It does own some forests, but it's primarily a home builder. And 70% of its earnings comes from US, single family home supply or construction. This is a Japanese listed stock, a Japanese builder, but actually it's primarily US new home builder. It's comparable to something like Lennar or NVR, DR Horton in the United States. In the past decade, this company has been very diligently deploying its cashflow generated from Japan and buying more and more US home builders. Today, its market share makes it a top 10 new homebuilder in the United States. It's a big player. This is a stock that is 7-8 times PE. When the Fund bought it, it was cheaper. Today, it's about 8 times PE, 1.4 times book, not too far above book. It yields 4 %+ dividend yield versus the Japan market at 2.5. It's a value stock where, but the business fundamentals, being a US new builder, the fundamentals should accelerate and improve when the US rates eventually come down, which is usually a growthier environment for a value stock. It's business with strong competitive advantage, being one of the top builders, being in a very attractive market in the United States, very strong long-term fundamentals given the under supply of US housing versus population growth, and the fundamentals should accelerate from here while still being eight times PE. So that's probably, of course, the weighting in the Fund will change over time as the stock moves and the upside and downside changes. But it's likely to be a core medium-term holding.
LDP: One final question for me, if you think of the year ahead, 2025, obviously there's been a lot of issues, been a lot of moving parts. We've had big elections around the globe. We've had the inflation starting to moderate, which is positive. What are the key things you're thinking about for 2025?
MZ: Thinking from top-down macro, one obviously important market for Japanese companies is the health of the US economy. I think we are still in that debate of whether US achieves quote unquote softer landing or not, to gauge that the labour market data that's coming out of the United States will be quite critical because employment determines the consumer's willingness and ability to spend eventually. So that's a number, especially unemployment is a number that has been rising. Whether the rise in unemployment can stabilise into 2025, or whether it continues a sharper rise that's a key critical factor to watch out for the United States. One more interesting outside market for Japan that's important is China, and the policy push or support that the government is putting in place for some of its battled industries like real estate, the support for consumers. Whether they can actually change, have an impact on the consumers and on some of the industrial sectors of China, where the impacts can actually be sustained and by how much that's something that will greatly impact some businesses in Japan for us to watch out for. I think if we look at the broader kind of global context. There are some important conflicts that have been occurring across the world that have impacted input costs, energy costs, supply chains. What happens there, how quickly some of those resolve, those will also have impacts on Japanese businesses. That's kind of the broader things to look out for. From a bottom-up Japan perspective, I think we are still very much at the cusp of real positive wage growth. We're still at the early phases of confirming month by month that shift. How that, if that is sustained, really begins to change consumers going into 2025. That's one area to watch out for. On the corporate action side, we are already seeing an increase in shareholder returns through rising dividends or larger buybacks, more buybacks announced by more companies. But the next phase to watch out for is corporate restructuring. That's something that's obviously not done easily or quickly, but that is quite key for Japan, when the Japanese market to structurally improve its earnings power and ROE to justify a re-rating of Japan as an entire market. Finding companies that can execute on some of those business restructurings, that's something to continue to look for in 2025.
LDP: Brilliant. Well, Min, thank you very much for your time and enjoy the rest of your time in Australia and look forward to speaking to you again.
MZ: Thank you very much for having me, Lukasz, and thank you for your time everyone.
