Key points

  • Areas such as IT and communications have been hit hard by the recent market rotation and this dynamic has impacted Fidelity Japan Trust PLC given our focus on small and medium-sized growth stocks. 
  • While the correction in valuations may have already largely played out, the unwinding of policy easing will accentuate the importance of bottom-up stock picking and focusing on companies that can continue to grow earnings over the mid-term.
  • We continue to look for companies that we believe are long-term winners with maintainable growth prospects and differentiated products in growing markets.

In recent weeks, there has been an extreme style rotation in Japanese equities, leading to the outperformance of value and sharp declines for growth stocks. This has occurred as accelerating rate hike expectations have driven up real yields in the US. The stock market has started to price in these developments, which has seen, for example, banks and insurance stocks significantly outperform. Conversely, growth-oriented sectors such as precision instruments, services and electric appliances have been the most significant underperformers. Given the rising momentum for US rate hikes, further volatility seems possible in the near-term.

A challenging period for growth investors

In this environment, our holdings in mid and small-cap growth stocks in the information & communication sector have been among the most significant detractors from performance. In particular, online platforms and Software as a Service-related names have corrected sharply. At the same time, companies tied to secular growth trends such as factory automation and electric vehicles that did well last year have been subject to profit taking. Given the market trends described above, the underweight exposure to traditional value sectors such as banks and automobiles has also worked against performance.

Another factor of the recent market phase that has generated headwinds for fund performance is the narrowness of price movements. This has produced strong intra-sector divergences and as a result natural hedges haven’t worked. For example, shares in Toyota Motor (an underweight position in the fund) have rallied sharply, but group company Toyota Tsusho (an overweight holding in the fund) has lagged. Given the extreme nature of these movements, we expect them to correct at some point.

Looking at the trust’s positioning, I have been taking some profits in stocks that have performed well and those that have been relatively insulated from the recent correction, and gradually adding on weakness where valuations are looking more attractive on a mid-term view. As a result, there has not been a significant change in terms of key holdings.

Moreover, the price-to-earnings ratio (PER) of the portfolio has come down quite considerably to a level that is in line with the market average, though the estimated earnings growth is far higher. The portfolio PER for 2022 still shows a premium versus the index as some of the Covid-19 reopening plays have yet to fully recover. The 2023 multiple is now in line and with a significantly higher rate of earnings growth and returns.

Focusing on long-term winners

I believe that the sharp correction in growth stocks and sectors is unlikely to go much further given the scale of the moves so far, though buying of value names that have yet to fully participate may continue. While the correction in valuations has largely played out for now (the convergence or crossover of value and growth valuations generally indicates that we are close to a bottom), the unwinding of global monetary easing will accentuate the importance of bottom-up stock picking and a keen focus on companies that can continue to grow earnings over the mid-term.

With this in mind, I am focusing on companies that I believe are long-term winners with maintainable growth prospects and differentiated products in growing markets. In particular, I like companies that are efficiency enablers in both the manufacturing (factory automation) and software (digitalisation) sectors.  Over the longer term, I am looking at companies that can contribute to - and support - Japan’s energy transition and the requirements for energy efficiency such as green energy, factory automation and EV components.

As always, we continue to evaluate new and under-covered opportunities, while focusing on companies that can continue to grow through 2022/23 and exceed market expectations over the mid-term.

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