Fidelity Japan Equities Fund

Andrew Mellor (AM): Hello, I'm Andrew Mellor. Thank you for joining us. With me today is Min Zeng, the Portfolio Manager of the Fidelity Japan Equities Fund. Hello Min.

Min Zeng (MZ): Good morning.

AM: Let's start please, with a little bit of information about yourself. How long have you been at Fidelity and how did you get into investing in the first place?

MZ: Okay, I've been at Fidelity for 13 years. Majority of that as an analyst. I've been running funds for about 4 or 5 years now. How I got into investing? My first investment was in 2009. I used my textbook money in University. $900. I think that was worth about two textbooks to invest in General Motors when it was close to (US) $1 per share. I thought there's no way the US would let General Motors go bust. I eenie, meenie, minnie, mo-ed between GM and Ford without really thinking too much and GM eventually went bust. So my initial life investment turned to zero. That's when I really realised investing, even if you think it's a good idea looking into the financials, the balance sheets, cash flow, that can be very critical in terms of making or breaking your investment.

AM: A good lesson, perhaps.

MZ: Yes. It was.

AM: And onto the product, Fidelity Japan Equities Fund, tell us a little bit about that product, how it’s structured, what it's designed to provide for investors.

MZ: Okay, so the Japan Equities Fund, it's comprised of about 50 to 80 stocks. The style it's  somewhat balanced, it has a value tilt, but it's somewhat balanced between value and growth. It is designed to provide the best ideas that's coming out of our Japan research team. We have a 12 member team. I visit individual companies together with our analysts. We do deep dive analysis on the earnings, valuations. And I pick the best stocks that I think are coming from our team to invest through Japan's growth and governance reform cycle.

AM: Excellent. And in terms of the investment process, maybe just tell us a bit about portfolio construction and position sizing as well please.

MZ: Sure. So of course the idea generation can come from anywhere. Our local analysts, our global analysts from London to our Asian offices, they're quite interconnected so ideas can come from the broader team as well. We do do that in-depth analysis with our analysts that I mentioned. Japan team covers about 300 stocks in total, actively covering, so there's quite a bit of a pool to choose from. From those 300, I mentioned the fund invests between 50 to 80, tracking error of the fund is generally three to six. Active money is 60 to 80%. I do take into consideration risks, for example, on an individual stock basis. A really good idea from an analyst, what does it provide to the fund? A stock that is going out, what is it detracting from the fund if I take it out? And then I do look at the overall balance of the fund, what type of macro exposures is it effectively exposed to? Is that the type of risk that I would like to take for the fund? That's how generally the portfolio is constructed.

AM: Okay. Let's maybe touch on risk a little bit. I guess Japan, like all markets, can be volatile at times. How do you think about risk and how do you manage risk in the portfolio?

MZ: Yes, I think on that there is that bottom up level and top down. The bottom up is really looking at what effective bet this stock is making. One example is are chemicals analyst. He might have a very strong opinion on the upside of a specific chemical stock. But if you really think of it, it is actually linked to the semiconductor supply chain. So effectively by putting this in I am adding to the semiconductor bit of the fund. Is that something that I want? Those are some of the bottom up considerations. Top down. I mentioned I do look at some macro variable impacts to the fund. So for example what is the fund's performance impact if the US ten year yields rise if the Japanese Yen is strengthening, what are the fund's exposures to that and is that the direction that I would like and is the magnitude something that the fund can withstand? That's the kind of daily process. Of course, quarterly the important process is we have a global fund risk review that looks into the trades of the fund, the positioning, the ESG characteristics, explaining some of the names that might pop up as potential risks. And so I think that the overall risk process is quite comprehensive from the daily level to a quarterly milestone basis.

AM: Yes. Fantastic. Thank you. And you touched on the Fidelity analyst team briefly earlier. Perhaps just talk about the importance of having an on the ground research team. Clearly Japan’s a very broad market, multiple sectors, multiple industries, the importance of that team and of course, the importance of local language analysts on the ground in Tokyo?

MZ: Sure, so Japan can be quite, there's a lot of undiscovered stocks in Japan, maybe not so much at the larger cap, but mid-cap, small-cap. Definitely that's the case in terms of lack of street coverage. That's an area where we tend to find a lot of great ideas. The importance of our analysts and their impact on the fund, I'll give you two examples. One is Hitachi, which has been a great stock over the past five years. The fund has owned it since five years ago. About two years ago I decided to start trimming because the upside became a little bit more limited based on what I thought. Our analyst back then really convinced me to stick with it. He took the time to teach me on the energy business that it’s now greatly exposed to. Well, it made me stop selling. Since then, the stock has done a fantastic job. And so the analyst really influenced whether a name, how much it goes in, how much it goes out. Those are very important inputs for myself.

AM: Yes Fantastic. Thank you very much Min. And thank you all for joining us.

Andrew Mellor (AM): Hello I'm Andrew Mellor. Thank you for joining us. With me today is portfolio manager Min Zeng of the Fidelity Japan Equities Fund and we're going to discuss some of the reasons why investing in Japan is an attractive opportunity right now. Thank you Min for joining us. Japanese equities, very interesting part of the market. We've seen deflation, mostly flat returns for really the last couple of decades until more recently, where Japan has been far more in focus among investors. Can you please tell us some of the structural factors and governance improvements that are leading to Japan being a more attractive investment destination for investors presently?

Min Zeng (MZ): Sure. I think corporate governance improvement is one topic that's a focus right now. One thing to mention is this path of improvement is not something that suddenly started recently. It's been a decade long journey since corporate governance code, stewardship code introductions into Japan, improving board structures, for over the past decade. Today, what's really changed is I think it's impacted by Covid, or instigated by Covid, the return of inflation and what we think, and corporates now think, as a structural inflation into Japan. That is changing the mindsets of companies that used to hoard cash under deflation, which was somewhat logical. To actually finding opportunities to deploy that cash, whether it's into growth opportunities or if not, returning it more to shareholders. That kind of discussion within the market, between investors and corporates, it’s much more active now and companies are much more willing to act at this point in time.

AM: Okay. Very interesting. Thank you. Min, so many investors have been underweight Japan equities for a long period of time. What are some of the areas in the Japanese market that may be appealing and attractive for global investors particularly?

MZ: Sure. I think, especially with the recent change in the dynamics of the economy and a big part of that is inflation, there are some sectors that clearly didn't benefit from deflation in the past and is now changing. One of them could be financials. The trajectory of the Bank of Japan's monetary policy that has been shifting and we expect that to continue. There are also very traditional unattractive sectors like construction where pricing power is returning to the industries and the companies that are operating and the entire supply chain within this sector, because of rising CapEx demand in Japan, declining labour supply, and company’s ability to just charge more for new projects. Of course there are always interesting stocks within the consumer sectors. That's an area where you can really pick winners and losers. There is a question in Japan now where if we are finally reaching a positive cycle of wage growth above the rate of inflation, how does that drive the next phase of consumption? Because until now it's only been the relatively wealthier where the consumption has been strong and then a trade down of the general consumer into lower priced products. So how does that shift? And of course there's always the sectors that are heavily globally competitive and impacted by the global economic cycle. Those can be robotics, semiconductors, automotives. There are always opportunities in those sectors to invest along specific cycles.

AM: And just on that point, do you think this is more of a a short term opportunity in Japan or some of these improvements and reforms are actually more medium and long term?

MZ: Sure. It's definitely medium long term. The meat of the improvement is medium long term. Short term we've seen as the market has re-valued, the market is pricing in the change in the corporate mindset, the corporates willingness to address the balance sheet that has been too strong, returning excess cash to shareholders, etc.. Medium term, what happens from here is companies, corporate Japan, restructuring underperforming businesses. That will drive a level of margin expansion of corporate Japan to drive earnings per share of the market itself. Eventually, as businesses shift into higher ROIC, structurally become higher ROIC, as they shift their business portfolio, the market kind of valuation itself could re-evaluate further. But that is a medium term outcome as companies execute on their plans to restructure.

AM: So in terms of timing, is this a good time for investors to consider a dedicated Japanese equities exposure? We saw some volatility in market sell off in July and August. The market recovered quite strongly from that. Is now a good time to consider it? And also, what sort of environments is your fund likely to outperform or underperform the market?

MZ: It's always a good time to think of investing. Volatility provides opportunity usually. That's what I'll say about exact timing. I think the Japan market in general, and for the fund, a good environment for this fund specifically is, we've been through a period of global industrial slowdown, if we begin to see a re-acceleration of growth, especially the industrial cycle, while inflation remains still intact, that level of inflation is higher than what we've known in the past, especially for Japan, that's an environment, that is better for the Fund.

AM: Okay. And maybe just to close around some stock examples, I think most Australian investors will be most familiar with some of the autos names in Japan, the electronics names in Japan, but maybe a couple of stock examples that you're currently holding in the portfolio as examples for us, please.

MZ: Sure. So the top sector that the fund owns is in construction. I'll introduce two names. One is a very boring general contractor called Obayashi in Japan. This is a company, It’s a sector I mentioned earlier that is benefiting from a really re-pricing in new projects as demand is strong and companies are short on supply. So it's a very typical strong demand/supply situation. We see multiple years of margin expansion driving earnings. These stocks in this sector, and particularly the one that the fund owns, is not priced more expensive than the market. It's in-line or slightly cheaper. It has a very high dividend yield. And so it's a stock that I think will do very well in terms of fundamentals, regardless of macro economic cycles. A second stock is called Sumitomo Forestry. Now it has nothing to do with forestry really. It does own some forests in Japan. Its main business is US new single family home construction which represents about 70% of its earnings. It is within the top ten suppliers of new homes in the US. It's a 7-8 times PE, 4% dividend yield stock, a value stock where the fundamentals of its business really improve if the interest rates in the United States come down, driving the housing cycle and long term we have a positive view on the US housing demand, given the supply shortage versus population growth that's happened over the past decade. So that's another stock that the fund owns.

AM: Okay. Thank you very much for those two excellent examples. And thank you for your time today Min. And thank you all for joining us.