For the quarter ending March 31, 2015, the Matthews Japan Fund rose 17.39% (Investor Class) while its benchmark, the MSCI Japan Index, returned 10.34%.

Matthews Japan Fund: Market Environment

Japan experienced a solid rally during the quarter, supported by the Bank of Japan’s unprecedented monetary easing, and an increase in equity allocations by domestic pension funds. The gain in Japanese equities came despite the yen exchange rate, which remained stable against the U.S. dollar. At least temporarily, this breaks the pattern of a weak yen diluting equity returns for U.S. dollar-based investors that has persisted since the beginning of the “Abe rally.”

Japanese corporate earnings have been robust with aggregate corporate profits reaching historical highs in 2014. Momentum remains positive as earnings estimates continue to be revised up, unlike those in U.S. and European markets. Driven by strong earnings, we have seen a steady stream of companies raising dividends and announcing share buybacks. Combined with the planned introduction of a corporate governance code, we believe corporate managers are feeling pressure to improve capital allocation policies.

Matthews Japan Fund: Performance Contributors and Detractors

Financial Products Group, a new position in the portfolio, surged during the quarter on the back of strong earnings and guidance revisions. The company creates and sells tax planning products to wealthy business owners. Demand has been robust as profitable business owners look to defer more taxes ahead of a scheduled corporate tax cut, while a round of equity raising last year increased the company’s ability to supply more products.

In terms of sectors, the industrials sector was the top contributor. Factory automation and robotics giant FANUC performed well on expectations of better investor communications and shareholder returns. The firm is notorious for refusing to meet with investors. However, citing the upcoming corporate governance code, the CEO decided to set up a shareholders relations department, and has announced greater emphasis on improving shareholder returns. Demand from a U.S. activist fund may have prompted the company to reconsider its stance toward investors.

Meanwhile, auto exporters such as Mazda Motor and Fuji Heavy Industries performed poorly as the wave of yen weakness grinded to a halt. Fundamentals remain relatively solid for these businesses, but we believe further downside for the yen is limited going forward, and hence we have trimmed our position in these names.

Matthews Japan Fund: Notable Portfolio Changes

During the quarter, we increased our exposure to construction and mining equipment company Komatsu. Its business has been under pressure due to low commodity prices but Komatsu is a solidly managed business with a globally recognized brand and financials that we believe can comfortably endure the current adverse conditions. Although we expect the tough business conditions to continue for the time being, we believe valuations are attractive relative to other companies of similar quality and global presence.

As a result of the merger of the Nomura Japan Fund into the Matthews Japan Fund last year, the number of holdings increased beyond its typical range. However, we intend to manage the Fund so that over time, the number of holdings will return to its typical range of approximately 50 to 75 holdings.

Matthews Japan Fund: Outlook

Japan’s overall equity market valuations remain attractive relative to U.S. and European markets despite the re-rating we have seen this past quarter. However, looking closely, there are certain sectors and individual companies in which valuations have become rich. In such an environment, we believe stock selection will become even more important to generate returns. We have started to take a slightly more cautious stance when evaluating new investment opportunities, particularly with regard to valuations. Still, we remain generally optimistic on the outlook for Japanese companies, given the scope of continued wage growth and improving shareholder returns. Initial results from wage negotiations between unions and management have shown acceleration in wage growth compared to last year. Coupled with the rapid decline in fuel prices, we believe there are sufficient grounds for a consumption-driven recovery. With the introduction of the corporate governance code, there is mounting pressure on corporate management to improve capital allocation policies in line with shareholder interests. Such trends should benefit Japan investors over the long term.

The views and opinions in this commentary were current as of March 31, 2015. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the Fund’s future investment intent.

Statements of fact are from sources considered reliable, but neither the Funds nor the Investment Advisor makes any representation or guarantee as to their completeness or accuracy.

As of 03/31/2015, the securities mentioned comprised the Matthews Japan Fund in the following percentages: Financial Products Group Co., Ltd. 1.6%, FANUC Corp. 2.0%, Mazda Motor Corp. 0.1%, Fuji Heavy Industries, Ltd. 0.7% and Komatsu, Ltd. 1.4%. Current and future portfolio holdings are subject to risk.

Via Matthews Asia

Matthews Japan Fund Up 17.39 Percent In 1Q15