Fidelity Japan Trust PLC

Update from Portfolio Manager

Dear Shareholders,

As we start the new year, and in light of recent market volatility, I wanted to take the opportunity to share my perspectives on the market; the portfolio's current positioning and my outlook going forwards.  

In terms of market performance, there has been an extreme style rotation in recent weeks leading to the outperformance of value and sharp declines for growth stocks (most evident in the buying of low Price to Book (PB) names and selling of high PB stocks). This has occurred as accelerating rate hike expectations have driven up real interest rate in the US. The stock market has started to price in these developments, which has seen, for example, banks and insurance stocks outperform by more than 10% year to date (YTD). 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.

In this environment, holdings in mid/small cap growth stocks in the information & communication sector have been among the most significant detractors from performance. In particular, online platformers and Software as a Service (SaaS) related names have corrected sharply since the previous quarter. At the same time, companies tied to secular growth trends such as factory automation (FA) and electric vehicles that did well last year have been subject to profit taking YTD. 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) are up by more than 10% versus TOPIX YTD, but group company Toyota Tsusho (an overweight holding in the fund) is down by almost 10% relative. 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 reopening plays have yet to fully recover, though the 2023 multiple is now in line and with a significantly higher rate of earnings growth and returns.

The sharp correction in high valuation and high-growth stocks that has been driving the value rally 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 midterm.

With this in mind, I am focusing on companies that are long-term winners with sustainable 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 (green energy, factory automation and EV components etc.). 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 midterm.

Take care and all the best,

Nicholas Price

Portfolio Manager - Fidelity Japan Trust PLC

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