SOURCE: Japan Equity Fund

Japan Equity Fund

September 06, 2011 18:48 ET

The Japan Equity Fund Announces Third Quarter Earnings

JERSEY CITY, NJ--(Marketwire - Sep 6, 2011) - The Japan Equity Fund, Inc. (NYSE: JEQ), a closed-end management investment company, today announced its performance results for the three months ended July 31, 2011, the third quarter of its 2011 fiscal year.

For the quarter ended July 31, 2011, the Fund incurred a net investment loss of approximately U.S. $167,000 (equivalent to a loss of U.S. $0.01 per share) resulting in net investment income for the nine-month period of approximately U.S. $140,000 (equivalent to income of U.S. $0.01 per share). In addition, net realized and unrealized gains from investment activities and foreign currency transactions during that same three-month period was approximately U.S. $4,062,000 (equivalent to a gain of U.S. $0.28 per share). As a result, the net realized and unrealized gain increased to approximately U.S. $7,860,000 (equivalent to a gain of U.S. $0.54 per share) for the nine months ended July 31, 2011.

In comparison, for the quarter ended July 31, 2010, the Fund incurred a net investment loss of approximately U.S. $184,000 (equivalent to a loss of U.S. $0.01 per share) resulting in net investment income for the nine-month period of approximately U.S. $1,000 (equivalent to income of less than U.S. $0.01 per share). In addition, net realized and unrealized losses from investment activities and foreign currency transactions during that same three-month period were approximately U.S. $6,805,000 (equivalent to a loss of U.S. $0.47 per share). As a result, the net realized and unrealized gains were approximately U.S. $367,000 (equivalent to a gain of U.S. $0.03 per share) for the nine months ended July 31, 2010.

On July 31, 2011, the total net assets of the Fund were approximately U.S. $98.2 million. The net asset value ("NAV") per share on that date was U.S. $6.79, based on 14,456,819 shares outstanding. In comparison, total net assets on July 31, 2010 were approximately U.S. $86.8 million, equivalent to a NAV of U.S. $6.01 per share, based on 14,446,336 shares outstanding. Assuming the reinvestment of the U.S. $0.055 per share dividend paid on December 30, 2010, the Fund generated an investment return of 8.75% for the nine months ended July 31, 2011, when measured against the NAV per share of U.S. $6.30 on October 31, 2010, based on 14,446,336 shares outstanding at that time. During the same period, the Fund's benchmark, the Tokyo Stock Price Index (the "TOPIX Index"), increased by 7.97% in U.S. dollar ("USD") terms.

As of July 31, 2011, the Fund had 99.57% of its net assets invested in Japanese common stocks. The remaining net assets were represented by a short-term USD-denominated time deposit (0.13%) and other assets less liabilities (0.30%).

As of September 6, 2011, the Fund's NAV per share was U.S. $5.82, based on net assets of U.S. $84.2 million. On the same date, the market price of the Fund's shares on the New York Stock Exchange closed at U.S. $5.37, representing a trading discount to net asset value per share of 7.73%.

Market Review and Outlook

The Tokyo market stayed within a boxed range, trading within a fairly narrow band during the three month period ended July 31, 2011. The outlook on corporate earnings in Japan has been positive, as manufacturers accelerated their recoveries from disrupted supply chains following the earthquake and tsunami disasters in March 2011. Paralysis stemming from Euro-zone debt problems, however, had a negative impact on the global economy. The Tokyo market, along with those markets in its peer countries, continued to swing between optimism and pessimism. Ironically, what remained stable was the Japanese yen ("JPY"). The JPY continued to increase in value against nearly every other global currency besides the Swiss franc. The JPY once again seems to be a "safe haven" amid uncertain financial market conditions. Although we believe the extent is often exaggerated, a strong JPY has a negative impact on Japanese producers, which contributed to the anemic performance of the Japanese stock market. The Tokyo market is now surrounded by a lot of uncertainty. While sovereign debt woes in the United States and Europe top the headlines, we believe the bigger concern whether or not the global economic recovery will grind to a halt. We are not likely to find any decisive answers to this question in the short term, and we believe that the market should therefore take its time trying to recover from investors' lost confidence. Even if the global economy were to peak, Japanese equities would have limited downside risk and overly cheap valuations: the average relative price is around 12 times next year's earnings estimates, while the dividend yield is about 2.4%. Furthermore, stocks are trading at an average price-to-book value of approximately 0.9 times.

Below we discuss key factors that will determine the direction of the Japanese market:

  • Downgrade of U.S. Treasury bonds and Japan
    S&P downgraded the credit rating of U.S. Treasury bonds from the top-notch AAA to AA+ on August 5, 2011, and behind China, the Japanese government is the second-largest holder of these securities. The credit rating downgrade is not likely to affect the investment strategy of trade-surplus countries, given that these countries' large surpluses can only be absorbed by purchasing U.S. Treasury bonds. Hence, we do not expect the credit rating downgrade to have dire consequences for the health of the global economy; however, most market participants are nervous about the outlook for the global economic cycle, and even minor negative news may affect the fragile market sentiment. As for the corporate side, very few companies hold large amounts of U.S. Treasury bonds, so they are not likely to be impacted much by the credit rating downgrade.

  • Quickly recovering domestic economy
    Japan's private sector has had a surprisingly quick recovery since the disruptions caused by the earthquake and tsunami in March 2011. Industrial production rose for a third-consecutive month in June, and corporate forecasts suggest that production is likely to recover to near pre-earthquake levels in August. Automobile producers now expect production volume to return to normal by September, one month earlier than previously estimated. Sentiment has also improved, as the Economy Watchers Survey, which is published by the Director-General for Economic Assessment and policy Analysis, Cabinet Office in Japan and asks business cycle-sensitive workers for their thoughts on economic conditions, showed that both the current conditions index and the expectations index returned to pre-earthquake levels in June. We also believe that the acceleration of reconstruction activity expected later this year and into next will further support Japan's economic recovery.

  • Corporate earnings recovery
    Earnings announcements for the first quarter (April-June) of fiscal 2011 have begun. As of August 1, 2011, 1,153 companies (34% of listed names on the Tokyo Stock Exchange's 1st Section) had announced earnings for the first quarter of fiscal 2011. Excluding financials and utilities, sales and recurring profits declined by 2% and 18%, respectively, from a year earlier. The ratio of interim achievement of company guidance for recurring profits in the first six-months of fiscal 2011 stood at 52%. Profit forecasts will likely be revised upward as corporate profits were most heavily impacted in the first fiscal quarter of 2011 by supply chain disruptions and weak economic activity in the aftermath of the earthquake and tsunami. Weak global economic activity and the JPY's appreciation remain key risk factors.

  • Yen exchange rate and Bank of Japan ("BoJ") policy
    The Ministry of Finance ("MoF") intervened in the foreign exchange markets on August 4, 2011 for the first time since its multilateral intervention in mid-March of this year. The value of the JPY almost reached its all-time low of 76.25 JPY per USD before the MoF through BoJ, engaged in constant selling of JPY versus the dollar pushing the U.S. currency to above 80 JPY. Unlike the March intervention, however, this operation was unilateral and, hence, its effectiveness is a bit questionable. At the very least, the intervention succeeded in prompting the BoJ to take more aggressive action in fighting the difficult the situations facing Japan. As such, the BoJ announced an increase to its asset purchase program from 10 to 15 trillion JPY immediately after the MoF's ForEx intervention.

  • Supplementary budget and reconstruction activities
    The Japanese government announced a basic plan for reconstruction, which requires a total budget of approximately 23 trillion JPY spent over a ten-year period, with the bulk of that amount (roughly 19 trillion JPY) concentrated in the first five years of the plan. The first and second supplementary budgets already total 6 trillion JPY, so the remaining 13 trillion JPY would have to be included in a third supplementary budget as well as in the initial budget for FY2012. The problem lies in finding a way to finance this budget. The ruling Democratic Party of Japan government plans to fund the budget partly by shifting some government spending and selling government assets, but it also plans to issue around 10 trillion JPY in reconstruction bonds. There is talk of a "reconstruction tax" hike as a means of funding the redemption of these bonds, including a temporary increase to core taxes (income tax, corporate tax and consumption tax). We believe it would be a major policy mistake to raise taxes too quickly, however, even if it is for reconstruction purposes, as its adverse impact on the Japanese economy would be enormous. Importantly, the Japanese government's fiscal policy is inevitably moving towards expansion, which is in sharp contrast to governments in the U.S. and Europe, which are heading into fiscal tightening mode.

  • "Hollowing out" of Japanese industry -- shifting domestic operations overseas -- a positive for corporate profits
    There is a growing concern that the hollowing out of Japanese businesses and manufacturers in particular will accelerate going forward. It has been argued that Japanese companies face five distinct difficulties, including appreciation of the JPY, a high corporate tax rate, delays in the implementation of economic partnerships such as the free trade agreement or Trans-Pacific Partnership, burdensome labor regulations, and CO2 gas reduction measures. The earthquake and tsunami disruptions introduced a sixth difficulty, notably an "unsecure electricity supply". Looking at investment activity among Japanese businesses, the ratio of capital investments outside the country to total investments has remained stable at between 10% and 15%, which is much smaller than the 30% figure for U.S. businesses. Increasing overseas instead of domestic investments means a reduction in capital investments in Japan as well as a decline in demand for domestic labor. On the surface, it seems that Japan's gross domestic product ("GDP") growth rate will have to be lowered in light of this shift; however, we believe that the hollowing out of Japanese industry will prove to have a positive impact on corporate profits. "Hollowing out" is essentially the flip side of the globalization of corporate Japan and, assuming that overseas returns on investment ("ROI") are higher than those in Japan and that "rational" companies will expand their overseas investments because of this higher ROI, the shift will likely to higher profitability among Japanese companies as well as a higher investment income surplus for Japan in the aggregate. Of course, it is the responsibility of the Japanese government to eliminate the aforementioned six difficulties while simultaneously promoting domestic employment. However, with the awakening, at long last, of Japanese corporations, which now seek to utilize their competitiveness in the overseas markets, the divergence between GDP growth and corporate profit growth will become wider. The expansion to overseas markets, even within traditionally domestic industries such as consumer staples and retail, can lead to higher returns on equity for Japanese companies.

Given the current uncertainty in the market, we are increasing our holdings of retail stocks, as they have continued to report robust sales figures even after the March earthquake. The retail sector is also one of the few beneficiaries of a strong JPY. We will maintain our overweight of financials as well, as we believe companies in the sector are trading in oversold territory and have limited downside. Whether we change the current cyclical-heavy portfolio will depend on our assessment of the global economy, which for now remains positive. With regard to stock selection, we are seeking what we believe to be "recession-proof" companies, for example companies dealing in medical devices and services such as Hamamatsu Photonics, which we expect to grow with the expanding global demand for such products and services regardless of economic ups and downs.

The ten largest industry classifications of the Fund's Japanese equity investments held as of July 31, 2011 were:

Percentage of
Net Assets
1. Electric Appliances 12.88%
2. Transportation Equipment 12.45
3. Banks 9.63
4. Machinery 6.73
5. Wholesale Trade 6.53
6. Chemicals 5.52
7. Retail Trade 4.79
8. Land Transportation 4.30
9. Nonferrous Metals 3.83
10. Insurance 3.78

The Fund's ten largest individual common stock holdings at the same date were:

Percentage of
Net Assets
1. Mitsubishi UFJ Financial Group, Inc. 4.88%
2. Honda Motor Co., Ltd. 3.87
3. Toyota Motor Corp. 3.75
4. Mitsubishi Corp. 3.48
5. JX Holdings, Inc. 2.70
6. Tokio Marine Holdings, Inc. 2.58
7. Mitsui Fudosan Co., Ltd. 2.18
8. Mitsubishi Electric Corp. 2.14
9. Seven & I Holdings Co., Ltd. 1.97
10. Orix Corp. 1.94

Net Investment
Income (Loss)
Net Realized and
Unrealized Gains (Losses) on
Investments and
Currency Transactions
Net Increase (Decrease) in
Net Assets
Resulting From
Total Per Total Per Total Per
QUARTER ENDED (000) Share (000) Share (000) Share
January 31, 2011 $ (232 ) $ (0.02 ) $ 9,226 $ 0.64 $ 8,994 $ 0.62
April 30, 2011 539 0.04 (5,428 ) (0.38 ) (4,889 ) (0.34 )
July 31, 2011 (167 ) (0.01 ) 4,062 0.28 3,895 0.27
For the Nine Months Ended July 31, 2011 $ 140 $ 0.01 $ 7,860 $ 0.54 $ 8,000 $ 0.55
January 31, 2010 $ (212 ) $ (0.01 ) $ 2,190 $ 0.15 $ 1,978 $ 0.14
April 30, 2010 397 0.02 4,982 0.35 5,379 0.37
July 31, 2010 (184 ) (0.01 ) (6,805 ) (0.47 ) (6,989 ) (0.48 )
October 31, 2010 435 0.03 3,707 0.26 4,142 0.29
For the Year Ended October 31, 2010 $ 436 $ 0.03 $ 4,074 $ 0.29 $ 4,510 $ 0.32
Net Asset Market Share
QUARTER ENDED Value Price* Volume*
High Low High Low (000)
January 31, 2011 $ 7.06 $ 6.23 $ 6.35 $ 5.40 1,710
April 30, 2011 7.26 5.79 6.66 5.35 1,899
July 31, 2011 6.96 6.26 6.38 5.75 712
January 31, 2010 $ 6.54 $ 5.73 $ 5.69 $ 4.74 1,548
April 30, 2010 6.64 5.96 6.02 5.11 1,374
July 31, 2010 6.49 5.76 5.93 4.82 1,067
October 31, 2010 6.47 5.82 5.64 5.10 1,396

*As reported on the New York Stock Exchange.

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