THE MARKET ENVIRONMENT
Major global markets moved higher in the first quarter, despite contending with a barrage of geopolitical pressures. Following the second rejection of her Brexit deal, Prime Minister Theresa May secured a two-week extension on the U.K.’s departure from the European Union (EU) with the exit date now set at April 12. The EU also offered a later exit date of May 22 should the prime minister ultimately receive approval from British Parliament on her version of Brexit before the end of March. In the meantime, members of parliament brought eight alternative plans to the floor, none of which achieved a majority. A subsequent third vote on May’s deal late in March also failed to pass, leaving Brexit very much in limbo.
Meanwhile, trade disputes proved challenging for the Chinese economy as February exports dropped over 20% from the year-ago period. The country’s industrial output growth also experienced its slowest pace of expansion in more than 15 years. In the U.S., even though manufacturing sector job growth at the end of 2018 was the highest it had been in the last 30 years, factory production during the first quarter reached the lowest level since 2017. Contrary to market analysts’ forecasts of gains, manufacturing output fell in January and February due to pressures of trade disputes and slower global growth. Monthly building permits also fell in excess of market projections. In Europe, the IHS Markit’s Purchasing Managers’ Index’s (PMI) March reading decreased to 51.3 from 51.9 the month prior, while the Flash Eurozone Manufacturing PMI sank to a near six-year low.
The European Central Bank announced increased stimulus, a decreased economic growth forecast for 2019 and a hiatus on interest rate increases until 2020. The Federal Reserve left key interest rates in the U.S. unchanged and noted it does not foresee raising rates in 2019, stating intent to employ patience and consider market concerns before taking action. Despite this, the reigniting of trade negotiations between the U.S. and China in the final days of March provided a late boost for global markets.
That being said, we use these periods of uncertainty in the market as opportunities to invest in temporarily undervalued companies by looking beyond readily available statistics to uncover hidden value. Our differentiated perspective comes from our unusually long time horizon, an unwavering focus on identifying quality businesses and a deep level of engagement with management teams.
In January, Olympus unveiled a corporate transformation plan with the goals to become a truly global medical technology company and greatly improve efficiency. To achieve these goals, the following changes will occur: 1) Hiroyuki Sasa will be replaced as president by the current CFO Yasuo Takeuchi, 2) three ValueAct directors will be appointed to the board, 3) operating expenditures will be frozen in an effort to improve margins, 4) the therapeutic business headquarters will be moved from Japan to the U.S. to help source better talent, be closer to customers and be closer on the ground to competitors, and 5) the company will organize staff with clear lines of accountability and a move to a merit-based compensation scheme. Later, Olympus announced the appointment of two new board members (one internal and one external), both of whom we find to be sensible choices who will hopefully lead to stronger governance and accountability at the company. We met with management in February and perceived soon-to-be President Yasuo Takeuchi’s openness to recommendations from ValueAct positively. Overall, we believe he is the right person to lead Olympus through this period of transition. While we are still evaluating the changes, we believe that this plan should lead to the probability of higher profitability at the company.
OTSUKA CORP delivered strong fourth-quarter earnings results in February. After weak first-half results, the company changed the structure of its sales staff by promoting younger employees who they believed could be more creative and offer customers a more robust suite of solutions. The fourth quarter showed the quantitative impact of the changes as sales increased 11% and operating profit margins improved to 7.2%. In addition, OTSUKA increased its dividend payout ratio from 42% to 48%. Overall, we continue to be extremely impressed with the company along with President Yuki Otsuka’s relentless work ethic and no-nonsense management style.
OMRON’s share price soared on news during the quarter that it would join the Nikkei 225 Index, which prompted passive investors to purchase the stock in an effort to more closely match the benchmark. We like that the company is the global leader in the field of automation with operations in more than 35 countries at a time when automation needs are growing, notably in China. We also appreciate OMRON’s focus on increasing shareholder value by cutting costs and, unlike many other Japanese corporations, utilizing a strong balance sheet for regularly repurchasing stock. The company is also aiming to better allocate capital by setting return-on-capital-employed targets. Moreover, we appreciate that its board of directors counters the norm in Japan with the inclusion of members from outside the company. In our view, this contributes to a good corporate governance structure and adds to our belief that OMRON offers a compelling investment opportunity.
We initiated a position in Sundrug during the first quarter. Shortly thereafter, the company’s fiscal third-quarter earnings results and lowered full-year guidance proved disappointing to investors. However, in our view, an aging Japanese population, a shift away from buying cosmetics at higher end stores, and a shift away from buying food and daily necessities at traditional supermarkets and general merchandise stores are driving growth for the drug store industry as a whole. Moreover, Sundrug’s size as one of the largest drug store operators in Japan positions it well to benefit from the consolidation of the drug store industry as larger players continue to take share from smaller operators who lack the scale and capital to compete. We also appreciate that the company produces strong returns on capital and equity with healthy free cash flow generation and conversion. Importantly, Sundrug is among the most profitable and efficient drug store chains in Japan with low cost operations thanks to its scale, an in-house distribution system, a strong technology infrastructure and high staff efficiency. We also appreciate management’s focus on and incentivized compensation tied to profitability along with the company’s positive reputation amongst its peers given President Saitsu-san’s operating discipline and cost-focused operations.
Despite no fundamental changes, NGK SPARK PLUG finished lower in the first quarter. The company’s nine-month results released in January tracked in line with our full year estimates thanks to a recovery in the third quarter from a weak second quarter. Third-quarter spark plug sales increased 1% year-over-year and 3% sequentially, while third-quarter sensor sales were up 4% year-over-year and 7% sequentially. Although original equipment manufacturer sales in China continue to be weak, this is being partly offset by market share gains in the country, which is consistent with our investment thesis. In March, a joint venture consisting of NGK SPARK PLUG, NGK Insulators, Noritake and TOTO was established for the development of solid oxide fuel cells. We like that NGK SPARK PLUG is the dominant supplier of spark plugs across the globe and among the top suppliers of emission sensors as spark plugs are an integral and critical part of gasoline-powered internal combustion engines. Despite a challenging operating environment, we think the company presents an attractive investment opportunity with a long runway for growth ahead.
Sumitomo Mitsui Trust released its nine-month results in January, which proved disappointing to investors. We met with management during the quarter and were pleased to see them take action to de-risk the business given heightened volatility in recent months. In the real estate business, we find that Sumitomo is well positioned should there be a downturn in the real estate market as the average mortgage customer at the company has two times the average income in Japan. Furthermore, the merger of Sumitomo’s two asset management entities should improve product development capability and achieve more scale, in our view. Overall, we find that management has the right strategy in a difficult operating environment.
During the quarter, we initiated a position in Sundrug and eliminated Nissan Motor from the portfolio.
Past performance is no guarantee of future results.