Brandes Investment Partners Japan Equity Strategy Notes Second Quarter 2021 (1 April– 30 June 2021)

The Brandes Japan Equity Strategy declined 4.29% (gross of fees), underperforming its benchmark, the MSCI Japan Index, which fell 0.28% in the second quarter.

Positive Contributors Several holdings in auto-related industries helped returns, most notably Tachi-S and Honda Motor. Additionally, Astellas Pharma and printing press manufacturer Komori performed well.

Performance Detractors A few of our health care holdings hurt performance, including Taisho Pharmaceutical, Takeda Pharmaceutical and H.U. Group.

Beyond the health care holdings, media firms TV Asahi and Fuji Media also weighed on returns, as did banks Kyushu Financial and Sumitomo Mitsui Trust, as well as automaker Nissan Motor.

Select Activity in the Quarter The second quarter saw increased activity compared to the first quarter. We divested two holdings (Screen Holdings and Tenma Corp) and initiated three positions (Meiji Holdings, Kaken Pharmaceutical and Shikoku Chemical). Additionally, we took advantage of some volatility within the Japanese equity market to reduce positions that had positive price movements, while adding to others that offered what we considered attractive purchase prices.

Full Sells Screen Holdings is a leading global provider of single wafer cleaning systems to semiconductor manufacturers. We initiated our position in the company in the first quarter of 2020. At the time, Screen had been facing intensifying competition, but we believed it was well equipped to maintain its market leadership and benefit from the industry’s expected annual growth over the next few years. In addition, the company should, in our opinion, be able to improve its operating efficiency through cost restructuring and other efforts. Trading at what we considered an appealing multiple to normalised earnings, Screen Holdings represented a well-positioned semiconductor equipment manufacturer with positive long-term growth potential. Given the cyclical nature of the semiconductor industry and capital expenditure budgets, we initiated a small position and gradually increased it as the margin of safety improved.

Screen’s earnings, along with its share price, strengthened during our holding period as the company’s end market (the semiconductor production equipment industry) saw a significant increase in capital spending. The analyst and the investment committee revisited the valuation in early January of 2021 to discuss how sustainable the trends were and how much credit should be reflected in the long-term cash-flow projections. We concluded that a sizeable increase in the intrinsic value estimate was warranted based on the positive cyclical trend and the company’s continued commitment to cost reductions and operating margin improvement. Accordingly, we kept the holding in the portfolio, with some pares in the interim until late May when we ultimately decided that the share price was trading significantly higher than what we believed it was worth (large negative margin of safety) and the risk/return profile was no longer attractive. Given there were other opportunities that, in our opinion, offer better margins of safety, we sold the position.

Unlike Screen, which was a relatively short-term holding compared to the portfolio’s average holding period of three to five years, we held the position in Tenma for over 10 years. Our allocation to the company did fluctuate during the holding period based on changes in intrinsic value estimates and other factors such as portfolio diversification and liquidity.

Tenma is a good example of an “old school,” deep value stock as it traded below net cash and represented what Benjamin Graham called a “net-net” (i.e., a company that trades below its current assets less all liabilities). There were three main components that attracted us to Tenma: 1) It has a solid balance sheet and the stock traded at a steep discount to net cash at times, 2) It has sustainable businesses in industrial molding products and household products, 3) The company’s earnings have been cyclical, with over 75% of earnings generated outside Japan.

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During our holding period, Tenma’s earnings were volatile, but dividends grew, excess cash was deployed to buy back shares, reducing shares outstanding by nearly 25% over the past 15 years, and management changed. Most recently, the company has been involved in a management/proxy battle between the large family owner and the new management and minority owners (including two activist funds).

Tenma’s shares performed well over the past year as the business has started to show signs of stability and new management is committed to reducing excess cash further over the next five years through dividends and share buybacks. Additionally, the company has revamped its board members composition to include a representative from one of the large activist shareholders. Following a review of this development, the investment committee re-priced the intrinsic value, reflecting some credit for the potential upside from recent changes. However, with the shares continuing to appreciate, we decided to reallocate the capital from Tenma to new investments (see below).

New Positions Using the proceeds from our two divestments as well as existing cash, we were excited to add three new positions to the portfolio.

Meiji Holdings is one of Japan’s most well-known packaged food brands with a corporate history dating back to 1916. The company generates the majority of its earnings from its food operations, primarily dairy products and confectionary products (primarily chocolate). Meiji also has a pharmaceutical business that contributes to approximately 20% of total sales, with vaccines representing the largest therapeutic category.

Similar to the investment case with Screen Holdings, we believe the market underappreciates Meiji’s strong position in its core food operation business, its stable and growing cash-flow generating abilities, its solid balance sheet, and the potential for margin improvement. In our opinion, Meiji represents an opportunity to invest in a strong franchise with upside optionality through margin improvement in the core business, as well as research and development (R&D) productivity in the pharmaceutical business.

Kaken Pharmaceutical is another business that we believe is solid and trades at an attractive valuation. Kaken is a small-cap Japanese specialty pharmaceutical company that develops and commercialises both branded drugs and generics in the fields of orthopedics, dermatology and surgery. The company has generated robust free cash flows and high returns on equity (ROEs) thanks to the success of its core product Clenafin, which is used in toe fungus treatment. The company has also been proactive in returning cash to shareholders through dividends and share buybacks, reducing shares outstanding by 15% over the past decade. Our view is that the current market valuation is not giving much credit to the long-term R&D pipeline optionality and the potential for margin improvement and cash- flow generation over the next five years with the currently marketed products. Key risks include its significant exposure to the price-controlled Japanese market, the patent expiration of Clenafin in 2025, and recent earnings decline due to the pandemic. Nevertheless, we believe Kaken offers a compelling risk/reward tradeoff at its current valuation level.

Apart from Meiji and Kaken, we also initiated a position, albeit small, in Shikoku Chemical, a manufacturer of specialty chemical and housing materials. With its strong market share in niche fields, Shikoku has been able to produce healthy margins and ROEs historically. While the business was adversely impacted by the global pandemic over the past year, we do not believe that there has been any permanent impairment. Some of the drivers for the potential undervaluation may stem from lack of English disclosure and analyst coverage, as well as low trading liquidity. Given its leadership in niche markets, we believe Shikoku Chemical provides an interesting investment opportunity at its current valuations.

Current Thoughts While we manage the portfolio for the long term and are focused on building a quality portfolio with undervalued companies that we believe will lead to strong returns over time, it is disappointing to see the names we referred in the “high-conviction” bucket in last quarter’s portfolio note contribute significantly to this quarter’s underperformance. This is not unusual—for this strategy and other products that we manage—as companies we like the most sometimes underperform for a period until the investment story potentially starts playing out. Unfortunately, the underperformance of these names in the Brandes Japan Equity Strategy has had a significant impact on the portfolio over the past year. We continue to monitor and discuss these names during the weekly investment committee meetings and remain positive about their prospects.

Last quarter, we discussed our overweight positions in banks and large positions in auto companies Nissan and Honda, media firms Fuji Media and TV Asahi, as well as Takeda Pharmaceutical. This time, we would like to take the opportunity to explain our large allocation to the health care sector. This positioning is not unique to the Brandes

Japan Equity Strategy, as some of our other products also have meaningful exposure to the sector today and have had it historically as well.

The Brandes Japan Equity Strategy has a fairly diversified basket of health care holdings, including a medical device manufacturer and distributor (Fukuda Denshi), a diagnostic lab company (H.U. Group), consumer health care businesses (Taisho and a portion of Nichiban’s business), a drug distributor (Vital KSK), and branded pharmaceutical companies (Takeda, Astellas, Kissei, Kaken).

We believe select health care companies tend to have attributes that long-term value investors favour, such as durable franchises, stable margins, strong free-cash-flow generation and healthy balance sheets. We feel some of these attributes, at times, may not receive the proper market valuation due to near-term issues such as poor R&D pipelines, regulatory uncertainty, and potential misunderstanding of the underlying business fundamentals due to the lack of analyst coverage.

Based on our long-term perspective and our search for undervalued optionality, we believe select health care companies provide numerous value-based investment opportunities, not only in Japan but globally. Pharmaceutical drug development can take more than 10 years, while medical device development also takes a few years. If an investor only has a 6- to 12-month time horizon, those companies in the early stages of product development may go unnoticed, thus providing an opportunity for long-term investors like Brandes, in our opinion.

Pharmaceutical companies are a great example of potential value investing opportunity due to the long-term nature of R&D and the way R&D is accounted in financial statements (expensed, not capitalised). New drug development, in general, takes about 10 years from the start of development to commercialisation, if not longer. This means that for new R&D projects invested today, the fruits may not be sown until 10 years later, while the cost of R&D is expensed immediately, and the value of that R&D is not reflected anywhere in the financial statements. While the value of each company’s R&D projects varies, our view is that they’re usually worth something. If one can find companies with market valuations that reflect very little of their R&D potential, this may result in investment opportunities with significant long-term optionality. While “waiting” for the R&D to bear fruit, shareholders may receive the benefit of dividends, potential of share buybacks, and steady cash-flow generation (reinvestment into the business).

The health care sector is also more prone to uncertainty due to regulatory and government policy changes. These changes are notoriously difficult to predict, but we believe we can appropriately incorporate the risks when estimating a company’s intrinsic value (i.e., by assigning lower margins, multiple, etc.). In our opinion, our long-term investment horizon may enable us to take advantage of short-term fear of uncertainty in the sector.

Lastly, we believe one of the strengths of the Brandes investment team is our global sector coverage, which plays a significant role in our valuations of health care companies. Unlike analysts that focus only on a specific/local market, our analysts can apply their global perspective and their knowledge of regulated and non-regulated health care markets in various countries, including emerging markets, which may help them find overlooked “gems.” As an example, when valuing a diagnostic lab company in Japan, the analyst can leverage the knowledge of operating margins of companies in the U.S., Europe and emerging markets, and analyse the drivers of the difference and apply that knowledge for the Japanese companies. For pharmaceuticals, comparing pipeline products and competing products in the same therapeutic field globally may allow one to have more knowledge of the potential of currently marketed and future products at times.

Conclusion While this quarter’s performance was again disappointing, we are not discouraged as we continue to have strong conviction in our process and in the value investment philosophy. We remain dedicated to construct and manage the portfolio for the best interest of our clients. Until the past few years, the Brandes Japan Equity Strategy had enjoyed a very long period of success while other value markets struggled mightily, so we understand and have been prepared for the potential of periods of underperformance. Our view is that we must remain disciplined, humble, and open to change, while continuing to remain faithful to what has gotten us this far: the commitment to our clients by remaining honest, reflective and optimistic about the long-term potential of our portfolios. As such, we would like to reiterate that we remain excited about the prospects of the Brandes Japan Equity Strategy. We hope that the investments will soon meet or exceed the expectations and trust placed by our clients.

We are always open for any dialogue regarding the portfolio, our process and philosophy, as well as the firm, so please do reach out anytime. Critical comments and observations are always welcome as well.

Lastly, we sincerely appreciate the relationship over the years, and hope we can maintain and reward the trust given to us. It is truly a privilege to manage the portfolio on your behalf.

Cash Flow: The amount of cash generated minus the amount of cash used by a company in a given period. Free Cash Flow: Total cash flow from operations less capital expenditures. Margin of Safety: The discount of a security’s market price to what the firm believes is the intrinsic value of that security. Net Cash: Total cash minus total debt. Normalised Earnings: Earnings adjusted based on economic cycles. Operating Margin: Operating income divided by net sales; used to measure a company’s operating efficiency. Return on Equity: Net income divided by shareholder’s equity. The MSCI Japan Index with net dividends is designed to measure the performance of large and mid cap segments of the Japan market. MSCI has not approved, reviewed or produced this report, makes no express or implied warranties or representations and is not liable whatsoever for any data in the report. You may not redistribute the MSCI data or use it as a basis for other indices or investment products. 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