The Japan Fund

Portfolio Manager Commentary as of 6/30/14
The Fund recorded a return of +7.94% in terms of Net Asset Value (NAV) per share during the quarterly review period from March 31, 2014 to June 30, 2014. The corresponding return figures for the TOPIX index (the “benchmark”) with gross dividends reinvested and for the MSCI Japan Index with gross dividends reinvested were +6.89% and +6.69% in U.S. dollar terms, respectively. Therefore, the Fund outperformed relative to its benchmark index by 1.05% (105 basis points) and outperformed the MSCI Japan Index by 1.25% (125 basis points).

An initial rally in the Japanese equity market in early April was quickly followed by profit taking after the Bank of Japan (BOJ) Governor’s statement indicating that there would be no additional monetary easing measures in the near term, while many Japanese companies announced conservative corporate earnings projections for fiscal year (FY) 2014 ending March 2015. According to the latest forecast in June, recurring profits of major Japanese companies (excluding Financials) were expected to grow by 7.6% year-over-year (yoy) for FY2014, which was lowered by 3.4 percentage points from the forecast in March. The market advanced in late-May, backed by rallies overseas and expectations regarding the growth strategy of the Abe administration. Overall, the TOPIX index (including dividends) rose by 5.0% in local currency terms during the review period. The yen appreciated slightly against the US dollar, gaining 1.9% during the review period, so the TOPIX index rose by 6.9% in USD terms as noted above.

The Fund seeks long-term capital appreciation derived not only from value stocks but also from growth stocks. Considering this objective, Nomura Asset Management utilizes a “multi-manager” approach to managing the Fund’s investments, while also selecting from both large-cap and small-cap stock markets in Japan. The Fund’s investments are initially allocated to three portfolio management teams who are responsible for the large cap value, large cap growth, and small cap blend strategies, respectively. Decisions regarding the allocation of assets to a particular style are made by a dedicated asset allocation committee. Through this style diversification, Nomura Asset Management aims to capture the broader investment opportunities as well as ensuring that the portfolio is well diversified.

In terms of style allocation, we have maintained the existing strategy throughout this review period. At the end of June 2014, we allocated 52.6% of the equity position to large cap value, 37.3% to large cap growth, and 10.1% to the small cap blend strategy. The total equity portfolio consisted of 295 stocks. The five largest sector weightings are Electric Appliances, Machinery, Transportation Equipment, Information & Communication and Banks. Within the top five sectors, the Fund held overweight exposures relative to the benchmark in the Machinery and Electric Appliances sectors, and it held underweight exposures to the Banks, Transportation Equipment and Information & Communication sectors.

The Fund’s outperformance of 1.05% against the benchmark for the quarter was the result of positive outcomes from both the style allocation strategy and stock selection results. The overweight position in the large cap value portion and underweight position in the large cap growth portion relative to the benchmark had a positive effect on the style allocation strategy.

Following Japan’s strong real GDP growth rate of 6.7% quarter-on-quarter (qoq, annualized) in first quarter 2014, the economy was expected to contract in 2Q2014, reflecting the consumption tax rate hike from 5% to 8% in April 1, 2014. Private consumption and capital investment plunged in April and recovered in May and June, an outcome that was mostly in line with prior expectations. The Bank of Japan’s 2Q14 Tankan report, a comprehensive quarterly corporate sentiment survey, showed that business confidence remained high even after the tax hike, while corporate capital spending plans for FY2014 were revised up from 0.1% to 7.4% (yoy) for large firms. We expected a temporary drop in real GDP in 2Q14 of -4.4% (qoq, annualized) followed by faster growth in 3Q14 of +3.7% (qoq, annualized). The Japanese economy could continue expanding with a +1.8% (yoy) real GDP growth rate in calendar year (CY) 2014 and +1.5% (yoy) rate in CY2015.

Japan’s core inflation (all items excluding fresh food) accelerated further in May, rising to +3.4% (yoy) after +3.2% in April and +1.3% in March. However, excluding the impact of the consumption tax hike on April 1, the underlying inflation rate would be +1.4% (yoy) in May and +1.5% in April (impact of tax hike based on BOJ’s estimate). The inflation rate was expected to slow in the second half of 2014 as the impact of the weaker yen fades from the economic data. On the other hand, Japan’s labor market has improved significantly. The unemployment rate fell to 3.5% in May, the lowest since August 1997, and the job offers to applicants ratio reached 1.09 in May, the highest in 22 years. The further labor markets tightened, the more wages would improve. That movement would make Japan’s inflation rate rise gradually without the further weakening of the yen. At the same time, it would support domestic demand in Japan, which means Japan would be able to overcome deflation.

In 2013, the Prime Minister Shinzo Abe and his administration launched a three part economic strategy, commonly referred to as the “three arrows”, to pull Japan’s economy from its long economic stagnation. The first was an unprecedented monetary easing, the second was a large fiscal stimulus package and the third was a set of structural reforms aimed at boosting the economy’s long-run rate of growth. The government released its initial third arrow or the “Japan Revitalization Strategy” in 2013, and launched a “Revised Japan Revitalization Strategy” in June 2014 in order to review the progress of already implemented polices and to provide basic guidance for remaining tasks. This revision was focusing on 10 key reforms which consisted of corporate tax reforms, including reductions in the effective corporate tax rate and enhancing women’s participation and advancement, etc. In addition, it was notable that 1) Enhancing corporate governance, 2) Reform for management of public funds and 3) Promotion of venture business were included as company level changes to restore Japan’s corporate sector earnings power. The government listed several new measures to be adopted, such as supporting The Tokyo Stock Exchange to draft the Corporate Governance Code for listed companies, revising the policy asset mix (basic portfolio) of the government pension investment fund (GPIF) with assets under management of 126 trillion yen (1.24 trillion USD), and establishing a Venture Business Creation Council, etc. The growth strategy is a supply-side restructuring of Japan’s economy centering on private sector reforms, but it will take more time to deliver any tangible results. We should therefore assess these measures from a medium to long-term perspective.

The TOPIX price-to-earnings ratio (PER) based on current earnings forecasts for fiscal year (FY) 2014 is 14.6, which was below the S&P500’s PER of 16.6 (as of June 30, Bloomberg estimates). The Price-to-book-value ratio (PBR) was 1.25, while that of the S&P500 was 2.73. In our assessment, Japan’s equity market valuations are still depressed and the growth potential of Japanese companies is not being discounted fairly due to the prolonged deflationary economic circumstances. As investors become more convinced that Japan can overcome deflation and can realize sustainable economic growth, the more fairly equity markets will discount the growth potential of Japanese companies.

We believe the Japanese equity market is attractive from a long-term investment perspective, and in our judgment, there are many attractive stocks available in this market. We will maintain a well-diversified portfolio and select the most promising candidates from among the value stocks, growth stocks, and small-capitalization stocks using our extensive equity research capabilities.

This material contains the current opinions of the Fund's manager, which are subject to change without notice. It should not be considered investment advice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long-term. Past performance is not a guarantee of future results. There is a risk of loss. Performance shown represents that of the Fund's Class A shares. Performance does not reflect any applicable front-end sales charge or redemption fees. Diversification and asset allocation do not guarantee a profit, nor do they eliminate the risk of loss of principal.

The Tokyo Stock Exchange Price Index (TOPIX) is an unmanaged capitalization weighted measure (adjusted in U.S. Dollars) of all shares listed on the first section of the Tokyo Stock Exchange. The MSCI Japan Index is a free-float weighted index that includes every listed security in the Japanese market. The S&P 500 Index is a broad based unmanaged index representing the performance of 500 widely held common stocks. One cannot invest directly in an index. Price to earnings (PER) ratio is the valuation of a company's current share price relative to company earnings. Price to book value (PBR) is a ratio used to compare a stock's market value to its book value. Book value is the total asset of a company minus total liability.

The MSCI information contained in this material may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an "as is" basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the "MSCI Parties") expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages.

Effective October 16, 2013, all of the Funds of Nomura Partners Funds, Inc. were closed to purchases and exchanges. As noted within the supplement dated April 4, 2014, the Board of Directors of Nomura Partners Funds, Inc. (the “Board”) has approved the reorganization of The Japan Fund, a series of Nomura Partners Funds, Inc., into the Matthews Japan Fund, a series of Matthews International Funds (the “Reorganization”). At any time prior to the Reorganization, shareholders may redeem their shares and receive the net asset value thereof pursuant to the procedures set forth in the Funds’ prospectus.


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