A different approach to Japan
Disclosure – Non-Independent Marketing Communication
This is a non-independent marketing communication commissioned by Schroders. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.
Back in the halcyon days of November 2019, as we settled in for what would be one of the wettest and most miserable winters on record in the UK – oblivious to the horrors that a weirdly sunny spring would bring – we published a piece examining what we believed might be a ‘generational opportunity’ in Japan.
After three decades of poor economic growth Japan had stepped back into the limelight under the stewardship of Shinzo Abe’s government and the age of ‘Abenomics’, and in our view these efforts were beginning to bear fruit.
The policies of the ‘Three ‘arrows’ – a combination of fiscal and monetary policy and structural reform designed to wake the Japanese economy from its long slumber – have been pursued since 2013 and by 2019 we were excited to see positive impacts from the programme to reform corporate governance.
‘After three decades of poor economic growth Japan had stepped back into the limelight’
This government has also led de-regulation efforts, including liberalising the labour market and agricultural sector, cutting corporate taxes and increasing workforce diversity alongside governance improvements.
The result is a sustainable drive to make the capital on Japan’s corporate balance sheet work harder and pull the country out of its multi-decade slump.
A key element of this structural reform is that Japanese companies should improve their capital allocation, and begin to return excess cash to shareholders through dividends and share-buybacks.
Already by the time we published that article in November we had seen incredible increases in share buybacks: in the six months to September 2019, these reached 4.7trn Yen, up 96% from the same period a year earlier and already higher than the total amount for the whole of calendar year 2018.
As we argued then, the Government Pension Investment Fund, the largest pension investor in the world, had also begun to use its influence as a major shareholder and this too would be a key reason to believe that progress would continue.
“With such heavy pressure being applied at the government level”, we said, “the reform story in Japan is only beginning, and should create the conditions for Japan to be a lucrative place in which to invest in the coming years.”
Much has changed since November 2019, clearly. The Corona Virus leaves a deep, painful global recession almost inevitable and indeed the Topix Index – Japan’s leading benchmark – is down almost 15% since the crisis really began to hit the headlines in February this year.
A recession, clearly, will impact manufacturers like Nissan and Toyota particularly, but that does not mean that our view has changed.
‘this is a country with built in resilience. It has weathered disasters before’
As anybody who saw the Pacific Ocean sweeping across entire cities in Japan in 2011 will attest, this is a country with built in resilience. It has weathered disasters before.
The nature of Japanese balance sheets is, in itself, of some benefit here. In a period of great uncertainty over near-term earnings, the sustainability of Japanese businesses is particularly crucial.
The speed of the economic collapse globally has allowed no time for re-sizing or repositioning of business models, leaving companies largely reliant on internal reserves. In this regard the strength of Japanese balance sheets should provide invaluable support.
Indeed, many aspects of Japanese business such as inefficient capital allocation, and a focus on stakeholders rather than shareholders, may well prove to be distinct advantages in this environment.
While nothing may protect short-term profits in Japan from the sudden onslaught of a global recession, companies in Japan are better placed than most to weather the storm.
As a result, with any visibility on timescale, investors should be reasonably confident about buying into distressed earnings and low valuations in Japan. It would be reasonable too, to expect smaller aggregate dividend cuts in Japan, as indeed we did after the global financial crisis.
Against this backdrop, Schroder Japan Growth fund provides an interesting option for investors, offering a solid yield and supported by a large and experienced team at Schroders.
The trust aims to generate long term growth via a diversified portfolio of around 70-85 Japanese equities with a strict focus on valuation which leads risk models to interpret it as having a ‘value bias’.
‘an interesting option for investors, offering a solid yield and supported by a large and experienced team’
It is important to note, however, that manager Masaki Taketsume does not pursue ‘value’ as a deliberate style. Indeed, the manager reduced his stake in Tsubakimoto – a Japanese manufacturer which, at the current valuation, certainly fits the billing as a value stock – in February because, despite being cheap, external uncertainties beyond management’s control were too much of a concern.
The focus is squarely on long term earnings growth and the apparent bias toward value is purely the outcome of process and the hard-wired focus on underlying valuations that this involves.
A side-effect of this focus on earnings growth, which naturally leads them to companies with prospects for higher dividends, is that the trust has delivered strong dividend growth, and currently yields 2.9% – second only among Japanese investment trusts to CC Japan Growth which specifically targets income as part of its objective.
Masaki pursues a bottom up, stock-picking approach, which is focused on fundamentals, and pays little regard to sector or industry weightings, using an in-house Fair Value Model to identify anomalies with the potential to generate alpha.
According to Morningstar data, the trust has tended to hold around 70% in large caps and a further 20% in mid-caps, with the remainder being in small-caps. Masaki believes that this structural overweight exploits the advantage of the deep in-house analyst team at Schroders, which is a particular benefit in Japanese small caps given the low levels of sell-side analyst coverage.
Schroders’ resources behind the trust are significant. Masaki has a total of 24 years of experience in investment. He works closely with Nathan Gibbs, investment director for Japanese equities.
Nathan, who relocated to London from Tokyo in 2016, contributes to portfolio strategy and debate, as well as interacting with Schroders’ investment resources in London. He has 35 years’ experience, much of it as a fund manager in Japanese equities.
The pair are supported by significant numbers based in the region. Masaki draws on the research of a team of eight sector analysts and three small cap specialists in Tokyo.
The average experience in the analyst team is 20 years. In addition to the London-based manager–, Schroders has three fund managers in Tokyo running separate strategies and using the same local research team. At the end of December 2018, the combined team managed a total of £11.4 billion in Japanese equities.
‘an interesting entry point for investors seeking to build their exposure to a recovery in Japan’
In performance terms, the trust has tended to lag behind the Topix index in recent years as ‘value’ style stocks which tend to make it into the portfolio have been out of favour since the end of the 2008 financial crisis.
High growth stocks have been the beneficiaries of monetary policies, especially quantitative easing, the world over, and Japan is no exception. The trust has delivered NAV total returns of 26.6% over five years, while the Topix Index has gained 46.7%.
The manager- – believes that value is unlikely to stage a ‘v-shaped’ recovery in the short term. However, Masaki does think a normalization of conditions – which allows the benefits of company-specific virtues to outweigh ‘style’ factors– is likely and, with that long-term recovery in mind, the trust remains structurally geared to the tune of around 10%.
Schroder Japan Growth is currently trading on a discount of around 17% – having traded at an average discount of 9.2% over the three years to the start of 2020.
Given the depressed underlying valuations of the companies in the portfolio this could be an interesting entry point for investors seeking to build their exposure to a recovery in Japan, especially as a diversifier alongside Japanese funds with a stronger ‘growth’ bias.
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