In a recent blog article entitled “A portfolio manager’s dilemma”, our Chief Investment Officer Guy Wagner raised the topic of the eternal dilemma a professional fund manager faces. It basically comes down to the decision between two approaches: playing the relative performance game by buying stocks that are currently favoured by investors, with the risk of not getting out in time, or playing the long game and sticking to a proven methodology that is currently underperforming, with the risk of losing clients before the market turns. From the perspective of an equity fund manager at BLI, the question should not even arise. We see no alternative to the latter approach.
Let me start with a little anecdote. In 2014 my wife and I sat with our then 7-year-old son in a Starbucks café in London. I explained to him that he owned a part of this business (as Starbucks was one the companies I invested in for him). I explained to him that from every coffee sold here, a tiny part of the proceeds would at some point end up in his pocket, in the form of dividends or by helping to lift the value of the company. This was obviously a fascinating revelation for him.
For my son’s investments, I have always stuck to the approach of buying companies that benefit from a competitive strength and have attractive growth prospects over the long term, while keeping it simple: there is not a single company in his portfolio for which I cannot explain to him in one sentence what they are doing and why they are good at it.
This approach to investing is also applied at BLI. Key concepts like keep it simple, invest in what you understand, recurring cash generation, high profitability are elements that govern our investment decisions. We seek companies that benefit from durable competitive advantages (technological know-how, customer captivity, network effects, economies of scale or a strong brand), which will allow them to create shareholder value. It is our strong conviction that selecting these quality companies, all the while keeping an eye on valuation, will lead to solid gains for investors over the long term.
History has proved us right. I have managed BL Equities Japan since its inception in June 2011 and the results are good (Figure 1). The fund (BL Equities Japan B Cap) returned ca. 260% between 30/06/2011 and 30/09/2023, which equates to an annual return of ca. 11%.
Figure 1
Source: Bloomberg
From the perspective of investors, this should be the only outcome that counts: How much has my money appreciated over a long-term horizon? My son is happy when he sees the performance of his equity holdings and when he sees how much they have appreciated since he has owned them. The only comparison he has is the savings account fed mostly by the grandparents, which only pales in comparison. Incidentally, he has never asked the question: “How much have other people made with their equity investments?”
Time is the friend of the wonderful business,
the enemy of the mediocre. Warren Buffett
This is, however, the question most frequently put to professional fund managers. More and more, we are compared to indexes and underlying ETFs that increasingly dominate the market environment. Over the long-term, we are not afraid of this comparison: since its inception, BL Equities Japan has achieved above market returns with lower volatility (Figure 2).
Figure 2
Source: Bloomberg
But it is over the short- to medium-term where things can become very tricky, as our approach leads to portfolios that are very different from the broad market indices. In very simplified terms, our roughly 50 investments in Japan can be classified as follows: a solid basis of defensive companies generating recurringly high cash flows, accompanied by market leaders in promising fields like automation, digital transformation, medical technology or specific growth niches. Entire market segments like banks, insurance companies, utilities and real estate are not represented and the behaviour of the portfolio in different market phases is often very different from that of the market. It is, for instance, much more closely correlated with the Quality-style (buying companies based on strong fundamentals) than the Value-style (buying companies because they are cheap) (Figure 3). At this point it is worth emphasising that while valuation is an important part of our methodology, the typical companies that are represented in the Value indices are not the companies we target. They are cheap because their fundamentals are bad, are often loss-making in cyclical downturns and are, in general, riskier assets, so not the type of names you want to own over longer periods.
Figure 3
Source: Bloomberg
In the short run, the market is a voting machine,
but in the long run, it is a weighing machine. Benjamin Graham
But they may have their moments in the sun and it is impossible to predict how long such periods will last. Over the past three years, we have witnessed the return to favour of value stocks in Japan, which has led to significant underperformance for the fund. Again, ignoring relative performance and just looking at this unemotionally from the perspective of investors only interested in their own wealth appreciation, the results over that three-year period are good: the fund has appreciated by 17.5%, which equates to an annual return of 5.5% (Figure 4).
Figure 4
Source: Bloomberg
Where it becomes ugly is when compared to the market (Figure 5). Some of the factors for the underperformance seen across many funds at BLI have been addressed in Guy Wagner’s recent article. They partly lie in the resilience of the global economy (which admittedly has caught some of us on the wrong foot), the discrepancy between company fundamentals and the economic realities, the craze for buying index trackers, and the increase in interest rates. More specifically in Japan, the focus over the last few years has been on value stocks. This is largely because the outperformance of quality stocks between 2015 and 2020 had led to a significant valuation gap between the two styles, paving the way for what followed between 2020 and today (Figure 6). Lower quality stocks found mostly in the value category have outperformed significantly, backed by increased investor appetite for more cyclical companies and companies with complex structures and the potential to restructure. Very cheap, but low-quality companies, for which market actors see the potential for some improvements in their derisory low profitability, have also done extremely well. While selecting such stocks may be a possible approach to investing, it is not an approach shared by us.
Figure 5
Source: Bloomberg
Figure 6
Source: Bloomberg
To illustrate this, the following graphs show the performance, both over a longer time frame (Figure 7) and over the short term (Figure 8), of three stocks that have been in the portfolio for more than 10 years. These are neither the best nor the worst performers over these periods, but they help explain very well what has happened.
Figure 7
Source: Bloomberg
Figure 8
Source: Bloomberg
Unicharm is a manufacturer of personal care products and one of the more defensive companies in the portfolio. It boasts leading market shares for baby diapers and feminine care products in several Asian countries. Although its stock has enjoyed excellent performance over the longer period, it started to suffer from the beginning of 2021, when the post-Covid rebound favoured more cyclical stocks. The long-term thesis remains intact and the company is well positioned to benefit from structural trends like a growing middle class in emerging markets like India and Vietnam.
Sysmex is the global market leader in haematology analysers, which are medical instruments that analyse the number, type and size of elements in the blood such as red and white blood cells. It has seen its share price correct since the beginning of 2022, when rising interest rates began to take their toll on high-growth stocks. Yes, market multiples for these types of stocks have probably been too high, but the sentence seems overly harsh. The outlook for Sysmex remains intact. It is well positioned to benefit from structural growth drivers like an ageing population in developed countries and better access to healthcare in emerging markets.
Fanuc is a manufacturer of factory automation equipment, mainly industrial robots and computerised numerical control (CNC) systems, which allow the automated control and monitoring of machining tools in manufacturing applications. Here Fanuc secures a commanding global market share of around 50%. While the stock has performed relatively closely in line with the overall market due to its more cyclical nature, it has underperformed significantly since mid-May, when the outperformance of value (and the associated correction in quality) stepped up another gear. Fanuc remains well positioned for long-term growth. Factory automation should benefit from structural trends like a decreasing labour force due to the ageing population and reshoring of manufacturing in developed countries, as well as the necessity for factory automation in emerging market countries as a result of increasing labour costs.
Image sources: Company Websites
Although the portfolio consists of a more diverse group of companies than the ones shown here, these three are typical of the companies we will continue to own. It is not an option to change our approach and play the relative performance game by chasing stocks that have had a good run over the last few years. I am convinced we would be doomed to failing miserably, because that is just not where our convictions and competences lie.
At this point it is important to specify that being long-term investors does not mean we ignore what happens in the economy and on the markets! A case in point: over the past year we have bought several goods-producing companies that should benefit from higher infrastructure and capex spending in a structurally higher inflationary environment. This is one of our longer-term theses for equity markets and the economy. We have purchased Tokyo Electron and Advantest, which produce equipment for semi-conductor production; Air Water, which produces industrial gases; Minebea Mitsumi, a producer of miniature bearings and electronics components; Ebara, a leading producer of industrial pumps; Kubota, a producer of agricultural machinery; and Kansai Paint, which produces paints mainly for the automotive and architectural sectors. As always, these are quality companies, often market leaders, which are bought with a long-term view, and not because we are hoping for a short-term performance contribution.
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Author: Steve GLOD, Fund Manager BL Equities Japan, info@bli.lu
Date of completion: 8 November 2023.
Publication date: 9 November 2023 at 09:00.
The author of this document is employed́ by BLI - Banque de Luxembourg Investments, a management company authorised by the Luxembourg Commission de Surveillance du Secteur Financier (CSSF).
