2021 marks the tenth anniversary of our Japanese equity fund. This is an opportunity for its manager, Steve Glod, to look back and share his views on the evolution and characteristics of the Japanese stock market.
1) Q: Take us back to 10 years ago. Why launch a Japanese fund?
The decision to dedicate one person to the Japanese market and launch a fund investing in Japanese companies was clearly based on some contrarian thinking, which has always characterised BLI’s way of approaching investments. After the bursting of Japan's huge asset-price bubble at the beginning of 1990, the market began a precipitous decline and a long slump that left many investors disillusioned. Japanese stocks were completely out of favour after these two so-called Lost Decades, leading to our conviction that we would be able to find many high-quality companies trading at attractive valuations.
2) Q: What have been the main developments over the past decade?
Japan has come a long way over the past decade, driven, of course, by the Abenomics programme initiated in December 2012. The objective was to revive Japan’s economy and end its persistent deflation via the ‘three arrows’ of aggressive monetary policy, fiscal spending and structural reforms.
While it inevitably has its flaws and the jury is still out on its long-term impact and success, it certainly served as a wake-up call to Corporate Japan. Japanese companies had already massively deleveraged in the decades following the bubble, and were starting to reap the benefits of a weaker yen and slowly improving economic situation to increase corporate profits. At the same time, corporate reforms and programmes to speed up digitalisation to tackle Japan’s structural issues and low productivity are slowly gaining traction. Reforms and policy measures have led to improvements in areas like the female labour participation rate, inbound tourism (at least before the pandemic), and corporate governance – three of the most tangible success stories of Abenomics. The improvements in corporate governance, like the unwinding of the notorious cross-shareholdings, better capital allocation, higher returns on assets and increasing transparency have been especially welcomed by investors. Structural issues remain, however, with poor demographics and a labour market that is becoming more and more stretched due to the decline in the working population.
3) Q: What has been your experience with the fund over these 10 years?
The fund has of course benefitted from these positive developments. Japan has found its way back onto the radar of investors. The fund’s AuM have grown from an initial €40m to €732m at end of November and since inception until end of November 2021, the BL Equities Japan JPY B Cap has returned 236.4%, which corresponds to an annualised return of 12.3% (or 11.29% in €). This is well above the returns that investors could attain in most other major markets, except for the US, and also well above the performance of its relevant benchmark index, the MSCI Japan. Furthermore, it has been generated with a very attractive risk profile; the fund consistently ranks among the least volatile in its asset class over short and long-term periods [1].
Over the past 10 years, there have been more difficult and more successful periods, both in absolute and relative terms. This is of course to be expected for a very selective approach to picking stocks, leading to a portfolio that deviates strongly from the market indices. In the first period, from June 2011 to December 2012, which was still a challenging time for the Japanese market, the portfolio benefitted from its rather defensive bias. In 2013, the year of the Abenomics rally, the fund underperformed significantly, as investors focused on high beta stocks and sectors where the portfolio had less or no exposure. This was also the last calendar year in which the fund underperformed the MSCI Japan, as the following years were more beneficial for our investment style with a focus on quality growth stocks. The current year has, again, proved to be more challenging, with momentum shifting more towards cyclical and value stocks. But to be honest, I feel uncomfortable about commenting on such short time periods. Over the long-term, a whole market cycle, the strategy of buying high-quality companies at attractive prices will inevitably deliver both good absolute and relative performance.
4) Q: How does BLI’s approach to investing work in Japan?
Our methodology works particularly well in Japan, as we are very selective when it comes to investing – which you clearly have to be in Japan. Japanese businesses are governed by a tight culture that is built on solidarity, discipline and long-term relationships, but also marked by conservatism and rigidity. Whereas ideally this leads to the meticulousness that has allowed many Japanese manufacturing companies to develop and refine world-leading products, it can also lead to the inertia that has caused many more Japanese companies to fall behind during the lost decades. The market indices still include many unprofitable companies that are artificially kept afloat due to Japan’s policy of lifelong employment with the same employer. They are also dominated by large but quite mature companies, often with complex structures hindering efficient management. On the other hand, Japan has many high-quality companies with good long-term growth prospects.
These are the businesses that we are looking for at BLI. We perceive businesses from the viewpoint of long-term company owners. We invest in simple businesses with clear and transparent business models, in companies we believe have a sustainable competitive advantage, are highly profitable and can reinvest their cash at high rates of return. And lastly, we want to make sure we don’t overpay for these high-quality businesses.
5) Q: Are there any other specifics to the Japanese market that are reflected in your investment style?
Put in very simplified terms, you could say that the Japanese market is dominated by three main types of investors. First, foreign investors who tend to periodically shift money out or into the market based on top-down considerations, with a focus on passive investments or a preference for large and well-known companies. Secondly, domestic retail investors who do little or no fundamental research and trade very actively based on short-term trends, basically ignoring valuations. And then we have the domestic institutions, like pension funds, which often also lack fundamental knowledge of individual companies and usually prefer to track an index.
This situation provides opportunities for active managers like us, who have a long-term investment approach and focus on company fundamentals. It allows us to buy or add to positions in out-of-favour stocks, but also necessitates discipline to reduce stocks where valuations have got a little out of hand. This is probably more often the case than in other regions and explains why this fund’s turnover is somewhat higher than the average at BLI.
Another element that is specific to our Japanese strategy is the differentiation between companies with a global and those with a purely domestic exposure. The market drivers, investor interests and underlying trends are often very different and having exposure to both categories is an added element that reduces portfolio volatility. And we find attractive investment candidates in both these categories. Export companies often benefit from a strong competitive advantage in terms of technological know-how, as well as product quality and service. This allows them to defend their market position against foreign competitors. Domestic companies on the other hand, evolve in an environment that is characterised by poor demographics and deflation, which makes it difficult to attain sustainable growth. Among these names, we are looking for niche companies that can see expanding market share and/or addressable markets.
6) Q: How does this shape the portfolio?
The portfolio is the sum of individual ideas selected on the basis of our stringent methodology. It includes companies that have carved out a strong competitive edge based on Japan’s long tradition of craftmanship and know-how in manufacturing. This is especially the case in the industrial, materials, medical technology and IT equipment segments. The focus in the technology sector is also on innovative and asset-light companies providing leading-edge software and services to markets that have ample room to expand. A traditionally high weighting in the more defensive consumer staples companies, whose potential for solid free cash flow generation we value highly, rounds up the portfolio and contributes to its defensive profile.
At the same time, the focus is on selecting companies that benefit from structural themes. These include challenges and opportunities from societal changes, like changing consumer habits, the emergence of the Asian consumer, urbanisation, an ageing population or labour shortages and affect companies with global or domestic exposure, although to a different extent. These trends will continue to drive technological changes and advancements in process automation, digitalisation, clean energy, healthcare or future mobility. The portfolio consists of companies that are favourably exposed to at least one of the trends we have identified.
7) Q: Can you provide us with some examples of companies?
Stock pickers like us with such a fundamental approach to investing love talking about our companies! In order to illustrate our long-term approach, I want to give examples of some companies that have been held in the portfolio for a long period of time.
One of the global leaders we own is Keyence, which develops and manufactures equipment for industrial automation, mainly sensors. The company has a unique business model, with direct distribution and fabless fabrication, where the manufacturing of its innovative products is outsourced to qualified contract manufacturing companies, allowing it to focus on product planning and development. Factory automation continues to drive growth for Keyence, but it also benefits from the IoT trend, which is boosting demand for sensors and vision systems. As manufacturing becomes more data intensive, all sorts of machines in the factory will require more sensors and vision systems to collect data.
In med tech, we own Asahi Intecc, another company with a market leading position. It manufactures PTCA guidewires, used in coronary angioplasty, a procedure for non-surgical treatment of narrowed blood vessels. It has world-leading expertise in wire-processing technology, allowing it to transform low-cost raw materials into high-precision medical devices. Growth opportunities are based on market size expansion and market share gains, while the outlook for new and innovative products for other applications, such as cerebral vascular treatment is also promising. Structural growth drivers include the trend to reduce healthcare cost burdens through the use of non-invasive technologies (leading to shorter hospital stays) and increased adoption of modern healthcare procedures in emerging countries.
In consumer staples, we own Unicharm, a manufacturer of personal care products (diapers, feminine care) with a strong overseas presence. Its competitive advantage is based on intangible assets, primarily its brand equity, a network effect due its entrenched retailer relationships, and technological strengths. Know-how in non-woven fabric and superabsorbent polymers (derived from its chemical heritage) constitutes the basis of its technological edge and allows Unicharm to consistently roll out innovative products. Its brand equity is evidenced by dominant market shares in its core products including sanitary towels, baby diapers, and adult incontinence products in Japan and many other Asian countries. Unicharm benefits from strong growth in Asian countries due to its successful premiumisation strategy.
In the domestic IT segment, we own Obic, a provider of ERP software for Japanese small-and mid-sized companies. These clients often have needs for customisation when integrating an ERP package, because they are likely to have very ‘Japanese’ processes and business practices. Due to its unique direct sales model, Obic has very close relationships with its clients and has accumulated significant know how about processes in a wide range of industries. It uses this know-how to constantly develop and improve its main product. This niche approach strongly differentiates the company from more global players and gives Obic an edge over larger rivals like SAP or Oracle Japan, which focus more on larger clients with less customisable products. The main structural growth driver is the need for SMEs to beef up an often outdated IT infrastructure to respond to labour shortages and increase productivity.
In domestic retail, we own Nitori Holdings, Japan’s only major furniture and home decoration chain, selling affordable furniture and interior goods. While historically Nitori has focused on large, suburban-type discount stores (comparable to Ikea), it has recently started opening small-format stores in city centres and pushed overseas expansion. It has a history of more than 30 consecutive years of sales and profit growth. Its philosophy of creating everything in-house, from product planning, sourcing and manufacturing in low-cost countries (very often in its own factories), to logistics (with its proprietary customs clearance system), through to sales (with a unique distribution system and a large store network), leads to an edge in terms of costs, marketing abilities and flexibility. Most of Nitori’s products are original, own-label merchandise and more than 90% are directly imported from overseas. It was one of the earliest movers among all Japanese retailers when it comes to this type of SPA model, which it has continuously improved over the decades.
Keyence, Obic, Unicharm and Nitori have been in the portfolio since the launch of the fund, while Asahi Intecc has been held for more than 5 years.
8) Q: Aren’t you at a disadvantage in managing a Japanese fund with a small team based in Luxembourg?
On the contrary, we are convinced that our small structure, our geographical location, our clear responsibilities and our stringent investment process help us achieve good performances. When picking stocks, we stay within our sphere of competence. Our analysis is based on publicly available information and we avoid investments in companies where we don’t have enough information. Also, we don’t focus too much on short-term news flow; instead we attach much greater importance to understanding the sustainability and long-term growth drivers of a business. In that context it is also important to remember that successful investing depends on having a sound process that allows us to make the right decisions and steer clear of classic cognitive errors. I have written an article on the subject of behavioural finance entitled ‘Seven sins of fund management’. It explains why we prefer strong personal responsibilities over group decisions, limit company meetings to the bare minimum, avoid forecasting and are not convinced that gaining as much information as possible leads to better decisions. All this can be well executed with small investment teams based in Luxembourg, leaving other approaches to the experts on the street. And being located here, we are shielded from the buzzing and noise surrounding the global financial centres, making it easier for us to focus on our long-term investment approach.
9) Q: What is your outlook for the Japanese economy and the market?
Many observers agree that the Japanese market looks particularly promising based on low valuations, improving capital allocation, higher profitability and low financial leverage. But significant economic challenges remain and it will be crucial to observe whether the country can put in place the right policies to overcome persistent deflationary forces in the face of demographic obstacles and high levels of government debt. However, I am not the right person to provide a deeper view on this, and certainly not to give a market outlook. Our approach is not to buy the market but to buy individual companies — businesses with strong competitive positions and solid fundamentals that allow them to create shareholder value over the long term, independently of macroeconomic or other external factors. Many companies in our portfolio have proved in the past that they can thrive in a difficult environment. Export companies have shown that they can defend their leading positions despite the scenario of a stronger yen, while many of our domestic leaders have grown their businesses even during recessionary periods.
10) Q: What will the main challenge be in terms of your portfolio management?
Although it might sound boring and repetitive, the challenge will be to continue to select the best companies based on our methodology and by strictly adhering to the process, which evolves only very little over time. One component that will, however, play an increasingly large role is the integration of ESG factors into the process.
While the ESG dimension was already factored into our pre-investment (exclusions, controversies screening) and post-investment (engagement & voting, monitoring controversies) analysis, it has gradually gained greater importance in the analysis of individual companies. It has become a fundamental element for the determination of the Cost of Equity (CoE) used in our valuation model, which is basically related to the perceived risk for the potential investment. A company with a solid ESG profile will be attributed a lower CoE, which in turn leads to a higher fair value, whereas an ESG laggard will be penalised with a proportionately higher cost of equity and hence a lower intrinsic value.
ESG considerations are also becoming more and more integrated into the qualitative part of company analysis. Besides the crucially important issue of carbon emissions, the focus for our Japanese companies is on their evolution in terms of corporate governance, where we analyse criteria like board composition and board diversity. It is in this domain that they have to make the most progress, forced also by regulatory policies pushing to break up old, encrusted corporate structures in the interest of all stakeholders. It will be our role as investors to engage with companies on these issues and raise their awareness about the ever-increasing importance of ESG considerations in their corporate communication. Unfortunately, Japanese companies have a tendency to sell themselves short when it comes to their efforts in this domain.
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Author
Steve Glod, Fund Manager, info@bli.lu
The author of this document is employed by BLI - Banque de Luxembourg Investments, a management company authorised by the Commission de Surveillance du Secteur Financier Luxembourg (CSSF).
