JPMorgan Japan Smaller Companies Trust has announced its annual results for the year ended 31 March 2017. During the period, the Trust’s NAV total return was +20.9% and its share price total return was +25.2%. These both underperfomed the trust’s benchmark which it says provided a total return of +34.6%. The chairman, Alan Clifton, says that this was because of a strong investor move in favour of cyclical and perceived ‘value’ stocks during the course of the year, which did not benefit the trust’s portfolio.
The investment managers (Shoichi Mizusawa, Nicholas Weindling and Eiji Saito) say that The positive return for the fiscal year was attributable to gains in the underlying asset class and the fall in the value of sterling. They say that, during the fiscal year, both sector allocation and stock selection detracted from relative performance. The biggest detractors included Invincible Investment Corp (Real Estate), Anicom (Insurance), GMO Payment Gateway (Software & Services), Asahi Intecc (Health Care Equipment and Services) and Sohgo Security Services (Commercial & Professional Services).
The managers say that, in general, the stocks that performed well prior to Brexit underperformed, and vice versa, often with little change in the underlying fundamentals. The managers say that all five stocks listed above had been strong performers in the previous fiscal year and, with the exception of Asahi Intecc, they were among the top five contributors. While there are company-specific reasons for underperformance, the managers say that stocks all suffered from profit-taking.
Detractors
Invincible Investment Corp
Invincible Investment Corp is a real estate investment trust that has increased exposure to hotels through acquisitions. The managers say that Invincible Investment Corp underperformed because of the slowdown in the growth of inbound tourists. They say that this, coupled with an increase in the supply of hotel rooms in Tokyo, led to a decline in the utilisation rate. This was the largest position in the portfolio at the end of last fiscal year. The managers reduced the position size firstly in April 2016 due to valuation considerations, then trimmed it further as they reduced their top-line expectations. However, Invincible Investment Corp has continued to underperform. The managers say that they believe that the valuation reflects excessive pessimism, and they are maintaining the remaining position.
Anicom
Anicom specialises in pet insurance, a market that is still in its infancy in Japan and one that the managers says is continuing to grow strongly. The ageing population is a tailwind for the company as an increasing number of elderly people live with pets and they have a high propensity to spend on their pets. The managers say that its earnings growth decelerated in 2016 as the company invested aggressively in new business initiatives, which was not received well by the market. The managers say that they disagree with that view since they consider that the market is still underpenetrated and their opportunity set will expand significantly if any one of them succeeds. The managers say that they have not made any change to the position.
GMO Payment Gateway
GMO Payment Gateway provides a payment processing service, with the primary focus on credit card payments for online shopping. It dominates the small merchandiser space and has grown strongly on the back of increasing diffusion of e-commerce. The managers say that it is diversifying its customer base to larger firms and public entities, into overseas markets, and also into new lines of business. The managers believe the company can continue to grow earnings by 20%-30% per annum over the medium term. In their view there is no reason for the underperformance other than profit-taking.
Asahi Intecc
Asahi Intecc is a medical equipment manufacturer. Its main products are PTCA guide wires and catheters. The market is growing by taking share from highly invasive bypass surgery. The managers say that Asahi Intecc has outgrown the market by increasing its market share with innovative new products. The managers are confident that the company will continue to offer huge growth potential and we are maintaining it as the portfolio’s top holding as of March 2017.
Sohgo Security Services
Sohgo Security Services is the second-largest operator of home and office security services in Japan after Secom. The managers say that the company has grown strongly under the new management team that took charge in 2012, following many years of stagnation. Its profit margin still lags that of Secom and the managers believe there is further scope for the company to expand its margins and therefore profit. The managers reduced the position size in early 2016 as the stock had done very well and the valuation became less compelling.
Positive contributors
Nittoku Engineering (Capital Goods), M3 (Health Care Equipment & Services) and Tokyo Individualized Educational Institute (Consumer Services) contributed most positively to performance:
Nittoku Engineering
Nittoku Engineering is the global leader in coil-winding machines for a variety of motors for smartphones and home appliances, as well as for sensors. The managers say that the automobile sector represents a growth opportunity for the Company as the number of sensors per vehicle continues to grow. In the long run, the managers think the company is very well positioned to benefit from the proliferation of the ‘internet of things’ (IoT) as the infrastructures require a large number of sensors.
M3
M3 operates websites used by doctors and helps pharmaceutical companies to reduce their marketing expenses. The managers say that it is the number one site in Japan and the United Kingdom, amongst other regions. The managers sold M3 in July after its market capitalisation rose to one of the top 100. This follows Sysmex (medical equipment) that they sold in March 2015 when its market capitalisation also rose to one of the top 100. The managers say that they owned both M3 and Sysmex for extended periods and rode the volatility in share price in the interim with strong conviction on their long-term growth outlooks. The managers say that aspire to repeat the same with many other holdings in the portfolio.
Tokyo Individualized Educational Institute
Tokyo Individualized Educational Institute operates intensive study schools and has steadily grown earnings under a new management team since 2012. The managers sold the entire position in March as valuations became demanding.
At a sector level, the bottom contributors include insurance (overweight), software & services (overweight), materials (underweight) and banks (underweight):
Insurance (overweight) performed poorly due to its largest constituent, Anicom, which is held in the portfolio.
There are two main subsets within the software & services sector: domestic-orientated services companies, which the managers say tend to be defensive in terms of both their earnings and share price performance; and internet companies. Both groups underperformed in general in a rally led by riskier financials and cyclicals.
Materials and banks (both underweight) outperformed thanks to what the managers says was increased optimism on the global economy.
Portfolio activity
The managers say that there has been little change in the overall structure of the portfolio. The turnover for the year was 14.9% and the managers say that this low turnover reflects the strong conviction they have over the stocks that they own in the portfolio. The gearing rose from 4.7% at the beginning of the fiscal year to 6.2% at the end of March 2017, after investing all the proceeds from the subscription shares exercise.
Outlook
The managers say that Japan’s economy continues to expand at a reasonable pace, although the growth rate remains constrained by the demographics. They believe that the global economic growth will accelerate as fiscal policies turn from a headwind to at least neutral, and possibly to a tailwind. The managers say that strong growth is broadening beyond the US to Europe and the emerging economies and that, encouragingly, earnings expectations have been improving across regions and sectors after several years of earnings recession in Europe and emerging markets. The managers base case is that corporate earnings in aggregate will grow strongly in 2017. They say that corporate governance reforms in terms of better capital management and shareholder returns, combined with unwinding of cross shareholdings, are slowly but steadily taking hold. The managers say that listed companies generally have healthy balance sheets and can afford much higher payout ratios, whilst the valuations are not at all demanding in their opinion. They say that the TOPIX trades on around 14x prospective earnings and 1.2x book value, and is cheap relative to its own history and relative to the rest of the world.
JPMorgan Japan Smaller Companies suffers as investors favour cyclical and value stocks : JPS