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Annual results and a covid-19 view from Baillie Gifford Shin Nippon

Baillie Gifford Shin Nippon targets up to 10% in unquoteds

Over Baillie Gifford Shin Nippon’s (BGS) annual results period to 31 January 2020, NAV per share rose by 8.9% compared to a 9.5% rise in the comparative index (MSCI Japan small cap index). The share price fell by 0.5% as the shares moved from a premium of 8.0% to a discount of 1.4%.

BGS said that in sterling terms, over three years, the comparative index is up 18.1%, whilst the company’s NAV and share price are up by 49.6% and 42.5%.

Performance drivers: tough year for high growth small caps as numerous headwinds impinged on confidence

BGS’s manager said the following, with respect to top-down performance drivers and stock selection:

“High growth small cap stocks in Japan endured a tough period over the past year as numerous macro headwinds dampened investor sentiment. Concerns over global growth, a slowing Chinese economy, the ongoing trade war between the US and China, and more recently, the emergence of a potentially lethal global pandemic, all resulted in a ‘risk-off’ sentiment. Consequently, business confidence in Japan remained depressed, leading to numerous companies deferring their investment plans in the face of falling orders from key end markets.

Amidst heightened volatility, Shin Nippon’s net asset value per share (after deducting borrowings at fair value) rose 15.3% during the first half of the year but fell 5.5% in the second half. Consequently, for the full year ending 31 January 2020, Shin Nippon’s net asset value per share increased by 9% compared to a 9.5% rise in the benchmark MSCI Japan Small Cap Index (total return in sterling terms). We believe a fairer way of looking at performance is to focus on the long-term. Over both five and ten years, Shin Nippon’s net asset value per share has compounded at around 20% per annum, thereby outperforming its benchmark by 8% and 9% per annum respectively. This illustrates the benefits of embracing volatility and adopting a patient and long-term approach to investing. It is also indicative of the fact that Japanese small caps can be a very rewarding asset class to invest in for the long-term.

Amidst a challenging backdrop, companies exhibiting strong sales and earnings growth were rewarded handsomely by the market. The share price of longstanding holding M3 more than doubled over the past year as its core online drug marketing business saw an acceleration in sales, contrary to market expectations. It also continues to expand into new areas like clinical testing and doctor recruitment. In clinical testing, M3 is able to recruit patients for clinical trials much quicker than its peers, thanks to its vast online database of doctors who can refer relevant patients. It is disrupting the healthcare recruitment industry in a similar vein, utilising its online database to refer doctors for suitable openings at medical institutions across Japan. It is making good progress in replicating its business model in markets like China and the US. All these initiatives are expanding M3’s addressable market and we continue to believe that it can grow rapidly for much longer than the market anticipates.

Infomart was another strong performer. Its online food ordering system for restaurants has become the de facto industry standard. To consolidate its already strong competitive position, it is continuing to add new features to its ordering platform. It recently launched an electronic invoicing system that is proving to be a major hit with clients from a range of sectors. The Japanese Ministry of Economy, Trade and Industry recently highlighted Infomart’s invoicing system as an example of an innovative solution designed to improve productivity and reduce costs. This endorsement has raised the company’s profile and has helped generate a lot of interest in its services. It has recently tied up with another portfolio holding, online payments services provider GMO Payment Gateway, to offer its customers short-term loans for working capital based on their credit history.

Shares of second-hand housing renovation specialist Katitas were also strong. It continues to grow rapidly as demand for its detached used homes remains strong. There are about 8 million empty or abandoned homes across Japan and this figure continues to rise each year given Japan’s demographics and the trend towards urbanisation. This provides Katitas with an abundant supply of houses to choose from, which it then renovates to a high standard and sells to first time buyers at a price much lower than a comparable new build. Katitas is nearly ten times larger than its closest competitor in terms of units sold, giving it a strong competitive edge. Scientific and semiconductor equipment manufacturer JEOL, also made a significant positive contribution to performance. Following the withdrawal of a key competitor, JEOL’s position in the scientific equipment business has improved considerably and it is seeing margins improve as a result. In semiconductor equipment, JEOL’s new product, which it has co-developed with Intel subsidiary IMS, is seeing exceptionally strong demand as it helps reduce costs and time in the semiconductor manufacturing process. It also enables the production of more complex semiconductor chips. This is proving to be a significant driver of earnings for the company and its long-term growth prospects look very exciting.

Unlisted holding Moneytree also continues to do well operationally. It is now working with all the megabanks in Japan as well as a host of regional banks. Its artificial intelligence enabled customer management software is seeing rising adoption across numerous financial institutions and the company is adding new features to make the software more comprehensive. The unique characteristics and growth potential of Moneytree is gaining wider recognition amongst other venture capital investors. The company recently completed a funding round where it was valued at more than twice the amount we paid for it in 2017. We are continuing to engage with many other such exciting and fast-growing unlisted companies in Japan and see this area as an important source of new ideas.

Online cosmetics retailer iStyle was the largest negative contributor to performance over the past year. It recently launched a software-as-a-service package that allows cosmetics companies to track the online and offline shopping behaviour of consumers. Unfortunately, adoption of this new service has been very slow. Concurrently, the company has seen a collapse in sales from its key Hong Kong and Chinese markets owing to ongoing political unrest and general economic weakness. All of this has forced management to revise down their medium-term financial targets leading to a loss of credibility amongst investors. Japan’s leading online takeaway operator Demae-Can (formerly known as Yume No Machi) also suffered from a weak share price as management continue to make heavy upfront investments to fend off the challenge from Uber Eats. This has resulted in the company making losses in the near term. Fabless semiconductor manufacturer Megachips reported significant losses following an ongoing restructuring program. As part of this, the company is exiting numerous loss-making businesses and is focussing on its most profitable chip business with Nintendo as well as its silicon-based timing device business. In the long-run, we believe the current measures will result in a sustainably profitable and better-quality business.”

Chairman Neil Donaldson on covid-19

“As I write this, the coronavirus continues to be a significant risk and one cannot possibly foresee the longer-term consequences for the Japanese economy, inbound tourism, the labour market or indeed the Olympic and Paralympic games. The Rugby World Cup in Japan last year was a huge success, with the eyes of the world on Japan. I sincerely hope that they will again have the opportunity to portray a strong and positive image to the outside world this summer.

An ageing population coupled with a shrinking workforce would on the face of it, be a huge worry. Japan, however, has been alert to these changing trends for some time now and has embraced what is known as the ‘silver market’ with enthusiasm.  Changing technology can bring huge benefits to all, with a greater unity of purpose and sense of urgency. The Government accepts that change is necessary to address these issues and in the longer term should be beneficial for the country. The Company’s Manager remains focussed on identifying companies with high growth potential and investing in them for the long term. Your Board remains positive that this approach should reward the patient investor.”

BGS: Annual results and a covid-19 view from Baillie Gifford Shin Nippon

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