Baillie Gifford Japan Trust (BGFD) has announced its annual results for the year to 31 August 2022, during which it provided an NAV total return of -16.3% compared to a -3.9% total return for the benchmark TOPIX index (in sterling terms). During the period, BGFD’s share price fell by 23.8%. BGFD says that its biases towards smaller companies, higher growth companies and gearing have been unhelpful over the last year. A final dividend of 9p per ordinary share will be put to shareholders for approval at the AGM. This represents a 50% increase on the 6.0p paid in relation to the prior year. BGFD’s gearing has increased from 9.8% to 17.5%, as a result of both share price moves and additional investment in “high quality growth companies”. It is worth remembering that BGFD’s managers have a long-term capital growth focus and its objective is to achieve long term capital growth. In this regard, BGFD highlights that, over the five year period it has provided an NAV total return of 22.8%, which is still ahead of the benchmark return of 20.0%.
Four companies subtracted at least one percentage point from BGFD’s return for the year (Rakuten -1.5%; Raksul -1.4%; CyberAgent -1.0%; and Mercari -1.0%. BGFD’s manager highlights that each of these operates in the internet area and says that they share the common feature of investing heavily to try and seize future opportunities. Rakuten has been building a new mobile phone network in Japan, funded by its profitable e-commerce and online financial service operations. Raksul is a young company involved in online printing, logistics on demand and online advertising. CyberAgent has been investing heavily in AbemaTV, perhaps best described as a cross between YouTube and Netflix, funded by its profitable advertising and gaming businesses. Finally, Mercari provides a platform for consumer-to-consumer second-hand good sales and is investing heavily in its US operations, funded by its more established and profitable Japanese operations.
On the positive side, BGFD’s holding in Inpex contributed 1.8% to the return. As a liquified natural gas (LNG) extraction company, its profits have increased sharply as gas prices have soared due to the Russian war on Ukraine.
Managers’ comments on portfolio activity
“In total we bought 8 new holdings and sold 10. As is typical the new holdings spanned a range of growth opportunities, from quality long-term franchises such as Nintendo (games consoles), Shiseido (skincare) and Pigeon (baby bottles) to newer high growth companies such as Oisix (meal kit delivery), Freee (cloud-based accounting) and finally eclectic growth companies such as Chugoku Marine Paint (anti-fouling ship paint), Shima Seiki (knitting machines) and Seria (bargain retail). These were funded by sales of existing holdings where conviction has waned. Overall turnover was 14.5%, meaning that 85.5% of the portfolio was not changed from the previous year.
The difficulties caused by Covid have temporarily negatively impacted the earnings of many usually high-quality businesses. While attitudes in Asia towards Covid remain generally more cautious than in Europe and the United States, we believe that the fundamental trends are in the same direction. Japan has very high vaccine coverage now and is re-opening for unrestricted tourism. Although the exact timing of earnings’ recovery is uncertain, we have very high conviction that it will happen. The new holding in Shiseido, the addition to Pola Orbis (high end skincare) and the purchase of Pigeon were all partly driven by this long-term conviction in recovery. Each of these was a highly profitable business prior to the pandemic and we assess them to have many years of growth ahead of them as consumers in many parts of Asia continue to grow in affluence. Sometimes share prices move far more than the long-term prospects of the underlying business. Pigeon was completely sold in 2018, largely on valuation grounds. Following some short-term issues, and with the shares trading 65% lower than our average selling price, we decided that the prospective returns were attractive enough to take a holding again.
“We have also been making additions across various high-growth businesses where the share prices have become much lower but where we retain conviction. Indeed, the trend towards digital transformation in Japan seems to have been strengthened by the pandemic. Digital payments, e-commerce, and online financial services are all more relevant. Therefore, we have increased holdings in 3 of the 4 most significant contributors to under-performance, which are all internet businesses, because our conviction in future returns has increased over the year.
“On the selling side two outcomes are worthy of comment. First, your Company is without a single car assembler for the first time in many years. This is because we have become increasingly of the view that consumer demand is now at a tipping point where we will see a rapid shift towards battery electric vehicles given that they have emission, running cost, and performance benefits while current challenges of range and initial price are improving. In general, the Japanese car companies are very good at making the cars of the near past but poorly positioned for this change in consumer preference. Previously combustion engine technology (including hybrids) and mechanical engineering skills have been critical and play to Japanese strengths. However, in the future battery technology and software are likely to be key, opening the car market to a range of new players. Rather than assemblers we favour companies that supply critical parts and components such as DENSO (air-conditioning and various electronic parts), Nidec (motors for battery electric vehicles) and Bridgestone (tyres).
“Second, we have sold Inpex (liquified natural gas), and reduced other resource-related names. While these have provided useful returns recently the situation is largely the opposite of companies negatively impacted by Covid. Regarding Inpex, the current situation has been very supportive of short-term earnings but technology development and environmental concern make natural gas an increasingly poor choice for energy generation.”
Managers’ comments on outlook
“Overall, there is no premium paid for the portfolio of shares in your Company relative to the Japanese market (EV/EBIT multiple of 13x in each case), despite our belief that the underlying portfolio has significantly higher forward-looking growth potential. Gearing has been actively increased as we have made a conscious decision to invest more in what we believe to be high quality growth companies at a time when their shares seem to us to be on sale. Net gearing at the end of the year was 17.5%.
“Given the difficulties globally and sharp share price falls it reflects very well on your underlying investments that in aggregate they have continued to grow their dividends. Consequently, your company will pay an increased dividend of 9p compared with 6p in the previous year, entirely covered by increased dividend income from the portfolio.
“Whilst it has been a difficult twelve months for the share price of the Company, it is perhaps worth re-iterating three sources of comfort. First, 85% of your Company is the same as the year before which means that our processes have been operating in a steady fashion. Second, in aggregate those companies have been paying out increased dividends (and doing significant share buybacks) suggesting both that cash is available and that directors have confidence in the future. Finally, given the growth profile of your Company’s portfolio it is striking that it does not trade at a meaningful premium to the Japanese market. The future is always uncertain, and volatility is inevitable, but in the past your Company has always managed to recover from setbacks and we believe that investing in quality growth companies will continue to be an effective way of preserving and growing wealth over the long term.”