Schroder Japan Growth (SJG) has published its annual results for the year ended 31 July 2022, during which it provided an NAV total return of 1.0%, outperforming its benchmark which produced a negative total return of -1.9% over the year. The share price fell -2.0% on a total return basis, with the discount averaging 11.0% over the year. In Yen terms the Japanese market rose by 4.5% in the 12 months, but the Japanese currency weakened across the period, which led to a lower return from the market in sterling terms. SJG’s manager’s bottom up approach has a value bias that has generally supported performance during the year. SJG’s gearing, which ranged between 10.4% to 12.1% during the year, also had a modest positive impact on SJG’s performance.
Update on potential tender in 2024
SJG has a target to deliver net asset value total return performance of at least 2% per annum above the benchmark over a four year period starting from 1 August 2020. Should this target not be met, the Board will put to shareholders a proposal for a tender offer of 25% of the issued share capital at a price equal to the prevailing net asset value less costs. This tender is contingent on the next continuation vote of the Company at the AGM in November 2024 being passed. So far, the Manager has delivered an annualised net asset value total return of 12.7% (over the first two years of the four year period) compared with 7.6% from the benchmark.
Key extracts from manager’s comments on market backdrop
“In the first half of 2022, aside from the ongoing human tragedy unfolding in Ukraine, Japan’s equity market was primarily driven by news flow on monetary policy and currency markets, together with concerns over the growing possibility of a US recession. Comments from the US Federal Reserve ahead of April’s interest rate increase clearly pointed to a widening interest rate differential with Japan materialising earlier than expected. This view was reinforced by the results of the Bank of Japan’s own policy meeting on 18 April, which confirmed no change in policy and the maintenance of the existing target of +/- 25bps for the 10-year bond yield. There was some surprise in the degree of commitment to this target shown by Governor Kuroda when he announced more details around the central bank’s operation of fixed-rate bond purchases. Prior to March, these operations had been extremely rare, and generally only deployed at specific moments of significant market stress. However, Mr Kuroda stated that these fixed-rate operations would be conducted every day throughout May, virtually guaranteeing no rise in bond yields, which quickly pushed the yen through the key psychological 130 level against the US dollar.
“Although the sharp weakening of the yen has prompted several public statements, the Bank of Japan’s room for manoeuvre on the exchange rate is, in reality, very limited. Shortly after the end of the review period, however, the Ministry of Finance did intervene directly in currency markets to support the yen. While such action could yield short-term results it is unlikely to create a long-term trend change in the absence of a fundamental shift in policy from the Bank of Japan. Throughout Japan’s two decades of deflation, investors have generally viewed yen weakness as positive for Japan since the benefits for exporters were seen to outweigh any potential inflationary impact, and it seems that Bank of Japan Governor Kuroda clearly remains very much in favour of this view. Since May 2022, however, the yen’s weakness has coincided with a reversal of several other factors, especially mobile telecom charges, which had been suppressing the year-on-year inflation rate in the previous 12 months. This soon became evident in the headline inflation numbers, which showed core CPI (excluding only fresh food) jumping to 2.2% in June as the significant reduction in mobile phone charges finally dropped out of the year-on-year numbers. Although this level is slightly above the Bank of Japan’s 2% target, the real question remains whether longer-term inflation expectations move higher in response, leading to more substantial wage growth as part of Japan’s normalisation after decades of deflation. Nevertheless, underlying inflationary pressure in Japan does now appear to be creeping up, and the year-on-year increase in producer prices continues to run well ahead of consumer prices.
“Despite successive delays in Japan’s domestic economic recovery, and heightened global uncertainty, Japanese corporations appear to be performing well and quarterly results announced during the fiscal year ended March 2022 were consistently ahead of expectations. This has been particularly true for manufacturing sectors that have benefitted from the global recovery, but non-manufacturing and service sector profits have also held up despite the successive restrictions imposed on domestic activity in this period. Around the end of the fiscal year, there was a further pick-up in global uncertainty so it was not surprising to see some companies making overly conservative forecasts for the new fiscal year. Overall, however, the tone of results and guidance was still slightly better than expected.”
Manager’s comments on portfolio performance
“The Fund’s bottom-up stock picking approach typically results in a moderate bias towards an overall “value” style (emphasising stocks on below-average valuations). This style has generally supported performance of the fund in the last 12 months as the market environment has typically responded to stock-specific drivers, which has allowed the Fund’s stock selection to add value.
“Although overall market trends in this period have been dominated by global news flow on monetary policy and Russia’s invasion of Ukraine, investors have also begun to recognise the earnings potential for many Japanese companies and individual stocks have reacted positively to upward revisions in earnings expectations.
“Net gearing in the Fund was 11.1% at the end of July 2022, having been in a range from 10.4% to 12.1% during the previous 12 months. The gearing has had a modest positive impact on Fund performance during the year, which has added to the gains made from stock selection.
“Among individual stocks in the portfolio, the largest positive contribution came from Tokio Marine, one of Japan’s major insurers. The stock price has performed consistently well throughout the last 12 months, reflecting the company’s improved Return on Equity and higher shareholder remuneration. There was also a strong performance from NTT, Japan’s largest telecom service provider. The company is typically seen as defensive, due to its relatively predictable earnings, but performance was very strong in the first six months of 2022, following some restructuring of group companies that was announced in late 2021.
“The Fund’s relative performance in this period also benefited from the weakness of Softbank Group, the telecom and investment conglomerate, which is a significant component of the benchmark, but is not held in the Fund. The stock had been strongly favoured by investors in 2020, but then underperformed throughout 2021, resulting in a positive impact for the Fund in this review period.
“Some of these positive impacts on Fund performance were offset by the underperformance of Ibiden a ceramics producer specialised in semiconductor packaging. This was mainly influenced by weakness across the technology sector in the first half of 2021, especially for stocks related to semiconductor production.
“There was also weakness in Trusco Nakayama, a mid/small-cap distributor of industrial tools and related supplies. The share price has reflected the company’s weaker top-line growth due to the slower than expected recovery of domestic industrial production, as well as the overall underperformance of mid/small-cap stocks in the first half of the period. The Fund maintains no holding in this stock as the real value of Softbank’s investment holdings is difficult to predict.”
Manager’s comments on portfolio activity
“During the 12-month period we added a new position in Rinnai, which manufactures water heaters. The company’s near-term earnings have been pressured by the combination of component shortages and material cost increases, which resulted in meaningful share price underperformance. However, the company is now implementing price increases to offset these higher costs and component shortages should gradually ease towards the second half of this fiscal year. Thanks to the ongoing structural shift in US & China towards more energy efficient tankless boilers, order backlog has been increasing, which should accelerate their earnings growth once component shortages improve. The recent share price underperformance has brought valuations down to low levels. The forecast Price/Earnings ratio reduces to around 10x, if we exclude cash of around 45% of market cap. We therefore concluded that the recent share price weakness is a short-term overreaction to current conditions and we added a new position in May.
“A new position was added in Nitto Denko. Investors tend to view the company’s earnings as highly dependent on the LCD market which has been benefiting from “stay at home” demand (for LCD TVs, PCs, etc.), which has already matured. This has left the valuations at a discount against other electric component and material stocks. However, we believe this is a misperception, as we see their businesses as more diversified, with several solid growth drivers such as nucleic acid medicine CDMO, high-density flexible PCBs as well as profitability improvements in industrial tapes through product reshuffling. As a result, we expect Nitto Denko to sustain solid earnings growth over the mid-term, which should lead to a revaluation of the share price.
“We initiated a position in Yokogawa Electric, which supplies measurement and control equipment used in factory automation, especially in industries such as chemicals, food and oil & gas. The stock looks particularly undervalued against its global peers given the near-term industry dynamics and the longer term growth potential from expanding autonomous solutions.
“We also added Ricoh, as we believe other investors have not yet appreciated the company’s transition towards a full IT service vendor for small and mid-sized businesses. The current valuation has been pushed down by shorter-term factors, including a slower than expected return to office working post-Covid, which has created an attractive entry point.
“A new position in NEC Networks & System Integration was also added to the portfolio. The company’s main businesses are IT service and telecommunication engineering and they are transforming themselves to move up the value chain in both these areas. In IT service, the company has traditionally been a subcontractor but they now are more engaged in valued-added IT service/solutions, including work from home solutions. In telecommunication engineering, they are improving their value propositions from simply installing hardware, such as wireless base stations, to upper-layer services. These management-led transformations should improve gross margins and lead to share price revaluation.
“An initial position was added in Kohoku Kogyo at its Initial Public Offering (IPO). This small-cap company is not yet closely followed by other investors, but has a dominant global market share in two niche electronic businesses: lead terminals for aluminium electrolytic capacitors and optical isolators for undersea optical cables. Valuations at the IPO looked attractive against other niche technology providers.
“Meanwhile, we exited the position in Nabtesco. The original investment thesis was that Nabtesco, with its dominant market share in precision reduction gears for industrial robots, would show a solid earnings growth along with the ongoing expansion of the market for factory automation. However, through its new mid-term plan, the company is planning aggressive growth in spending in all of its business segments. Given the relatively lacklustre track record in realising benefits in areas other than the precision reduction gear business, we are increasingly concerned about its weakening capital discipline. We therefore concluded that there are better alternatives to give exposure to the growth in factory automation, so we decided to sell out of the position.
“We sold the position in Pan Pacific International, a retailer operating under the Don Quijote brand. While we acknowledge that their earnings may hit a cyclical bottom, we have become more concerned about their future growth prospects. We feel their discount store format may be losing some of its attractiveness to (younger) consumers, who tend to make a search online to decide on potential purchases, rather than visiting stores just to find interesting items, which has been the benefit of Don Quijote’s unique store experience. In addition, while the recent management changes look reasonable we wonder if this may hinder the competitiveness of their bottom-up management where each store manager has a high level of authority. We decided to sell the position as we felt our concerns over long-term competitiveness may put further pressure on the stock’s valuation, which remained at a premium to the market average.
“The position in Miroku Jyoho Service was also sold. The company is a software and IT service provider which we expected to benefit from the growth in IT spending by small/mid-size businesses. However, the earnings recovery has been slower than expected, which may reflect some market share losses against emerging cloud-based vendors. We now have lower confidence about their competitiveness and management execution, so we have sold out of the position.
“Two positions were sold as a result of corporate actions. One small position was sold in AT Group, which operates Toyota car dealerships in Aichi prefecture. The company is a classic example of a “traditional” small-cap value stock in Japan and saw a 78% gain in February after the announcement of a management buy-out. The position in Hitachi Transport System was sold after a steep rise in the share price, triggered by a buyout proposal from KKR.
“Overall, the number of holdings has been further reduced to 66, continuing the trend seen over the last couple of years, as we look to place more emphasis on higher weightings in stocks where we have the greatest conviction.”
Manager’s comments on outlook
“The recent rebound in Japan’s industrial production, after some Shanghai-lockdown induced weakness, has underlined the relative strength of manufacturing sectors in Japan. The successive delays in a domestic consumption recovery has mainly impacted non-manufacturing sectors, although we would still look for Japan to grow above its long-term trend rate this year as the large fiscal package, agreed in late 2021, is implemented. However, we still need to carefully watch the development of Covid infections as the high level of risk aversion in Japan could still dictate a more cautious approach than that seen in Europe. This is likely to be particularly evident in the very gradual approach to the reopening of Japan’s borders to foreign travellers.
“The strong result for the ruling LDP in July’s Upper House elections has reinforced the position of Prime Minister Kishida but, beyond the election, the government faces a range of key long-term policy decisions. These include fundamental, and constitutional, questions on defence and a particularly difficult balancing act on energy policy. The war in Ukraine has thrown into sharp relief Japan’s dependence on imported energy and its relative lack of energy security over the long-term, with almost all nuclear plants remaining offline since the Fukushima earthquake in 2011. Although Tokyo has narrowly avoided power cuts during record high temperatures in the early summer 2022, Mr Kishida has nevertheless felt empowered to open up a public discussion on the restarting of nuclear plants.
“Looking further ahead, equity investors will need to adjust gradually to the change in governor at the Bank of Japan as Mr Kuroda’s term comes to an end in March 2023. With Mr Kuroda so closely associated with the current policy of yield curve control, it is hard to envisage any substantive changes in the near-term. However, before the end of 2022 we could see technical changes in the way the policy is implemented, which could indicate more clearly the direction of travel likely to be seen under his successor.
“The main upward pressure on prices in Japan comes from a combination of higher imported energy costs, coupled with the sharp weakening of the yen so far this year. Although these factors could gradually fade from the year-on-year inflation rate going into 2023, Japan does seem to be heading into a period of moderate but sustainably positive inflation. While producer prices have been rising for some time, we have recently seen more anecdotal evidence of companies looking to pass on these increases to end-product prices, but consumers remain very price sensitive after two decades of deflation. Although some particular sectors may struggle in this environment, overall margins do appear to be resilient so far and we are comfortable that aggregate corporate profits for the listed sector continue to grow. In the immediate future, however, the heightened global uncertainty may mean that relative market valuations remain at a discount against this longer-term outlook for corporate profits. We are also very positive on the ongoing improvements in corporate governance and the scope for this to generate real value for investors. Although this is partly a qualitative assessment through our discussions with company managements, there are also measurable impacts such as improving return on equity and a record level of share buybacks announced in the early part of the current fiscal year.”