Baillie Gifford Shin Nippon has published its accounts covering the 12 months ended 31 January 2024 and the figures do not make good reading. Over the year, the NAV declined by 14.9% and the share price by 20.5%. The MSCI Japan Small Cap Index rose by 6.3%.
Over five years, the index was up 24.1% while the NAV was down by 6.8% and the share price was down 26.3%.
The statement says that portfolio performance has remained weak since the decline in impact of Covid-19 as large-cap value stocks have been very much in favour compared to high growth small cap stocks. Most of the portfolio’s poor performers over the past year were companies with meaningful exposure to China. There was wide sectoral dispersion among the portfolio’s top performing stocks.
New conditional tender offer
The board is committing to a one-off performance-triggered tender offer for up to 15% of the issued share capital if the NAV underperforms the MSCI Japan Small Cap Index over the three years to 31 January 2027. [QD comment: the question is – is this too little, too late? After five years of underperformance, will shareholders be prepared to be patient for another three?]
Turnover for the financial year was 12.1%, with seven positions exited and five new positions initiated. There are currently four private companies in the portfolio accounting for 3.7% of total assets.
The year end discount was 14.6%. 4,395,000 shares were bought back in the reporting period and are currently held in treasury.
The persistent share price weakness of most holdings across the portfolio, together with their strong operational performance has meant that the portfolio as a whole has been de-rated significantly and, relative to the comparative index, although valued at a small premium it should deliver much faster sales growth.
As the focus on fundamentals takes a firm hold, portfolio performance should recover. The board and managers remain of the view that exceptional long term returns are likely to be generated by young, disruptive, fast-growing and entrepreneurial smaller businesses in Japan.
Revenue return per share was 0.94p (2023 1.11p). Having been in deficit for a number of years, the revenue reserve has moved to a surplus. The Board is recommending a final dividend of 0.80p per share, being broadly the minimum required to maintain investment trust status.
The chairman’s statement looks at the reasons for the underperformance and concludes that the problem is:
- growth stocks being out of favour, with high growth Japanese small cap stocks indiscriminately sold, particularly by domestic Japanese investors, in favour of value stocks;
- the portfolio has had historically longstanding structural underweights in the energy, industrials, financials and materials sectors, all of which have done exceptionally well over the past couple of years. In aggregate, these sectors account for just over 40% of the comparative index and being underweight has impacted relative performance; and finally
- rising interest rates and geopolitical risks have tilted investors towards stocks perceived to be ‘safe’. These tend to be highly cyclical (global industrials, shippers), interest rate sensitive (financials), invested in real assets (trading companies, miners) and extremely low valuation (often less than 0.5 times price-to-book). These characteristics are not favoured by the portfolio manager.
Extracts from the manager’s report
Over the past year, there was wide sectoral dispersion among the portfolio’s top performing stocks. The top contributor to relative performance was Megachips, the largest supplier of custom-made chips for Nintendo’s gaming consoles. The company has benefited from the success of Nintendo’s Switch console and is using the profits generated from this business to expand into new areas where it is already making strong progress. Recent holding SWCC, was another strong performer. It makes electrical wires and cables for power companies and was first purchased for the portfolio in May 2023. Since then, the share price has risen by nearly 80%. It is run by its first ever female president in its nearly 90-year history. Under her leadership, it is transforming itself from a manufacturer of commodity products to a high value-added component supplier. It has expanded its opportunity set by capturing demand in renewables and electric vehicles. Margins have been on an improving trend, and it appears that there is considerable upside remaining in the shares. Online shoe retailer Jade Group (previously named Locondo) was another strong performer. It is forecast to grow profits at nearly 80% in the current fiscal year and yet trades at very low multiple of profits. It has secured a leading market share in Japan and is continuing to expand rapidly. Management has also been buying back shares regularly which is quite unusual for what is an immature small cap company.
Longstanding holding Bengo4.com also performed well. Growth of its online legal business has accelerated following the introduction of a range of artificial intelligence enabled services which have been well received by the legal community. Its digital contracts business, CloudSign, is also making rapid progress and has already achieved a dominant share of the public sector market. Elsewhere, enterprise software provider oRo generated stronger than expected sales and profit growth. Its cloud-based project management and cost accounting software attracted increased interest among small and medium enterprises. Its good operational performance was rewarded by the market, resulting in a strong share price. Japan’s largest drugstore chain, MatsukiyoCocokara, was also among the portfolio’s top performers. It is benefiting from a revival in inbound tourism and the integration with Cocokara Fine, a smaller peer acquired three years ago, continues to progress well, resulting in significant synergies.
Most of the portfolio’s poor performers over the past year were companies with meaningful exposure to China. They suffered from a sharp fall in demand as a weak Chinese economy forced corporate and individual consumers to rein in spending. Premium motorcycle helmet manufacturer Shoei was among the largest negative contributors to performance. Along with weak consumer demand, it is also facing regulatory change in China which has forced it to modify the specification of its helmets to comply with the new rules. This has resulted in additional costs which have squeezed its profit margins in the short term. Sensor manufacturer Optex is also suffering from weak demand in China. Factory automation is its key end market, and the Chinese factory automation sector continues to remain sluggish following a period of inventory correction. It was a similar story for automatic lathe manufacturer Tsugami which experienced a sharp fall in orders from its Chinese customers who are taking a cautious stance towards forward-looking investments.
Second-hand home renovation specialist Katitas was another holding that performed poorly. It was embroiled in a tax dispute with a regional tax agency that resulted in the company taking a one-off hit to profits as it was forced to pay a fine. This incident was taken negatively by the market. We believe this was an isolated incident. Fundamentally, Katitas remains a strong business, with a solid competitive edge and very attractive growth prospects. Litalico, which provides education and welfare for disabled adults and children, also performed poorly. Its shares have halved over the past two years despite sales growing at over 20% per annum and profits at over 30% per annum over this period. Management is investing aggressively in rolling out learning centres nationwide and this has held back further margin expansion in the short term, and which was taken by the market as a disappointment. In contrast, we see this as positioning the company for future growth.
As alluded to earlier, there has been a significant uptick in corporate activity in Japan, driven by activist investors and private equity groups. Although this is centred mostly around old economy large cap companies, we are seeing some of this activity spill over to small caps. Within the Company’s portfolio we have had two stocks, outdoor camping equipment manufacturer Snow Peak and staffing company Outsourcing, that have both announced a management buy-out supported by Bain, one of the largest private equity groups globally. This has been done at an average premium of around 50%. Another portfolio holding, Wealthnavi, announced a capital and business alliance with MUFG Bank, part of the MUFG Group which is one of the world’s largest financial conglomerates by assets. Wealthnavi is Japan’s largest robo-advisory firm for wealth management and as part of this deal, MUFG is taking a 16% stake in Wealthnavi. By leveraging MUFG’s considerable resources and vast customer base, we believe Wealthnavi can potentially transform its growth opportunity.
BGS : 2023 was a year to forget for Baille Gifford Shin Nippon