Investment Strategies

Value And Growth – Japan’s Promise And Performance

Tom Burroughes Group Editor 22 August 2023

Value And Growth – Japan’s Promise And Performance

This news service recently talked to a UK-based investment house that concentrates on Japanese investments and the opportunities it sees building in the country.

Japanese equities have increasingly caught investors’ attention. While not necessarily proving to be the hottest market in 2023, the market’s rise is one of the more positive financial stories of this year so far. We have already written several articles on the area. (See examples here, here and here.)

A few weeks ago, this news service met with Zennor Asset Management, a London-based firm specialising in the country, and we met James Salter, chief investment officer, and David Mitchinson, CFA. The firm runs two funds: The Zennor Japan Fund, and The Zennor Japan Equity Income Fund.

The Zennor Japan Fund is a Luxembourg-domiciled UCITS fund investing in Japanese equities. Launched in February 2021, it aims to achieve long-term capital growth and generate excess returns against the broad Japanese market by mainly investing in companies listed, domiciled and operating in Japan. It is actively managed without reference to a benchmark and focuses on special situations in the Japanese market by investing in companies which trade at a discount to intrinsic value and have strong catalysts. For example, as a result of parent/subsidiary consolidation, capital allocation changes, or earnings growth that is superior to the broader market.

The Zennor Japan Equity Income Fund, meanwhile, is a UK UCITS fund investing in Japanese equities. This fund, which was launched in April this year, aims to provide a meaningful and growing level of income whilst preserving and growing capital. The climate for enhanced shareholder returns is improving in Japan amid a corporate governance revolution. The fund focuses on investing in companies that are able to grow cash flow and sustain dividends through time which will in turn provide a growing stream of income for our investors. 

This publication asked both men about the funds, and their investment approach.

You adopt different approaches to investing – growth and value. Can you talk a bit about how your approaches complement each other? 
Zennor AM: We both come from very different backgrounds. However, certain evolutionary changes were necessary for us to incorporate into their understanding of intrinsic value. I continue to specialise in value but am now more focused on finding a catalyst to unlock that value, and thus avoid “value traps.” I am also running some of his “winners” in the GARP space for longer. The combination of value and GARP is our main philosophy. David, having been focused on “growth” has been more focused on the GARP side.

There’s been quite a drumbeat of noise about Japan in recent weeks, and people are waking up to the performance of the market. Why has this happened just now? 
Zennor AM: It has been in a stealth bull market for over 10 years. Corporate governance reform began during Abenomics and has steadily become a major theme in the market. Recent moves by the TSE to encourage companies to explain their cost of capital/return on invested capital spread combined with getting price-to-book ratios over 1x are very encouraging. Nearly 50 per cent of companies in the TSE First Section trade below book value. There has been very little multiple expansion in the Japanese market in the last 10 years. Earnings growth has been tremendous because of rationalisation and buybacks. The foreigner has been a net seller in the last five years with corporates as the major buyer.

Starting at a broad, macro level, what do you think is the reason why the Japanese stock market is delivering these returns?
Zennor AM: Whilst there is lacklustre growth in the economy, many Japanese companies have radically transformed themselves through cost cutting and streamlining. In addition to this, we are seeing huge changes in capital allocation. NTT, the telecommunications company has seen operating profit rise by 80 per cent over 10 years but earnings per share have risen by 300 per cent. The company has bought back close to 50 per cent of the company.

On a more fundamental level (valuations, governance reforms – such as more assertive shareholders and desire for cash to be put to work) just how far can the rally in Japanese equities go? What sort of metrics do you track to ensure that you and your clients don’t get carried away? 
Zennor AM: The rally has been significant. In theory, if all companies on the exchange were to go to book value the Nikkei could exceed ¥40,000. However, a long experience in Japan means that you must expect two steps forward and one step back. Certainly, there will be a strong lobby by some companies against the recent TSE reforms. The foreigner may not come back. If he does not, then history suggests that the market will still go up as he is a good reverse indicator.

David Mitchinson has talked about a lack of “financialisation” of the Japanese economy. Can you elaborate on that a bit in terms of where the country is heading?
Zennor AM, Mitchinson: The situation in Japan is not one where we are asking firms to replace operational focus with financial leverage to boost returns. What we are asking is that companies look at their business models and reflect that equity capital is very expensive. This means that firms should pay as much attention to their working capital, under-utilised and surplus non-operating assets and how they fund their business as they do to their production line operational efficiency.

This is an area where many Japanese firms have been used to treating capital as very abundant and very cheap. Now, like labour, capital is becoming more expensive so firms will have to economise on how they deploy this and work their existing assets harder. The first step is to address excess cash and financial assets. In time we expect that this same increased capital discipline will extend to tougher choices on redefining core operations and questioning as to who is the ‘best owner’ of some assets. 

Finally, Warren Buffett, having added holdings of Japan’s five largest trading houses, has caused a lot of attention. How significant is that? 
Zennor AM: Buffett’s support for Japan is interesting. He has upped his weighting in trading companies but will also look elsewhere to deploy capital. Buffett understands that these companies sit at the heart of many corporate relationships and as these evolve, they may provide opportunities for him to deploy capital and acquire attractive assets. 

How deep-seated is the Japanese corporate world’s holding of so much cash? 
Zennor AM: The large cash positions are a function of the deflationary period of the last 30 years. Previously Japanese companies had used a lot of leverage – secured against ever-rising assets – to fund their business. As the banking system slowly failed after the bubble companies found themselves unable to secure the financing that they needed and were forced to focus on internal cash flows and assets to secure capital. The falling asset prices (peak to trough -90 per cent) also meant that cash was quite attractive as a store of value. 

Shareholders were also slow to use their power to encourage firms to focus on capital efficiency and this allowed management to favour mediocrity and safety rather than optimise for returns. The unwinding of the Keiretsu system means that this is increasingly untenable and the corporate governance reforms have encouraged shareholders to assert themselves and push companies to take their interests more seriously. Many companies realise that large cash positions now mean increased risk from activists rather than more safety.

What signs are both of you seeing that wealth managers and other fund buyers are getting more interested in Japan as a diversification play?
Zennor AM: There has been an uptick in interest. This is probably most advanced in Asia where China has become problematic for some investors, followed by Europe where the improving governance story is well appreciated. The US is lagging and investors there are still looking for reasons to confirm their underweight stance. Whilst global investors have reduced some of the substantial underweight, they remain under-exposed against benchmarks and we sense that much of the change has come through ETFs and futures, so it is tactical rather than a strategic change to be overweighted and to allocate to dedicated funds. Overall, there is an awareness that the corporate governance story in Japan is distinct compared with Europe or the US. 

How much of the stock rally is being driven by domestic investors?
Zennor AM: Historically there has been a perception that foreign participation was necessary to drive the market higher. We believe that foreign buying would be a welcome addition but only to supplement the strong domestic fund flows. This is coming primarily from the corporate sector – now significant buyers of their own equity every year. The performance of the Japanese stock market over the years after Abenomics is not due to foreigners who have been substantial sellers but almost entirely due to domestic demand. Somehow, despite this foreign selling, the market is at 30-year highs. So foreign buying is nice but not necessary. 

On a more fundamental level (valuations, governance reforms – such as more assertive shareholders and desire for cash to be put to work) just how far can the rally in Japanese equities go? What sort of metrics do you track to ensure that you and your clients don’t get carried away? 
Zennor AM: Over time there is a dramatic opportunity for the market to re-rate further. Simply for every non-financial stock to reach book value would suggest a market 25 per cent higher. However, we think that the real story is one of more focused businesses, generating higher returns on capital and commanding a multiple that is meaningfully higher than book value. For instance, if we look at Komatsu and Caterpillar both firms have similar businesses, with similar operating margins but due to increased asset efficiency at CAT their ROE is 4x higher and the stock market multiple is also meaningfully greater. For now, the story is simply one of balance sheets starting to receive some value from stock market investors. This to us suggests a very large and long-run opportunity as we move from returning excess cash to improving business models. 

We look at stocks from a variety of angles depending on the scenario. Some firms may have very valuable assets that are not properly reflected. In this case, we focus on this asset value, in others, it is about the cash flows of the business being under appreciated or masked by weak non-core operations and something changes that will make this more visible. 

Some firms may be meaningfully under earning and their PE may look high but the price-to-sales ratio or asset-based valuations are very compelling if they can improve. In many cases these weak operations consume cash flow, drive high earnings volatility and depress the multiple who investors are willing to pay as they drag down RoIC and increase the capital cost of the business. 

Our focus is on the intrinsic value – some firms deserve to trade very cheaply on assets whilst others deserve to trade at a premium multiple – our task is to find those firms trading very far below this intrinsic value and identify positive catalysts that will help them to re-rate towards fair value. The current 12x PE, 0.8x PBR and 0.5X EV/Sales are not suggestive of wildly overpaying for businesses. These are not adjusted for cash, securities or mark to market of assets of which our investments have large amounts. 

It seems that the pandemic – with the lockdowns, restrictions and actions of the world’s central banks – seems to have played quite a role in changing markets. Can you elaborate?
Zennor AM: The pandemic accelerated several pre-existing trends. First, it has highlighted supply chain vulnerabilities – this has revealed that we have been under-investing in infrastructure and resiliency. Second, it hardened the cold war-esque democracy vs autocracy divide and is leading to an abandonment of the idea of conversion towards free markets and free societies and a reassessment of how much dependency is appropriate with strategic competitors. Both factors are stimulating large, long-run shifts in capex and investment away from China and into ‘home’ countries. 

The US Inflation Reduction Act (IRA) is merely the latest example of this. In Japan, this manifests itself in large new semiconductor investments and a shift towards Asean and away from China for future capex. The lockdowns have finally driven firms to radically change their outdated IT practices and embrace much greater IT usage and more flexible ways of working which should bolster long-run productivity. Finally, in many countries, the stimulus moved from financial assets (QE) towards direct injections of high-powered money to consumers and investment. This has driven demand higher and taken up the slack in many areas pushing inflation higher. 

For Japan, which has been struggling with disinflation this is a potential positive. Firms and consumers, which are both clearly getting used to changing prices and wages in many areas, have begun to improve after being stagnant for many years. Our view is that structurally we are more likely to see higher inflation than in the past 20 years as this new capex in resiliency, energy transition pick up and the huge disinflationary impact of China integrating with the world ends. It may come at the cost of higher capex (good for Japan), higher prices for many goods (not great for consumers) and less efficiency (not great for anyone) but maybe also will lead to a rebalancing towards recently unrewarded sectors.

During our discussion, you (James Salter) spoke about how a lot of firms aren’t covered by analysts. How significant is this lack of coverage today and do you think it will change when people realise what is going on? 
Salter: Coverage is woeful outside the top 200 companies not just in quantity but particularly in quality. Economically the incentive for brokerages to cover these firms is currently quite small. We suspect a much more active market for corporate activity will stimulate more interest from brokers. This may be as simple as being retained for ‘defence advisory,’ prospective M&A, and corporate restructuring efforts where having broker coverage could be an advantage.

As firms become keener to engage with investors, they will also be more likely to reward coverage – just one Japanese firm that we know of has an IR department with Bloomberg access! This is also a reflection of the growing demand from clients who see the latent potential in these firms. We expect this to be a slow-burn improvement. For now, there is a large information asymmetry between those who go and speak and engage with under-covered companies and those who only access brokerage reports. 

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