Japan, with its new prime minister and having passed through a series of reforms to the way its firms operate, presents an intriguing investment proposition. We talk to a firm that operates in this space.

Japan has waxed and waned in its attractions for wealth management clients in recent years. The country has a new government, led by its first-ever woman Prime Minister, Sanae Takaichi. The Asian nation has been through a series of changes, such as to how company shareholders are rewarded. 

This publication recently spoke to the team at Zennor Asset Management, managers of the WS Zennor Equity Income Fund, which has slightly more than £200 million ($263 million) in assets. It was launched in February 2021 and had its soft close on 15 September. The Open Ended Investment Company (OEIC) version remains open for the time being. 

Q: There have been corporate governance reforms in Japan. These changes have been in force for a while now. What would you say has been the main impact so far in terms of shareholder returns? 
Zennor: The reforms are multifaceted, so they impact not just operational returns and profits but also the deployment of legacy balance sheets (e.g. land, buildings, and stocks), and especially increased discipline in how companies invest in the future. We have directly seen this impact in terms of higher dividends and buybacks by companies. Over the past 10 years, these have increased several times. 

Q: There is a very diverse mix of businesses in Japanese conglomerates. Overall, do you see more signs of these conglomerates “unbundling” and dividing into more specialised component parts to unlock value? 
Zennor: There are lots of conglomerates in Japan. Warren Buffett warns about “de-worsification” and these firms have really embraced this, unfortunately; fundamentally, it reflects a lack of disciplined thinking about capital allocation. We now see signs of companies being far more strategic about what they do. 

Large-cap examples would include Fujitsu, which focused on its core software integration business whilst exiting hardware, phones, retail, semiconductors, etc.  Smaller firms are following suit, with our holding, Sakai Chemical, exiting its Titanium Dioxide business. In September, Sony spun out its financial business through a ‘tax-free’ spin, and we believe other companies are highly likely to use this technique. 

Q: It has been said that 66,000 Japanese firms shut down in 2024 because they lacked a succession plan. How severe is this problem and does this mean a great deal of businesses are up for sale? If so, what are the valuations of such firms? Are buyers seeking significant discounts? 
Zennor: The biggest issue is in the unlisted sector. Most listed firms can find someone to run them. However, on the private side, ownership and management are often combined. Many of these are quite substantial enterprises, but employees just aren’t rich enough to buy them and, in any case, they usually lack the founder/CEO mindset to do so. 

Frequently, they can be bought at relatively low multiples because of the lack of good buyers. Equally, it should be stressed that many sellers are as interested in a good home for their business as they are in a high price. Our holding Genda has a typical acquisition multiple of 2 to 3x cash flow in Japan. There is also a growing number of mid-market PE firms that focus on this, such as Integral. 

There are several other companies focused on acquisition-driven growth in areas as diverse as waste management, bottling, industrials, LPG distribution, and elevators. Often selling non-core assets is good for the seller and the buyer. Too many assets in Japan are “stuck” in the wrong place and can be stronger companies with the “best owner.”

Q: A few weeks have elapsed since the arrival of a new Japanese premier. What’s the sense so far of where Japan is heading on fiscal/monetary policy and what does this mean for your portfolio and the areas you invest in?
Zennor: We think Sanae Takaichi is not going to pursue a radically different direction. She seems likely to provide much more decisive leadership, which was lacking with [Fumio] Kishida and [Shigeru] Ishiba. She has realigned the LDP alliance with Ishin, which is a more natural fit than the Komeito [party]. 

Her broad stance is to run the economy a little “hotter,” emphasise looser monetary and fiscal policy, and to prioritise defence. We believe this should be good for Japanese assets, and we have seen large moves in defence-themed stocks. However, these are not radically new policies from the government, so it remains to be seen just how different her policy is in practice. 

Takaichi's big advantage is that her popularity is very high, she is well aligned with core LDP players, so the internecine struggle between right and left of the party should diminish. We expect she will call an election to capitalise on her popularity. Her true political priorities will likely become established at this point. 

Q: Let’s talk about Japanese inheritance tax and how this affects family firms. 
Zennor: Japanese inheritance tax is 60 per cent. This means that even wealthy families struggle to pay the tax on listed assets. One incentive to delist is that the private market value is opaque and through careful structuring, the family exposure can be significantly reduced. This creates a powerful incentive for families to go private, transfer assets and then potentially relist. 

Q: In general terms, how would you set out the case for investing in Japan to a wealth management firm/end client etc? 
Zennor: The key distinctive story in Japan amongst developed markets is the revolution in corporate governance. The US and Europe went through this process in the 1980s and 1990s, during which firms de-conglomerated and utilised idle assets. 

Our fund has tended to be much less volatile than the market (up and down), but it is a very actively managed fund, so it does not look very much like the benchmark. As the fund is seeking to pay a growing income stream (in yen) this naturally biases you towards well-managed companies with strong cash flow and strong balance sheets. They are typically less volatile than the broader market. 

This may mean that the fund deviates substantially at times from the index return. Whilst we think governance reform should be the core of any Japan strategic allocation, we do know that we are often held alongside other Japan strategies or as an “alpha” driver. Personally, I only have Zennor Japan funds but my exposure is not representative!

Q: How do you handle exchange rate fluctuations (yen vs dollar, sterling etc)?
Zennor: We only offer unhedged share classes. Our belief is that the yen is very undervalued and at some point, is likely to strengthen. So far, we have not been correct. Where possible we try and avoid very directional bets based on the foreign exchange outcomes. If the company is really struggling at today’s FX rate, they likely have a compromised business model. 

Q: Please discuss three or four firms that you hold/really like to hold that illustrate your investment philosophy?
Zennor: We own a self-storage company called Arealink. It is the largest company in this field in Japan and has steadily grown its units year after year. Historically, it also had more volatile development business.

The opportunity was that this volatile and capital-intensive business masked the quality of their core franchise and left the firm trading at a very cheap multiple. We engaged with the founder and explained how this had increased the cost of capital for Arealink and that investors were very attracted to the high growth annuity revenue stream but deterred by the development volatility. The company committed to scaling this business back and in their latest medium-term plan will shrink this segment even more radically. With the freed-up capital, they have been able to increase dividends and accelerate the core business growth. The company trades at less than half the valuation of similar listed global peers and has a net debt-free balance sheet (unlike many peers), presenting us with a highly attractive growing dividend stream at a low valuation.

Recently we acquired HiLex. This is an auto parts company well known to us for many years. It has suffered along with many companies in the transition to electric vehicles but has been progressively shifting its business towards unimpacted areas, including medical. As a result of these headwinds, it traded at a big discount to financial assets. Finally, the new CEO has taken decisive action by reducing costs in North America and making a shrewd acquisition in Japan. 

This purchase offers an opportunity for upside but was made at a bargain price. Trading at a low PBR, with a strong balance sheet and positive change underway, we felt that this opportunity was very attractive. Even today, the PBR multiple remains very low. 

We also purchased a software company, JustSystems. They are closely linked to Keyence and follow them with outstanding execution, but with limited focus on balance sheet management. Their business model is around 75 per cent recurring, with a very high margin, and growth rates are accelerating as they expand beyond Japan. We see a long growth runway ahead of them that is not properly reflected in their 10x EBITDA multiple. 

Q: What firms have you sold or cut exposures to recently, and why?
Zennor: We recently sold a company called Kurimoto. When we bought it, the multiple against assets was only 0.3x, and it had a very large cash position. We spoke to the CEO Mr Yagi about the need to utilise the cash and to respond to the Japan Stock Exchange (JPX) request for “management conscious of the cost of capital.” Over two to three years the dividend was aggressively increased, and the company also bought back its own shares. 

These positive steps to reward shareholders saw the multiple increase to over 1x book value. At this point we saw more compelling opportunities elsewhere. We thanked Mr Yagi for the tremendous job that he had done and then sold.