Investment Strategies
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.