Atlantis Japan Growth Fund — New dividend policy will pay out 4% of NAV pa

Japanese economic growth forecasts have come down over the course of this year, likely due in part to the October 2019 increase in consumption tax from 8% to 10%, although government stimulus, which includes higher public spending and tax breaks, may offset the worst of the demand impacts. However, unlike in April 2014, when the tax increased from 5% to 8%, there has not been a spike in demand ahead of the hike; time will tell if this is due to confidence in the stimulus proposals, or an indicator of a generally cautious consumer. On a positive note, Japan is hosting the Olympics in 2020, which should stimulate demand within the broader economy. Inbound tourist flows have already been in an uptrend in recent years due to eased visa restrictions, growth of low-cost carriers and promotion by the Japanese government. Structural changes are also providing growth opportunities within the country, and with the 2% inflation target a long way off, the Bank of Japan is likely to continue its loose monetary policies. Within Japan, there is an increased focus on the Corporate Governance Code; there are moves towards more efficient allocation of cash at the corporate level and higher returns to shareholders via dividends and share buybacks, which over time should increase the appeal of Japanese equities to global institutional investors.

Over the last five years, small-cap Japanese equities have outperformed both the wider Japanese and world markets, all in sterling terms (Exhibit 2, LHS). In aggregate, on a forward P/E multiple basis, Japanese shares continue to trade at a meaningful discount to global equities (13.5x vs 14.8x). The current 8.9% discount is meaningfully wider than the 5.6% average discount over the last five years. This valuation differential may provide a margin of safety for investors seeking Japanese equity exposure.

AJG was launched on 10 May 1996, and is a Guernsey-registered investment company listed on the Main Market of the London Stock Exchange. Its investment manager is specialist fund management firm Quaero Capital, with Tokyo-based Atlantis Investment Research Corporation (AIRC) acting as investment adviser. AIRC was established in 1996 and is an independent firm with four investment professionals who have an average of more than 30 years’ investment experience. Taeko Setaishi has been AJG’s lead adviser since 1 May 2016 (having formerly been its deputy fund adviser for 20 years). The fund aims to generate long-term capital growth from a diversified portfolio of Japanese equities. It may invest up to 100% of gross assets in companies listed on any Japanese stock exchange and up to 20% of NAV in companies listed overseas that have significant operations in Japan. Up to 20% of NAV, at the time of investment, may be allocated to equity warrants or convertible debt; however, AJG’s current portfolio is entirely invested in publicly listed Japanese companies, including REITs. A maximum 10% of the portfolio may be held in a single company. At the time of borrowing, gearing up to 20% of NAV is permitted; at end-September 2019, net gearing was 1.5%. Typically, the fund’s currency exposure is unhedged. AJG’s investment performance is benchmarked against the TOPIX. Data from Northern Trust and Bloomberg show that from the fund’s inception to end-July 2019, AJG’s NAV total return in sterling terms was +291.2%, which is significantly ahead of the benchmark’s +61.9% total return.

Setaishi notes that global economies are decelerating, and Japan is no exception, with consensus GDP estimates for the year ending 31 March 2020 of around 0.3–0.5%. While, in aggregate, there have been negative earnings revisions in Japan, the adviser is continuing to focus on those companies with favourable growth attributes. She says this does not just benefit shareholders, but also motivates a firm’s management team, employees (including better staff retention, which is a big problem in Japan) and customers. Setaishi comments that higher earnings provide capex for future growth, and encourage a better corporate governance culture, with the potential for improved shareholder returns.

The lead adviser highlights one of the important themes within AJG’s portfolio, all of which have longevity in terms of investment. ‘New opportunities’ are companies benefiting from structural change within Japan. Some are new businesses, including financial and business consultancy services, while others are new models for established firms. Setaishi comments on AJG’s holding in Nihon M&A Center, which has been in the portfolio for around a decade and is benefiting from the higher number of mergers and acquisitions in Japan – drivers of this include labour shortages and an ageing population, leading to a higher number of retiring business owners. She believes that Nihon M&A Center has growth potential for many years to come.

In Q119, the Japanese equity market rallied strongly, along with other global markets. Setaishi explains that subsequent weakness in Japan was driven by selling by overseas investors, while domestic buyers have been net purchasers. She says that certain Japanese companies’ shares are favoured by overseas investors; she tends to avoid these as they can experience exaggerated fund flows. The adviser says that the selling by overseas investors has been technically rather than fundamentally driven; if investors wish to express a negative view on Asia, selling Japanese equities is an obvious choice given the much higher liquidity available compared with other markets in the region.

Portfolio construction is based on a disciplined, bottom-up approach to stock selection. Setaishi believes that company share prices are ultimately driven by profits growth; she seeks companies with secular growth potential, competitive advantages and strong cash flows, that are trading at a discount to their perceived intrinsic value. The resulting portfolio typically contains 60–70 primarily small- and mid-cap Japanese equities, which are often under-researched and can be mispriced.

AIRC has a four-stage investment process:

Position size is a function of Setaishi’s level of conviction in the holding, while taking a stock’s liquidity into account (typically, starting positions are 0.5% of the fund, before being built to 2.0% and then allowed to run). AJG’s portfolio has a high active share (95.6% at end-September 2019); this is a measure of how a portfolio differs from its benchmark, with 0% representing full index replication and 100% zero commonality. Holdings may be sold if there is a downturn in a company’s operating environment, following an earnings disappointment, if there is an unjustified change in a firm’s business model, or if a position becomes too large.

At end-September 2019, AJG’s top 10 holdings made up 30.9% of the portfolio, which is a higher concentration compared with 26.3% 12 months earlier; only three positions were common to both periods. During this time, the largest exposure changes on a market cap basis are a lower weighting to companies between £500m and £2bn (-10.5pp), with higher weightings to larger firms (£5bn to £10bn, +5.7pp) and smaller companies (<£500m, +4.6pp).

In terms of sector exposure, over the last 12 months to end-September 2019, the greatest increase is in healthcare (+2.4pp), with a lower weighting in industrials (-4.3pp); although this sector remains the largest active bet versus the benchmark (+19.5pp). The fund continues to have no exposure to the consumer staples and energy sectors, which make up c 10% of the TOPIX.

Setaishi focuses on a couple of relatively new additions to AJG’s portfolio, Japan Medical Dynamic and QB Net Holdings (QB). Japan Medical Dynamic is a beneficiary of Japan’s ageing population. It was historically a seller of medtech products, but now as a result of mergers and acquisitions, it has its own manufacturing operations. Its product range includes bespoke implants, which are contributing to the firm’s increasing market share. Around 40% of Japan Medical Dynamic’s sales are generated in the US and 86% of revenues are from its own products, which is enhancing margins. QB stands for Quick Barber. Its model is based on a fast, cheap customer turnaround in high-footfall locations (10 minutes for c $11), and is also relatively attractive to employees in terms of better pay and working conditions compared with traditional barbers. The company is benefiting from consolidation in a very fragmented market, where the top 10 players have a combined market share of less than 5%. Setaishi is hopeful about a change in the shareholder base, which currently contains some investors with a shorter-term horizon. Recent complete disposals include Money Forward (a platform business whose products are taking longer than expected to monetise), and SharingTechnology (which provides services to deal with household problems; however, the founder left the company less than 12 months after it listed, which Setaishi says was a red flag).

In FY19 (ending 30 April) AJG’s NAV and share price total returns of -0.1% and -0.2% respectively were better than the -2.9% total return of the benchmark. Positive contributors included Lasertec (semiconductor production equipment), Benefits One (corporate benefits administration), Daifuku (material handling/logistics systems equipment) and Asahi Intecc (medical equipment).

Setaishi highlights some of the fund’s main contributors to performance so far in 2019. Successful holdings include Japan Elevator Service (investors are focusing on infrastructure spending ahead of the 2020 Olympics), Lasertec (delivering good earnings in a recovering semiconductor sector) and PeptiDream (a profitable biotech company). Less successful positions include Recruit Holdings (which has been unwinding its cross-holdings), SharingTechnology (founder departed the company), and Link & Motivation (faltering business momentum).

In absolute terms, over the last three, five and 10 years, AJG has generated annual total returns of 12.5–15.3% (NAV) and 13.1–15.3% (share price). The fund’s relative returns are shown in Exhibit 8; they include dilution of more than 10% from the issuance of subscription shares in October 2016 and October 2017. AJG has outperformed the TOPIX over one, three, five and 10 years, with particular relative strength over three and 10 years. It has also significantly beaten the performance of the bellwether UK index over three, five and 10 years.

The board adopted a hard discount control mechanism in 2013, whereby a continuation vote was held if AJG’s shares traded, on average, at a greater than 10% discount to NAV during any rolling 90-day period (in normal market conditions). It now employs a less formulaic approach to managing the discount, using share repurchases. The company has the authority, granted annually, to buy back 14.99% of its outstanding shares; so far, in FY20, 0.3m shares (0.7% of the share base) have been repurchased at a cost of £0.7m.

Over the last three years, AJG has traded in a wide range of a 0.4% premium (February 2018) to a 14.6% discount to NAV (November 2018). Its current 13.2% discount is wider than the 8.9% to 9.6% range of average discounts over the last one, three, five and 10 years.

AJG is a closed-end investment company with one class of share; there are currently 41.8m ordinary shares in issue, with a further 4.7m held in treasury. The company has a ¥1.5bn (c £10m) credit facility with Royal Bank of Scotland International, of which ¥1.0bn (c £7m) is currently drawn. At end-September 2019, net gearing was 1.5%.

Over time, AJG’s capital structure has been simplified, which the board believes should make it more appealing to shareholders. The company’s subscription share mechanism was discontinued in November 2017 (having successfully raised c £11m in FY16 and c £15m in FY17). AJG had a facility (at the board’s discretion) that enabled shareholders to sell all or part of their holdings via a six-monthly redemption of up to 5% of the company’s outstanding shares. However, the board believes that paying a regular dividend, out of capital reserves when required, is an effective and low-cost way to provide additional liquidity and a fairer way to distribute capital to all shareholders (see following Dividend policy and record section). The last redemption opportunity was in September 2019. On 24 September, the board announced that 2.9m shares (6.57% of the share base) had been lodged for redemption, which would be scaled back to 5% (2.2m shares).

The board has announced a change to AJG’s fee structure; starting in FY20, Quaero Capital will be paid an annual management fee of 1.00% up to £125m of NAV, 0.85% between £125m and £175m, and 0.70% on NAV above £175m (the previous fee was a flat 1.00% of NAV). No performance fee is payable. In FY19, AJG’s ongoing charges of 1.63% were 6bp higher year-on-year, but considerably lower than 1.91% in FY16, illustrating the benefits of spreading fixed costs over a larger asset base.

AJG has a four-yearly continuation vote, with the next due at the 2023 AGM. Shareholders voted overwhelmingly (99.9%) in favour of continuation at the 2019 AGM in September.

At the September 2019 AGM, AJG’s shareholders approved a new dividend policy. There will be regular quarterly payments of 1% of the company’s NAV (based on the average daily NAV in the final month of the financial year). These will be paid in March, June, September and December. The first payment under AJG’s revised policy will be in December 2019; based on an average NAV of 237p in April 2019, the December 2019, March 2020 and June 2020 distributions will be 2.37p per share. If there were four rather than three dividend payments in respect of FY20, this would equate to a prospective dividend yield of 4.2%.

The board notes that investors are increasingly seeking income and are becoming more comfortable with dividends that are paid out of capital as well as revenue reserves. It believes that compared with six-monthly redemptions, a smaller and more frequent dividend will be less disruptive with regard to AJG’s portfolio construction.

In Exhibit 11, we show the three closed-end funds in the AIC Japanese Smaller Companies sector that have been trading for more than a year (AJG actually has an all-cap strategy). AJG’s NAV total returns rank first over the last 12 months, second over three years, third over five years and second over 10 years. (The company’s returns include more than 10pp dilution as a result of subscription share issuance between October 2016 and October 2017.) AJG has a wider than average discount and the highest ongoing charge, arguably due to spreading fixed costs over a smaller base. It has a below-average level of gearing and currently does not pay a dividend, although as shown in the previous section, shareholders have recently approved a change in the company’s dividend policy.

To enable a broader comparison, we also show the six closed-end funds in the AIC Japan sector and the seven open-ended funds in the IA Japanese Smaller Companies sector. AJG’s total returns are above the closed-ended averages over the last one, three and 10 years, and below over five. They are above the averages of the open-ended funds over one and three years, broadly in line over five years, and below over 10 years.

There are four directors on AJG’s board, all of whom are non-executive and independent of the manager. Chairman Noel Lamb was appointed to the board on 1 February 2011 and assumed his current role on 1 May 2014. The other three directors are: Philip Ehrmann (appointed on 25 October 2013), Richard Pavry (appointed on 1 August 2016) and Michael Moule (appointed on 5 February 2018). The directors have backgrounds in investment trusts, investment management, corporate finance and law.