Atlantis Japan Growth Fund — Will patience be rewarded once earnings recover?

AJG, a Guernsey-registered investment company listed on the London Stock Exchange, was launched on 10 May 1996. The fund’s investment manager is Quaero Capital, a specialist fund management firm, and Tokyo-based Atlantis Investment Research Corporation (AIRC) acts as investment adviser. AIRC is an independent firm established in 1996. It has four investment professionals who possess an average of over 30 years’ investment experience. In May 2022, Taeko Setaishi celebrated her sixth anniversary as AJG’s lead adviser, having previously been its deputy fund adviser for 20 years.

The fund’s objective is to realise long-term capital growth through investment in a diversified portfolio of listed Japanese equities. Performance is benchmarked against the Tokyo Stock Price Index (TOPIX). AJG has the capacity to invest in small-, medium- or large-cap stocks. It is authorised to invest up to 100% of gross assets in companies listed on any Japanese stock exchange and up to 20% of net asset value (NAV) in overseas-listed companies that have significant operations in Japan. Up to 20% of NAV can be invested in equity warrants and convertible debt, although the lead adviser is not utilising such instruments at present. Holdings in a single company are limited to 10% of the portfolio. Gearing of up to 20% of NAV is permitted and the manager uses gearing tactically when significant market setbacks create attractive investment opportunities. At the end of September 2022, the portfolio had 3.0% net gearing. AJG’s currency exposure is usually unhedged.

AJG pays a regular quarterly dividend of 1% of the company’s NAV (based on the average daily NAV in the final month of the financial year). The dividends are paid out of capital reserves in September, December, March and June of the subsequent year. The fund currently offers a prospective yield of 5.4%, based on the current share price and the four quarterly dividend payments of 2.15p payable in September 2022, December 2022, March 2023 and June 2023 in respect of the financial year ended 30 April 2022.

AJG’s performance has been under pressure for most of the last year to end September 2022. The fund’s return has been negative over this period and it has underperformed its benchmark (see details below). Taeko Setaishi, AJG’s lead adviser, attributes this underperformance to the combined adverse effects of several factors on the fund’s growth-oriented portfolio – ongoing COVID restrictions in China and, to a lesser extent, Japan, escalating tensions between China and the US over China’s ambitions in Taiwan and Russia’s invasion of Ukraine have all taken a toll. The surge in energy and commodity prices triggered by the outbreak of war compounded already serious global inflation pressures and led investors to the realisation that aggressive US interest rate rises would be necessary to break the inflationary spiral. The prospect of sharply higher rates – not just in the US, but also in the UK, and Europe – in turn caused a ’huge’ shift in investor sentiment away from growth stocks in favour of value, including in Japan, says Setaishi. Global tech stocks experienced a particularly aggressive sell-off, due to the detrimental impact that higher interest rates have on the valuations of such long-duration stocks. Japanese tech stocks were caught up in the rout, and AJG’s tech holdings, even those with solid earnings, saw share price declines.

For Setaishi, this shift from high-growth names to value was the biggest surprise over the past year, and the lead adviser cites several reasons why she remains cautious about the near-term outlook. Japanese consumer sentiment is still poor, and consumer spending has not seen the post-COVID bounce experienced by other major economies. Inbound tourism is still restricted, so this sector also remains weak. Furthermore, the yen has depreciated by about 30% against the US dollar since its pre-pandemic peak, including more than 10% since the invasion of Ukraine, and this, combined with persistent supply chain disruptions, has increased business costs and further delayed the corporate recovery.

However, Setaishi stresses that many of AJG’s portfolio holdings have pricing power and can pass on higher costs to their customers. In addition, 30% of AJG’s portfolio investments are exporters, which will benefit from the weaker yen. So, in general, Setaishi believes that the fund’s investments have continued to perform well despite the challenges of the current environment, even if this is not, at present, fully reflected in their share prices.

Despite her current caution, Setaishi seems quietly confident that a recovery in corporate earnings will emerge sometime soon, supported by several factors, and she expects improved earnings to be the catalysis for renewed interest in growth stocks and an associated improvement in AJG’s performance. In her view, the ongoing reopening of the Japanese economy will ensure that domestic demand will strengthen, assisted by the government stimulus packages implemented, but not fully utilised, during the depths of the pandemic. In addition, she foresees further improvement in corporate governance practices among Japanese businesses, which should enhance long-term returns and unlock value.

As evidence of the potentially positive performance impact of an improvement in market sentiment towards growth stocks, as and when it arrives, Setaishi cites the ‘major’ market reversal of July 2022 away from value back to growth. This move was triggered by diminishing inflation fears and rising anxiety about the possibility of recession. It was accompanied by a pick-up in the performance of small-cap stocks, and both these developments had an immediate and significant favourable impact on AJG’s performance given its bias towards growth and small-cap stocks – the portfolio returned 10.3% on a NAV basis in July, versus a benchmark return of 5.7%. (However, July’s growth rally lost some momentum in August and AJG’s performance has since lagged the market.)

Setaishi believes that a little more patience may be required before market conditions turn decisively in AJG’s favour, but her conviction in an eventual recovery in market sentiment towards growth stocks is further illustrated by the fact that she has been increasing portfolio gearing cautiously, to 3% at end September 2022, from 1.2% a year earlier. Also, the lead manager is keen to assure shareholders that she is alert and primed to increase gearing further and take advantage of investment opportunities generated by the growth sell-off ‘when the time is right’.

In the meantime, recent portfolio activity has been fairly limited. Setaishi still favours stocks at the forefront of digital transformation and the increase in the portfolio’s overweight exposure to the technology sector has been one of the two biggest shifts in the portfolio over the past year (Exhibit 1). Additions to this sector include a new position in Internet Initiative Japan (IIJ), which provides internet connectivity and network-related equipment sales and services, and top-ups to several existing holdings. Exposure to financials has also increased, lessening the portfolio’s underweight to this sector, due largely to the strong performance of Premium Group, the portfolio’s largest holding at end September 2022.

There has also been a smaller increase in exposure to consumer discretionary, and although overall exposure to real estate names has declined, the manager has added a new position in Katitas, a residential construction company specialising in second-hand home renovations. Traditionally, used homes have been unpopular, trading at significant discounts to new homes. However, several factors have conspired recently to increase their appeal, especially to young homebuyers. New home prices have risen since the onset of the pandemic, as teleworking has reduced the need to commute and as families seek larger homes in suburban and rural areas. At the same time, the supply of second-hand homes is rising thanks to Japan’s ageing population. The government has implemented subsidies to encourage the use of these homes to meet demand, in part because this is much more environmentally friendly than demolishing existing homes and replacing them with new ones, as is the usual practice in Japan. At present, second-hand homes comprise only 15% of the total market in Japanese residential real estate, compared to 80% in the United States, so Setaishi sees substantial growth potential for this market, and Katitas is at the forefront of this trend.

To fund these acquisitions, the lead adviser has made several outright sales or trims. At the sectoral level, the largest decline had been in AJG’s healthcare holdings, where Setaishi has sold several companies, including PeptiDream, a biotech health company whose performance has been particularly disappointing over the past year. She has also disposed of other names whose businesses have been adversely affected by the pandemic. For example, she reduced exposure to Senso, a supplier of artificial cartilage used in knee operations. Demand for this company’s products declined as routine operations ceased, and earnings declined accordingly. The lead adviser also closed a long-term position in 3-D Matrix, a supplier of medical equipment and products, including a surgical glue which stops bleeding. This company has been selling its products in Europe and Australia for several years and recently received approval from the US and Japanese governments to distribute its products in these major markets. The news boosted the share price and, with little prospect of further upside, Setaishi closed the position.

The decline in exposure to utilities over the past year was the result of the outright sale of Renova, a renewable energy company, last December. Setaishi sold this former top 10 holding after it unexpectedly lost a government bidding process to develop a major offshore wind project. The surprising news saw the stock price plummet, but her swift decision to sell nonetheless resulted in a return of more than 100% on the investment.

The lead adviser has also taken trimmed a couple of AJG’s largest positions, including Lasertec and Tokyo Electron, which make semiconductor parts and equipment respectively. These partial sales have seen both names drop out of the portfolio’s top 10 holdings in recent months, although Setaishi remains very positive on both these companies over the medium term, based on the view that demand for semiconductors will continue to grow for several years. She also reduced exposure to Nihon M&A – another former top 10 holding which provides mergers and acquisition-related services to companies in Japan and internationally. The market for such services is still small and growing, but some concerns about disclosure issues saw the share price drop sharply early in 2022 and led the lead adviser to reduce the position.

The sell-off in growth stocks, combined with the sale of Renova and the reduction in exposure to Lasertec, Tokyo Electron and Nihon M&A, has resulted in several changes to AJG’s top 10 holdings over the past year, although Nidec, a producer of specialist industrial components, and Shift, a software services company, both remain in the top five (Exhibit 2). As a result, the portfolio is somewhat less concentrated, with the top 10 holdings now comprising less than 28% of the portfolio, compared to more than 35% a year earlier. The top holdings remain spread across a variety of sectors. At the end of September 2022, the portfolio comprised 60 stocks, down slightly on the year.

At the market cap level, the most notable shift in the portfolio over the past year has been the significant increase in exposure to stocks with market caps below £500bn, to almost 43% of the portfolio at end September 2022, from 21.7% a year earlier (Exhibit 3). However, this shift has been the result of stock price declines among AJG’s larger holdings, rather than new acquisitions of smaller-cap stocks. In fact, the lead adviser is maintaining a cautious approach to small-cap companies, as she views them as more financially vulnerable to challenging and uncertain times than their larger, more resilient counterparts.

AJG’s style bias towards growth stocks has seen the fund underperform over the past year to end September 2022. It returned -32.0% on a NAV basis and -32.5% in share price terms, compared to a benchmark return of -13.5% over this period. This stint of underperformance has undermined the fund’s performance track record over three and five years, but it has outperformed its benchmark over 10 years on a NAV basis and almost matched the benchmark in share price terms (Exhibit 5, right-hand side). AJG’s average annualised return was 9.7% on a NAV basis and 8.9% in share price terms, compared to the benchmark return of 9.2%. The fund has also outpaced the UK market, represented in Exhibit 6 by the CBOE UK All Companies index, on a NAV and share price basis, both recently, over the past three months, and over the 10 years to end September 2022 – a reminder to UK-based investors of the merits of diversification away from their home market.

As discussed above, the recent market reversal towards growth stocks in July this year provided a temporary boost to AJG’s performance, although Setaishi is not convinced that this is necessarily the start of a more sustained shift in market sentiment back to growth stocks. Rather, she views it more as an indication of the potential performance uplift in store, as and when corporate earnings recover and growth and long duration stocks make a more concerted recovery.

At the sector level, the portfolio’s style bias in favour of growth stocks meant that its technology and electrical machinery stocks had the most adverse impact on performance over the past six months. Detractors included Lasertec and Nidec. AJG’s exposure to the services sector also weighed on returns. In addition to Nihon M&A (mentioned above), GMO Financial Gate, a provider of cashless payments infrastructure, also detracted. GMO’s results have been good, and it has been growing quickly, but its high valuation was dragged down by the recent sell-off.

The adverse performance impact of these positions has been partially offset by the positive return contribution of other holdings, including Japan Material, a provider of specialised gas and ultra-pure water used in the production of semiconductors. Skill shortages in this niche industry have kept barriers to entry high, the company is investing in cutting-edge technology and foreign demand is growing, assisted by recent yen weakness. Setaishi expects the company’s EPS to grow by 10–15% pa over the next few years. This positive picture has driven very strong share price growth over the past year, making the holding AJG’s second largest position at end September 2022.

Its largest holding at end September 2022, Premium Group, has also performed strongly. This company provides financing, warranties and servicing for second-hand vehicles, a previously underserviced part of the auto market. Its services are proving popular with car dealers and consumers. AJG’s recent purchase, IIJ, has also performed remarkably well since acquisition. Another relatively new position in Amvis Holdings, a nursing care and hospice facilities provider, is enhancing returns due to strong demand from Japan’s ageing population, while shipping company Nippon Yusen has benefited from the cessation of air transportation during the pandemic.

AJG’s shares have typically traded at a discount to cum-income NAV. The discount has averaged 9.8% over the past 10 years. As is the case with most investment companies, periods of increased uncertainty have an adverse impact on AJG’s discount. For example, its discount widened sharply for a brief period following the onset of the coronavirus crisis, peaking at more than 20% in March 2020. Thereafter, AJG’s discount narrowed somewhat, establishing a trading level around 12% between mid-2020 and early 2022, until the outbreak of war in Ukraine when it widened briefly to 19%. These developments were all consistent with the experience of other investment companies. AJG’s discount has since fluctuated in a range between 10% and 19% (Exhibit 7) and is presently wider than the discount of any of its peers, as discussed below.

The board adopts an active discount management policy. It has the authority, renewed annually, to buy back up to 14.99% of outstanding shares if it believes the discount is unduly wide. In the financial year ended 30 April 2022, the company repurchased 378,000 shares (0.81% of the share base), to support the share price. This compares with the previous financial year, when no shares were repurchased. During the current financial year, the board has purchased a further 194,500 shares (as at 17 October 2022).

AJG’s discount has scope to narrow, as and when performance returns to form. The fund’s relatively high dividend payment may also increase its popularity among investors. The board has repeated its commitment to reduce the ongoing charge, and progress on this front should also support the share price over time.

AJG’s focus on small-cap companies over recent years has placed it within the AIC’s Japanese Smaller Companies sector (Exhibit 8). Like its two most established peers within this group, Baillie Gifford Shin Nippon and JPMorgan Japan Small Cap Growth & Income (JSGI), AJG targets capital growth but, unlike Baillie Gifford Shin Nippon, it also has a commitment to pay a regular dividend (as does JSGI). However, AJG has an all-cap strategy and during the height of the pandemic the lead adviser shifted her attention more towards large or mega-cap stocks. So, to provide a broader comparison, Exhibit 8 also includes six closed-ended funds drawn from the AIC’s Japan sector.

Compared to its smaller-cap peers, AJG’s performance on a NAV total return basis ranked third over one, three and 10 years and second over five years. Performance has lagged the average return of its peers in the AIC Japan sector over most periods shown. AJG’s discount is the widest among all its AIC peers, which is surprising given its strong longer-term performance, and the fact that its yield of 5.4% is the second highest of all its peers. This may be due in part to AJG’s ongoing charge, which is higher than any of its peers, having risen to 1.65% at end FY22, from 1.58% at end FY21, due to a fall in net assets over the last financial year. The fund’s 3.0% net gearing is slightly higher than the average of its small company peers, but lower than any of its Japan sector peers.