Atlantis Japan Growth Fund — A waiting game, with an attractive dividend

Japan has been slower than western industrialised nations to exit pandemic-induced restrictions, and unlike other major economies, Japan is not experiencing a surge of pent-up demand now the economy is fully open once more. On the contrary, the savings ratio is still rising as households are saving, rather than spending, their government handouts, due to their persistently cautious, deflationary mindset.

However, despite this lack of momentum, AJG’s lead adviser Taeko Setaishi believes that the Japanese economy is ‘not in bad shape’, and there have been some recent positive developments that should support corporate earnings. For one, inbound tourism is beginning to rise now that China has reopened. Tourist numbers are still only about half the level of January 2019, but visitor numbers are expected to continue increasing. Furthermore, the Japanese government has passed its latest budget, which includes a list of spending initiatives including increased funding for defence, aged care, retraining and childcare to encourage women to return to work. Although detailed programmes to distribute these funds are yet to be determined, this money will eventually find its way into the economy.

Japan’s labour market is tight, with demand for skilled workers especially strong in a number of fields. Businesses are also struggling to hold onto existing staff. To date, companies have been reluctant to increase wages to ease these pressures. Only the largest corporations, covering around 20% of the workforce, are beginning to raise pay rates, but Setaishi expects smaller companies to eventually follow the lead of larger corporates and raise wages to ensure they meet their workforce requirements. This should provide some impetus to consumer spending over time.

Supply side inflation pressures have been rising, driven by commodity price increases and yen weakness. Corporates have been as reluctant to raise prices as they have to raise wages, for fear of losing customers. Instead, they have been cutting costs and realising operational efficiencies. However, Setaishi believes this is beginning to change, which bodes well for companies’ capacity to maintain profit margins and earnings. And Japanese companies are still cash-rich, allowing continued improvement in shareholder returns via increased dividends and share buybacks.

AJG’s lead adviser is a bottom-up stock picker and is always on the lookout for companies with high growth potential, supported by high market shares, high barriers to entry, associated pricing power and sustainable earnings, or companies where there is scope to increase efficiencies. Since the yen’s sharp depreciation against the US dollar, Setaishi has been more focused on identifying domestic service companies that are less exposed to currency fluctuations that destabilise the earnings of businesses reliant on imports and exports (see further details below).

While the market has, for the moment, veered away from the kind of companies she prefers, in favour of more cyclical and value names, Setaishi is determined to retain the consistency of her investment style. AJG’s long-term track record of capital growth and performance in line with the benchmark is evidence of the effectiveness of this approach (see the Performance section for further discussion). In her view, ‘it is always possible to find growing companies’, and, after such a steep market correction, valuations are attractive, with scope for significant recovery when corporate earnings, and market sentiment towards growth names, improves.

Setaishi’s conviction in the trust’s capacity to recover is illustrated by the fact that she continues to raise portfolio gearing cautiously. At end February 2023, it stood at 3.8%, from 3.0% at end September 2022 and 1.6% at end February last year. However, her key message to investors is the same as it was at the time of our last note in October 2022: a little more patience is needed until market conditions turn back in AJG’s favour.

In the meantime, Setaishi is keen to highlight positive developments at AJG’s investment adviser, Atlantis Investment Research Corporation (AIRC). It has bolstered its investment team with the addition of two new members, both industry veterans. Robert Tull, who has over 25 years’ experience in the Japanese equity market in both portfolio management and investment bank research, joined the team in 2022. Kojiro Nakamura re-joined AIRC in 2021, bringing with him almost 40 years’ experience covering a variety of sectors within the Japanese equity market. Both Hull and Nakamura are broad generalists, although Hull has a background in financials, insurance, and micro caps, while Nakamura has a particular interest in real estate, machinery, construction, healthcare and digital transformation, so their respective backgrounds are complementary. They join Setaishi and two other longstanding team members, Kyomi Ando and Robert Jameson, taking the total team to five members.

AJG has, in recent years, focused on smaller-cap stocks (Exhibit 3). This is an area of the market that is significantly under-researched by most analysts, and Setaishi believes that the extent of AIRC’s research resources, and the combined experience of team members, makes AJG unique in the market, giving it a distinct advantage in its efforts to identify interesting investment opportunities in the vibrant, innovative small-cap space.

While AJG’s lead adviser remains true to her long-term investment approach, recent market events have elicited some changes to the portfolio’s composition, to reduce its near-term exposure to sectors most affected by the market’s tilt away from growth stocks (Exhibit 1). Setaishi has reduced holdings in technology stocks, although the portfolio is still significantly overweight this sector, and in healthcare, which has resulted in a small underweight to this sector. One notable increase in exposure is to financials, which the lead adviser expects to benefit from the normalisation of interest rates within Japan. Japanese banks have been growing lending steadily and with spreads likely to widen as rates increase, the sector looks set for an extended period of profit growth. However, like their western counterparts, the nearer-term performance of Japanese bank stocks has been undermined by the recent collapse of Silicon Valley Bank (SVB) and its knock effects on Credit Swiss and investor confidence in the global banking system. There have also been more modest increases in exposure to consumer facing sectors, especially those companies set to benefit from the recovery in tourism, although the fund is still notably underweight these sectors.

At the stock level, the lead adviser has added several new names. The recovery in tourism has inspired two acquisitions: Open Door, a travel website, and Invincible Investment REIT, a hotel real estate investment trust specialising in mid-range accommodation; both of which are expected to revive as inbound tourism returns to pre-pandemic levels. AJG also opened a position in EDP, which has world-leading technology used to produce high-quality lab grown diamonds (LGDs). The company listed in June 2022 and the position was initiated soon after, motivated by EDP’s strong growth potential. This company has no competition in Japan and few competitors elsewhere in the world. LGDs currently represent less than 10% of the diamond market, but their potential is huge, with scope to dominate the diamond trade in much the same manner that cultured pearls are now used in most pearl jewellery. EDP has a strong order book and has seen successive earnings upgrades since listing. The stock is also attractive from an ESG perspective, as LGDs do not require mining, which disrupts the environment and is notorious in some parts of the world for its use of child labour and other exploitative labour practices.

Other new holdings include Intloop and Creek & River, which are both now among AJG’s top 10 holdings. These acquisitions highlight the lead adviser’s recent focus on domestic service companies that do not have exposure to currency fluctuations. Intloop provides support services for skilled freelance systems and software workers. It was acquired soon after its initial public offering in July 2022 on the view that it has potential to benefit from the current shortage of IT staff, and a general drive to upgrade IT systems as digitalisation spreads across the economy. Creek & River is an employment agency catering to various freelance professionals, including software engineers, chefs and architects, and it has similarly strong growth prospects, as it is also positioned to capitalise on Japan’s widespread shortage of skilled labour.

These acquisitions were financed by profit-taking on several of AJG’s largest positions. For example, the lead adviser trimmed holdings in Tokyo Electron and Lasertec. Both these positions were getting too large, and valuations were beginning to look expensive after strong gains. Setaishi was also unsettled by reports that both these companies have been exporting chips to China to satisfy the demand of electric vehicle manufacturers, rather than honouring existing contracts to other customers. She also took profits on Industrial and Infrastructure REIT on concerns about the impact of rising rates on the fund’s underlying investments, and on GMO Financial Gate, a supplier of cashless payment systems for retailers. This company was a winner in the COVID-19 driven shift to cashless payments but sold off during 2022 after strong returns in the previous two years.

A long-held position in M&A Nihon was also closed, as its growth prospects have deteriorated. This company was, for some time, the only way to gain exposure to the growth in M&A activity. However, several smaller, fast-growing competitors have now entered the market. M&A Nihon has also been hit by an accounting scandal, and it has been losing employees to its competitors, so Setaishi sold it to buy its young, faster growing competitor M&A Capital Partners, which trades at a much lower valuation, with a P/E ratio of around 20x, compared to M&A Nihon’s valuation of 50–60x.

These changes have seen a significant transformation in AJG’s top 10 holdings over the past year. Only Japan Material, a provider of specialist chemicals used in the manufacture of semiconductors and other tech products, remains among the fund’s largest holdings (Exhibit 2). Most notable among the new arrivals is the number of service companies, including not only Intloop and Creek & River, but also Internet Initiative Japan, the country’s first internet service provider, Amvis Holdings, which runs hospices providing end of life care, and Bellsystem24, which operates call centres.

The portfolio has also become more concentrated. The number of holdings declined to 54 at end February 2023, from 60 at end September 2022, which suggests the lead adviser has increased her conviction regarding the stocks the trust now holds.

At the market cap level, the most notable change in the portfolio over the past year has been an increase in exposure to stocks with a market cap below £500m (Exhibit 3), a shift we noted in our last note. However, as we said then, this is the result of stock price falls among AJG’s largest cap holdings, rather than new acquisitions of smaller cap names.

AJG’s style bias towards growth stocks kept performance under pressure during the review period, as these stocks fell out of favour with investors, despite the fact that the fundamentals of most of the trust’s portfolio holdings remain healthy, thanks to continued high cash positions, low debt and steady earnings outlooks. The global market’s style preference for value over growth hit tech stocks particularly hard, and this hurt AJG’s returns, as the trust is significantly overweight IT due to the attractive, innovative characteristics and growth potential of many names in this sector.

In the six months to end February 2023, the trust declined by 3.2% on an NAV basis, compared to a benchmark return of +0.6%, although the share price return was +3.7%, representing some narrowing in the share price discount to NAV (see discussion below). The picture was similar over one year, where the NAV fell by 5.8% compared to a benchmark gain of 1.7% and a share price gain of 4.3%. This near-term underperformance has had an adverse impact on average annual returns over three and five years. However, annual returns over 10 years averaged 7.8% in the period to end February 2023 in NAV terms and 8.4% in share price terms, close to the benchmark return of 8.0% on the same basis (Exhibit 5).

Given AJG’s growth tilt, it is noteworthy that the trust has outperformed the TOPIX Growth Index over one and 10 years. It has also outpaced the UK market over 10 years – a reminder to UK-based investors of the long-term benefits of diversification (Exhibit 6).

At the stock level, contributors to performance over the past six months included Intloop, which was acquired at a low valuation relative to its growth potential and subsequently performed well after it announced expected earnings growth in excess of 50% over the coming year. Premium, which provides finance and warranties for second-hand vehicles, was another positive contributor to returns as the market is finally coming to appreciate the extent of Premium’s ambitions to extend its offering across the used car value chain. Shift, Japan’s leading software testing company, and Oxide, a manufacturer of optical devices, also added to returns, as did Amvis Holdings, the hospice care provider. End-of-life hospice care is a new market in Japan, but Amvis is tapping a previously unmet need and demand for its services is strong. The lead adviser is also pleased with the early performance of EDP, the LGD producer, since its acquisition in mid-2022. The stock has benefited from successive earnings upgrades.

Recent detractors from performance included Nidec, a world leader in the manufacture of electric and brushless motors. Despite record earnings in Q322, earnings growth has begun to slow, and the company has been dogged by succession issues. Lasertec, Tokyo Electronic and GMO Financial Gate also detracted. All performed very strongly in the early days of the pandemic but have been hurt more recently by dramatic downward revisions to their growth expectations. The story is similar for VisasQ, a business services provider, although its sell-off was compounded by a major overseas acquisition at a questionable valuation. Other detractors included S-Pool, an employment agency providing services to disabled workers and their employers, and Wacom, a manufacturer of electronic writing tablets, while recent developments related to the demise of SVB and Credit Swiss are likely to adversely impact the performance of AJG’s financial names in the next month or more if investor jitters about the sector persist. However, the lead adviser remains confident in the longer-term outlook for these companies, and all remain within the portfolio.

AJG’s shares have typically traded at a discount to cum-income NAV, which has averaged around 10% 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, and most investment trusts have seen their discounts widen during the volatility of the past year.

However, 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 (0.8% 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 511,000 shares (as at 17 March 2023). This programme of regular buybacks appears to be having the desired effect; during the past six months, the discount has narrowed from almost 20% to less than 10% at end February, although it has since widened somewhat (Exhibit 7).

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

AJG pays a quarterly dividend set at 1% of the average net asset value per share during the final month of the preceding financial year. The dividend is paid out of capital reserves at the end of each quarter. As the average daily NAV per share for April 2022 was 215p, the quarterly dividend rate for FY23 will be 2.15p per share for the four dividends paid in September 2022, December 2022, March 2023 and June 2023. This represents a decrease of 25.3% on the previous year’s dividend of 2.88p per share. Based on the current share price and the total FY23 dividend payment, this represents a prospective yield of 5.4%.

For further information about AJG’s fund profile and investment policy, see Edison’s detailed note of 19 July 2021.