Atlantis Japan Growth Fund — Focused on Japan’s innovative smaller companies

The Japanese economy is continuing its recovery from last year’s pandemic-induced contraction. Manufacturing production has returned to pre-pandemic levels and capital expenditure is increasing. Japanese businesses have, until now, lagged companies in the rest of the developed world in their adoption of information technology and digitalisation. However, the pandemic has highlighted the necessity for change to meet demand for online services in both the government and private sectors, and the rush to catch up is boosting capex spending. The pandemic has also forced companies to cut costs, which should support profitability over the medium term. Japanese exports remain strong, especially to the US, where demand has been fuelled by the Biden administration’s generous income support programmes. While spending on consumer services remains weak and all spectators have been banned from the forthcoming Tokyo Olympics, the government’s vaccination programme is now meeting its target of one million vaccinations per day. Consequently, the services sector should revive in coming months once citizens are more able to dine out, travel and attend cultural and sporting events.

Assuming these greater freedoms do not trigger another wave of the coronavirus, AJG’s lead adviser, Taeko Setaishi, expects Japanese GDP growth of 2.5–3.0% in the current fiscal year, which ends in March 2022 (FY22), to be followed by growth of 2.0–2.5% in FY23. This forecast is slightly less optimistic than the latest projections from the International Monetary Fund (IMF), which forecast Japanese growth of 3.3% in 2021 and 2.5% in 2022. Whatever the precise outcome, the Japanese recovery is set to be more muted than in other major economies – the IMF forecasts a rebound of 5.1% in advanced economies this year, followed by growth of 3.6% in 2022, while China is projected to expand by 8.4% this year and 5.6% next year.

Nonetheless, Japan’s improving economic outlook supported Japanese equities in late 2020 and early 2021. The TOPIX index surpassed its pre-pandemic high in February 2021. As in other markets, cyclical and value companies set to gain most from the economic rebound outperformed, as investors rotated out of technology and other growth stocks and into more economically sensitive sectors such as consumer discretionary, transport and financials.

The Japanese market has traded mainly sideways since February this year, but consensus forecasts point to a 44% rebound in operating profits in FY22. Such robust corporate earnings (if realised), combined with a sustained, albeit modest, economic recovery, should underpin the Japanese market in the coming year and beyond. Furthermore, Japanese equities remain attractive relative to other major developed markets. Based on Datastream indices, on a forward P/E multiple basis, the Japanese market is currently trading at a multiple of 15.8x versus 17.9x for the world index and 22.3x for the US market (Exhibit 1, RHS). This suggests there is further potential market upside as and when international investors recognise the opportunities available in this market.

Taeko Setaishi, AJG’s lead adviser, is heartened by forecasts of a strong recovery in corporate profits, as she targets stocks that offer the prospect of sustained earnings growth over the long term, not just growth driven by a cyclical recovery. Accordingly, she has not been tempted to participate in the rotation into cyclical and value stocks that began last November. She believes this rotation has now run its course. ‘Value stocks were attractive after last year’s crash, but have since rallied significantly, so they are less attractive now and their earnings growth is not sustainable, especially in comparison to AJG’s holdings, which are chosen because of their long-term earnings growth potential’, she says.

Setaishi sees several potential risks to corporate profitability. Rising oil and commodity prices are one such risk, so she favours companies that have the means to mitigate this risk, either by passing on price increases to customers or by reducing their production costs. The lead adviser cites the auto industry as one sector in which product innovation is delivering cost savings. In response to higher steel prices, car manufacturers are using more aluminium, which is lighter and stronger than steel and has the additional advantage of improving vehicles’ energy efficiency. Another concern for the lead adviser is the shortage of semi-conductor chips, which is already severely disrupting global production of electronic products such as phones, white goods and electrical vehicles. She avoids companies vulnerable to such disruption and has increased the portfolio’s exposure to companies providing inputs into the production of semiconductors (see next section).

AJG’s lead adviser also has her eye on forthcoming political events. Japan’s dominant Liberal Democratic Party (LDP) holds power and the LDP’s leader, Yoshihide Suga, is Prime Minister. Since taking office in September 2020, Suga has continued the reform efforts of his predecessor Shinzo Abe and implemented additional significant reform initiatives, including measures intended to hasten the digitalisation of the Japanese economy and improve corporate governance. He has also committed Japan to achieving carbon neutrality by 2050. A general election is due in September and the LDP is expected to retain power. Setaishi expects Suga to hold onto the LDP leadership and hence the prime ministership, despite his declining popularity, as one of his two main opponents has indicated he will not contest the next LDP leadership election and the other has not yet confirmed his candidacy. She is hopeful that once Suga is returned to office, he will redouble his reform efforts, including the consolidation of Japan’s regional banks, which have so far resisted incentives and pressure from several successive governments to merge and rationalise.

Setaishi is concentrating her investment research on the technology sector, healthcare products and services, business consultancies and other financial services – all areas where she sees the greatest potential for long term earnings growth, especially amongst Japan’s innovative smaller cap companies. Historically, she has favoured smaller-cap stocks, but during the worst of the pandemic portfolio acquisitions were mostly larger companies whose scale and cash reserves ensured they were better placed to weather the crisis. However, now that the Japanese recovery is gathering momentum, the lead adviser once again sees most opportunities amongst smaller-cap stocks. ‘I expect smaller companies to outperform large stocks, as they usually do in an economic upturn’, she says (see following section for details of recent acquisitions).

AJG’s lead adviser is keen to stress the fund‘s aim to outperform over the long term. It has achieved this objective (see Performance section), although she acknowledges the fund may underperform the market from time to time. Setaishi argues that while all stocks will initially be boosted by an improving economic outlook, and cyclical stocks will outperform early in the cycle, Japan is a mature economy that is unlikely to continue growing at its current pace. ‘Only those companies with the scope to grow earnings on a sustainable basis will see share price increases and outperform over time’, she says. Setaishi intends to persist in her search for such companies, to ensure the fund continues to deliver long-term outperformance for its shareholders.

Most of AJG’s recent acquisitions reflect the lead adviser’s renewed confidence in the outlook for smaller-cap stocks and her focus on technology stocks. At the end of June 2021, 51.3% of the portfolio was held in stocks with markets caps of ¥2.0bn or less. This compares with 47.8% at the same time last year.

She has purchased Giftee, an internet retail company that sells gift vouchers. This market is in its infancy in Japan, but it is expanding rapidly and its growth potential is illustrated by the success of such products in Korea. Japan’s card payment systems are presently desegrated, creating connectivity problems between voucher providers and retailers, but once this issue is addressed, Setaishi believes Giftee is well positioned to lead the expansion of this market. GMO Financial Gate, which offers a range of online financial services including cashless payments and currency exchange, is another recent small cap acquisition. The lead adviser likes this company partly because it allows consumers to transact directly, removing the middleman and reducing costs accordingly. The stock has performed well since acquisition and became a top 10 holding in June (Exhibit 3).

She has also purchased a digital publishing company called PR Times, which specialises in electronic press releases. Demand for this service has increased as target readership has moved online. In addition, the government’s efforts to improve corporate governance practices have put Japanese companies under pressure to increase disclosures and communicate more effectively with shareholders and the market more broadly. This has expanded demand for digital corporate news services. Corporate change has also been the driver behind the purchase of Visas Q, a consulting platform that matches expert advisers with customers and bills by the hour. This service provides clients with rapid, low-cost, low-risk access to specialist advice. The lead adviser hopes to leverage the increasing popularity of online shopping via the acquisition of Japan Logistics, a REIT specialising in wholesale and retail distribution centres.

The extremely strong demand for semiconductors has prompted the lead adviser to increase exposure to this sector via the purchase of Sumco, which manufactures silicon wafers used in the production of semiconductors. The fund already owns Shin-Etsu, Sumco’s main competitor. Between them, these two companies supply 60% of the global market in silicon wafers and offer Japanese exposure to what promised to be long-term growth in the global semiconductor industry. Setaishi has also purchased auto credit company, Premium Group, which is the only Japanese company providing warranties for used cars. It has leveraged its network of dealers and repair shops to grow its business. However, as Sumco and Premium are both larger-cap companies, the lead adviser has made only small purchases, each worth about 0.5% of portfolio value, as she sees many other investment opportunities amongst smaller companies.

Profit-taking on some existing larger-cap positions has provided the funds for these new acquisitions. The lead adviser has trimmed holdings of strong performers such as Lasertec, which supplies equipment to semiconductor producers, and renewable energy supplier Renova, although both remain among AJG’s top four holdings (Exhibit 3). She has also closed positions in SuRaLa Net, an online educational content provider that she felt lacked further upside momentum, and in the internet retailer Z Holdings, which was hurt by the revelation that it had misled the market about the location of its servers.

Recent annualised portfolio turnover has remained around 32–35%. At the end of June 2021, the portfolio held 66 stocks, compared to 61 at the end of the previous financial year. At end June 2021, the fund had 0.1% net gearing, compared to the permissible limit of 20% of net assets. Setaishi is currently wary of increasing the level of gearing, as the portfolio’s volatility is quite high compared to the market, increasing its vulnerability to any unexpected market downside. However, she continues to look for opportunities to use gearing to boost returns once uncertainties related to the pandemic and the general election dissipate.

AJG has outperformed its benchmark in the long term. However, recent performance has been mixed. For the financial year ended 30 April 2021, AJG returned 22.9% on an NAV total return basis and 31.3% on a share price basis, outperforming the benchmark TOPIX index, which returned 16.1%. However, as noted in the fund’s recently released annual report, performance varied across the financial year. It was very strong in the first half of the financial year, according to the annual report, due to the ongoing strong performance of the portfolio’s holdings of growth stocks in the technology, pharmaceutical and machinery sectors. Conversely, the report says that performance in H2 was more muted due to the rotation out of growth into lagging value shares in the physical retail, transport and banking sectors. The annual report cited particularly strong contributions to FY21 returns from two semiconductor equipment suppliers, Lasertech and Tokyo Electron, biotech materials supplier Cellsource, the renewable energy distributor Renova, and precision motor maker Nidec. All these companies are top 10 holdings (Exhibit 3).

The main detractors from performance over FY21 were industrial machinery company Daifuku, the employment services company Recruit and Nihon M&A Centre, which provides M&A services to small and medium-sized companies. This company’s share price came under pressure in response to critical comments by a government minister. However, in the lead adviser’s view, the market overreacted to these comments, so she has maintained her position in anticipation of a share price rebound. She has also maintained exposure to Daifuku and Recruit, which she also expects to regain lost ground as the economic recovery consolidates.

At the sector level, positive contributions to relative performance over the past financial year came mainly from AJG’s overweights to growth stocks in the technology and healthcare sectors (Exhibit 2), while its underweights to consumer sectors and communications services, and an overweight to machinery, hurt relative returns.

Following the adverse impact of the value rotation in the six months to end April 2021, AJG’s performance has improved more recently. In the three months to end June 2021, the fund returned 1.6% on an NAV basis and 1.4% on a share price basis, outpacing the benchmark, which fell 0.9% (Exhibit 5). Recent returns have been supported by the ongoing positive performances of Renova, Cellsource and Lasertec. Another top 10 holding, cashless payments company GMO Financial Gate, also enhanced returns, as did used car financier Premium Group. These positive contributions have been partially offset by the adverse impact of the portfolio’s positions in Daifuku, Recruit, drug manufacturer Mizuho Medy and semiconductor component producer Tri-Chemical Laboratories.

AJG’s position in Yamashin Filter, which produces industrial filters, has also come under recent pressure. The company slipped into loss due to rising distribution costs. However, Setaishi has maintained the holding as she expects the company to resolve its distribution problem shortly. She also sees significant scope for expansion thanks to rising demand, especially from China and the US, thanks in part to a global push to replace glass fibre filters with environmentally friendly alternatives.

Despite these recent fluctuations in performance, AJG continues to outperform over the longer term (Exhibits 5 and 6). In the five years since Setaishi became lead adviser, the fund has made an annualised return of 13.1% on an NAV basis and 11.6% in share price terms (at end June 2021), compared to a benchmark return of 9.3%. It has also outperformed its benchmark decisively on both NAV and share price terms over 10 years. AJG has also outpaced the MSCI Japan Small Cap index in both NAV and share price terms over one, three, five and 10 years and outperformed the world market over 10 years and the UK market over three, five and 10 years – a reminder to UK investors of the benefits of diversifying their portfolio away from their home market.

Given AJG’s focus on small-cap companies over recent years, it is a member of 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 as discussed above, acquisitions during the height of the pandemic tended to be large or mega-cap stocks. So, to provide a broader comparison, Exhibit 8 also includes the six closed-ended funds included in the AIC’s Japan sector, along with eight open-ended funds which also concentrate on Japanese companies.

Compared to its smaller-cap peers, AJG’s performance on an NAV total return basis ranks fourth over one year, third over three and 10 years and second over five years. It has matched the average performance of its peers in the AIC Japan sector over three years and outperformed the average over five and 10 years. It has also outpaced the average of open-ended funds over three and five years. AJG’s discount is amongst the widest of its closed-ended peers in both the small-cap and all-cap Japan sectors. Its ongoing charge is slightly higher than the average of its small-cap peers and well above that of its Japan sector peers. The fund’s 0.1% net gearing is at the low end of the range across both AIC sectors, while its prospective yield (see below) is the highest of all its AIC peers in both sectors.

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 2021 was 288p, the quarterly dividend rate for FY22 will be 2.88p per share for the four dividends payable in September 2021, December 2021, March 2022 and June 2022. This represents an increase of 32.7% on the previous year’s dividend of 2.17p per share. Based on the current share price and the next four dividend payments, this represents a prospective yield of 4.6%.

The board monitors the fund’s share price discount to cum-income NAV and 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 2020, the company repurchased 313k shares (0.75% of the share base) at an average price of 221p per share. However, the board did not use this authority to buy back any shares during FY 21, as AJG’s share price discount narrowed over the period. Despite some subsequent widening in the discount, the board has not undertaken any buybacks so far this year. The current discount of 10% (Exhibit 9) compares with average discounts of 12.6%, 11.6%, 10.4% and 9.1% over one, three, five and 10 years, respectively. The discount has scope to narrow if the fund maintains its track record of long-term outperformance and/or investor appetite for Japanese equities increases.

AJG is a Guernsey-registered investment company listed on the London Stock Exchange. It was launched on 10 May 1996. The fund’s investment manager is the specialist fund management firm Quaero Capital 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 have an average of more than 30 years’ investment experience. In May 2021, Taeko Setaishi celebrated her fifth anniversary as AJG’s lead adviser, having previously been its deputy fund adviser for 20 years.

The fund aims to realise long-term capital growth through investment in a diversified portfolio of listed Japanese equities. Performance is benchmarked against the TOPIX index. 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 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 at the end of June 2021, the portfolio had 0.1% net gearing. AJG’s currency exposure is usually unhedged.

AJG’s advisers AIRC employ a bottom-up stock-picking approach, which is based on the view that expected corporate profits growth is a key determinant of equity valuations over the long term. The investment process is designed to identify companies with strong competitive advantages, positive cash flows and medium- to longer-term growth potential, which are trading at a discount to their intrinsic value. Sector exposure is a result of the accumulation of individual positions.

AIRC’s investment advisory team comprises four analysts/advisers, who follow a four-step investment process:

The advisory team exchanges information constantly and meets formally each week to discuss the previous week’s company meetings and to review the buy list. Due to the pandemic, company meetings are mostly conducted online. AIRC’s proprietary research is a team effort, but decisions on which buy-list stocks are purchased are the sole responsibility of the lead adviser, Setaishi. She seeks to avoid those Japanese companies popular with international investors on the basis that they tend to be liquid stocks, which investors use as a proxy to express their views on the whole of Asia. This means flows fluctuate with investor sentiment and share prices can be volatile.

The portfolio usually contains around 60–70 stocks. When initiating a position, the lead adviser begins with a small holding (0.5–1.0%), which she may increase up to around 2.0% of the portfolio’s value, depending on her level of conviction and the liquidity of the stock. Position sizes may increase further depending on subsequent performance. Stocks will be sold if they constitute too heavy a weighting within the portfolio, if there is an unjustified shift in a company’s business model, or a downturn in the operating environment.

In the fund’s FY21 annual report, AJG’s Chairman re-iterated that responsible investing is central to the fund’s investment philosophy and process. The company’s investment manager, Quaero Capital, signed the United Nations’ Principles of Responsible Investing charter (UNPRI) in 2015, demonstrating its commitment to responsible investing and it has since joined the Institutional Investor group for Climate Change and the Carbon Disclosure Project, in an effort to improve financial markets’ response to climate change.

AJG does not have specific ESG or sustainability objectives, but the board and the lead adviser believe that integrating ESG risks into the fund’s financial analysis supports better decision-making. The fund does have some exclusions motivated by ESG considerations. Consistent with the management company’s commitment under the UNPRI and International Humanitarian Law, AJG does not invest in companies involved in the production and supply of indiscriminate weapons. It also excludes companies whose conduct is in ‘systematic and severe breach’ of the United Nation’s Global Compact, which supports companies committed to responsible business practices in the areas of human rights, labour relations, the environment and corruption. As a reflection of its commitment to clean energy transition, AJG also excludes companies with significant exposure to coal mining and coal powered energy if they have no plans to reduce these exposures and meet the carbon emissions targets outlined in the Paris Agreement on climate change.

The board believes that identifying and understanding the ESG risks and opportunities affecting the companies in which the fund invests is fundamentally important for long-term investors such as AJG. To this end, ESG analysis is completed alongside financial analysis for each holding or prospective holding, using external ESG data and information provided by the companies. The team also meets the management of both current and prospective holdings. The lead adviser draws on the strong relationships she and her team have built up over many years in the market, to encourage transparency and alert company managers to potential ESG risks.

AJG is a closed-end investment company with one class of share. There are 41.8m ordinary shares in issue. Its capital structure has been simplified with a view to increasing its appeal to shareholders and potential investors. Until September 2019, AJG had a facility that allowed 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, at the AGM held in September 2019, this policy was replaced by regular quarterly dividend payments, which are made from capital reserves when required. The board believes regular dividend payments are a simpler, more effective and low-cost way to provide shareholders with liquidity and regular income (see Dividend policy section).

The company has a ¥1.5bn (c £10m) credit facility with Northern Trust (Guernsey). At end June 2021, net gearing was 0.1%, compared with 3.2% at end January 2020, just before the onset of the pandemic. AJG’s fee structure has changed recently. From 5 July 2020, Quaero Capital is paid a tiered annual management fee of 1.00% up to £125m of NAV, 0.85% between £125m and £175m, and 0.70% above £175m. This compares with a previous flat fee of 1.00%. No performance fee is payable. For the financial year ended 30 April 2021, AJG’s ongoing charges of 1.6% was marginally lower than the previous year’s 1.64%, but lower than the 1.91% fee during FY16. The board maintains it will continue its efforts to make further reductions to fees. AJG has a four-yearly continuation vote. The last vote was held in September 2019 and 99.9% of shareholders voted in favour of continuation. The next vote is due at the 2023 AGM.

AJG’s board comprises five independent, non-executive members (see Exhibit 10). The board and its advisers have acknowledged a concern about board diversity, which was raised recently by a significant minority shareholder. To address this concern, a search was undertaken and Yuki Soga joined the board as a non-executive director on 1 July 2021. Between them, the directors have backgrounds in asset management, investment trusts, corporate finance and law.

Chairman Noel Lamb has announced his intention to stand down at the end of January 2023, after almost nine years as Charman. He will be replaced by Michael Moule. The board has reiterated its intention to continue the process of refreshing board membership.