Atlantis Japan Growth Fund — Impressive outperformance continues

The Japanese economy has begun to rebound from the coronavirus crisis, but the recovery is uneven and may suffer a further setback from a third wave of the virus. Infections surged with the onset of winter and will likely rise further as a result of the New Year holidays. Japanese industrial output is rising, exports have recovered thanks to demand from China and retail sales have returned to pre-pandemic levels. However, capital expenditure remains weak and the hospitality sector is still struggling to recover from the suspension of domestic and inbound travel, despite a government scheme to encourage domestic tourism. While the latest Tankan business sentiment survey showed that companies are still generally cautious, the consensus among forecasters is for a sharp recovery in profits over the next couple of years. After growing at a modest 0.7% in 2019, the International Monetary Fund (IMF) expects the Japanese economy to contract by 5.3% in 2020 and to experience only a partial rebound in 2021. It forecasts growth of only 2.3% next year, a more insipid recovery than the IMF foresees for any other advanced economy or China. The Japanese government has implemented aggressive fiscal stimulus to support the recovery, including a third supplementary budget in December 2020, which included ¥40trn in direct spending to encourage the adoption of digital technology and a reduction of carbon emissions. This focus on the environment is consistent with Prime Minister Suga’s recent commitment to make Japan carbon-neutral by 2050, while also fostering growth via the development of alternative, low-carbon-energy options. The latest supplementary budget also included credit guarantees and loan facilities to support smaller businesses and is expected to boost GDP by 3.6% over the next couple of years.

Signs of a nascent, if weak and patchy recovery, combined with the government’s stimulus efforts, have provided support for Japanese equities. Investors have also become increasingly confident in the ability of Prime Minister Suga to continue the structural reform agenda initiated by former Prime Minister Shinzo Abe. The election of Joe Biden as the next US president has also helped investor sentiment by easing concerns about regional trade tensions. When this news was followed closely by the announcements of several proven COVID-19 vaccines, the Japanese stock market regained its pre-pandemic level, supported by foreign buyers, and the Nikkei 225 index is currently hovering near a 30-year high.

Despite these recent gains, Japanese equities continue to trade at a discount to global markets. Based on Datastream indices, on a forward P/E multiple basis, the Japanese market is currently trading at 18.5x versus 20.1x for the world index and 24.3x for the US market (Exhibit 2, RHS). Japanese equities look particularly attractively priced if Prime Minster Suga’s structural reform agenda delivers the new investment opportunities and productivity gains that some market participants, including AJG’s lead adviser, Taeko Setaishi, predict.

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. Taeko Setaishi has been AJG’s lead adviser since 1 May 2016, 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. 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 November 2020, the portfolio had net gearing of 0.7%. AJG’s currency exposure is usually unhedged.

Setaishi sees ‘significant social, economic and structural changes emerging as a result of the coronavirus crisis’, which she expects will create attractive new investment opportunities in digitalisation, tele-healthcare, and merger and acquisition (M&A) activity, among other areas. The lead adviser is optimistic that the trend towards greater digitalisation spawned by the pandemic will be reinforced by the Suga government’s latest policy initiatives, aimed at encouraging the adoption of digitalisation across both the public and private sectors of the Japanese economy. ‘This is an area in which Japan has some way to go to catch up with other developed nations’, Setaishi says. ‘The productivity gains realised should be substantial and many software and hardware providers will be particular beneficiaries.’

The lead adviser also welcomes the government’s increasing focus on the environment, especially the reduction in carbon emissions. She believes that tax concessions and other measures to encourage companies to reduce emissions are likely to inspire significant innovation, capital expenditure and investment opportunities, for example, as coal-fuelled power stations are decommissioned and replaced by low-emission energy sources, especially solar power. Tele-healthcare is another area in which Setaishi sees significant growth potential. Investment in this sector has been given impetus by fears that Japan’s conventional health system may be overloaded as a result of the pandemic.

Setaishi believes that AJG’s ‘focus on a growth-oriented, bottom-up, stock-picking investment style means that the fund should be well positioned to identify and participate in these emerging opportunities. Patient investors with a long-term perspective should be rewarded as these opportunities play out over time’, she concludes.

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. Where possible during the coronavirus crisis, company meetings have been 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 stocks. When initiating a position, the lead adviser begins with a small holding (0.5–1.0%), which she may increase over time 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.

At end-November 2020, the portfolio held 58 stocks, almost unchanged over the past six months. Portfolio turnover has recently been around 33% pa, somewhat below the level at the end of June 2020. At the end of November, the portfolio’s top 10 holdings made up 35.1% of the portfolio, up from 32.3% a year earlier (Exhibit 1). Several of these holdings reflect the lead adviser’s focus on companies set to benefit from Japan’s drive to digitalise. AJG’s largest position is Nidec (4.8%), the world’s leading small precision electric motor maker, used particularly in hard disk drives. Holdings in Tokyo Electron (3.7%), the world’s third-largest assembler of semiconductor production equipment and M3 (3.2%), the internet-based medical services company, also play into this digitalisation theme, as do positions in Keyence (2.8%), a producer of factory automation systems, Daifuku (3.3%), a major material handling system supplier and Bengo4.com (2.8%), which provides web-based marketing support and an electronic signature service to lawyers and accountants. This company has links to around half of all Japanese lawyers.

The lead adviser’s expectation of rising demand for M&A services underpins AJG’s second-largest position, in Nihon M&A Center (4.1%). This company provides consulting and advisory services to small and mid-sized companies and matches them with potential buyers. The Japanese government’s push towards renewable energy should provide a further boost to the performance of AJG’s third-largest holding, Renova (4.0%), which is a major supplier of energy generated from renewable sources, including offshore wind-power generation. Pharmaceutical company CellSource (3.2%), which has developed a natural remedy for joint problems based on blood extraction, and medical devices supplier Asahi Intecc (3.2%) complete the list of top 10 holdings.

Some recent portfolio acquisitions have also been consistent with the themes of digitalisation and tele-healthcare. The lead adviser has added a position in GMO Financial Gate, a cash settlements provider, which has benefited from the move towards cashless transactions in restaurants and shops during the pandemic. It also provides vending and ticket machines and laundromats. Demand for GMO’s services has also been driven by rising labour costs and the lead adviser believes this company has great potential. She has also purchased a position in Shift, a software-testing company. Software developers prefer to outsource this function because testing in-house is costly and diverts highly skilled, in-house engineers away from more productive, higher-value endeavours. However, only 1% of testing is presently outsourced, so the software-testing market has significant scope to expand. AJG has also initiated a position in JMDC, a medical data processing company, which supports life and non-life insurance providers. It operates small clinics in the countryside that link patients with medical specialists in cities, without the need to travel. Other new additions to the portfolio include Strike, a provider of M&A intermediary services, and investor-relations services company IR Japan Holdings.

The lead adviser has also made some precautionary sales of companies particularly vulnerable to the adverse demand effects of the pandemic. These include processed-food supplier Nichirei and two employment agencies – Fullcast, which specialises in part-time and short-term workers, and Creek & River, which focuses on freelance workers in creative industries. She has also sold the position in Japan Excellent, a J-REIT specialising in office space, QB Net, a hair-salon chain and Aiful, a consumer-financing company and provider of unsecured loans. After strong share-price gains, Setaishi also took profits in Lasertec, which has a monopoly position in the provision of semiconductor mask-inspection systems. It now comprises only about 2% of the portfolio, down from 7.4% at end-June 2020. She also took profits on Insource, which organises seminars, in anticipation of a drop in demand for live events. Other disposals include Trusco Nakayama, a specialised trading company that supports manufacturers and Mitsubishi Electric, a global leader in the supply of electrical and electronic goods.

On a sectoral basis, at the end of November 2020, the portfolio’s largest overweight positions relative to benchmark were information technology (+12.9pp), industrials (+11.2pp) and healthcare (+8.3%). The largest underweight positions were in consumer discretionary (-10.8pp), financials
(-8.7pp) and consumer staples (-8.4pp). The lead adviser stresses that the portfolio has no exposure to regional banks. This industry is widely acknowledged to be in need of consolidation and is in Prime Minister Suga’s sights as a target for structural reform, but there has been no indication as yet on the detail of the government’s plans for this.

During the past few years, AJG’s focus has been on small-cap stocks. However, recent purchases have extended the portfolio’s more recent trend towards larger-cap holdings (Exhibit 1). At the end of November 2020, its weighting in mega-cap stocks (larger than £10bn) was 27.7%, up from 19.2% at end-June 2020, at the expense of its holdings in large-cap companies (between £5bn and £10bn). Its weighting in companies worth between £500m and £2bn rose to 33.5% from 24.7% over the same period due to a cut in holdings of smaller companies (> £500m) to 15.8% from 24.5% as at end-June 2020.

Net gearing stood at 0.7% at end-November, compared to 3.0% at the same time last year. The lead adviser is presently very cautious about the use of gearing. Performance has been robust without it and with the Nikkei 225 index close to a 30-year high and markets recently subject to bouts of extreme volatility, she prefers to keep gearing low, to avoid amplifying downside risk in the event of a market downturn. As at end-October 2020, the fund was entirely invested in publicly listed Japanese companies and J-REITs. It had no exposure to any structured financial products, convertible bonds, equity derivatives or currency hedges.

AJG’s performance remains impressive. It has delivered substantial outright gains and outperformance of its TOPIX benchmark over both the short and longer term (Exhibit 5, RHS). In the six months to end-December 2020, the fund returned 31.2% on a share-price basis and 19.0% on an NAV basis, compared to a benchmark return of 10.4%. It has also outperformed its benchmark in both share price and NAV terms over one, three, five and 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 also outperformed the MSCI Japan Small Cap index and the MSCI AC World index over most periods shown in Exhibit 6. The fund’s returns have also outstripped those of the broad UK market, represented here by the MSCI UK All Cap index, over all periods beyond three months, which serves as a reminder to UK investors of the potential diversification benefits of investment overseas.

AJG’s sector selection was a major contributor to performance over the six months to end-October 2020. Its overweight positions in services, electrical appliances, information and communication services, pharmaceuticals and machinery sectors all enhanced returns. The lead adviser’s orientation towards growth stocks also assisted performance, due to the outperformance of growth stocks over value stocks during the period.

However, stock selection has also continued to contribute positively to performance. Positions in pharmaceutical supplier CellSource, the legal referral website Bengo4.com, renewable energy supplier Renova, semiconductor production equipment company Lasertec and corporate adviser Nihon M&A Center all enhanced returns. Nidec, the precision motor manufacturer, semiconductor producer Tokyo Electron, rental linen supplier Elan and the software tester Shift, also added to returns. Positions in S-Pool, the employment and business solutions company, technology hardware supplier Japan Material, Yamashin Filter and J-REIT Industrial & Infrastructure Fund had adverse effects on AJG’s performance.

AJG’s shares traded at a discount of around 10% to cum-income NAV for most of the past three years, until the onset of the coronavirus crisis drove the discount wider, in line with the experience of most investment companies (Exhibit 8). Early in the crisis, AJG’s shares traded at a discount mostly in the high teens, but it has since recovered steadily due to its strong NAV performance and greater interest from UK investors in Japanese stocks and growth-style investing. The narrower discount may also be due in part to AJG’s relatively new dividend policy, which has been welcomed by investors (see Dividend policy section below for details). As at 8 January 2021, the shares were trading at a discount of 8.1%.

The board proactively manages the discount. It has scope to buy back shares, up to 14.99% of those outstanding. In line with general practice among investment companies, the board makes use of this facility if it believes the discount is too 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, so far in the current financial year, the board has not availed itself of this option (Exhibit 1).

AJG is a closed-end investment company with one class of share. There are currently 41.8m ordinary shares in issue. Its capital structure has been simplified over time with a view to increasing its appeal to shareholders and potential investors. Up until September 2019, AJG had a facility, which 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 for further discussion).

The company has a ¥1.5bn (c £10m) credit facility with Northern Trust (Guernsey). As at end-November 2020, net gearing was 0.7%, compared with 3.0% at the same time last year. AJG’s fee structure has changed recently. Starting 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 2020, AJG’s ongoing charges of 1.64% was marginally higher than the previous year’s 1.63%, but lower than the 1.91% fee during FY16. The board maintains that 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.

A new dividend policy was approved by AJG’s shareholders at the September 2019 AGM. A six-monthly redemption facility was replaced with a regular dividend paid to all shareholders on a quarterly basis. This dividend is set at 1% of the average net asset value per share during the final month of the preceding financial year. As the average daily NAV per share for April 2020 was 217p, the next four dividend payments were each set at 2.17p per share, payable at the end of September 2020, December 2020, March 2021 and June 2021. Based on the current share price, this represents a prospective yield of 2.9%. These quarterly interim dividends will be paid out of capital reserves.

In the recent half-yearly report, the chairman of AJG’s board reiterated the board’s view that distributing from capital resources is beneficial for all shareholders and will help the fund gain the attention of a wider audience over time, a claim which appears to be substantiated by the recent narrowing of AJG’s discount.

AJG’s focus on small-cap stocks over recent years has meant that it is presently a member of AIC’s Japanese Smaller Companies sector, whose constituents are shown in Exhibit 9. However, AJG has an all-cap strategy and recent acquisitions have continued to shift portfolio weightings more towards larger and mega-cap stocks. So, to provide a broader base for comparison, Exhibit 9 also includes the six closed-end funds which comprise the AIC Japan sector and eight open-ended funds which also focus on Japanese companies.

Compared to its peers in the AIC Japanese Smaller Companies sector, AJG’s performance on an NAV total return basis ranks second over all periods shown. It has also outperformed the average of its peers in the AIC Japan sector and the average of its open-ended peers over all periods shown. AJG’s discount is wider that most of its closed-end fund peers in both sectors and its ongoing charge is the highest. Its net gearing is the second lowest of all its closed-end peers and its prospective yield (see previous section) is higher than most of its peers in both sectors.

AJG’s board comprises four independent, non-executive members. Chairman Noel Lamb assumed this position on 1 May 2014, having joined the board on 1 February 2011. Philip Ehrmann was appointed on 25 October 2013, while Richard Pavry joined on 1 August 2016 and Michael Moule was appointed on 5 February 2018. Between them, the directors have backgrounds in asset management, investment trusts, corporate finance and law.

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, the board has initiated a process of board refreshment and it will update shareholders in due course.