Atlantis Japan Growth Fund — Outperformance and a high income, at a discount

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 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 at the end of December 2021, the portfolio had 0.7% net gearing. However, the manager is prepared to use gearing tactically when significant market setbacks create attractive investment opportunities. 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 will be paid out of capital reserves and will be paid in March, June, September and December. The fund currently offers a yield of 5.3%, based on the last three dividend payments and the one due in March 2022, and the current share price.

Taeko Setaishi, AJG’s lead adviser, believes that several domestic concerns that weighed on Japanese growth and market sentiment last year have now abated. The vaccination roll-out has gained momentum (the vaccination rate now stands at 85%), while the political uncertainty sparked by the resignation of Prime Minister Yoshihide Suga, and the subsequent general election, has dissipated with the election of Suga’s successor, Fumio Kishida. In addition, supply chain disruptions in the auto industry and other consumer goods sectors appear to be easing. So Setaishi is cautiously optimistic about the outlook for the Japanese economy and equity markets in 2022.

She expects economic activity to be supported by the supplementary budget delivered by the new prime minister in December 2021. In her view, Japan is always slower to respond to crises and change than its western counterparts, so the Japanese government’s response to the pandemic has been less aggressive than in other major economies. However, she sees 2022 as ‘a year of catch-up for government spending and thus growth’. In addition to boosting consumer spending, AJG’s adviser expects the December 2021 stimulus package to encourage increased spending on public infrastructure, digitalisation efforts and research and development. She expects Japanese GDP to grow by around 2.5% in 2022, considerably better than the contraction in activity experienced in H221, although this forecast is more conservative than the IMF’s latest projection, which predicts a 3.2% increase in GDP this year.

Setaishi is nonetheless mindful of the risks to growth posed by rising energy and commodity prices and by supply shortages, especially in the semiconductor sector, but she is proactive in her efforts to mitigate these risks. In the case of rising prices, she seeks out companies such as portfolio holdings Shin-Etsu Chemical, Lasertec and Tokyo Electron, with the pricing power to pass on higher costs to customers. And she has sought to capitalise on the shortage of semiconductors and components by increasing AJG’s exposure to companies that provide inputs to this sector. For example, she has recently opened a position in Oxide Corporation, a manufacturer of optical devices, lasers and crystals used in semiconductors (discussed further below).

AJG’s lead adviser believes that Japan’s improving economic outlook bodes well for Japanese equities. In her view, the underlying fundamentals and performance of Japanese companies remains robust. She expects sales growth of 6–7% across the whole market in the current fiscal year ended March 2022 (FY22), while operating profits are set to rise even more strongly this year and beyond, as companies’ efforts to cut costs and improve efficiency begin to pay off.

However, Setaishi is very selective in her choice of portfolio holdings, and she has not been distracted by some recent fluctuations in performance that have been driven by short-term shifts in investor sentiment in favour of cyclical and value stocks (discussed in the Performance section below). Instead, she remains focused on companies capable of delivering sustainable earnings growth, on the view that this is integral to AJG’s capacity to maintain its long-term record of capital growth for shareholders.

Japan’s new prime minister has not had any impact on the investment themes that underpin Setaishi’s investment decisions. In the adviser’s view, in sharp contrast to former Prime Minister Suga, there has so far been little clarity regarding Prime Minister Kishida’s policy objectives. Kishida has spoken about ‘new capitalism’, without providing details of what this may mean for the economy, businesses and workers. And he does not appear to share Suga’s firm commitment to a net zero carbon emissions target by 2050 and strategies needed to reduce Japan’s reliance on fossil fuels. Kishida only briefly attended last November’s COP26 conference, a major forum of world leaders and key figures in the environmental movement, and he did not announce any new environmental initiatives to mark the occasion.

In this policy vacuum, Setaishi has not been able to identify any new areas of activity that will benefit from government policy and thus represent possible new investment opportunities. However, as she observes, ‘fortunately, in some areas, government policy is secondary to the impetus provided by the need for companies to compete’. She cites the trend towards digitalisation as a particularly clear example of companies investing to maintain and enhance competitiveness. Digital transformation has been a key investment theme for Setaishi for some time and she is pleased to see recent increases in related capital expenditure by many businesses, including Toyota’s recently announced plans to accelerate its electric vehicle program and the development of its new model line up over the next five years. Other investment themes underpinning AJG’s investment strategy include renewable energy sources, where Setaishi expects to see strong growth regardless of the level of government involvement, and healthcare and related services, which will see increasing demand from Japan’s rapidly ageing population.

AJG’s lead adviser believes the portfolio is well-positioned for the economic and market recovery she is expecting this year, and with no changes to the themes guiding investments, she stresses that she is broadly happy with the portfolio as it stands. She has therefore made no significant shifts in the portfolio’s structure in recent months, with one notable exception.

In late December 2021, Setaishi sold the fund’s entire position in Renova, the only Japanese company focused solely on renewable energy sources. This may seem surprising given that renewable energy is a key investment theme, and Renova has ranked as a top 10 holding for some time. The stock comprised 4.1% of the portfolio in November 2021 and had been a major contributor to performance over the past year. However, the company’s prospects deteriorated suddenly in December. Given its prominent position in Japan’s renewable energy sector, it was widely expected to win a government bidding process to develop a major offshore wind project in Akita prefecture. It was already working on the project, in collaboration with key strategic partners including East Japan Railway Co and Tohoku Electric Power, which are, respectively, the largest power user and the main power supplier in the region. When the contract was unexpectedly awarded to another contender, Renova’s stock price plummeted by 55%. The adviser’s decision to exit the stock nonetheless realised a return of more than 100% on the investment.

Other, less significant recent portfolio adjustments include the closure of a position in clothing retailer Fast Retailing. This disposal was motivated in part by ethical considerations, as the company allegedly uses cotton produced by slave labourers from China’s Uighur community. Setaishi also took profits on Nintendo, a gaming company whose stock has risen sharply over the past year.

Setaishi used the proceeds of these sales to increase exposure to two of the fund’s main investment themes: digitalisation and healthcare. She continues to increase positions in the semiconductor sector, including the recent acquisition of Oxide, which makes optical devices, lasers and crystals used in semiconductors and PET scanners/medical equipment. Lasertec, a producer of semiconductor parts and AJG’s largest position (Exhibit 1), is a major client of Oxide’s and Setaishi views the diversity of the company’s products and markets as a strong positive. She has also opened a position in Nihon Denkei, which manufactures electronic measuring instruments and related computer equipment for domestic and international clients. Its products include copper sheets for batteries used in vehicles and consumer electronics. Nihon Denkei is a small company, but it commands a high market share in a niche market, and the adviser is attracted by the fact that it uses recycled copper.

Within healthcare, Setaishi has added to AJG’s exposure to 3-D Matrix, a medical equipment and products company that makes surgical gels for use in surgical treatments and regenerative medicine. The fund has owned this stock for 10 years. During this time, 3-D Matrix has been selling its products in Europe and Australia, and it has recently received approval from the US and Japanese governments to distribute its products in these large markets as well. In November, AJG also acquired an exposure to Amvis, a healthcare and nursing services provider with strong recent performance and favourable growth prospects given that demand for nursing services will continue to rise as Japan’s population ages.

However, despite this recent portfolio activity, Setaishi’s overall comfort with the current portfolio structure means that portfolio turnover has been relatively low over the past year, at around 30%, compared to usual range of 30–80%. Recent changes to the portfolio’s sectoral weights are thus mainly the result of changes in market valuations, rather than any shift in investment strategy.

In the year to end December 2021, the most notable changes to sectoral allocations were a large rise in exposure to IT, due to strong gains in these stocks, combined with the acquisition of some additional exposure to this sector, as discussed above (Exhibit 2). This has significantly increased the portfolio’s overweight to IT, which is now more than twice the index weighting. This increased weighting came at the expense of exposure to industrials, healthcare and utility names (resulting from the recent sale of Renova), although the portfolio remains overweight in industrials and healthcare. It is also overweight real estate. Consistent with the fund’s focus on growth, rather than cyclical and value stocks, the portfolio’s most notable underweights are to economically sensitive sectors such as financials, materials and consumer discretionary sectors.

In terms of market cap, historically, the lead adviser has focused on smaller-cap companies. However, AJG has an all-cap strategy and during the pandemic, portfolio acquisitions tended to be large or mega-cap stocks, which the adviser believed had the scale and cash reserves to weather the crisis. More recently, as her confidence in the economic outlook has increased, she has added to the portfolio’s holdings of smaller-cap companies (Exhibit 3).

At the end of December 2021, the portfolio comprised 63 stocks, up from 60 at end December 2020.

AJG’s recent performance has been uncharacteristically mixed. In the six-month period to end December 2021, the fund returned 5.3% on a share price basis, and 0.1% in NAV terms, reflecting a narrowing of the fund’s discount, while its benchmark, the TOPIX, returned 1.7%. Over the year to end December 2021, AJG’s shares declined 10.4% and its NAV declined, 9.6%, compared to a benchmark rise of 2.0%. However, the fund has outperformed its benchmark consistently and decisively over all periods beyond one year (Exhibit 5); over the 10 years to end December 2021, its shares have returned 13.5% on an average, annualised basis, while its NAV has risen by 13.6% pa on this same basis. This compares favourably to an average benchmark return of 10% pa over the same period. AJG has also outperformed the MSCI Japan Smaller Companies Index, the UK market and most of its nearest closed-ended peers over three, five and 10 years (Exhibit 6).

AJG’s focus on growth stocks has been the main reason for its recent intermittent underperformance, adversely affecting performance during two intervals over the past year. As in all other major markets, Japanese growth stocks underperformed cyclical and value names in late 2020 and early 2021, as these more economically sensitive stocks benefited from a surge of optimism following the arrival of viable vaccines. This so-called ‘recovery rally’ proved short-lived, and growth stocks resumed their market leadership, supporting AJG’s performance between May and November 2021. However, cyclical and value names modestly outperformed growth stocks again in the final month of the year. This was once again consistent with developments in the US and global markets, as the omicron variant, while more contagious, causes milder symptoms than previous strains of the virus.

Aside from the portfolio’s style bias in favour of growth stocks, recent detractors from relative returns at the stock level include Recruit Holdings, a provider of staffing and employment services. This company has been profitable, and the price has risen over 50% over the past year, so it has added to absolute performance, but detracted from relative performance, as AJG was underweight relative to the benchmark. Nidec, a producer of specialist industrial equipment and a top 10 holding, also detracted from relative returns, as did semiconductor materials firm Tri Chemical Laboratories. The share prices of both these companies have drifted lower over the past year, after previous strong gains. PeptiDream, a biotech healthcare company also detracted. Its recent disappointing performance saw the stock slip out of the MSCI Japan Index, which compounded the share price decline as the stock was abandoned by investors who favour larger stocks. However, the manager continues to hold PeptiDream due to its unique technology, which facilitates the rapid development of next generation drugs. She also likes the fact that the company aims to become a world leader in ethic drug discovery. Its stated objectives include contributing to society via its efforts to meet unmet medical needs and promote industry-wide innovation. It also seeks to ensure its research and production processes are environmentally sustainable. Company-specific issues also weighed on Asahi Intecc, a medical equipment supplier and IR Japan Holdings, an investor relations firm, although both these holdings remain in the portfolio on the expectation that recent setbacks will prove short lived.

The adverse performance impact of these positions was partially offset by the positive impact of other holdings, including Lasertec, and Tokyo Electron, the portfolio’s two largest holdings. Several other top 10 holdings including CellSource, a biotech play, Shift, a software outsourcing company, and GMO Financial Gate, a cashless payment system also enhanced returns, as did 3-D Matrix, and recent purchase Amvis Holding.

Renova enhanced returns over the year but detracted from performance in December following news that it had missed out on a contract for a major offshore wind project. As discussed above, this stock was sold outright late in the year, realising a return in excess of 100% since acquisition.

One other factor has worked against AJG in recent months. The small and mid-cap stocks it favours have underperformed larger caps due to a surge in new listings (IPOs). Companies have been rushing to list before a change in Tokyo Stock Exchange listing rules takes effect in April. There were 32 IPOs in December alone, taking the number for the year to 125, a 15-year high. AJG’s manager believes that retail investors have been selling their existing smaller-cap holdings to fund their participation in these new listings. This activity has adversely affected AJG’s position in Nihon M&A, a small-cap M&A services provider, which was one of the names apparently sold by investors to fund the purchase of new listings. However, the pressure on smaller-cap stocks should ease in the new fiscal year once new listings return to more normal levels of 90–100 per year.

AJG’s shares have typically traded at a discount to cum-income NAV. The discount has averaged 9.3% over the past 10 years. And as was the case with most investment trusts, the discount widened sharply for a period following the onset of the coronavirus crisis, peaking at over 20% in March 2020. However, since then, the fund’s discount has been on a narrowing trend (Exhibit 7). AJG’s share price has no doubt been supported by its long-term track record of outperformance and by its relatively high and competitive dividend; the fund offers a yield of 5.3%.

The board’s active discount management policy may also be supportive of the share price. The board monitors the fund’s discount 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 313,000 shares (0.75% of the share base) at an average price of 221p per share. The board did not use this authority to buy back any shares during FY21, as AJG’s share price discount narrowed over the period. However, following some subsequent widening in the discount, the board has purchased a total of 155,000 shares so far during the current financial year (as at 26 January 2022).

AJG’s discount has been on a narrowing trend over the past eighteen months or so, and it has scope to continue narrowing, provided the fund’s performance improves and its relatively high dividend payments are maintained. The discount may also have the prospect for narrowing due to the board’s ongoing efforts to reduce charges, which have fallen from 1.64% in FY20 to 1.58% at end FY21.

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, 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 included in the AIC’s Japan sector.

Compared to its smaller-cap peers, AJG’s performance on an NAV total return basis ranked fifth out of five over one year, due to its growth bias, which meant performance lagged in early 2021. Performance ranked second over three and five years and third over 10 years. Performance has exceeded the average return of its peers in the AIC Japan sector over five years, although it has lagged the average over three and 10 years. Somewhat surprisingly given its good longer-term performance, and the fact that its yield of 5.3% is the second highest of all its AIC peers, AJG’s discount is the widest of its peers in both the small-cap and all-cap Japan sectors. This may in part be due to AJG’s ongoing charge, which is the highest of all its peers. The fund’s 0.7% net gearing is at the low end of the range across both AIC sectors.