How should one frame the fact that two of the 11 investment trusts investing in Japan have effectively thrown in the towel in the past six months, with both Aberdeen Japan IT (AJIT) and Atlantis Japan Growth Fund (AJG) proposing to roll over into Nippon Active Value Fund (NAVF)?
According to Russell Investments’ cycle of investor emotions, fear, depression and panic are followed by capitulation, which slides into despondency and therefore signals the point of maximum financial opportunity. Yet the Japanese equity market is very far from a cyclical low, with both the headline Nikkei 225 index and the broader Topix index this year reaching levels not seen since 1990.
On one level, the capitulation of AJG and AJIT is part of a broader trend in the investment trust sector this year, with both trusts having been identified as sub-scale in Winterflood Investment Trusts’ May 2023 report, Small Funds, Big Dilemmas. AJG has total assets of just £81m, making it the smallest fund in the AIC Japanese Smaller Companies sector, while AJIT, at £94m, is some £200m below its next-biggest peer in the AIC Japan sector. Both trusts also have the worst 10-year performance record in their respective sectors.
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NAVF is a relative newcomer, having been launched in February 2020, and is currently the third smallest fund across the two sectors; however, its 28.1% one-year share price total return has only been bettered by CC Japan Income & Growth Trust, at 29.7%. Each of the rollover proposals offers a 25% cash exit; assuming this is taken up in full, the deals could swell NAVF’s AUM by £130m, taking it to a comfortable level of £310m. How this extra cash will be deployed in a small-cap portfolio where the top 10 holdings currently account for two-thirds of net assets may be a story for another day, although NAVF has stated that “a larger capital base will allow the investment adviser to pursue its activist strategy in opportunities involving companies with larger capitalisations”.
Engagement
NAVF’s activist approach is likely to have been a key consideration for the boards of AJG and AJIT when seeking the combination. Over the past decade, the Tokyo Stock Exchange, through the introduction of corporate governance and stewardship codes, has been making efforts to encourage listed Japanese companies to increase their focus on shareholder returns, and gentle pressure from outside investors is one way to help achieve this aim.
Joe Bauernfreund, manager of the AVI Japan Opportunity Trust (AJOT) prefers the term ‘engagement’ to ‘activism’, but says the recent acceleration in the TSE reforms means he is “beginning to preach to the converted” on unlocking shareholder value. “The codes have demonstrated that they are having an impact on corporate behaviours in Japan,” he explains. “It took some time to get off the ground and for corporates to buy into the intentions, but now across large and smaller companies, there is evidence of a change in attitudes towards shareholders, shareholder returns, and corporate governance in general.”
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Across the Japanese investment trust sectors, Bauernfreund points out that the more value- or engagement-focused funds (such as AJOT and NAVF) have been doing better, while for both small- and large-cap growth funds, “performance over many years does not look great”. However, growth-orientated manager Nicholas Price of Fidelity Japan Trust (FJV) believes the tide could be about to turn. “There is a lot of change in terms of corporate governance and opportunities to improve returns, and it is time to buy the change,” he says. “Growth has become very cheap, so there is a good opportunity for investors to buy cheap growth. The market has changed a lot, and that change is starting to be reflected in performance.”
Valuations
Price points to favourable valuations in the Japanese market, despite the big index gains this year. He says the broad market P/E multiple is a little below average, suggesting there is some upside available, while on a price-to-book basis, the market is still trading quite close to book value, compared with Europe at close to 2x book and the US at around 4x book. One of the focuses of the TSE reforms is to tackle companies trading below book value – which made up around half of all listed companies in 2022 – through encouraging the deployment of excess cash on measures such as share buybacks and increased dividends. An improving economic backdrop could also be a tailwind for this, says Bauernfreund.
“One reason why companies are so cheap and have so much cash is because of deflation,” he explains. “The Bank of Japan’s recent moves have been very encouraging – fundamentally, what has led to all this talk about the end of yield curve control is phenomenally positive. Now we are seeing some signs of wage growth and a relatively strong economic environment.
“What has been notable in the last six to nine months is that capital flows have turned positive and started to pick up (at least before the summer lull), reinforced by the idea that perhaps this time it is different – dangerous words, but supported by not only cheap valuations and a better macro backdrop, but also companies that are focused on shareholder returns to an extent they have never been before. However, with so much still to do on balance sheet efficiency, there is still plenty of upside to go for.”
Headwinds
Looking at the risks to this positive scenario, Bauernfreund says that while the commitment to change has been demonstrated, there remains some resistance from the older corporate generation, “so it may take longer than we wish”. The other factor is that from a capital flow and asset allocation perspective, Japan – in common with the UK – has become less and less relevant on the global stage. “It has gone from being the biggest country in the MSCI World index in 1989 to now being 8-9% while the US is over 60%, so although we have seen a pick-up in capital flows that has been supportive, that could reverse,” he cautions.
Price, meanwhile, also sees global factors as among the biggest risks: “Japan is quite an export-orientated economy and is quite dependent on global growth, so a deep recession in China or the US would not be good for Japanese equities, even if the Japanese economy does well.” However, the manager offsets this risk through focusing more on domestic companies and those with their own secular growth drivers.
More often than not in the past 30 years, the Land of the Rising Sun has proved to be more the Land of the False Dawn for investors. However, with a genuine commitment to unlocking shareholder value and an improving domestic backdrop, this time it really might be different. While the months ahead may reduce the number of Japan investment trusts for investors to choose from, a more streamlined universe will still offer a broad range of strategies for those willing to ride the wave of reform.
