Japan, with its new prime minister and having passed through a series of reforms to the way its firms operate, presents an intriguing investment proposition. We talk to a firm that operates in this space.
Japan has waxed and waned in its attractions for wealth
management clients in recent years. The country has a new
government, led by its first-ever woman Prime Minister, Sanae
Takaichi. The Asian nation has been through a series of changes,
such as to how company shareholders are rewarded.
This publication recently spoke to the team at Zennor Asset
Management, managers of the WS Zennor Equity Income Fund,
which has slightly more than £200 million ($263 million) in
assets. It was launched in February 2021 and had its soft close
on 15 September. The Open Ended Investment Company (OEIC) version
remains open for the time being.
Q: There have been corporate governance reforms in Japan.
These changes have been in force for a while now. What would you
say has been the main impact so far in terms of shareholder
returns?
Zennor: The reforms are multifaceted, so they impact not
just operational returns and profits but also the deployment of
legacy balance sheets (e.g. land, buildings, and stocks), and
especially increased discipline in how companies invest in the
future. We have directly seen this impact in terms of higher
dividends and buybacks by companies. Over the past 10 years,
these have increased several times.
Q: There is a very diverse mix of businesses in Japanese
conglomerates. Overall, do you see more signs of these
conglomerates “unbundling” and dividing into more specialised
component parts to unlock value?
Zennor: There are lots of conglomerates in Japan. Warren Buffett
warns about “de-worsification” and these firms have really
embraced this, unfortunately; fundamentally, it reflects a lack
of disciplined thinking about capital allocation. We now see
signs of companies being far more strategic about what they
do.
Large-cap examples would include Fujitsu, which focused on its
core software integration business whilst exiting hardware,
phones, retail, semiconductors, etc. Smaller firms are
following suit, with our holding, Sakai Chemical, exiting its
Titanium Dioxide business. In September, Sony spun out its
financial business through a ‘tax-free’ spin, and we believe
other companies are highly likely to use this technique.
Q: It has been said that 66,000 Japanese firms shut down
in 2024 because they lacked a succession plan. How severe is this
problem and does this mean a great deal of businesses are up for
sale? If so, what are the valuations of such firms? Are
buyers seeking significant discounts?
Zennor: The biggest issue is in the unlisted sector. Most listed
firms can find someone to run them. However, on the private side,
ownership and management are often combined. Many of these are
quite substantial enterprises, but employees just aren’t rich
enough to buy them and, in any case, they usually lack the
founder/CEO mindset to do so.
Frequently, they can be bought at relatively low multiples
because of the lack of good buyers. Equally, it should be
stressed that many sellers are as interested in a good home for
their business as they are in a high price. Our holding Genda has
a typical acquisition multiple of 2 to 3x cash flow in Japan.
There is also a growing number of mid-market PE firms that
focus on this, such as Integral.
There are several other companies focused on acquisition-driven
growth in areas as diverse as waste management, bottling,
industrials, LPG distribution, and elevators. Often selling
non-core assets is good for the seller and the buyer. Too many
assets in Japan are “stuck” in the wrong place and can be
stronger companies with the “best owner.”
Q: A few weeks have elapsed since the arrival of a new
Japanese premier. What’s the sense so far of where Japan is
heading on fiscal/monetary policy and what does this mean
for your portfolio and the areas you invest in?
Zennor: We think Sanae Takaichi is not going to pursue a
radically different direction. She seems likely to provide much
more decisive leadership, which was lacking with [Fumio] Kishida
and [Shigeru] Ishiba. She has realigned the LDP alliance with
Ishin, which is a more natural fit than the Komeito
[party].
Her broad stance is to run the economy a little
“hotter,” emphasise looser monetary and fiscal policy, and
to prioritise defence. We believe this should be good for
Japanese assets, and we have seen large moves in defence-themed
stocks. However, these are not radically new policies from the
government, so it remains to be seen just how different her
policy is in practice.
Takaichi’s big advantage is that her popularity is very high, she
is well aligned with core LDP players, so the internecine
struggle between right and left of the party should diminish. We
expect she will call an election to capitalise on her popularity.
Her true political priorities will likely become established at
this point.
Q: Let’s talk about Japanese inheritance tax and how this
affects family firms.
Zennor: Japanese inheritance tax is 60 per cent. This
means that even wealthy families struggle to pay the tax on
listed assets. One incentive to delist is that the private market
value is opaque and through careful structuring, the family
exposure can be significantly reduced. This creates a powerful
incentive for families to go private, transfer assets and then
potentially relist.
Q: In general terms, how would you set out the case for
investing in Japan to a wealth management firm/end client
etc?
Zennor: The key distinctive story in Japan amongst
developed markets is the revolution in corporate governance. The
US and Europe went through this process in the 1980s and 1990s,
during which firms de-conglomerated and utilised idle
assets.
Our fund has tended to be much less volatile than the market (up
and down), but it is a very actively managed fund, so it does not
look very much like the benchmark. As the fund is seeking to pay
a growing income stream (in yen) this naturally biases you
towards well-managed companies with strong cash flow and strong
balance sheets. They are typically less volatile than the broader
market.
This may mean that the fund deviates substantially at times from
the index return. Whilst we think governance reform should be the
core of any Japan strategic allocation, we do know that we are
often held alongside other Japan strategies or as an “alpha”
driver. Personally, I only have Zennor Japan funds but my
exposure is not representative!
Q: How do you handle exchange rate fluctuations (yen vs
dollar, sterling etc)?
Zennor: We only offer unhedged share classes. Our belief
is that the yen is very undervalued and at some point, is likely
to strengthen. So far, we have not been correct. Where possible
we try and avoid very directional bets based on the foreign
exchange outcomes. If the company is really struggling at today’s
FX rate, they likely have a compromised business model.
Q: Please discuss three or four firms that you
hold/really like to hold that illustrate your investment
philosophy?
Zennor: We own a self-storage company called Arealink.
It is the largest company in this field in Japan and has steadily
grown its units year after year. Historically, it also had more
volatile development business.
The opportunity was that this volatile and capital-intensive
business masked the quality of their core franchise and left the
firm trading at a very cheap multiple. We engaged with the
founder and explained how this had increased the cost of capital
for Arealink and that investors were very attracted to the high
growth annuity revenue stream but deterred by the development
volatility. The company committed to scaling this business back
and in their latest medium-term plan will shrink this segment
even more radically. With the freed-up capital, they have been
able to increase dividends and accelerate the core business
growth. The company trades at less than half the valuation of
similar listed global peers and has a net debt-free balance sheet
(unlike many peers), presenting us with a highly attractive
growing dividend stream at a low valuation.
Recently we acquired HiLex. This is an auto parts company well
known to us for many years. It has suffered along with many
companies in the transition to electric vehicles but has been
progressively shifting its business towards unimpacted areas,
including medical. As a result of these headwinds, it traded at a
big discount to financial assets. Finally, the new CEO has taken
decisive action by reducing costs in North America and making a
shrewd acquisition in Japan.
This purchase offers an opportunity for upside but was made at a
bargain price. Trading at a low PBR, with a strong balance sheet
and positive change underway, we felt that this opportunity was
very attractive. Even today, the PBR multiple remains very
low.
We also purchased a software company, JustSystems. They are
closely linked to Keyence and follow them with outstanding
execution, but with limited focus on balance sheet management.
Their business model is around 75 per cent recurring, with a very
high margin, and growth rates are accelerating as they expand
beyond Japan. We see a long growth runway ahead of them that is
not properly reflected in their 10x EBITDA multiple.
Q: What firms have you sold or cut exposures to recently,
and why?
Zennor: We recently sold a company called Kurimoto. When
we bought it, the multiple against assets was only 0.3x, and it
had a very large cash position. We spoke to the CEO Mr Yagi about
the need to utilise the cash and to respond to the Japan Stock
Exchange (JPX) request for “management conscious of the cost of
capital.” Over two to three years the dividend was
aggressively increased, and the company also bought back its own
shares.
These positive steps to reward shareholders saw the multiple
increase to over 1x book value. At this point we saw more
compelling opportunities elsewhere. We thanked Mr Yagi for the
tremendous job that he had done and then sold.
AloJapan.com