Baillie Gifford Japan does not fear recession

The strongest returns came from holdings in the commerce and services sector, which includes several internet-related holdings and companies in employment services. Notable contributions came from recipe website Cookpad (2193:TYO), medical equipment manufacturers Sysmex (6869:TYO) and Shimadzu (7701:TYO), and discount retailer Don Quijote (7532:TYO), which is benefiting from inbound tourism. The trust has also outperformed historically.

Performance

Source: Morningstar as at 27 November

Manager Sarah Whitley "hopes to do similar" next year and is not concerned about recent figures which suggest Japan has moved back into recession.

"Japanese gross domestic product (GDP) seems to be less and less related to profits," she explains. "We have seen in the last quarter that profits were quite strong, with only a few disappointments, which were resources and China-related. For the current financial year ending in March 2016 the consensus view is that the expansion is only going to be around 1.6 per cent, while profit growth is likely to exceed 10 per cent despite recent weakness. This is partly due to more than half of profits now coming from overseas, and drivers of change within the economy, along with a greater focus on shareholder returns."

Ms Whitley also thinks the figures may be revised, meaning the country is not in recession, and adds: "We are very much long-term stockpickers with high active share and low turnover so we are more interested in long-term drivers."

She believes three key forces are driving Japan.

Changes in corporate governance including the introduction of a stewardship code are encouraging institutional investors to constructively engage with the companies they invest in. "We believe that there will be fundamental change over a five-year period and that this will lead to lower cash holdings on balance sheets and increasing dividends, along with investment for growth," says Ms Whitley.

Labour shortage as more workers retire mean companies won't have to be run to maintain employment and this will have "very positive implications for productivity".

Holdings that could benefit from this include Outsourcing (2427:TYO), which was added in the trust's last financial year. It provides services for manufacturing, IT and civil engineering companies. Regulatory change is providing new opportunities for staff placement and is likely to lead to consolidation in the industry. Ms Whitley says that it has been a great investment so far and will probably make the holding bigger.

There has also been a surge in tourists visiting Japan, with numbers reaching 13.4m in 2014 and likely to exceed 18m this year. "This new source of demand is helping certain retailers and manufacturers, as well as increasing the occupancy rates of hotels," says Ms Whitley.

During the trust's last financial year she added Nippon Ski Resort Development (6040:TYO) when it conducted an initial public offering. It buys underperforming ski operations and improves their facilities, and there are many further opportunities to expand as foreign tourists ski more in Japan.

Baillie Gifford Japan has over half its assets in secular growth stocks which are less sensitive to the economic cycle, meaning Ms Whitley is less likely to make major changes. "We look at individual buy ideas and consider if they are more exciting than what is already in the portfolio," she says. "Or we will sell if the original investment thesis on a share has become invalid, although we are prepared to wait to see if the thesis works and don't sell on the first bad news."

The trust's investment income increased 15 per cent over its last financial year, reflecting higher dividends, although revenue gain per share was 0.28p, down from 0.47p, as expenses increased due mainly to higher management fees which rose because of the increase in NAV. The annual management fee is 0.95 per cent on the first £50m of net assets and 0.65 per cent on those above, although the 0.9 per cent ongoing charge is the same as in 2014.

The trust is growth focused and did not pay a dividend in its last financial year, as has been the case in prior years, because its revenue reserve remains in deficit. Unlike a number of trusts it charges all its expenses to income.

Ms Whitley does not believe the Japanese market is overvalued because earnings have kept up. "We expect more growth in earnings, in particular secular companies," she says. "And we will pay a higher price to book value and price/earnings ratio (PE) for a company than the market, for which we get companies with stronger balance sheets which can grow faster and deliver a better return on equity. It is a reasonable trade-off."

Source: Morningstar, *Baillie Gifford

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