Land of the rising fund?

Last year certainly wasn't a boring one for Japan watchers. A controversial Olympic games, surging Covid rates, the downfall of a prime minister and the rise of another made for a 2021 to remember – if not for those invested in its equity market. The Topix, one of the more widely followed Japanese indices, made a sterling total return of just 1.7 per cent in 2021, something that pales in comparison with the turbocharged gains of the S&P 500, FTSE All-Share and the FTSE Europe ex-UK indices – as well as the US-heavy MSCI World.

This explains why the region might not appear prominently in many portfolios – something that forms part of the case for buying it now. Japanese shares trade on modest valuations, look under-owned and could be in for some good news now that the country’s economy appears to be in a better place than it was last year.

Add to that the long-established narrative about Japanese corporates looking to treat shareholders better via improved dividends and other measures, and the potential is clear. Our latest gauge of asset manager outlooks (‘How fund managers are positioning for 2022’, IC, 13 January 2022) suggests that professional investors, at least, are taking the plunge.

And there is no shortage of funds to choose from: the Investment Association Japan sector alone includes 89 portfolios of different stripes, both active and passive. There is a good level of variety in the approaches taken by these funds, from the value-minded Man GLG Japan CoreAlpha (GB00B0119B50) that prospered in last year’s cyclical rally to Lindsell Train Japanese Equity (IE00B7FGDC41), whose focus on strong brands failed to pay off in 2021. While these and other well-established funds have had their share of good times, a lower-profile option also stands out.

A portfolio built to last

Like many of its peers, FSSA Japan Focus (GB00BWNGX432) had a fairly discouraging 2021, with the fund down nearly 9 per cent, as measured by sterling total return. But further back, it has generated outstanding returns. It remained among the best-performing all-cap Japanese equity funds over three and five years to mid January, and the best performer in its peer group between its launch in October 2015 and mid January.

While basing decisions on past performance alone is extremely risky, the fund’s process still sets it out as a promising core holding over the longer term. Its managers, Martin Lau and Sophia Li, have an aggressive focus on ‘quality’ investment metrics. A recent commentary for the fund noted that they focus on companies with strong management teams that “can generate sustainable earnings growth and return on equity without relying on leverage or the macro environment”. Like other ‘quality’ advocates, they like businesses with dominant franchises, strong balance sheets and steady cash flows. Their stockpicking process also has an emphasis on meeting and getting to know company management. The process results in a fairly concentrated portfolio and the fund had just 40 stocks at the end of November.

If its managers like defensive characteristics, they also favour structural growth stories, which they target via a set of different themes. At the end of September, their long-term investment themes were global factory automation and robotics leaders, 'best-in-class' consumer franchises dominant in the Asia Pacific region, manufacturers in niche industries with an edge, companies looking to address Japan’s structural labour shortage and internet names that can disrupt old-fashioned industries. This broad set of ideas allows the fund to target growth in multiple ways. Some of its more prominent recent holdings include Lasertec (JAP:6920), a semiconductor equipment production company, GMO Payment Gateway (JAP:3769) and electronic goods company Sony (JAP:6758).

An added bonus these days are the fund’s environmental, social and governance (ESG) credentials, something that partly stems from a focus on the strength of company managements. Lau and Li look for founders and management teams who act “with integrity and risk awareness”, and FSSA Investment Managers overall has a good record of conscientious engagement with the companies it invests in.

FSSA Japan Focus Fund’s managers say they engage extensively with companies on environmental, labour and governance issues. While ensuring that a company is well-run has obvious merits in and of itself, businesses that fare well on ESG metrics could also continue to benefit from increased investor interest. A Morningstar sustainability rating, awarded at the end of November, gives the fund four out of a possible five of its ‘globes’.

The fund’s managers’ interest in market leaders is also apparent. For example, they praised Lasertec last year for treading a “narrow path”, that’s to say securing a globally dominant position before gradually expanding into adjacent product areas. 

They also noted that its research and development culture and attractive product pricing should act as a high barrier to entry, adding: “It is commendable that despite its monopolistic position, [Lasertec] charges a fair price for its products to maintain long-term partnerships with customers.”

Uncertainty ahead

FSSA Japan Focus' managers said at the end of September that the fund was “positioned predominantly towards companies with exposure to domestic demand” in response to broader global uncertainties. This could bode well if improvements in the Covid situation, an easing of supply bottlenecks and the recent arrival of hefty fiscal stimulus spell good news for the Japanese economy in the short term.

The short term, of course, comes with plenty of unknowns. Unexpected difficulties could knock a domestic recovery off course, and inflation and rising interest rates – among other issues – could put global investors off quality growth stocks. This could mean tough times for the fund, and its concentration means that idiosyncratic problems for just a handful of holdings could have a major negative impact on its own performance. 

There is also no guarantee that the Japanese market will come back into favour this year. While this is a fund to buy for its astute focus on longer-term growth trends rather than a quick win, these caveats are worth bearing in mind.

Portfolio construction considerations are worth weighing up, too. The fund’s quality bias could see it left out in the cold if investors have further appetite for cyclical assets, making it a possible complimentary holding alongside a value portfolio such as Man GLG Japan CoreAlpha. FSSA Japan Focus is also managed without any benchmark constraints. This and its concentrated nature mean that it can differ significantly from the best-known Japanese indices. But, so far, that difference has mainly tended to be a positive for this fund.

FSSA Japan Focus’s managers have amply proved that their approach works well over time, while the difficulties of the past year do not justify a loss of faith in its process or managers’ stockpicking skills. The fund remains a promising play on some of the best growth stories in an often-overlooked investment destination. Buy. DB