A value-biased Japan trust on a discount

After a year on the rise, investors might legitimately wonder whether the Japanese market has further to go. On the one hand, 2024 could be a slightly more complicated year for the country’s economy, which is behind other Western economies in its cycle. The post-Covid recovery started later, and after years of loose monetary policy aimed at boosting inflation, the Bank of Japan (BoJ) has been reluctant to end its negative rates policy. But inflation has now been above its 2 per cent target for a while, and economists think the bank could start tightening sometime next year, which might lead to a more muted environment for stocks.

On the other hand, the Japanese market’s prospects still look promising, with analysts forecasting that earnings will continue to grow. Reasons for optimism about the country include inflation and improvements in corporate governance.

Inflation in Japan, initially sparked by higher energy and raw materials costs, looks increasingly driven by wage growth. If this continues, it could be a real positive for the country, potentially encouraging consumers and corporations to invest their cash, creating economic growth in the process. 

While a gradual change of stance is expected from the BoJ next year, Schroder Japan’s manager, Masaki Taketsume, says that if the bank merely normalises monetary policy and ends negative rates, the impact on equities should be limited. A more worrying scenario would be if high inflation proved stubborn and the bank were forced to increase rates significantly.

Of course, Japan is far from immune to potential troubles in the global economy – for Taketsume, recession fears in the US or China are of greater concern. Nonetheless, the domestic outlook is encouraging.

One source of confidence is Japan’s corporate governance culture, changes to which have been under way for a while. Taketsume believes what started as a box-ticking exercise has now gathered real momentum and more companies focused on shareholder outcomes. Inflation could also make it more attractive for companies to either reinvest cash or juice cash returns.

Value tilt

Schroder Japan invests in about 60 “quality but undervalued” stocks in Japan, resulting in a value-tilted portfolio. The manager looks for companies with low classic valuation multiples but where a catalyst for improvement is apparent.

Its stocks are categorised as either: ‘market misperceptions’, or companies where management is making changes to improve performance that the market has not priced in; ‘market oversights’, or undervalued companies, especially in the small and mid-cap space, where there is less research coverage; and ‘short-term overreactions’, or “ideas arising from abrupt but transitory events which push valuations of quality companies temporarily to unsustainably low levels”.

A recent addition to the portfolio was LY (JP:4689), an internet company that owns the country’s main messaging app, Line, as well as Yahoo! Japan. The services are hugely popular but historically they have been poorly monetised. However, Taketsume says the company, which was created this year through the merger of Z Holdings, an internet holding company of SoftBank Group, and four subsidiaries, is making strides on that front.

The biggest contributor to the trust’s performance in the year to July 2023 was Ibiden (JP:4062), a mid-cap company that makes electronic components used in cloud computing and artificial intelligence data centres, in which the trust has a 1.8 per cent holding. The company sold off in 2022 but recovered sharply earlier this year off the back of the artificial intelligence rally, giving a boost to the trust’s performance, although the share price has come down a bit in the second half of the year. 

The trust has recently sold its position in chemical company Kureha (JP:4023), which accounted for 1.2 per cent of the portfolio as of July and was a key detractors to the trust's performance during the year. Taketsume says that while the stock still looks cheap, he doesn’t see a catalyst for improvement or earnings growth in the short term. 

The trust’s value bias differentiates it from other peers focused on the region, which tend to be more growth-focused. Over the past three years, value has outperformed growth in Japan, as is clear from its comparative performance.

This does mean the trust could underperform if the tables turn back and a growth rally emerges. But Taketsume argues that growth outperformed value for a long time before the past few years, and that the latter therefore still has a long way to fully recover.

The trust is currently tilted towards companies that operate in the domestic economy – a position Taketsume favours due to the country’s stronger relative outlook compared with the global economy. A bias towards small- and mid-cap companies helps boost this exposure to the domestic economy, and to stocks that have lagged the wider market.

Discount

Schroder Japan has a solid long-term track record and has been consistently ahead of its benchmark of late. It has set a target of outperforming the index by 2 per cent a year over the four years from 1 August 2020, which it looks in a good position to hit. Failing that, it is planning a tender offer for a quarter of its share capital, at net asset value (NAV) value less costs. As of 27 November, the trust was trading at a discount to NAV of 10 per cent. Although this has narrowed over the course of the year, the trust is still the second-cheapest in the AIC’s Japan sector, as the chart below shows.

For investors who feel confident about Japan’s prospects, investing through an investment trust rather than an open-ended fund could be rewarding, with the potential for discounts to close further and enhance any NAV wins. Naturally, this works both ways, and any downturns could be exacerbated by discounts potentially widening; the trust’s gearing – equal to roughly 8 per cent of assets – could also magnify gains or deepen losses.

As always when investing internationally, investors should also consider currency risk. This year’s returns from Japan have been considerably lower in sterling than they were in yen terms, owing to the latter’s weakness. There are hints that the yen might be close to hitting the bottom, and the BoJ tightening policy could help strengthen it. 

On balance, there is a lot to consider, and the past few years have taught investors that economic dynamics do not always pan out as expected. But Schroder Japan looks like a solid way to gain exposure to a market that is making some exciting progress after a long period of stagnation.