- Japanese smaller companies look relatively well priced
- High private investor ownership means they can be more volatile
- Baillie Gifford Japanese Smaller Companies looks attractive for long-term investors
The National Institute of Population and Social Security Research think tank projects that Japan’s population will fall from roughly 126m today to 88m by 2065, with senior citizens making up over a third of the population. As a result, asset manager Baillie Gifford argues that “Japan must act decisively to disarm this ticking demographic time bomb”.
While an aging population makes economic growth harder, there are other reasons why investors have been put off Japan. These include memories of the crash in the late 1980s, a corporate sector with little regard for shareholders and a lack of investment in new technologies. However, as recent stock market performance shows, shrewd investors can find great opportunities in this market. That’s the view of Warren Buffett at least, who drew headlines by investing over $6bn (£4.31bn) in Japanese trading houses in the second half of last year.
“In recent years Japan has been rather in the shadow of China given the growth delivered by the latter, but over the last decade Japan has been evolving into a much more business and shareholder friendly place,” says Ryan Hughes, head of active portfolios at AJ Bell.
The prudent management of companies over a long period has also left them with low levels of debt and plenty of cash on their balance sheets, which should make them relatively resilient.
Some of the best opportunities in Japan are found among smaller companies as disruptive, under-researched e-commerce, health tech and software firms are helping to modernise the economy. Japanese companies have generally viewed IT as a cost centre rather than a tool to provide a competitive edge. This leaves huge scope for smaller software companies that help to make business more efficient as the country pushes to boost productivity.
While these high growth stocks tend to be on higher ratings, they still look attractively priced compared with their US and Chinese peers, on average. The forward price/earnings ratio of MSCI Japan Small Cap Index was 17, compared with 27 for MSCI USA Small Cap Index and 19 for MSCI UK Small Cap Index, at the end of January. The chart below shows how small and mid-cap indices compare in terms of price performance.
For smaller companies Japanese exposure, the Baillie Gifford team stands out. Praveen Kumar, who has managed Baillie Gifford Japanese Smaller Companies Fund (GB0006014921) and Baillie Gifford Shin Nippon (BGS) since 2015, has an excellent track record. He follows the Baillie Gifford approach of buying promising companies for the long term and maintaining a high active share, meaning that the fund bears little resemblance to MSCI Japan Small Cap Index.
This open-ended fund is slightly larger than Baillie Gifford Shin Nippon, with assets of £1bn compared with £764m, but they are managed via the same investment philosophy and process. The differences between the two are largely down to their legal structures – Baillie Gifford Shin Nippon is an investment trust so can use gearing (take on debt), and invest in smaller and unquoted companies. The two funds' holdings have a 90 per cent crossover but Baillie Gifford Shin Nippon has more holdings – 78 versus 74. It also holds smaller companies that, typically, Baillie Gifford Japanese Smaller Companies Fund eventually buys – if and when they succeed.
Largely because of gearing, Baillie Gifford Shin Nippon has performed better over the past five years. However, it was trading at a premium to net asset value of 4.5 per cent on 24 February, and has traded at a premium for most of the past year following a period of strong performance. So Baillie Gifford Japanese Smaller Companies Fund looks better value at time of writing. But if you do hold this fund, you might benefit from keeping an eye on Baillie Gifford Shin Nippon because if it moves out to a discount it could present an attractive opportunity to swap into it.
Over half of Baillie Gifford Japanese Smaller Companies is invested in disruptive and rapid growth businesses that aim to solve structural issues in Japan. Kumar says the current crisis is accelerating trends in favour of these companies which is why performance has been so strong,. But he still thinks valuations are attractive and growth prospects are strong.
While he admits that the valuation on a couple of holdings might look “a bit extreme”, he adds that in aggregate the portfolio trades at a discount compared with other markets. And, for the best part, small-caps are trading at a discount to large-caps in Japan so you get both an attractive price and better growth prospects. Kumar thinks that the earnings prospects of a number of his holdings are very strong, which could lead to them re-rate as the earnings come through.
The fund’s largest sector exposure is industrials, at 27 per cent of assets, with information technology making up 18 per cent, consumer discretionary 14 per cent and healthcare 10 per cent. Three-quarters of Baillie Gifford Japanese Smaller Companies' holdings have net cash on their balance sheets, which is relatively unusual for high-growth smaller companies funds – particularly those that invest in the US.
The fund’s largest holding is Demae-can (JAP:2484), one of Japan’s largest online food delivery websites. While the online food delivery sector is quite small in Japan relative to other countries, it’s growing very quickly and Demae-can is about four times larger than Uber Eats, its closest rival. Kumar says it has an excellent management team and the scope to cover all of Japan.
Bengo4.com (JAP:6027), the fund’s second-largest holding, is a website for legal services in Japan that enables people to search for a lawyer. With increasing instances of litigation, and the government’s desire to improve access to lawyers and raise the quality of advice available to individuals, Kumar believes that there should be strong ongoing demand for Bengo4.com’s services.
Other major holdings include Tsugami (JAP:6101), a machine tool manufacturer specialising in automatic lathes, GMO Payment Gateway (JAP:3769), an online payment processing platform, and Raksul (JAP:4384), an internet services firm.
The fund has a low annual turnover of holdings of 15 per cent, reflecting Kumar’s aim to buy and hold the best companies. The fund’s stated objective is to outperform MSCI Japan Small Cap Index, as stated in sterling, by 1.5 per cent per year over rolling five-year periods. And over five years to 31 January the fund has made an annual average total return of 19.7 per cent compared with 10.9 per cent for the index.
A drawback of investing in Japanese smaller companies is that they are very volatile, and a high proportion of their shares is held by private investors who tend to be more speculative and short-termist. While volatility can be helpful in generating returns, it can also mean a bumpy ride along the way, so investors in Japanese smaller companies need to be patient. The fund's future returns, meanwhile, may be more muted given its recent terrific run.
However, the structural changes happening in Japan mean the types of companies Baillie Gifford Japanese Smaller Companies invests in look attractive for long-term investors and its managers have a good record of picking the right ones. Buy.
|Baillie Gifford Japanese Smaller Companies|
|IA Sector||Japanese Smaller Companies||Sharpe ratio||0.47|
|Fund type||Oeic||Standard deviation||23.55%|
|Fund Size||£1.01bn||Ongoing charge||0.61%|
|No of holdings||74**||12 month yield||0.29%|
|Set-up date||01-Apr-83*||More details||bailliegifford.com|
|Manager start date||01-Dec-15|
|Source: Source: Morningstar 25 February 2021, *Baillie Gifford, **Morningstar 31 December 2020.|
|Fund/benchmark||1 year total return (%)||3 year cumulative total return (%)||5 year cumulative total return (%)||10 year cumulative total return (%)|
|Baillie Gifford Japanese Smaller Companies||38.64||25.26||130.57||397.17|
|Baillie Gifford Shin Nippon share price||56.29||23.95||166.67||594.12|
|Baillie Gifford Shin Nippon NAV||44.36||29.96||158.67||532.46|
|IA Japanese Smaller Companies sector average||26.11||15.66||98.27||216.67|
|AIC Japanese Smaller Companies sector average||24.79||11.90||112.44||262.33|
|MSCI Japan Small Cap index||11.88||5.43||63.40||145.07|
|Source: FE Analytics as at 25 February 2021|
|Top 10 holdings|
|GMO Payment Gateway||3.00%|
|Source: Baillie Gifford, 31/01/21|
|Sector breakdown (%)|
|Source: Baillie Gifford, 31/01/21|