Investment Strategies

Value And Growth – Japan’s Promise And Performance

Tom Burroughes Group Editor 22 August 2023

Value And Growth – Japan’s Promise And Performance

This news service recently talked to a UK-based investment house that concentrates on Japanese investments and the opportunities it sees building in the country.

Japanese equities have increasingly caught investors’ attention. While not necessarily proving to be the hottest market in 2023, the market’s rise is one of the more positive financial stories of this year so far. We have already written several articles on the area. (See examples here, here and here.)

A few weeks ago, this news service met with Zennor Asset Management, a London-based firm specialising in the country, and we met James Salter, chief investment officer, and David Mitchinson, CFA. The firm runs two funds: The Zennor Japan Fund, and The Zennor Japan Equity Income Fund.

The Zennor Japan Fund is a Luxembourg-domiciled UCITS fund investing in Japanese equities. Launched in February 2021, it aims to achieve long-term capital growth and generate excess returns against the broad Japanese market by mainly investing in companies listed, domiciled and operating in Japan. It is actively managed without reference to a benchmark and focuses on special situations in the Japanese market by investing in companies which trade at a discount to intrinsic value and have strong catalysts. For example, as a result of parent/subsidiary consolidation, capital allocation changes, or earnings growth that is superior to the broader market.

The Zennor Japan Equity Income Fund, meanwhile, is a UK UCITS fund investing in Japanese equities. This fund, which was launched in April this year, aims to provide a meaningful and growing level of income whilst preserving and growing capital. The climate for enhanced shareholder returns is improving in Japan amid a corporate governance revolution. The fund focuses on investing in companies that are able to grow cash flow and sustain dividends through time which will in turn provide a growing stream of income for our investors. 

This publication asked both men about the funds, and their investment approach.

You adopt different approaches to investing – growth and value. Can you talk a bit about how your approaches complement each other? 
Zennor AM: We both come from very different backgrounds. However, certain evolutionary changes were necessary for us to incorporate into their understanding of intrinsic value. I continue to specialise in value but am now more focused on finding a catalyst to unlock that value, and thus avoid “value traps.” I am also running some of his “winners” in the GARP space for longer. The combination of value and GARP is our main philosophy. David, having been focused on “growth” has been more focused on the GARP side.

There’s been quite a drumbeat of noise about Japan in recent weeks, and people are waking up to the performance of the market. Why has this happened just now? 
Zennor AM: It has been in a stealth bull market for over 10 years. Corporate governance reform began during Abenomics and has steadily become a major theme in the market. Recent moves by the TSE to encourage companies to explain their cost of capital/return on invested capital spread combined with getting price-to-book ratios over 1x are very encouraging. Nearly 50 per cent of companies in the TSE First Section trade below book value. There has been very little multiple expansion in the Japanese market in the last 10 years. Earnings growth has been tremendous because of rationalisation and buybacks. The foreigner has been a net seller in the last five years with corporates as the major buyer.

Starting at a broad, macro level, what do you think is the reason why the Japanese stock market is delivering these returns?
Zennor AM: Whilst there is lacklustre growth in the economy, many Japanese companies have radically transformed themselves through cost cutting and streamlining. In addition to this, we are seeing huge changes in capital allocation. NTT, the telecommunications company has seen operating profit rise by 80 per cent over 10 years but earnings per share have risen by 300 per cent. The company has bought back close to 50 per cent of the company.

On a more fundamental level (valuations, governance reforms – such as more assertive shareholders and desire for cash to be put to work) just how far can the rally in Japanese equities go? What sort of metrics do you track to ensure that you and your clients don’t get carried away? 
Zennor AM: The rally has been significant. In theory, if all companies on the exchange were to go to book value the Nikkei could exceed ¥40,000. However, a long experience in Japan means that you must expect two steps forward and one step back. Certainly, there will be a strong lobby by some companies against the recent TSE reforms. The foreigner may not come back. If he does not, then history suggests that the market will still go up as he is a good reverse indicator.

David Mitchinson has talked about a lack of “financialisation” of the Japanese economy. Can you elaborate on that a bit in terms of where the country is heading?
Zennor AM, Mitchinson: The situation in Japan is not one where we are asking firms to replace operational focus with financial leverage to boost returns. What we are asking is that companies look at their business models and reflect that equity capital is very expensive. This means that firms should pay as much attention to their working capital, under-utilised and surplus non-operating assets and how they fund their business as they do to their production line operational efficiency.

This is an area where many Japanese firms have been used to treating capital as very abundant and very cheap. Now, like labour, capital is becoming more expensive so firms will have to economise on how they deploy this and work their existing assets harder. The first step is to address excess cash and financial assets. In time we expect that this same increased capital discipline will extend to tougher choices on redefining core operations and questioning as to who is the ‘best owner’ of some assets. 

Finally, Warren Buffett, having added holdings of Japan’s five largest trading houses, has caused a lot of attention. How significant is that? 
Zennor AM: Buffett’s support for Japan is interesting. He has upped his weighting in trading companies but will also look elsewhere to deploy capital. Buffett understands that these companies sit at the heart of many corporate relationships and as these evolve, they may provide opportunities for him to deploy capital and acquire attractive assets. 

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