Investing with real conviction without regard for a benchmark and exploring companies up and down the market capitalisation scale are two key ingredients for maximising returns in Japan, according to Baillie Gifford’s Matthew Brett and Praveen Kumar.
The managers of the five FE Crown-rated Baillie Gifford Japan trust said their high-conviction, long-term investment philosophy has led to a small-cap bias, where the best growth prospects can be found.
However, they noted that being open-minded to larger companies that meet Baillie Gifford’s criteria is also a key element to their investment process.
“We believe in genuinely long-term growth investing,” they noted. “This means maximising returns by only investing in companies in which we have real conviction.
“It also means holding companies for long time periods so that investors benefit from the significant increases in business value that can occur over many years in growth companies.”
As part of their investment process, the team groups holdings in four different styles of growth with different risks and opportunities: secular growth, growth stalwarts, special situations stocks, and cyclical growth stocks.
Secular growth stocks which make up the largest part of the portfolio, include with the opportunity to grow rapidly but where there are a number of potential outcomes.
Growth stalwarts, meanwhile, show less rapid but more predictable growth, and special situations are companies whose recent performance has not been good but where there is reason to believe that improvements are underway.
Finally, the cyclical growth stocks are those whose earnings that do not rise every year but where the managers expect the earnings to be higher from one cycle to the next.
According to the managers, although the mix of the four different styles of growth does change, the team’s approach to investing is likely to result in a high weighting towards secular growth.
They said performance is primarily driven by individual company share prices with an asymmetric nature of stock returns over five and 10 years, which means a good idea can do much more to help returns than a bad idea can hinder them.
“Over the last year the largest contributor to performance – SBI – delivered more than double the performance that the worst – Rakuten – subtracted,” they noted.
Performance of SBI over 1yr
Source: Google Finance
“Over five years each of the top 10 contributors individually delivered more performance than the worst subtracted. Therefore, we continue to believe that it is important for us to focus on the upside potential of individual stocks and stay the course when we have found a good idea.”
Regarding performance of the trust in 2018, the managers said some of the best contributors so far have been internet businesses but that companies in other areas such as real estate have also stood out.
Additionally the best performers in 2018 include companies that aren’t yet well-known outside Japan including aforementioned financial services group SBI, internet advertising and content company CyberAgent, real estate business Katitas, staffing services provider Outsourcing.inc and SanBio, which develops regenerative cell medicines.
They also continue to back entrepreneurialism in the country and to favour businesses with solid franchises and a long growth runaway.
As such, the managers bought two newly-listed companies – Katitas and online market app Mercari – and three more (Zenkoku Hosho, Sato Holdings and Shimano) that are “leaders in their respective niches and companies where we believe that there are many years of growth to come”.
Three other additions to the portfolio include Noritsu Koki, Rizap and JAFCO, which the managers said have been transformed by more dynamic management.
With many historic issues having improved in Japan under reform-minded prime minister Shinzo Abe, the Baillie Gifford managers noted that the over-arching theme is one of “a normalising of the investment environment”.
“Japanese corporate governance has continued to progress and a concrete output of this is that shareholder returns through dividends and buybacks have continued to rise,” they said.
“While areas for improvement remain, especially regarding cash hoarding, we should also acknowledge that the absence of scrip dividends, very low options issuance and lack of excessive pay for managers are helpful for minority shareholders.”
Meanwhile, the pair said the political situation remains quiet as Abe continues his journey to become Japan’s longest serving prime minister.
Japan’s CPI since 2005
Source: Statistics Bureau of Japan
While there continues to be lively debate around whether the Bank of Japan will be able to achieve 2 per cent inflation the managers noted that conversations around deflation have become “vanishingly rare”.
“We have moved beyond the destructive effects of deflation,” they said. “Wages are rising, unemployment is very low, land prices in the major urban areas are rising, and bank lending is growing. Meanwhile corporate confidence is strong, evidenced by strong rises in capital expenditure.
Regarding the risks, the pair noted that the most obvious ones on their radar are the changes to established international norms and the risk of a recession.
“Many of the companies that we own are still nearer the start than the end of their growth,” the managers explained. “The Internet continues to allow companies to compete against incumbents with a powerful combination of a lower cost-base and better service.
“Robotics and automation businesses listed in Japan have world-leading competitiveness and a very large growth opportunity as they enter new industries. Finally, new categories of growth companies continue to appear – emerging healthcare being a recent example.”
They added: “Since the global financial crisis of a decade ago we have enjoyed a largely synchronous global economic expansion creating significant opportunities for Japanese businesses. Cycles are difficult to predict but inevitable.”
Finally, the managers noted that, while volatility and set-backs will happen from time to time, the most important thing for the team continues to be having access to quality growth companies.
Over five years, Baillie Gifford Japan Trust has delivered a 142.98 per cent total return compared with a gain of 114.78 per cent for the average trust in the IT Japan sector and a gain of 84.14 per cent for the TSE TOPIX index.
Performance of trust vs sector and benchmark over 5yrs
Source: FE Analytics
According to data from the Association of Investment Companies, the trust is trading at a 2.3 per cent premium to net asset value (NAV), is 9 per cent geared, and has an ongoing charge of 0.78 per cent.