Compass - September 2019
I hope you have had a lovely summer. I have visited the Welsh seaside and have been swimming in the River Thames in Oxfordshire...
Foreword
By Annabel Brodie-Smith
I hope you have had a lovely summer. I have visited the Welsh seaside and have been swimming in the River Thames in Oxfordshire.
It’s back to school time, the trains are packed again, Australia’s retained the Ashes and the new normal of Brexit chaos has returned. But on the very bright side, the Rugby World Cup starts next week in Japan. As a rugby-loving Wales supporter, I can’t wait, which may explain why this month Compass is ‘Turning Japanese,’ to borrow an 80s song title.
We have talked to a scrum of Japanese managers, including the managers of Baillie Gifford Japan, JPMorgan Japanese and Fidelity Japan amongst others. Read our article to find out more about their investment approach, where they are finding the best opportunities and what impact the world cup and the Olympic Games in 2020 will have on Japan.
Ian Cowie, our investment expert, explains why he’s ‘Big in Japan’ - yes those 80s songs were good. He explains why Japanese shares “remain far below the peak they reached nearly three decades ago” and why Japan may be of interest to investors. As a major casualty of the trade war between the US and China, Japan has suffered recently but “short-term setbacks may offer an opportunity for medium to long-term investors to obtain value.” Japan are unlikely to win the world cup “but the event may focus more people’s attention on the Land of the Rising Sun.”
The suspension of the open-ended fund, Woodford Equity Income, remains in the news and this has demonstrated that the closed-ended structure of investment companies is particularly well suited to investing in unquoted companies. Investment companies are increasingly focused on unquoted opportunities as businesses stay private for longer and the number of public companies shrinks.
So recently, I spoke to three investment companies investing in fast-growing private companies, Richard Watts, manager of Merian Chrysalis which invests in later-stage private companies across Europe, Suresh Withana, manager of Adamas Finance Asia which invests in private companies across Asia, and Richard Matthews, Co-Founder of Augmentum Fintech which invests in unquoted fintech companies. Watch the video or read their views on the attractions and risks of investing in unquoted companies, the benefits of the closed-ended structure and where they are currently finding interesting companies.
Managers discuss the attractions of investing in private companies, the benefits of the investment company structure for these assets, where they are finding opportunities and their outlook for the sector.
Finally, the Infrastructure sector and Renewable Energy Infrastructure sector invest in a range of assets from roads and railways to wind farms and solar parks and offer an average yield of 4.6% and 5% respectively. Watch our new videos on Infrastructure and Renewable Energy Infrastructure opposite to find out more about what they offer to investors, and the benefits and risks of investing in this area.
Have a good month.
Annabel Brodie-Smith
Communications Director, AIC
Find out how investing in roads, schools and railways helps produce attractive returns and grow the economy.
Managers explain how wind farms, solar parks and energy storage are benefiting investors and the environment.
Turning Japanese
Investment company managers make the case for Japanese markets.
With the Rugby World Cup starting next week and the 2020 Olympic Games on the horizon, Japan is set to be the focus for many around the world in the coming months.
For investors, long-term performance from investment companies focused on the region has been rewarding, with companies from the Japan and Japanese Smaller Companies sectors returning an average of 250% and 195% respectively over the past ten years.
But the past 12 months have seen returns turn negative, and many investors believe Japanese shares continue to be undervalued. Could now be an attractive entry point? The AIC has spoken to the managers of Japan-focused investment companies about their investment approach, where they are finding opportunities, the impact of the Rugby World Cup and Olympics, and their outlook for Japan.
Investment approach
Joe Bauernfreund, Manager of AVI Japan Opportunity Trust, said: “At AVI we look to invest in under-researched and misunderstood companies. This approach leads us in turn to small-cap Japanese companies, a segment of the market which is poorly covered. Of the 28 companies in our portfolio, only four are covered by more than one analyst and, as a result of investors’ general aversion to Japan, all are unloved. These factors have led to us finding abnormally low valuations in good-quality, highly cash-generative companies.”
Matthew Brett, Manager of Baillie Gifford Japan Trust, said: “We are bottom-up, growth-orientated investors with low turnover. Our aim is to identify businesses with attractive industry backgrounds, strong competitive positions, attractive financials and favourable attitudes towards shareholders. Once we develop conviction that we have a strongly different view about a company’s long-term prospects, we buy the shares and then hold them to benefit from the growth in the underlying business.”
Taeko Setaishi, Lead Adviser of Atlantis Japan Growth Fund, said: “The investment approach at Atlantis Japan Growth is based on the assumption that long-term earnings growth drives equity prices. The investment adviser, Atlantis Investment Research Corporation (AIRC), employs a growth-oriented, bottom-up stock picking investment style with decisions based on proprietary fundamental research. This style can, but does not necessarily, result in a portfolio bias toward small and medium capitalised companies.”
Opportunities
Taeko Setaishi, Lead Adviser of Atlantis Japan Growth Fund, said: “Japan’s economy is undergoing significant structural change, which in turn is creating numerous attractive investment opportunities in the healthcare, technology and the services sectors. In services, we believe one is spoiled for choice. Examples include Recruit Holdings, a global leader in recruitment and other HR functions, and Bengo4.com, a lawyer and accountant referral website. In the healthcare sector, our investments include elderly care provider Solasto and drug discovery enabler PeptiDream. In technology, we expect sustained earnings growth from the semiconductor production equipment assemblers Lasertec and Tokyo Electron.”
Matthew Brett, Manager of Baillie Gifford Japan Trust, said: “The two major current areas of investment for the Baillie Gifford Japan Trust are internet and factory automation companies. In total, these comprise approximately 40% of the portfolio. For example, we are very enthusiastic about Softbank which we believe has world-class assets, including a large investment in Alibaba, ARM and many exciting venture companies, trades at nearly a 50% discount to the sum of these investments, and is managed by the extremely value-added Mr Son. Also, we like FANUC, which is a leading global robotics company that has the potential to see accelerating growth as robotics expands to new industries and applications and where management have begun to return much more cash to shareholders.”
Nicholas Price, Manager of Fidelity Japan Trust, said: “While there have been no significant changes to the overall composition of the company’s holdings, I have selectively increased positions in oversold semiconductor-related companies and component makers. New investment ideas, for example in companies that are likely to be rerated as internal change leads to a period of renewed growth, have also been added. A prime example is endoscope maker Olympus, which has implemented a long-term restructuring plan ‘Transform Olympus’ to enhance profitability and improve capital efficiency. I also continue to search for opportunities to invest in innovative companies at the pre-IPO stage. Conversely, I have reduced exposure to machinery and chemicals stocks where the risk/reward balance had deteriorated, and near-term upside appeared limited. I have also actively taken profits in strong performers, in the retail and medtech sectors.”
Nicholas Weindling, Manager of JPMorgan Japanese Investment Trust, said: “We currently find compelling investment opportunities in structural growth areas like e-commerce, automation and opportunities created by an aging population, as well as companies prioritising improving shareholder returns.”
Joe Bauernfreund, Manager of AVI Japan Opportunity Trust, said: “Fujitec is a global lift manufacturer with sales in Japan, China, Southeast Asia, North America and Europe. The most appealing aspect of the business is the maintenance revenue that Fujitec receives after installation. These maintenance contracts can last for decades, producing steady, recurring profit, which explains why Fujitec’s global peers trade on enterprise value-to-earnings before interest and tax multiples approaching 20x. However, Fujitec, which operates the same business model, is on a multiple of just 5x. Fujitec’s balance sheet is hugely overcapitalised, which means we are, in effect, investing 56% of our capital in cash and listed securities while gaining exposure to a high-quality, profitable operating business at a low valuation – all the while receiving a 4% dividend yield.”
Impact of Rugby World Cup and 2020 Olympics
Taeko Setaishi, Lead Adviser of Atlantis Japan Growth Fund, said: “The impact of the World Cup and Olympics will be at least twofold. Firstly, close to two trillion yen has been spent on associated infrastructure, such as stadiums and facilities. Estimates suggest this expenditure peaked in 2017-2019 and the impact has largely been delivered. Secondly, In-bound tourist flows have been on an uptrend for the past three to four years due to eased visa restrictions, Low cost carriers and government promotion. However, Olympic arrivals will likely push visitor numbers well over the 40 million target set by the government. More importantly, this flow should maintain Japan’s position as an attractive tourist destination for years to come.”
Nicholas Price, Manager of Fidelity Japan Trust, said: “It’s great to see big global sporting events here in Japan and I will be watching with interest. While the run-up and legacy effects of the two events are difficult to quantify, there should be economic benefits through inbound tourism and construction investment. However, it’s not a material investment in the portfolio.”
Nicholas Weindling, Manager of JPMorgan Japanese Investment Trust, said: “We see little long-term impact from the rugby and the Olympics. We’re looking for investments with good duration. That said, stocks relating to tourism and Japanese brands, such as Shiseido and Fast Retailing, should be beneficiaries and offer long-term duration.”
Outlook
Taeko Setaishi, Lead Adviser of Atlantis Japan Growth Fund, said: “Perhaps the major challenge Japan will encounter in the medium-term is an ageing population slipping into depopulation. Rising productivity and greater workforce participation have offset, to a degree, the negative effects of depopulation. This development is already producing significant social change, particularly around public finances and welfare expenditure priorities.
“On the positive side of the ledger, Japan continues to run a significant current account surplus, is politically stable, and possesses a deep repository of patents available for monetisation. The stock market, on a 12x forward price-to-earnings ratio, appears undervalued, particularly in light of the improving corporate governance. However, Japan, unfortunately, is located in a politically unsettled corner of northeast Asia which it shares with four nuclear powers, and relations are cool at best. Geopolitical risk is significant, and outside of Japan’s influence.”
Matthew Brett, Manager of Baillie Gifford Japan Trust, said: “We believe that the Japanese stock market contains a number of very attractive individual businesses and the prospects for the shares of those companies over the long-term are as good as quality businesses listed anywhere in the world.”
Nicholas Price, Manager of Fidelity Japan Trust, said: “Japanese stocks have lagged their global peers so far this year, as uncertainty over US-China trade frictions and the impact on the global economy have clouded the outlook for corporate earnings. While the analyst revision index has already reached its typical bottom and earnings trends should stabilise in the coming quarters, share prices are likely to remain volatile amid a steady stream of political news flow.
“While not immune to external headwinds, the Japanese economy remains stable. Confidence among Japanese manufacturers has clearly weakened, but sentiment in the non-manufacturing sector is holding up. Employment conditions remain tight, with the job-offers-to-applicants ratio at record levels. Capital expenditure plans are supported by non-cyclical factors such as investment in labour saving technology and research and development. The Bank of Japan remains highly accommodative and extensive counter measures will be deployed to mitigate the effects of the October 2019 consumption tax hike from 8% to 10%.
“From a valuation perspective, Japanese stocks priced in a significant level of risk in late 2018 and continue to look undervalued at around 12x forward earnings. With valuations testing historical lows in some parts of the market, there are opportunities to capitalise on disconnects between near-term sentiment and mid-term fundamentals.”
Nicholas Weindling, Manager of JPMorgan Japanese Investment Trust, said: “The outlook for Japan is increasingly mixed. Set against a backdrop of slowing global growth and sluggish earnings growth in Japan’s cyclical sectors, valuations of the TOPIX continue to be lower than its own history, as well as other major markets. On the policy front, Japan continues to make progress in tourism, free trade and corporate governance. The market is likely to reward companies with improving governance policies overall, including shareholder returns, internal controls and disclosure.”
Big in Japan
Ian Cowie explains why there's value in the Land of the Rising Sun.
Ian Cowie
The Rugby World Cup in Japan this month may help investors tackle a problem of success. Trying to identify value or assets worth buying today has become increasingly difficult after the longest bull run on record in many developed markets, where share prices trade at or near all-time highs.
However, the media scrum that will kick off in Tokyo on September 20 should remind investors that share prices in Japan remain far below the peak they reached nearly three decades ago. While the past is not necessarily a guide to the future, buying low can sometimes be the first step toward making a profit.
One way to assess whether shares are cheap or expensive is to express their price as a multiple of corporate earnings to calculate a price/earnings ratio. This can be further refined by taking account of earlier ratios to give a cyclically adjusted P/E (CAPE).
On that basis, Japanese shares are more than 25% cheaper than American shares because the latter’s stock market is trading on a CAPE of about 30 while the former is nearer 22. The global average for developed markets is 25, according to analysis by Star Capital. Japan, the world’s third-largest economy after America and China, is heavily dependent on technology and trade. This has made it a major casualty of tit-for-tat tariff hikes in the trade war between both of the world’s biggest economies.
That is reflected in the fact that the average investment company excluding specialist exceptions, such as venture capital trusts, has delivered total returns of 3% over the last year but the average fund in the AIC's Japan sector shrunk by 5%. Meanwhile, the Japanese Smaller Companies sector fared even worse and fell by 11%.
However, short-term setbacks may offer an opportunity for medium to long-term investors to obtain value. Bear in mind that during the last five and 10-year periods, the average total return from all conventional investment companies was 73% and 289% respectively.
But the comparable returns over the same periods for Japan investment companies were 105% and 300%. Meanwhile, the Japanese Smaller Companies sector did even better and delivered total returns of 136% and 470%. Despite these facts, the average Japan company is priced at 7.7% below its net asset value (NAV) while Japanese Smaller Companies typically trade 11% below NAV, compared to an industry average discount of 4.3%.
Coming down from the clouds and moving from macroeconomics or sector averages to specific shares and their performance, Baillie Gifford Shin Nippon - a Japanese smaller companies investment company - has had a difficult year but remains one my most valuable shareholdings and a top-performer. While it fell by 15% over the last 12 months, it delivered sparkling total returns of 165% over the last five years and an eye-stretching 637% over the last decade. It trades at a modest discount of 2.8% to NAV.
Against all that, income-seekers may be disappointed that this company pays no dividends; nor is that unusual. The AIC Japan and Japanese Smaller Companies sectors state “not applicable” under the heading “dividend yield”.
However, there are notable exceptions. For example, in the former sector Schroder Japan Growth yields 2.1% and trades at a 13% discount to NAV. It has delivered dividend growth over the last five years at an annualised rate of 15%. If that rate of payouts progress is maintained over the next five years, it would more than double shareholders’ income.
Here and now, JPMorgan Japan Smaller Companies is another exceptional yielder in this country, delivering 4.3% dividend income and the shares can be bought at a discount of 11% to NAV.
Japan is unlikely to win the Rugby World Cup this year but the event may focus more people’s attention on the Land of the Rising Sun, including investors seeking income, capital growth or a mixture of both.
Treasure hunt
Managers seek private company gems.
Richard Watts, Manager of Merian Chrysalis, Suresh Withana, Manager of Adamas Finance Asia and Richard Matthews, Co-Founder and COO of Augmentum Fintech, discuss investing in private companies
Recent events have illustrated that the closed-ended structure of investment companies is particularly well suited to investing in unquoted companies.
Investment companies are increasingly focused on unquoted opportunities as businesses stay private for longer and the number of public companies shrinks. Data from Pantheon International has shown that the number of North American and European listed companies in 2017 had decreased by 29% from 20,326 to 14,393 since 2008.
At a roundtable held by the AIC, Richard Watts, Manager of Merian Chrysalis which invests in later-stage private companies across Europe, Suresh Withana, Manager of Adamas Finance Asia which invests in private companies across Asia, and Richard Matthews, Co-Founder and COO of Augmentum Fintech which invests in unquoted fintech companies, discussed the attractions and risks of investing in unquoted companies, the benefits of the closed-ended structure for this type of investment and where they are currently finding opportunities.
This follows the AIC’s launch in May of its new Growth Capital sector. Separate from the existing Private Equity sector, Growth Capital is home to investment companies which generally take non-controlling stakes in unquoted companies with high growth potential.
Annabel Brodie-Smith, Communications Director of the Association of Investment Companies (AIC), said: “Using an investment company to invest in unquoted companies gives investors access to a professionally managed, diversified portfolio of private companies not normally available to individual investors. It has been interesting to see several new launches of investment companies targeting fast-growing private companies, along with existing investment companies widening their remit to allocate more of their portfolios to unquoted assets.
“But investing in these hard-to-sell assets is high-risk and requires a long-term mindset. The closed-ended investment company structure frees up the manager from having to worry about inflows and outflows, while at the same time giving investors a chance to sell when they want to via the stock market. In contrast, open-ended funds that invest in illiquid assets can come unstuck when investors want their money back.”
Why private companies?
Richard Watts, Manager of Merian Chrysalis, said: “Over the last decade an increasing number of companies have chosen to stay private for longer in order to de-risk an IPO. Unencumbered by stock market volatility, businesses often achieve significant growth and return on investment during the later stages of unquoted life.”
Suresh Withana, Manager of Adamas Finance Asia, said: “We find that many high-quality Asian SMEs struggle with access to traditional sources of financing, especially those in nascent industries; many of these SMEs are typically private companies. The resultant financing gap means that there is a plethora of investment opportunities for Adamas Finance Asia. In particular, we target companies that are likely to have an attractive exit route through a public listing or by acquisition at a premium, giving them a greater growth potential over a publicly listed alternative.”
"Unencumbered by stock market volatility, businesses often achieve significant growth and return on investment during the later stages of unquoted life"
Richard Watts, Manager of Merian Chrysalis
Richard Matthews, Co-Founder and COO of Augmentum Fintech, said: “We invest in disruptive private fintech companies across Europe, where the fintech opportunity is still in its nascency. We view the fintech sector as at ‘the end of the beginning’, and with its maturity comes unprecedented growth. Public market pressures are leading companies to stay private for longer, and the trend is towards the bulk of a company’s value being generated prior to public exit. We provide exposure to high performing assets before their value is realised. We are the UK’s only publicly listed fintech fund, and we are proud to have opened up an emerging and hard to access asset class for institutional and retail investors. Our structure provides inherent liquidity and means we can provide patient capital to our portfolio companies, unrestricted by conventional venture capital timelines.”
Where are you finding opportunities?
Richard Watts, Manager of Merian Chrysalis, said: “With the European unicorn scene thriving, led by capital-light, tech-enabled disruptors, we’ve already made sizeable investments in a number of attractively valued, high-growth companies, including TransferWise and Klarna. Importantly, and of equal significance as knowing where to invest, we are clear on which companies to avoid. We don’t invest in businesses in the infancy of their journey or sectors such as biotech, where success is so varied.”
Suresh Withana, Manager of Adamas Finance Asia, said: “One of the great economic themes across Asia today is the increasing spending power of the middle class. We consider investments in healthcare and pharmaceuticals, education and technology as attractive ways to gain exposure to this ongoing trend. We source opportunities through our network, leading to proprietary deal flow which investors would not ordinarily be able to find themselves.”
Richard Matthews, Co-Founder and COO of Augmentum Fintech, said: “We focus on the disintermediation and disruption of traditional services across the financial spectrum. We invest in ambitious, talented fintech teams across Europe at Series A funding and beyond, with investment sizes of £2 million plus and our four key areas are banking services, for example our current portfolio includes Zopa, iwoca, Habito and Tide, asset and wealth management (Farewill, interactive investor, WhiskyInvestDirect), technology infrastructure (Onfido, DueDil) and insuretech.”
What do you look for?
Suresh Withana, Manager of Adamas Finance Asia, said: “We look for companies that operate in an industry with a favourable regional outlook with clear growth prospects. We also prefer to invest in companies that have positive cash flows derived from non-cyclical products. We support strong and proven management teams with a clear plan to execute their growth strategy.”
Richard Matthews, Co-Founder and COO of Augmentum Fintech, said: “When evaluating potential investments, an exceptional team is a must. We only invest in teams that have the talent, passion and grit to transform sectors and become industry leaders. We’re uncompromisingly data-driven and look for strong unit economics that are sustainable with scale. We avoid propositions that imply huge capital-intensive requirements to reach scale and profitability. The size of the opportunity is crucial - our investments must operate within large markets, have strong scaling capabilities, and have a clear route to exit. We seek sector-redefining propositions – there is huge potential for businesses that can truly disintermediate and disrupt financial services; we cut through the noise to find truly game-changing businesses. Lastly, we only invest where we can add value – this is core to our investment thesis. We are active investors and will turn down investments where we feel we are not the absolute best investors for the company.”
How does market uncertainty affect your portfolio?
Richard Watts, Manager of Merian Chrysalis, said: “With market uncertainty unlikely to be alleviated soon, we believe the opportunity for unquoted investments will continue to grow, leading to a greater number of attractively valued businesses, particularly against a listed market background.”
Suresh Withana, Manager of Adamas Finance Asia, said: “Our portfolio companies are not publicly listed and our investment timeline is relatively long term so our investments are not subject to volatile price movements which publicly listed investments suffer from. We have also witnessed that market uncertainty, such as the ongoing China/United States trade war, can create investment opportunities elsewhere in the region.”
Richard Matthews, Co-Founder and COO of Augmentum Fintech, said: “Many of the fintech businesses that Augmentum are investing in have global ambitions, and already operate cross-border with operations throughout Europe. Of those that are UK based, many rely on the four pillars that have allowed the UK to become the global fintech centre. These four pillars, capital, regulation, central bank support and government engagement will ensure the UK remains one of the leading fintech centres in the world.”
Venture Capital Trusts (VCTs)
Venture Capital Trusts (VCTs) are another form of closed-ended investment company that give their shareholders access to smaller private companies with high growth potential. VCTs, which currently manage assets of £4.7 billion, offer generous tax benefits to investors because of their value to the growing economy.
