Aberdeen Japan owns a concentrated portfolio of Japanese equities, aiming to generate long-term capital growth by buying high quality businesses with the ability to compound their earnings growth steadily over the cycle.
The trust is managed by the Aberdeen Standard Asian Equities Team, who look for stocks with high quality management and good or improving corporate governance as well as strong financial characteristics which suggest they should be able to generate above-market growth over the long run.
The trust’s style has been out of favour in recent years, and this has resulted in it sinking to a discount of 12.4%, significantly wider than the peer group average.
However, performance has been strong in 2019, with the trust ahead of the index by 330 basis points over the calendar year to date. This follows a rather more difficult 2018 in which some of the trust’s holdings suffered due to exposure to the US / China trade war and Chinese deleveraging.
Key themes in the portfolio are automation and robotics as well as medical innovation, areas in which Japanese companies are among the world’s leaders. The trust is also benefitting from increasing evidence of corporate governance reform in Japan, supported by a drive by the government, which is hoping to boost economic productivity and growth.
The trust will also offer a more substantial income than it has in the past this year, with the board expecting a minimum distribution of 15p next year compared to 2019’s 5.4p (this would amount to a 2.6% yield on today’s share price). The trust will pay out all the income, 3p from revenue reserve and an amount from capital reserves. The trust will also switch to a semi-annual dividend.
Aberdeen Japan’s quality style has been out of favour in recent years, as investors have preferred to go all out for growth. However, the trust has many of the features shown to be typical of a successful actively managed fund: it is concentrated, tends to operate with a low turnover and is highly active relative to its benchmark. We would also note that with the US federal reserve making more dovish noises, and global growth metrics looking weak, we could well see more troubled markets over the coming years in which a more defensive portfolio might do better and win favour relative to the more aggressive growth trusts.
The current discount of 12.4% is wide relative to the peer group, although we note that the one income mandate in the AIC Japan sector (CC Japan Income & Growth), is trading on a discount of just 1.3% and pays a 2.6% yield. The new income policy could therefore see a re-rating of this trust once it is absorbed by the market, although CC Japan income & growth does not pay out of capital.
|A highly active, concentrated portfolio which has alpha-generating potential
||Unhedged, and the Yen often weakens when Japanese equities perform strongly
|The government is pushing to improve corporate governance, supporting one of the trust’s key themes
||Japan could suffer from a global trade war given the openness of its economy
|The style has been out of favour and therefore could be due a rebound
||As the portfolio is highly active, periods of under and outperformance are both possible
Aberdeen Japan owns a concentrated portfolio of Japanese equities, aiming to generate long-term capital growth by buying high quality businesses with the ability to compound their earnings growth steadily throughout the cycle. The trust has historically held around 40 stocks and concentrated on larger companies, although this has changed slightly over the last year as the portfolio has grown to 49 companies, with the managers broadening their exposure to smaller and mid-sized companies.
The trust is team-managed with a concentration on bottom-up stock analysis and rigorous investigation of new ideas. Although the team is headed by Kwok Chern-Yeh, Head of Investment Management – Japan and Keita Kubota, Deputy Head of Japan Equities, the team aim to find consensus on any buys and sells for the portfolio, and to ensure the companies held are consistent with the core requirements of the Aberdeen Standard Asian Equities Team across all their portfolios, and indeed the wider Emerging Markets teams.
As regards company fundamentals, key desired characteristics include a high and sustainable return on equity and strong balance sheets with low or easily manageable levels of debt. The team also highly prize good corporate governance, and this is a major focus of their due diligence on a stock. The team looks for strong management teams with interests in alignment with those of shareholders and good corporate governance records and policies as well as strong financial fundamentals.
Once they have found companies which meet these ‘quality’ yardsticks, then they monitor their valuations, aiming to invest at attractive levels rather than overpay. Once invested, the bias is to remain so, however, with more tolerance of shifting valuations. The team looks at a company’s valuation relative to its history as well as to its peers to be sure that they are not paying over the odds. However, “quality” is very much the priority rather than “value”, and it is the strength of a company’s financial, business and management positions which is critical to it being bought.
The aim is to buy and hold for the long term in order to take advantage of the best companies’ ability to consistently generate above market returns. Over the past three calendar years the turnover ratio has averaged 22%, according to Morningstar data, consistent with a holding period of roughly five years. However, the turnover was a little higher in 2018 thanks to the shift into more small-cap stocks.
More of these companies meet their quality requirements than in the past, while the valuations are a little more attractive than the large caps after the strong run in Japan in 2016 and 2017. There is very little analyst coverage of small and mid-sized companies in Japan, which the team think makes it easier to generate alpha. Having met up with Kwok Chern-Yeh, the team seem excited that they have found some underappreciated stocks with great potential in this market.
The trust is managed with a benchmark-agnostic approach which means that all stocks are selected because the manager thinks they are the best individual investments in the market rather than to meet a quota or ensure that a particular sector or industry is represented. This approach means that the trust has some very active sector positions, with a major underweight to the financials sector and a very high overweight to the healthcare sector, as well as no holdings in utilities or oil and gas.
The healthcare sector position has been a source of some of the best-performing stock ideas in recent months. These companies are less dependent on global trade, which has been under threat as tariffs are imposed between China and the US, and more dependent on other secular growth trends.
Aberdeen Japan has a 3.6% position in Chugai Pharmaceutical. The company has had breakthrough therapy status awarded to four of its drugs in the US, including treatments for auto-immune diseases and haemophilia. The drug for the latter condition has been approved by European regulators and has recorded sales above expectations as a result. The trust also owns drugmaker Shionogi, manufacturer of a new flu vaccine, Xofluza, and also has market-leading drugs in HIV treatment through a tie-up with GlaxoSmithKline. Another holding in the sector is Asahi Intecc, a medical device manufacturer which builds the wires used in heart surgery and other serious operations.
Another theme in the portfolio aside from medical innovation is automation and “smart” factories. Japan has the world’s leading companies in this area, and Aberdeen Japan owns both Fanuc and Keyence. Robot-maker Fanuc’s shares suffered in 2018 as China’s economy has slowed and concerns about tariffs have weighed on markets. However, sales have picked up to other geographies, and the company has a diverse portfolio of products which should make it more resilient over the longer run. Keyence, by contrast, has held up relatively well in a falling market, buoyed by rising operating profits in its Q2 update. Keyence also has a diverse range of products, focussing on using technology to make factory systems more efficient, with significant cash on the balance sheet. It is the largest position in the portfolio at 4.5%.
The second-largest position in the trust also has a technology angle, although it sits in the materials sector: Shin-Etsu is a chemicals company which generates 30% of its operating profit from silicon used in computer chips. The company sold off last year despite barnstorming results.
TOP TEN holdings as at 30.04.19
% of portfolio
Source: Aberdeen Standard Investments
Another theme in the portfolio is corporate reform. The government of Shinzo Abe, in power since 2013, has made improving corporate governance a key aim as it tries to increase productivity in the Japanese economy, which has suffered low growth for decades. This plays into the hands of the managers’ keen focus on corporate governance and belief in engaging with company management to improve governance in the interests of shareholders.
Recent corporate governance boosts to the portfolio include a buyback at Shin-Etsu, which continues to discuss further distributions to shareholders. The company has been reticent to return capital thanks to a bad experience in the past when it allowed its balance sheet to become weak – this was the company’s first buyback since 2009. Amada Holdings also made changes to free up its balance sheet last year, by shifting some of its leased equipment to a third party so raising its capital position, and then issuing a dividend. The company has also been selling off excess real estate.
The team believe that companies are being encouraged to be more open to reform due to the labour shortage in Japan which is a result of their poor demographics and which is requiring a greater focus on efficiencies. Capex in Japan is at record levels thanks to this pressure on human resources. However, Chern cautions that change can be slow in Japan, and although a record number of resolutions were raised in 2018’s financial year end shareholders’ meetings, every single one was voted down. This will be a gradual process, he warns, although it is very real, with more buybacks already announced in 2019 than were seen in all of 2018. The government’s newest initiative is to clean up the murky relationships between many parent and subsidiary companies.
Before 11 July 2018 the trust was 50% hedged back into sterling, but this has now been completely removed, eliminating a cost to the fund but leaving it exposed to movements in the pound / yen exchange rate. During the period that the hedge was in place, it had a net neutral effect on shareholder returns but cost £1m, so we support its removal as being in the interests of long-term shareholders who should be prepared to sit through periods of exchange rate volatility.
Gearing tends to be a constant feature of Aberdeen Japan. The board monitors the levels of gearing and expects it to vary between 5% and 15% over the course of a cycle, although the level at any one time is up to the manager. The managers have tended to keep gearing stable around 10% over the long run. In Q4 of 2018 it crept up to 12.5% as the manager took the opportunity of the sell-off to pick up some new positions, mainly in smaller companies. The gearing is taken through two short-term facilities with ING, one of two years’ duration and the other of one year’s duration. Interest rates in Japan are very low, and the weighted average cost of the facilities is just 0.75%.
Performance in 2019 has been strong relative to the index, following a period in which the quality and value elements to the strategy have been out of favour. The trust is up 10.5% in NAV total return terms over the calendar year to date, compared to 7.2% for the TOPIX. The peer group average is higher though, at 13.5%.
As the graph below shows, the quality exposure helped the trust outperform the index in 2014, but in 2016 and 2017 the world economy saw a growth and momentum-led rally which the trust lagged in its market. During this period the high-growth, tech-focused trusts outperformed. Aberdeen Japan was also hurt in relative terms in 2016 by the Yen hedge, removed in July 2018.
Last year, 2018, was particularly tough for the trust thanks largely to the emergence of the trade war between the US and China. The trust has a number of holdings whose largest and most important market is China, so the slowing of capex in that country in response to the trade war (and Chinese deleveraging) hit hard. For example, robotics company Fanuc and industrial gear manufacturer Nabtesco both saw slowing order books. There were also relative losses in the technology sector and related stocks in other industries. For example, chemicals company Shin-Etsu has sold off dramatically; 30% of the company’s operating profits are derived from selling silicon wafers used in computing. The stock has done poorly despite sales and profits rising and the company hiking its dividend and discussing a share buyback. The team see no change to the long-term prospects of the companies, however, and regard this as an unwarranted sell-off, so are sticking with their positions.
Overall, the trust has therefore lagged the peer group over the past five years, and lagged the index, albeit to a lesser degree. NAV total returns are 60.4% over the period, compared to 71.7% for the index and 99% for the peer group.
While 2018 was a poor year, 2019 has been more encouraging so far. However, the trust tends to lag in the sharpest rallies given the quality element to the strategy. In our view, this positioning could well prove advantageous if the global economy enters a difficult period. Although Japan suffers from being a market very open to the global economy, and suffers contagion from a slowdown elsewhere, Aberdeen Japan’s portfolio is made up of companies which the managers believe are resilient to poor economic conditions, and with the US federal reserve inching towards a looser monetary policy and growth indicators looking sluggish across the globe, these more defensive companies could come back into favour.
ONE-YEAR RELATIVE PERFORMANCE
From the 2020 financial year, the trust will pay an enhanced dividend which would amount to a roughly 2.6% yield on today’s share price, using the board’s estimate of the minimum likely payout. This will be comprised of the entire income received, 3p from the revenue reserve and a contribution from capital. The board anticipates a minimum payout of at least 15p for the year, using the assumption of a 5.2p payout from capital. This compares to just 5.4p in the 2019 financial year. The previous policy was to only commit to paying out enough to maintain investment trust status (at least 85% of income), which led to variable dividends, with extra volatility from the sterling / yen exchange rate. The current dividend yield, using last year’s payout, is 1%. From this financial year there will be an interim dividend as well as a final dividend.
The trust is managed from Asia by the Asian Equities Team at Aberdeen Standard Investments. The team structure has not changed with the merger with Standard Life, although some senior personnel have been promoted upwards. The Asia Pacific Equities Team is now led by Flavia Cheong from Singapore, with her Deputy Kwok Chern-Yeh being based in Tokyo. There are seven team members in Japan, with two new additions this year at a junior level. The collegiate approach and consistency of strategy is one of the key selling points of the Aberdeen Standard Investments approach. The team seek consensus on stock picks, and don’t rush to invest before the proper due diligence has been done. They place a great emphasis on engagement with management to improve corporate governance, which we think has a great chance to boost returns in the coming years as the Japanese government is making improving governance in Japanese companies a priority in a bid to boost productivity and growth in an economy which has been sluggish for decades.
The trust has tended to trade on a discount between 10% and 15% over the past two years. At the time of writing it is at 12.4%. During this period investors have favoured trusts with a higher growth factor exposure, which have generally outperformed. Aberdeen Standard Investments’ “slow and steady”, quality approach has been less in favour. Although the trust has outperformed the index year to date, this has not led to a significant narrowing of the discount, in our view because it is still a short time period and because some of the peers have outperformed the benchmark by more.
The board has supported the share price with a buyback programme, although there is no specific figure they have defended. In our view, a more sustained period of good performance is more likely to have a lasting effect, which may take a reversal of the appetite for high growth at all costs. We note that the highest growth trust in the sector is trading on a premium. Excluding this (Baillie Gifford Japan) and the income fund (CC Japan Income & Growth), the average discount is 10.5%, in line with that of Aberdeen Japan. Clearly the more bearish outlook from the US Federal reserve makes a higher interest rate regime less likely, which would be one potential cause for a style rotation. However, it is not clear how the highest rated growth stocks would react if the global economy slows, led by the US, so there are still risks to the highest rated growth stocks.
The trust will hold a continuation vote if the trust trades on a discount of more than 10% over the 90 days prior to the end of the financial year in March, which reduces discount risk by either keeping the discount under control or giving investors the chance to vote on continuation. A negative vote would provide investors with the option to exit at close to NAV.
The ongoing charges are 1.1%, compared to an average of 0.95% in the AIC Japan sector. This is more competitive than it looks given the small size of the trust – at £91m in net assets it is the smallest portfolio in the sector. The OCF includes a management fee of 0.75%. From 1 June, this has been charged on the lower of NAV or market cap, which will result in a saving given the trust trades significantly below par, and which motivates the manager to close the discount. The KID RIY is 1.24%, below the 1.45% average for the sector, although methodologies can vary.