Aberdeen Japan

AJIT invests in high-quality Japanese equities, while paying a high dividend…

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This is a non-independent marketing communication commissioned by Aberdeen Japan. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.

Aberdeen Japan

Summary

Aberdeen Japan Investment Trust (AJIT) is a Japanese equity strategy dedicated to investing in what the managers believe are the highest-quality companies in Japan. The team, based predominantly in Tokyo, implement a detailed investment process which exhaustively analyses a company’s overall quality, both in terms of conventional quantitative factors (such as having a high ROIC) but also in terms of the quality of management. We outline this further in the Portfolio section.

One of the important features of AJIT is its allocation to small- and mid-cap companies. A truly all-cap mandate, AJIT has an overweight to small and mid-caps compared to its benchmark, the TOPIX Index. Governance reform also plays a large role in AJIT’s investment process. The team actively engage with many of their holdings to promote policies conducive to better governance and shareholder returns, as we detail in the ESG section.

AJIT has performed remarkably well over 2020 in our view, with a one-year NAV return of 22% outperforming its benchmark’s 9.2% return and its peer group’s 19.8%. Returns have been helped by the strategy of buying high-quality companies, which allowed AJIT to weather the COVID-19 crisis better than the broader Japanese equity market, as shown by AJIT’s lower drawdown during the crash.

AJIT has recently adopted a new dividend policy, whereby it now pays out its dividend through a combination of revenue and capital, leading to a 278% increase in its dividend in the last (2020) financial year. It currently yields 2% on a historical basis. Like much of the Japanese equity peer group, AJIT trades at a discount, currently c. 7.9%.

Kepler View

We view AJIT as offering investors a consistent and reliable approach to Japanese equity investing, thanks to the managers’ clear focus on what they deem to be quality companies. While this quality bias has large overlaps with conventional market definitions, the team’s multifaceted investment approach also highly values a management team with a strong pedigree and a business with inherent competitive advantages.

This dedicated quality bias comes with advantages and disadvantages. The team’s dedication to quality should give investors confidence in the stability of the portfolio, but there will be periods where quality names come in and out of favour, and periods where AJIT’s performance will primarily be driven by the market cycle. However, this has been to its advantage over 2020, as its strong outperformance has been down to both the superior stock-picking of the team and also increased demand for high-quality companies that should be able to survive the pandemic.

We also believe that AJIT’s allocation to small caps is a distinct advantage. Not only does this improve the value-add of the managers by analysing thinly covered stocks, it also improves the diversification benefit of the trust in a manner dedicated large-cap strategies cannot. Thanks to the new dividend policy, AJIT may now be one of the few ways income-focussed investors can access high-quality Japanese companies without having to sacrifice income.

Bull
Bear
Dedicated quality bias with a focus on company management
Quality factor can fall out of favour, impacting performance
Small- and mid-cap allocation offers potential sources of alpha and diversification
The use of gearing can amplify losses
Recent changes to dividend policy greatly enhance its income potential
Higher OCF than the sector, due in part to its smaller size

Portfolio

Aberdeen Japan Investment Trust (AJIT) seeks to achieve long-term capital growth through an investment process that identifies the highest-quality listed Japanese equities. AJIT has been run by Chern-Yeh Kwok and Flavia Cheong since 2006, with co-manager Hisashi Arakawa joining the strategy in 2020. The team are directly supported by the four additional investment professionals in the Japanese equity team, and leverage the work of the 16 members of the Asia Pacific equity team.

While there are many nuances to AJIT’s investment process, it can be summarised as investing in high-quality companies at reasonable prices following a bottom-up investment process and being unrestricted by market cap. The team believe that quality is in and of itself a source of alpha, as the market systematically underestimates the profitability of high-quality companies. This belief would seem well evidenced by AJIT, as some of the largest contributors to its recent returns are also its longest-held holdings. The team’s assessment of quality is ultimately the core of their investment process, looking far beyond the typical metrics associated with the quality factor, such as a high ROIC. Instead the team take a detailed approach to quality assessment, with eight broad factors which they use when determining the quality of a company, such as management pedigree, balance sheet strength and sustainability of competitive advantage. Chugai Pharmaceutical, their tenth-largest holding, is an excellent demonstration of these factors in our view, as through its innovation into new types of drug treatments it avoids many of the regulatory pricing pressures which depress the prices of more commonplace drugs. In doing so, the team note that Chugai has both a competitive advantage by being first to market, and also attractive industry characteristics by operating in a part of the pharmaceutical sector which is sheltered from policy risk.

AJIT’s investment process uses a blend of qualitative and quantitative factors, with the team placing a strong emphasis on the outcomes of their meetings with management, having met over 300 companies in 2020 alone. The team’s physical location is a clear advantage here, given that the majority of team members are located in Tokyo. They also benefit from the cross-coverage provided by the broader Aberdeen Standard Investments analyst teams. The AJIT team can utilise the work done by other teams when assessing the quality of their companies’ international suppliers, the strength of overseas demand or their international competitors. We believe it is important to highlight the pedigree of the management behind AJIT, with Chern-Yeh Kwok acting as the head of the Japan team, and Flavia Cheong acting as the head of Asia Pacific.

The team’s assessment of management is one of the key determinants of a company’s quality, with four of the eight determinants of quality being directly related to a company’s management team. The team look for a strong pedigree and track record, evidenced by actions such as sustainable and profitable reinvestment of cash flows and a management team who have survived multiple market cycles and crises. The team’s assessment of the latter factor proved a lifeline for AJIT during 2020 because many of their holdings’ managements had already survived multiple crises (including non-economic events such as earthquake damage), and were thus well prepared for the impacts of the current pandemic as a result.

Assessment of managements goes beyond their operational competency, with the team making a detailed analysis of their investments’ corporate governance. The team aim to avoid companies with inefficient, cash-heavy balance sheets, instead actively seeking companies with a policy of returning cash to shareholders, either through profitable reinvesting or through distributions. The team are also cognisant of the inefficiencies stemming from poor corporate structures, such as ‘poison pills’ and financing issues. While these issues can prevent a company’s inclusion into AJIT’s portfolio, they can also be a source of alpha, as successful resolution of these issues is often reflected in a company’s share price. The team proactively engage with companies when they see such opportunities for governance improvements. Their holding Sanken Electric is one such company, where to allow better access for overseas investors the team encouraged the company management to list its subsidiary on the Nasdaq. This unlocked value for the overall company, directly leading to share price gains for Sanken as a result. In general, the team make thorough use of ESG analysis in their investment process, which we cover in detail along with their engagement activities in the ESG section.

The team’s strict adherence to their quality criteria means that their holdings will often have higher ROIC and ROE, stronger balance sheets (e.g. efficient cash levels, low leverage) and higher margins – all factors which make up part of the quantitative analysis performed by the team. As is expected from their investment process, the key quality metrics for AJIT are all superior to those of its benchmark, the TOPIX Index. The team are aware that many of their names have a lower dividend yield than the TOPIX, with this being something of a conscious decision as the team believe that many of the high-yielding companies are actually low-quality names and potential ‘value traps’.

While the team believe there are quality companies in both the growth and value space, a common consequence of higher quality is also a higher price, as the market places a premium on many of the factors which make up AJIT’s investment process. While the team pride themselves on the quality of their holdings, they are not prepared to pay any price, retaining a valuation sensitivity within their investment process. Valuation assessments are made relative to each company’s own history, as well as on a relative basis to industry peers. Both the quality and price metrics can be seen in the below table.

Price ratios and quality Factors



AJIT
TOPIX
Price Ratios
P/Earnings Ratio

32.4

19.7


P/Book Ratio

2.9

1.3


P/Sales Ratio

2.7

0.9





Quality Factors
Debt to Capital %

15.3

29.0


Net Margin %

12.3

7.9


Return on Assets (ROA) %

6.6

4.4


ROE %

10.0

8.1


P/Free Cash Flow Ratio

34.4

23.4


ROIC

8.7

6.7









Source: Morningstar, as at 31/01/2021.

Past performance is not a reliable guide to future returns

In our opinion a key differentiator of AJIT, as well as a source of return and diversification, is its allocation to small- and mid-cap companies. While not explicitly a small-cap strategy, the managers have the freedom to invest wherever they see the best-quality companies. The small- and mid-cap space gives the team further opportunities to add alpha, not only through the unique opportunities the small-cap space provides, but also from the sector’s lack of analyst coverage. Japanese small caps have less analyst coverage than Europe, the US or even other parts of Asia, with an estimated 75% of Japanese small caps having only one or no analyst coverage. AJIT is currently tilted towards large-cap holdings, with 53% of the portfolio allocated to the space, as the team believe that large-cap companies will be better able to benefit from the post-pandemic global recovery, given their higher exposure to international demand. Despite this tilt, AJIT retains a higher exposure to small and mid-caps than the TOPIX, with the breakdown by market cap shown below.

Allocation by market cap

Source: Aberdeen Standard Investments, as at 31/01/2021

Given the team’s bottom-up approach, AJIT’s portfolio reflects their highest-conviction holdings rather than any sort of sectoral or thematic conviction. An interesting quirk of their investment process is that their quality bias innately lends itself to risk management, in our view. For the team risk management begins with the analysis of a company, and they believe the best approach is to avoid any stocks which they deem to carry too great a risk (e.g. value traps, valuation risks, binary outcomes). The team view sufficiently high-quality companies as having fewer tail risks, as well as greater operating stability and margins conducive to a lower volatility. The top ten holdings of the current portfolio can be seen below.

Top ten holdings

Name

Weight (%)

Shin-Etsu Chemical

4.7


Tokio Marine

4.5


Toyota Motor

4.3


Keyence

3.9


Sony

3.7


Daikin

3.4


Amada

3.0


Nabtesco

2.9


Misumi

2.7


Chugai

2.3


Total

35.4










Source: Aberdeen Standard Investments, as at 31/12/2020

Recent additions to the AJIT include holdings in WealthNavi, with AJIT having participated in its 2020 IPO, which has doubled in value since coming to market. WealthNavi has become Japan’s largest robo-advisory firm, rapidly growing because of an expanding young-investor demographic and a lack of returns from conventional savings accounts. The team are also increasingly bullish on the opportunities presented by the global demand for sustainability, with an increasing portion of their portfolio being tilted towards the beneficiaries. One such name is Murata, another recent purchase. Murata is a global leader in the development of electronic components, but most importantly it is a leader in multilayer ceramic capacitors, a key component in the production of electric vehicles. Other recent purchases since our last note include Daiichi-Sankyo, a pharmaceutical company with an attractive pipeline of drugs for cancer treatments; and Zenkoku Hosho, Japan’s largest third-party mortgage guarantor and a prime beneficiary of Japan’s low interest rate environment. Conversely there were also recent sales by the team, including of their position in Shionogi, another pharmaceutical company, due to concerns over its outlook and future growth. They also sold out of Seven & I Holdings, the retail group which owns the 7-Eleven chain, due to its slow progress around governance reforms despite the active engagement by the team on these issues.

Gearing

AJIT currently has a 10% level of net gearing. The board considers a gearing level of around 10% to be appropriate, although with stock market fluctuations, this may range between 5% and 15%. The board has allowed the use of gearing to be at the discretion of the managers (Source: JPMorgan Cazenove, as at 31/01/2021).

While AJIT’s current gearing is in line with the board’s expectations, it is slightly lower than its long-term average of 11.5%. Since our last note gearing has been reduced slightly, and while gearing was increased earlier in the year to take advantage of the market crash, its relative size has since been reduced due to the increase in the NAV of the trust. While the board believes that the current level of gearing will enhance shareholder returns, AJIT remains at the lower end of its peer group’s levels of gearing, with the peer group’s current average gearing being 13%.

AJIT implements its gearing through a fixed-term loan facility of JPY1.3bn (fully drawn down) and a revolving loan facility of JPY1bn which is in place until January 2022 (of which JPY400bn has been drawn down); the trust’s borrowings total JPY1.7bn.

Gearing

Source: Morningstar, as at 31/01/2021

Returns

Over the last five years AJIT has been able to deliver an NAV total return of 74.3% and a share price return of 86.2%, outperforming its benchmark the TOPIX Index, which returned 68.1% over the same period. This does, however, represent an underperformance against its peer group, which generated an average NAV return of 94.9%. However, we would note that much of the peer group’s return can be attributed to the strong performance of its heavily growth-focussed strategies, a bias which is not fully comparable to AJIT’s quality focus.

Five-year performance

Source: Morningstar.

Past performance is not a reliable indicator of future returns.

As can be seen by the discrete annual performance, AJIT’s outperformance has not been consistent across the years. We believe that this does not reflect any inherent failings by the managers (e.g. because of a prolonged period of poor stock-picking), but rather the varying tailwinds and headwinds that support the quality factor in Japanese equities. The pick-up in Japanese quality stocks is clear to see in 2019 and 2020, with much of the prior performance gap between AJIT and its benchmark closing over this period. AJIT’s strongest period of discrete calendar year performance was over 2020, where the inherent resilience of quality companies, and perhaps also the team’s ability to identify the best of the cohort, paid off.

Discrete annual performance

Source: Morningstar.

Past performance is not a reliable indicator of future returns.

Over the last year AJIT has generated an NAV total return of 22%, outperforming its benchmark’s 9.2% return and its peer group’s 19.8% NAV return. AJIT’s focus on high-quality companies (i.e. those with strong balance sheets and seasoned managers) allowed the trust to weather the COVID-19 crash better than many of its peers, with AJIT seeing a lower drawdown over March. As much as it managed to avoid the downside, AJIT was also able to capitalise on the post-crash recovery, benefitting from many secular trends emerging from the pandemic, like the increase in demand for technology and remote working solutions or the surge in demand for pharmaceutical products. AJIT has unfortunately begun to underperform at the start of 2021, as the market has rotated into value names at the cost of the more expensive holdings which performed well during the downturn, a factor which is unfortunately out of the managers’ control.

One-year performance

Source: Morningstar.

Past performance is not a reliable indicator of future returns.

At a stock-specific level, the top contributors for 2020 were Chugai Pharmaceutical, Nippon Paint and Shin-Etsu Chemical. Chugai Pharmaceutical is a particularly poignant holding given that a drug it created to combat arthritis has been found to cut the risk of death from COVID-19 by 25%, with the treatment being recommended for use in the UK. AJIT’s top-performing small cap was NEC Networks & System Integration Corp, whose communications technology was a clear beneficiary of the shift to remote working. Conversely, the major detractors for AJIT included Tokio Marine Holdings, a major overweight for the strategy which is yet to recover from the COVID-19 crash due to the broader headwinds impacting the global insurance industry.

Looking forward, we understand that the team will continue to look for opportunities in the major themes they believe offer the best investment opportunities in Japan. Some of their themes, such as a move towards a paperless society and the demographic issues facing Japan (specifically the need to help support an ageing population and to find solutions to Japan’s increasing labour shortage), are more local in nature. However, the team also foresee global opportunities which Japanese companies can exploit. The rising middle class in Asia presents new markets for premium Japanese brands, with there being a regional advantage for Japanese names which is not present for many of their Western competitors. As we outline in the ESG section, the team are conscious of the need for sustainable solutions to the world’s environmental problems, such as the mass adoption of electric vehicles. While many of these trends reflect the ‘new Japan’ economy, something we define in our recent article on Japan, the team do not wish to pigeonhole the strategy as one which primarily focusses on the opportunities in ‘new Japan’. Instead they see the potential for quality companies across the whole spectrum of the Japanese market, and that prevailing trends are currently more supportive of ‘new Japan’ companies than old, which is reflected in their outlook.

As a more general commentary, the team are increasingly bullish on the outlook for Japanese equities. They note that the implementation of mass vaccinations has bolstered global demand, benefitting many of Japan’s major exporters as well as leading to a general euphoria for stock markets across the world. The team also believe that prior opinions around the impact of COVID-19 on Japanese companies were overstated, with many Japanese companies having successfully adapted to the pandemic, in some cases even coming out stronger as they leverage the opportunities presented by the crisis. The team continue to see corporate governance reform as a positive driver for shareholder returns in the future. Although while there continue to be positive signs (like the increase in share buybacks by Japanese companies), much work still remains to be done.

Dividend

Shareholders endorsed a new dividend policy at the financial year (FY) 2019 AGM. The dividend is now composed of three elements: the revenue return per share for the year, 3p from revenue reserves and an amount from capital reserves. The dividend was also changed from an annual distribution to semi-annual. The most recent full-year dividend – which was also the first dividend under the new policy – was 15p per share, in line with expectations of the new policy. The dividend in FY 2020 was a 278% increase on the prior year’s dividend of 5.4p per share.

AJIT’s current historical dividend yield is 2%, based on the last full-year dividend. The most recent interim dividend paid was 6p per share, in line with the previous financial year’s. We estimate AJIT to have a revenue reserve coverage of 1x based on the last full-year dividend, although the ability to pay from capital reserves makes this less important. We estimate that AJIT currently has revenue reserves of c.15.2p per share as at the most recent interim report. The team also tend to avoid the larger dividend-paying companies to avoid jeopardising the trust’s overall total return in exchange for yield, due to concerns about these companies’ quality and potential ‘value traps’. Thankfully, under the new policy income can be supported by the capital reserve.

Dividend and revenue return per share

Source: Aberdeen Standard Investments

Past performance is not a reliable guide to future returns

Management

The trust is managed from Tokyo by the Japanese equity team at Aberdeen Standard Investments. AJIT is run by Chern-Yeh Kwok, Hisashi Arakawa and Flavia Cheong. Hisashi Arakawa is based in Tokyo, along with four other team members in Japan, while Chern-Yeh is based in Singapore. The team seek consensus on stock picks, and do not rush to invest before the proper due diligence has been undertaken. They place a great emphasis on engagement with managements to improve corporate governance, which we think has a great chance of boosting returns in the coming years. This is because the Japanese government is making a priority of improving governance in Japanese companies in a bid to boost productivity and growth in an economy which has been sluggish for decades.

Chern-Yeh Kwok is head of Japanese equities, having transferred from the Singapore team in January 2011. Chern-Yeh joined Aberdeen Standard Investments (Asia) in 2005 from MSCI Barra where he was an equity research analyst. Hisashi Arakawa joined Aberdeen Standard Investments (Asia) in 2016, having previously been vice-president in the corporate banking group of The Development Bank of Japan. Flavia Cheong is head of Asia Pacific equities on the Asian equity team where, as well as sharing responsibility for company research, she oversees regional portfolio construction. Before joining Aberdeen Standard Investments (Asia) in 1996, she was an economist with the Investment Company of the People’s Republic of China, and earlier with The Development Bank of Singapore. The team structure did not change with the merger with Standard Life in 2017, although some senior personnel were promoted upwards.

Discount

AJIT currently trades on a 7.9% discount, wider than the average 2% discount of its peers. While the difference between the two has widened since our last note, we must add a caveat that much of this is down to the two growth-focussed strategies within the peer group trading at a much narrower discount than the rest of the trust’s peers. AJIT trades at a much more comparable discount to peers when we remove these two, with the remainder of the peer group having an average discount of 8.5%, based on the remaining four trusts of the original six (Source: JPMorgan Cazenove, as at 15/02/2021).

The board operates an active discount control policy, with the intention of preventing AJIT trading at excessively wide levels via the use of share buybacks when deemed appropriate. This approach does not target a specific discount level, and is instead focussed on repurchasing shares when the board believes doing so will add value for investors.

Since the start of 2020 the board has repurchased 643,349 shares. These repurchases represent c. 5% of the current shares in issue (as at 31/01/2021), with the current shares held in the treasury representing 13%.

AJIT is required to hold a continuation vote should the shares trade on an average discount of more than 10% over the 90 days prior to the end of the financial year in March. This occurred in the previous financial year ending 31/03/2020, with shareholders voting overwhelmingly in favour of continuation. While there remains some time until the next financial year end, between the months of November and January AJIT traded at an average discount of 10.5%.

Discount

Source: Morningstar

Charges

AJIT has an ongoing charges figure (OCF) of 1.04%, compared to an average of 0.76% in the AIC Japan sector. The small size of the trust, at c. £114m in net assets, clearly impacts upon the charges by reducing any benefits of significant scale. The OCF includes a management fee of 0.75% on the lower of the trust’s market capitalisation or net asset value, incentivising the managers to see the trust trade in excess of NAV, which is charged at 60% to capital and 40% to revenue. The KID RIY is 1.35% (which includes the cost of gearing), below the 1.39% average for the sector, although calculation methodologies can vary.

ESG

As we mention in the Portfolio section, ESG considerations are a core part of the team’s investment process, with governance reform being considered a potential source of alpha for AJIT. Governance issues have long been in vogue within Japan, thanks to many government-led initiatives on governance reform. The team incorporate many of the typical facets of corporate governance analysis into their research, such as shareholder alignment, board structure and disclosure quality.

Yet what is considered more important than their incorporation of governance analysis into a company’s valuation is the team’s engagement on these issues. The team actively try to encourage governance improvements through direct dialogue with their underlying holdings. This is not done simply for reasons of principle, as the team believe that in doing so they can unlock much of the latent value in a company and thus improve AJIT’s total return.

One example of this is their engagement with Kansai Paint. As a result of dialogue between AJIT’s team and Kansai’s management, the company went on to restructure its non-performing operations and assets, as well as appointing an independent board director and a senior manager with a strong financial background – initiatives which are a clear value-add for shareholders. An example of the team’s ongoing engagement are their current discussions with Okinawa Cellular, where the AJIT team are continuing to pressure the company to distribute some of its capital-heavy balance sheet to shareholders.

The team’s ESG analysis is not solely focussed on corporate governance, though: social and environmental issues also play a role in their analysis of a company. The rising demand for sustainability is a key trend within the portfolio, and while AJIT is not an explicitly ESG strategy, the team do acknowledge the world’s need for sustainable solutions and the opportunity this presents for companies able to fulfil this demand. The team are also conscious of the need for Japanese companies to be aligned with their local communities and to be compliant with good social practices. This includes assessing how their underlying companies treat their employees, and how they manage their broader supply chains (something the broader Asian equity team assist in).

Morningstar rates AJIT’s sustainability as ‘average’ relative to the wider Japan large-cap equity category. This rating assesses the sustainability of the underlying holdings, rather than how the team integrate ESG analysis. We also caution that there are some limitations to ESG ratings when assessing AJIT, as a result of the trust’s small-cap holdings. Many of AJIT’s large-cap peers will not have the same, if any, allocation to small- and mid-cap companies that AJIT has. There are also disclosure issues surrounding small and mid caps, where their lack of resources prevents them providing the same levels of ESG disclosure as their large-cap peers, leading to them being under- or misrepresented by ratings agencies.

Fund History

Disclaimer

This report has been issued by Kepler Partners LLP.  The analyst who has prepared this report is aware that Kepler Partners LLP has a relationship with the company covered in this report and/or a conflict of interest which may impair the objectivity of the research.

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