JPMorgan Japanese (JFJ) continues to offer investors a portfolio of Japanese equities picked through bottom-up stock picking. Run by Nicholas Weindling and Miyako Urabe, with Nicholas recently passing his ten-year anniversary as manager, the portfolio is made up of quality growth stocks across the market capitalisation spectrum, leveraging heavily on the managers’ understanding of Japan’s secular trends. Portfolio companies are often at the forefront of the solutions to Japan’s demographic issues and environment challenges, or simply offer some of the fastest growing prospects amongst Japan’s major brands or in the digitisation and automation sectors.
Thanks to its quality growth bias, JFJ has been able to generate very strong performance over 2020, capitalising on the momentum behind the COVID-19 ‘winners’ like ecommerce and online services. However, 2021 so far has seen a wider rotation out of quality growth and into recovery and value stocks, companies which often lack the long-term structural growth opportunities of JFJ’s holdings. Despite a brief period of underperformance from the start of 2021, JFJ has outperformed the AIC Japan peer group average and its benchmark over the longer term.
JFJ continues to have exceptionally strong ESG credentials, having been rated as high by Morningstar (placing it in the top 10% of its peers). This rating can be attributed in part to the team’s understanding of the governance issues plaguing many Japanese companies, as well as their recent investments in a renewable energy provider, a new ‘environmental’ thematic allocation for JFJ. JFJ has the lowest OCF in the sector, at 0.65%.
In our view JFJ continues to offer one of the best ways to tap into the domestic Japanese market, investing at the heart of Japan’s new growth opportunities. The team have a strong track record of successfully identifying the major secular trends driving the economy, which has translated to five years of outperformance of both the AIC Japan peer group and benchmark. While it has underperformed in the near term, this is probably an unavoidable consequence of quality growth investing and JFJ’s managers remain confident that their long-term view to secular growth investing will return to outperformance, an opinion also held by us.
Over the years JFJ has largely remained consistent in the sectoral trends which underpin its portfolio, though we are excited by its recent addition of an environmental theme. Not only does it further enhance JFJ’s already strong ESG credentials, but it also is evidence of the flexibility of the team and their awareness of the changing market environment in both Japan and abroad, especially important as we enter a post COVID-19 economy.
Investors should be conscious that the combination of a high level of gearing, exposure to small cap stocks, and a clear quality growth bias can enhance JFJ’s volatility. This has played out recently with the market’s rotation into value and cyclical stocks at the expense of quality growth as it begins to price in a post-pandemic recovery, enhancing the downside volatility for JFJ. However we believe JFJ’s returns more than compensate for its risk, with JFJ having the highest Sharpe ratio of its peers over the last three years and below average beta.
|Dedicated to investing in the secular growth trends underpinning the Japanese economy
||Has recently underperformed due to rotation into value and cyclical stocks
|Long-term track record of outperformance
||The use of gearing can amplify losses
|Well-resourced team located in Tokyo, providing invaluable local knowledge
|| A failure of one sectoral factor to materialise will impact multiple holdings
JPMorgan Japanese (JFJ) offers investors a flexible bottom-up portfolio of Japanese equities, investing across the market capitalisation spectrum and utilising the managers’ understanding of Japan’s structural growth trends to select what they believe are the best opportunities. JFJ is managed by Nicholas Weindling and Miyako Urabe, with Nicholas recently passing his ten-year anniversary as manager of JFJ. The team are able to leverage on JPMorgan’s substantial roster of 14 sector analysts, part of the 30 investment specialists that make up the Japanese desk, the majority of which are based on-the-ground in Tokyo. This is a distinct advantage for JFJ as not only does it allow the managers to harness the wider team’s regional knowledge but it also improves their access to company management, an important consideration given JFJ’s allocation to small and mid-cap stocks.
The managers aim to be at the heart of Japan’s new growth. This means identifying companies which they believe are best able to capitalise on the trends underpinning ‘New Japan’. For the managers, this encapsulates the opportunities presented by Japan’s social and demographic changes, the impetus behind digitisation and automation, the most exciting brands within Japan, and more recently the opportunities presented by environmental change and the increasing demand for sustainable solutions. We cover the concept of both ‘New Japan’ and ‘Old Japan’ in detail in our recent editorial. Yet, despite the team’s focus on sectoral themes, they remain dedicated bottom-up stock pickers, with the themes being only one factor underpinning the managers’ growth expectations, albeit a major one.
When analysing a company, the team use three broad factors: Economics, Duration, and Governance. Economic analysis aims to understand a company’s ability to create value for shareholders; encapsulating factors like sustainable return on equity, balance sheet strength and cash generation. Duration assesses the sustainability of said value creation, where the team look for strong economic moats, competitive advantages and industry structures conducive of long-term growth. The final component is Governance analysis, observing factors like shareholder alignment, ownership structure and capital allocation. While governance is always an important factor in the analysis of any equity, it is acutely important in Japan, given its long history of poor governance. The team believe that the current impetus around governance reform by the Japanese government presents a suite of opportunities as companies become increasingly aligned with their shareholders, improving return on equity and presenting the JFJ team with an opportunity to add further alpha.
The team also make use of a 98-question risk checklist, to identify potential ‘red flag’ risk factors which may materially impact performance, with three quarters of the questions focussing on ESG issues; we expand on this later in our ESG section. Valuation also plays an important role for the team, as while JFJ is a growth focussed strategy it is not ‘growth at any price’. The team use a valuation framework based around five-year expected returns, with attention paid to earnings growth, dividends, and valuation.
The resulting portfolio currently constitutes 76 stocks. While a comparatively large number, this is reflective of the exposure to small and mid-caps which typically require a larger number of holdings to diversify away their substantial idiosyncratic risk (smaller companies are often more sensitive to economic and company specific announcements). One of the unique aspects of the investment process and portfolio construction is the team’s proprietary strategic classification system, whereby companies fall into premium, quality or trading classifications. This is a hierarchy system which categorises companies by their overall quality, with premium representing the highest quality company and trading the lowest. So onerous is this classification that only 5.9% of the TOPIX falls into the premium rating, compared to 35.5% in JFJ’s portfolio. Since our last meeting there has been a slight increase in the overall quality of the portfolio with 97% of JFJ being allocated between quality and premium currently, compared to 94% at the time of our last note.
Given the managers’ long-term view to investing, they have been largely consistent in their analysis of the trends underpinning Japan. We highlight much of the rationale behind their selection of these structural growth opportunities, plus give stock examples, in our prior note. Headline examples include Keyence, a global leader in automation with a c. 50% profit margin, poised to take advantage in both the developed and emerging market demand for automation. Many industrial economies are lagging behind developed Asia in the adoption of automation, and the team believe this has led to a huge opportunity set as they catch up. The team also believe that many of the trends which were accelerated by COVID-19 will continue to underpin the Japanese economy, as companies are unlikely to want to forgo the efficiency improvements they have brought simply because of economic normalisation. This includes companies like Bengo4.com, which transformed the e-signature space in Japan, and GMO Payment Gateway, which capitalised on Japan’s transition away from a cash heavy society (Japan only has a c. 20% usage of cashless payments). The current thematic breakdown of JFJ’s portfolio can be seen below.
There has been one major change to JFJ’s thematic allocation since our last note, being the inclusion of the environmental theme which now represents 5% of the portfolio. The team are conscious of the global trend towards decarbonisation, as well as Japan’s own initiatives with the incumbent government having recently set a net-carbon-zero target for Japan by 2050. With these trends comes a host of opportunities for companies which can facilitate decarbonisation. There are also some Japan-specific factors at play as well, with Japan being a net importer of coal, and the earthquakes over the past decade having limited Japan’s nuclear capacity (with the Fukushima earthquake being the headline example). As a result, Japan has its own domestic limitations in clean energy production which need to be overcome to achieve carbon neutrality. To take advantage of these opportunities the team have recently initiated a position in Renova, the renewable energy developer and power producer, generating electricity through solar, biomass, geothermal and wind energy. The team believe Renova is well placed to capitalise on Japan’s current low penetration of renewable energy and in particular the low levels of wind-power so far developed, something which investors may find odd given Japan’s island status and potential for offshore turbines.
Other new positions to the portfolio include Hennge, a cloud based digital security company which provides a single secure login service, a play on Japan’s increasing drive for digitisation. Another purchase includes Benefit One, the employee benefit provider. The team believe it will benefit from Japan’s tight labour market as companies fight for a dwindling talent pool, having to provide increasing employee benefits to remain competitive. This is especially true in the small and mid-sized space as they lack the scalability to provide competitive benefits in-house. To fund these new purchases the team have trimmed a number of positions which have done exceptionally well in recent months, especially their holdings of M3 and Base. JFJ’s current top ten are as follows:
Top 10 Holdings
Source: JPMorgan, as at 28/02/2021
As we discuss in the performance section, JFJ has been caught up in the headwinds impacting growth stocks globally. With the mass rollout of vaccines, and the hope that economic activity will begin to normalise, investors have begun to rotate out of the COVID-19 ‘winners’ and into cyclicals, value, and lower quality stocks. These companies saw their share prices fall over the crisis but remain poised to see a potential reversal in fortunes with economic normalisation. The team are acutely aware of the impact such sentiment can have on the portfolio, pointing to its performance in 2016 as a similar scenario. However, the team take a long-term view to investing and they remain confident that the secular trends underpinning their companies will continue to be prevalent far into the future, outlasting short-term shifts in sentiment. The current quality and price metrics for JFJ and the TOPIX can be seen below.
Price and quality metrics
|Price ratio||Quality indicator (%)|
|NEXT FUNDS TOPIX ETF||19.46||1.30||0.92||8.93||22.10||4.24||8.37||6.66|
|Magnitude of difference||2.1x||4.7x||5.2x||2.3x||1.5x||2.0x||1.8x||1.8x|
Source: Morningstar, as at 17/03/2021
The high price ratios for JFJ when compared to its benchmark, the TOPIX, are an indicator of a more expensive portfolio. For example, the higher price to earnings ratio (P/E), where investors are paying almost twice as much for a unit of earnings than they would buying the TOPIX. This is a common characteristic of growth companies, where investors are pricing in strong future earnings and sales rather than what is being generated today (with current data being reflected in the ratios). However, the quality metrics, like return on equity (ROE) and a return on invested capital (ROIC), indicate that the portfolio is of a better financial quality as JFJ’s underlying companies are generating more returns per unit invested, something that is also associated with growing companies. The overall combination means that, while investors are paying more for earnings or sales, they are being compensated by companies with better financial health and growth prospects.
JFJ currently has gearing of c. 15% (as at 18/03/2021), slightly above the peer group’s weighted average gearing of 14%. This is split between two elements. Firstly, there is a structural loan of senior secured loan notes worth c. ¥13bn (equating to c. £86.2m at current exchange rates). This equates to c. 8% of net assets at the time of writing. This is a mixture of five different secured notes, maturing between 2028 and 2048 at five-year intervals, which pay a weighted average of c. 1.1% interest per annum. These were arranged to lock in long-term borrowing at low interest rates.
Secondly, should they deem it appropriate, the managers can also employ a three-year floating rate revolving credit facility of ¥11bn (c. £72.9m at current exchange rates, or c. 6.8% of net assets). As at 30 September 2020 (JFJ’s financial year end) JFJ had drawn down ¥9.5m of this facility.
The board expects that ordinarily gearing will operate in a range of between a 5% net cash position and 20% geared. Gearing is applied tactically as a function of the observed bottom-up company-specific opportunities, as opposed to a reflection of a broader market outlook from the team.
While JFJ’s five-year average gearing of 8.5% is below that of its peer group’s 13.6% simple five-year average, we highlight that its current 15% level of gearing is still relatively high for the listed equity space. Such a high level of gearing can enhance the volatility of JFJ beyond what investors may typically expect for an investment trust, especially considering its growth stocks bias and allocation to small caps, sectors already associated with high volatility.
Gearing from 2018 onwards
Despite the near-term market rotation which has negatively impacted the trust, the long-term sectoral tailwinds which underpin the team’s philosophy have allowed it handily to outperform both its peers and benchmark, the TOPIX index (proxied by the NEXT Funds ETF). Over the last five years, JFJ has managed to generate a NAV total return of 117.5%, and a share price return of 145.3%, easily beating its AIC Japan sector peer’s simple average NAV return of 96.6%, and the 73.0% of the TOPIX. This long-term performance is also the preferred metric by which the JFJ team measure themselves as, while they are aware of the varying market environments under which the trust may potentially under or outperform, they retain an unswerving commitment to their investment process. They aim to always focus on the long-term drivers of performance: durable economic advantages and structural growth opportunities.
Past performance is not a reliable indicator of future results
JFJ’s discreet annual performance (in the graph below) clearly shows the environments under which JFJ’s style outperforms, with 2020 marking the greatest period of outperformance over the past decade. Such periods of outperformance are those under which growth, quality and small caps outperform. Outside of company specific tailwinds, these periods are when the market is willing to pay a premium for growth, which can be during a period of prolonged economic growth and low opportunity cost, as we saw during 2019; or during periods of economic uncertainty, where there is little visibility around broader growth opportunities and thus investors flock to known growth-stocks. Conversely JFJ underperforms during periods where value or low quality outperforms, which is most often the case during a recovery of economic growth, or a sudden surge in broader market demand. One such period was in the second half of 2016 when the incoming stimulus from the Trump government saw a surge in market demand, disproportionately supporting low price-to-book value stocks and hurting JFJ’s relative performance.
Discreet annual performance
Past performance is not a reliable indicator of future results
2020 and the start of 2021 has been a ‘game of two halves’, where for much of 2020 (primarily during recovery from the initial COVID-19 crash) JFJ handily outperformed both the peer group and benchmark. For much of the year the market was placing a premium on companies which could demonstrate growth potential or were of sufficient quality to come out of the pandemic unscathed. The structural tailwinds which supported many of JFJ’s holdings were actually accelerated by COVID, as the demand for services like ecommerce, online healthcare, and digital advertising increased with the pandemic. This meant that JFJ was well placed to not only capitalise on the broader rotation into quality growth (with sector selection contributing 13.7% to JFJ’s NAV return over 2020) but stock selection was also very positive, contributing 21.9% over the year.
Past performance is not a reliable indicator of future results
The start of 2021 marked a reversal in fortunes however, as the market began to price in a post-pandemic recovery and saw a rotation into value and cyclical stocks, anticipating a turnaround in their fortunes once economies normalised. Given JFJ’s commitment to long term quality growth investing, they were an unfortunate casualty of the recent market dynamics. Though JFJ’s recent YTD underperformance is disappointing, having returned -9.6% in NAV terms, it pales in comparison to the incredible run it had over the prior ten months, with JFJ having generated 77.0%. This is equivalent to an overall 12-month NAV total return of 60.2%, far exceeding the 36.2% return of the TOPIX and ahead of its peer group’s 57.2% simple average return.
JFJ does rank as one of the more volatile funds in the peer group, with a three-year NAV volatility of 21.1 compared to the peer group’s simple average of 18.6 and TOPIX’s 12.1 (based on month end data), a possible result of its allocation to small caps and growth stocks which have historically been associated with higher volatility than large cap and value stocks, not to mention the trust’s gearing. However, the higher volatility is somewhat misleading, as not only does JFJ have a three beta of 1.21, lower than the peer group’s 1.23 simple average, it has more importantly generated the highest risk adjusted returns of any trust over the period, with a NAV sharp ratio of 0.55, well in excess of the 0.30 of its peers and the 0.26 of the TOPIX. These enviable risk stats not only reflect the superior portfolio construction and stock selection of the JFJ team, in our view, they also represent the potential that secular trends have to generate strong growth profiles for JFJ’s investments. Such secular trends can provide catalysts for long term earnings growth which in turn insulates companies from the broader market forces that can drive global equity volatility, dampening the beta and improving the risk/return profile.
JFJ’s primary objective is to maximise the total return it provides to shareholders, and not the provisions of income. The board’s current dividend policy is to pay out the majority of the revenue available each year and thus any dividend paid out by JFJ will be the secondary consequence of its investment process. While the board has no view towards a progressive dividend policy or growth trajectory, they have in the most recent financial year decided to increase the dividend by 2%, the first increase since 2017. This was done despite the marginal fall in income of JFJ due to the challenging market environment brought about by the pandemic. The most recent full year dividend paid was 5.1p per share, equating to a current dividend yield of 0.8%, slightly below the weighted average 0.9% yield of its peer group. Based on the most recent report, full year to 30/09/2021, we estimate JFJ retains a revenue reserve coverage ratio of 0.7x.
As we have mentioned before, the team are cognisant of the evolving corporate governance environment in Japan, with more efficient capital allocation, and better alignment of management and shareholder interests. Japanese companies have long been associated with low dividend payout ratios and cash heavy balance sheets, but as a result of the governance reforms they are well positioned to maintain dividend payouts and dividend growth into the future, despite the recent pandemic-induced impediments.
Dividend and revenue per share
JFJ is managed by Nicholas Weindling and Miyako Urabe, both of whom are based in Japan; 2020 marked the tenth year of Nicholas’s tenure as manager. Nicholas and Miyako are both portfolio managers in the fundamental growth team. Nicholas has been at JPMorgan for 14 years, having previously worked at Baillie Gifford on its Japan desk. His style includes a focus on secular growth opportunities and long holding periods, and a willingness to pay for long-term growth. Miyako has been with JPMorgan for seven years, having previously worked at Morgan Stanley and Credit Suisse.
The managers draw on the research of a team of 14 analysts who specialise in different sectors. Including all the portfolio managers on the desk, JPMorgan has 30 investment professionals on the ground in Japan and conducts over 4,000 company meetings a year. The team also make use of other analysts across all of JPMorgan Asset Management, as and when their expertise is needed, with over 360 investment professionals across the globe. This provides excellent sources of information and ideas in an under-researched market, which is an advantage in the post-MiFID II world in which research on Japanese companies is shrinking from a low base.
Despite its long-term outperformance, JFJ has historically traded on a discount to the AIC Japan sector. However, over the latter half of 2020, the strong performance led to a significant narrowing of the discount such that the current discount of 2.9%, compares to the peer group’s simple average discount of 7% (and JFJ’s own long term average discount of 9.8%). It should also be noted that the two largest strategies within the peer group, JFJ and Ballie Gifford Japan (both growth-focussed), trade at much narrower discounts than the peers. Baillie Gifford Japan trades at a premium of 4.1% currently.
If ‘value’ stocks continue to perform strongly at the expense of growth, then there is a clear risk that the discount could widen back out again toward historical averages. That said, the board is committed to ensuring JFJ trades at a stable discount or premium over the long term, commensurate with investors’ appetite for Japanese equities. To that end the board operates a share buyback mechanism in order to prevent too extreme a discount, with 2020 marking the first time in seven years the board utilised its ability to buy shares back. Over the last 12 months the board bought back a total of 1.6 million shares, equating to 1.0% of the current shares in issue, with the most recent repurchase being made on 23/03/2021 when JFJ traded on a 4.1% discount.
Past performance is not a reliable indicator of future results
JFJ’s OCF of 0.65% makes the trust the cheapest in the Japan sector, a clear advantage for the trust. This compares to the sector simple average OCF of 0.82%. The management fee is 0.65% on net assets up to £465m, 0.485% on assets between £465m and £930m, and 0.4% on assets above £930m; this gives a blended fee of c. 0.55% on the current net assets of £1,059m. The latest KID RIY figure is 1.41%, slightly above the sector average of 1.39% although we note that calculation methodologies vary between trusts. (Source: JPMorgan Cazenove, as at 18/03/2021).
While JFJ does not seek to label itself as an ESG fund, its ESG credentials are clear, both in terms of its conventional ESG integration and in terms of how the team view secular drivers of growth in Japan. As mentioned in our portfolio section the team utilise a 98-question checklist when analysing a company, aiming to identify material risks, with three quarters of these questions revolving around ESG issues. While these questions are not explicitly delineated by E, S, and G, and instead grouped by economics, duration and governance, they still capture many of the key issues which need to be addressed in ESG analysis. Example questions include: Does the company have issues with toxic emissions, waste management or other environmental damage? Does the owner have a history of poor governance, or of abusing minority shareholders? Does the company have issues with labour relations?
The team also have a clear understanding of the sectoral drivers which underpin governance reform and environmental opportunities. As we highlight earlier, the team see long term opportunities in companies able to capitalise on the move toward environmental sustainability and decarbonisation. They have also had a long awareness of the opportunities presented by governance reform in Japan and the potential pitfalls which arise from Japan’s poor corporate governance structures; with governance analysis being one of the three pillars of their company analysis. Irrespective of their formal ESG analysis, this awareness of governance and environmental factors naturally steers JFJ’s portfolio towards companies which screen well for ESG. One example of this is the total CO2 emitted by JFJ’s portfolio compared to the TOPIX, where for an investment of $1m JFJ will generate 6.3 tons of CO2, 3.5% of the output of the TOPIX for an equivalent sized investment.
JFJ has received a Morningstar sustainability rating of High, the best possible accolade, meaning it ranks amongst the top 10% of Morningstar’s Japan Large-Cap Equity peer group (which includes both open and close ended strategies). JFJ’s high portfolio sustainability, plus its recent investments into environmental companies, continue to support our belief that the trust offers ESG conscious investors an excellent solution for Japanese equity investing.