Baillie Gifford Shin Nippon 26 April 2024

Baillie Gifford Shin Nippon (BGS) aims to deliver high long-term returns by investing in Japanese smaller companies with exceptional growth potential. Historically, the trust has delivered outstanding returns when the market has been moving in its favour, such as in the 2015 to 2020 period. Since 2021, however, a number of factors have been working against it, with both small caps and growth stocks falling out of favour, and Performance has suffered.

However, manager Praveen Kumar reports that company fundamentals still overwhelmingly look strong. The portfolio’s sales growth, both achieved and expected, remains over twice that of the market, while the premium being paid for this extra growth has got smaller and smaller. While he has made some efforts to ensure sources of growth in the portfolio are diversified, he remains committed to the low turnover and highly active approach and has recently been finding opportunities in companies exposed to the AI revolution. The trust retains its geared position in the market, with net gearing of c. 18% as of the end of March. Praveen notes that the strategy saw tough periods following the dot-com bust and the Great Financial Crisis, and in both cases, this was followed by strong periods of returns.

As BGS’s style has fallen out of favour, the Discount has widened. In response to this and the challenging performance of recent years, the board has committed to a performance-conditional tender offer for 15% of the shares to be made if the NAV per share underperforms the MSCI Japan Small Cap Index on a total return basis over the next three years (to 31/01/2027).

Japan is in favour with investors in 2024, as corporate governance reforms aimed at unlocking value in companies with low price-to-book metrics take effect. This has pushed investors into cheaper companies, rather than the higher-growth companies that BGS invests in, and similarly to companies with poorer, complicated governance rather than the more entrepreneurial firms Praveen favours. Additionally, larger companies have taken most investor attention, perhaps due to their greater liquidity and familiarity as underweight investors look to get involved.

However, another reason for Japan being in favour is the relatively strong economic situation it is in, with modest inflation and wage growth meaning that the Bank of Japan has been able to move away from negative interest rates. In our view, this creates an encouraging picture for corporate earnings growth in Japan which could see smaller companies do well on a fundamental level. That said, we will likely need to see a broadening of investor interest into the small cap space and into higher-growth companies to see BGS outperform.

Calling a turning point is difficult, but BGS looks attractive on a fundamental level at the moment. The growth metrics look strong, while Praveen notes that the focus on profitability in the Japanese market is being felt in his portfolio companies too, and means management teams are incentivised to boost returns. If sentiment shifts, we think this could be a powerful combination.