JPMorgan Japan Smaller Companies

Last updated 05 February 2020

Investing in high-growth potential opportunities, with a new dividend policy...

Disclosure – Non-Independent Marketing Communication

This is a non-independent marketing communication commissioned by JPMorgan Japan Smaller Companies. 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.

JPMorgan Japan Smaller Companies

Summary

JPMorgan Japan Smaller Companies Trust (JPS) looks to deliver capital growth through investment in small and mid-cap Japanese companies, excluding the largest 200 Japanese companies by market capitalisation. The investment managers, Eiji Saito, Naohiro Ozawa and Michiko Sakai, seek to identify the best growth opportunities in high-quality companies within the Japanese market.

Since April 2018, it has been a policy of the trust’s board to distribute dividends totalling 1% of NAV (as measured at the end of the quarter) on a quarterly basis. This was instituted to broaden the trust’s appeal to investors seeking yield, with the view that this will ultimately help the share price trade closer to NAV.

Importantly, this change does not impact the investment strategy of the trust, which has historically delivered outperformance of the benchmark. This strategy follows the stock-analysis framework of the wider JPMorgan Japanese equity team, a well-resourced and deep pool of analysts and portfolio managers based in Japan.

With a wide pool of under-researched stocks amongst the roughly 4,000 listed companies in Japan, the managers believe this level of resource gives them an advantage in identifying market pricing inefficiencies. The process seeks the best growth opportunities available in the Japanese small-cap market, places emphasis on understanding management strategy and the operational environment of the underlying business, and incorporates certain thematic considerations around the Japanese economy and market.

As at 30/01/2020, JPS’s shares traded on a discount to NAV of c. 6.0%; as a result of the new dividend policy, they yield c. 4.3%.

Kepler View

The Japanese small- and mid-cap markets offer a plethora of companies with little or no broker research, increasing the likelihood of pricing inefficiencies and potential stock-picking opportunities. Coupled with the ongoing positive effect of gradual adjustments to corporate governance, in our view this gives significant opportunities to active managers seeking to generate long-term outperformance from Japanese small and mid-caps. The highly active portfolio within JPS, with high differentiation from the benchmark index, improves the chances of stock-picking materially benefitting performance.

These are all attractive attributes from a relative returns outlook. However, the discount has remained somewhat intractable over the long term, and it remains to be seen whether the new dividend policy will entice sufficient interest to alleviate this. Whilst the portfolio has strong, long-term structural drivers, the unashamed growth nature of the portfolio means it is likely to be negatively impacted at periods of market inflection or reversal, exacerbating downside risks. Japanese companies are perceived to carry greater exposure to the global economic cycle.

This notwithstanding, the geared exposure to the strong growth credentials of the underlying portfolio, combined with a c. 4% dividend, mean the shares will be attractive to certain investors looking for an active manager in a market which offers significant opportunities to active managers.

bull bear
Positioned to benefit from leading companies in areas with strong secular drivers Bid-offer spreads on small-cap stocks can spike in periods of market volatility, exacerbating drawdown
Extensive analytical resources based in Japan, a thinly researched market Dividend will have to be funded from capital, and will likely be volatile
Highest dividend yield of trusts in Japan, and persistent discount relative to peers Gearing can exacerbate the existing tendency to underperform in falling markets

Portfolio

JPMorgan Japan Smaller Companies Trust (JPS) seeks to build a portfolio of the best growth opportunities in the Japanese market. Managed by Eiji Saito, Naohiro Ozawa and Michiko Sakai, JPS is able to draw on significant analytical depth of resource within JPMorgan, with a deep and experienced team of analysts feeding research into the strategy.

Whilst the managers adopt a highly growth-oriented strategy, for investors this is balanced by a board policy, introduced in April 2018, whereby, in the absence of unforeseen circumstances, the board aims to pay a regular dividend distribution of 1% of NAV quarterly (based upon quarter-end NAV levels), to be primarily paid from capital. This has been introduced with a view to helping widen the investor base, though we note that the response from existing notifiable investors seems to have been positive too, with net share purchases over this period from this group of investors in aggregate.

The portfolio management team follow the same investment process as the wider JPMorgan Japanese team, with an emphasis on investing in high-quality businesses with the ability to consistently and sustainably grow earnings over the long term.

Eiji, Naohiro, Michiko and the wider JPMorgan analytical team conduct, on average, over 4,000 company meetings a year, seeking to understand the growth prospects and management strategy in place for different companies for delivering growth. With an average of 100 new companies being listed in the Japanese market every year, there is no shortage of opportunities to explore, and the managers make a point of meeting the management of every company which is undergoing an IPO.

Such is the proliferation of listed companies in the Japanese market that frequently holdings have no or very limited sell-side broker coverage, reducing publicly available research and improving the opportunity for pricing inefficiencies.

From their own research, the managers build a core stock universe or around 400 companies, a small percentage of the wider stock universe in the Japanese market, which the managers believe represents the most attractive growth opportunities over the next 5-10 years.

Once the team feel they understand the company fully, they will look to strategically classify the stock as either ‘Premium’, ‘Quality’, or ‘Trading’. These terms encompass a range of considerations, including capital efficiency within a business (and capital intensity within the industry), competitive advantages and innovation, strong corporate governance, and an assessment of what the appropriate valuation of the stock should be.

With these factors assessed, stocks are ranked on a scale of 1 to 5 (with 1 indicating strong outperformance is expected). The portfolio will consist primarily of a range of companies ranked 1 or 2 by the team, though stocks that are considered 3 or 4 may be included under certain circumstances.

The ‘Premium’, ‘Quality’, or ‘Trading’ categories themselves denote the general desirability of the stock, with a preference for ‘Premium’ and ‘Quality’ companies. However, the criteria for ‘Premium’ in particular is sufficiently strict that there is a paucity of options to build the portfolio solely with these companies (with the wider JPMorgan team estimating that only 12 out of c. 4,000 companies listed in Japan meet their criteria for ‘Premium’). As such, companies categorised as ‘Trading’ will be considered for inclusion, particularly if there is compelling evidence of likely operational improvements that would cause the team to upgrade the stock. This may even be a matter of longevity, with the team requiring at least a three-year track record as a listed company before a stock can be bucketed as ‘Quality’ (and even longer for ‘Premium’).

As a result of the investment process, stocks in the portfolio will generally exhibit superior returns on equity (ROE) to the wider market, and usually operate with a competitive advantage over most of their peers. As an output, the process generally lends itself to overweight positions in sectors such as technology. This is a function of the process, which has an emphasis on the best ideas from across the market, and relative sector exposure is not something the manager targets or focusses closely on (other than in a portfolio management context).

sector exposure

Sector

%

Benchmark

JPS relative exposure

Industrials

27.5

26.5

1.0

Information technology

27.1

13.0

14.1

Consumer discretionary

10.6

15.8

-5.2

Materials

10.1

9.2

0.9

Communication services

6.0

3.5

2.5

Healthcare

5.0

6.4

-1.4

Consumer staples

4.0

7.5

-3.5

Real estate

3.3

8.7

-5.4

Financials

3.1

7.6

-4.5

Utilities

0.0

0.9

-0.9

Energy

0.0

0.9

-0.9

Cash

3.3

0.0

3.3

Source: JPMorgan, as at 31/12/2019

In addition to a superior level of exhibited ROE, the managers believe the portfolio’s earnings growth will be substantially above that of the benchmark over the coming five years at the aggregate level. Unlike many other Japanese smaller companies strategies, the JPS portfolio contains a roughly equal split of domestic and overseas revenue generators, with the managers noting that overseas markets frequently offer consumer markets growing strongly. In many of these markets, rising numbers in the middle classes and increasing numbers of aspirational consumers mean that Japanese brands are considered attractive and attract a quality premium.

This premium is not necessarily restricted to areas traditionally associated with Japanese knowledge leadership, such as electronics. A recent purchase made by the team was Milbon, Japan’s leading supplier of hair care products for salons. The company is seeing rapid growth in both South Korea and China, and the managers of JPS believe that management have a strong strategy in place to continue to grow sales in the Chinese market in particular.

Positions will generally be introduced at around 1%, with a view to increasing this to around 2% if the team observe the business developing as they anticipate. Successful investments are generally run, and as a result the portfolio will own some mid- to larger-cap companies, such as Asahi Intecc. Asahi Intecc is a manufacturer of stainless-steel wire ropes, and is in the managers’ ‘Premium’ classification. Roughly 20 years ago, Asahi diversified into the healthcare market, which has subsequently proven to be a strong driver of growth. Thematically, this fits in with one of the key themes considered by the wider Japanese team, which is that of an ageing society and increased healthcare requirements.

top ten holdings

Holding
% of assets
Taiyo Yuden

2.9

Benefit One

2.8

Raito Kogyo

2.6

DTS

2.5

MIURA

2.2

Bengo4.com

2.1

FP Corporation

2.1

Misumi Group

2.0

Nohmi Bosai

1.9

Mitsubishi UFJ Lease & Finance

1.8

TOTAL

22.9

Source: JPMorgan, as at 31/12/2019

Whilst the company already holds a market share of c. 70% in Japan for this product, the team believe it is a global leader and can ultimately attain a similar level of market share globally. As such, they believe Asahi Intecc can grow earnings per share by between 10-15% p.a. over the next five to six years, and they anticipate a Return on Equity of c. 17% p.a. over the coming six years. Having themselves first invested c. 10 years previously, the team remain happy to continue to run this position even though the strong growth experienced means the company now has a market capitalisation of around $8bn.

As a result of their long-term outlook, turnover is relatively low at around 20% p.a. (calendar year 2019), however, investments will be sold if the managers believe the investment case, either at an industry or company level, has changed materially or if they detect that corporate governance performance is deteriorating. Similarly, positions may be exited if the team feel too great a valuation is being attached to them, or simply if they believe they have identified a superior opportunity elsewhere.

The lack of broker coverage for many of the managers’ holdings often results in significant share price volatility when company results are announced. However, the managers prefer to avoid reflexively trading at times of heightened volatility, and will look to follow up any results announcements with further meetings with company management. This allows them to assess how well management understand the structural growth opportunity for the business, how the short-term trading updates pertains to this, and how well the business strategy is being executed.

With the emphasis on strong corporate governance which is embedded in the investment process, it is unsurprising that the team are concerned that recent legislative changes from the government could undermine corporate governance reform in Japan (we discussed some of these issues recently). Nonetheless, the managers believe that the journey to corporate governance reform that Japan has been on in recent years is a structural, long-lasting development, and they note that company management teams are themselves highlighting the need for changes.

Gearing

JPS has gearing amounting to c. 8.5% of NAV as at 30/01/2020. The company policy is to operate a gearing range of between 5% net cash and 15% net geared in normal market conditions, with the option of raising this to 10% net cash or 25% net geared with the board’s agreement in ‘extraordinary’ circumstances. A three-year revolving floating rate loan of ¥4bn is utilised tactically; there is no structural gearing in place.

Historically, the managers have proven reasonably flexible in altering their net market exposure depending on their outlook. Gearing may also be used for buybacks.

net gearing

Source: Morningstar and JPMorgan

Returns

Over the past five years to 31/12/2019, JPS has delivered share price and NAV returns of c. 124% and c. 110% respectively. This compares favourably with a passive product tracking the Japanese small-cap market, which delivered returns of c. 88%, whilst a passive product following the Japanese market as a whole would have returns of c. 67%. At a sector level, JPS has marginally underperformed peers in the Japanese small-cap sector, which returned an unweighted average of c. 133% and c. 112% in share price and NAV returns respectively. The wider (all-cap) Japan sector saw share price and NAV returns of c. 88% and c. 93% respectively, showing the outperformance of small caps over this period.

five-year returns vs peers and benchmark

Source: Morningstar

Returns over calendar year 2019 were strong in absolute and relative terms, with share price and NAV returns of c. 36% and c. 27% respectively against c. 15% and c. 14% for the wider Japanese market and Japanese small-cap market, with gearing, stock selection and sector allocation all contributing. This also represented outperformance of both the Japan Smaller Companies and Japan peer groups, which generated share price and NAV returns of c. 21%/21% and c. 25%/24% respectively.

Share price returns were boosted by a narrowing discount over this period, with Q4 2018 having largely seen risk aversion amongst global investors and a widening of the discount into the start of 2019. As well as a beneficial impact from gearing in a rising market, portfolio returns benefitted from both stock contributions and sector allocations, with the relatively structural sector overweight position in technology-related companies such as semiconductor manufacturers a notable contributor, as was stock selection in the commercial & professional services sector.

2019 returns vs peers and indices

Source: Morningstar

JPS’s relative performance typically benefits from rallies in growth or quality stock factors, or from small-cap outperformance, whilst any market preference for value strategies has historically acted as a headwind. This can be seen in the chart below, which shows the monthly NAV returns of JPS on a rolling 12-month basis relative to the wider market, as well as those of growth- and value-factor indices relative to the wider market.

Periods of value or growth outperformance are shown to the right hand side of the horizontal axis. Periods where JPS outperformed are shown in the upper half on the vertical axis, and vice versa. Whilst we can see these factors are not the sole determinant of relative returns (outliers can be seen in all directions), there is a general trend for the superior relative NAV returns to correlate to superior returns from growth strategies, with the inverse true of value strategies (though reassuringly this appears a weaker correlation, suggesting stock-specific factors have helped to alleviate any stylistic headwind).

rolling 12-month nav returns relative to market compared to growth and value factor returns relative to market

Source: Morningstar

Dividend

JPS shares have a historic yield of c. 4.3% as at 30/01/2020. The aim of the trust is to generate long-term capital growth; however, since April 2018 the board has implemented a dividend policy which aims to pay out a regular quarterly dividend equivalent to 1% of NAV on the last business day of each financial quarter. This is designed to help reduce the discount and discount volatility through widening the shareholder base.

This dividend policy has had no impact upon the investment policy, with the necessary level of distribution largely paid out of capital. As such, dividends per share will likely remain volatile (based as they are on NAV), but should the trust succeed in generating long-term capital growth, investors should see income distributions continue to grow in monetary terms.

This new policy resulted in a total dividend of 18p per share in the financial year 2019. Thus far in the 2020 financial year, two distributions of 4.4p and 4.6p per share have been made; a further dividend of 4.7p per share has been declared, with a final distribution to be calculated on 1% of NAV on 31/03/2020.

The trust lacks revenue reserves, and will need to raise cash to meet these distributions. However, the managers are well aware of these requirements, and we understand that the portfolio should contain sufficient liquidity to readily raise these sums without impacting upon portfolio construction.

Management

The trust is managed by Eiji Saito, Naohiro Ozawa, and Michiko Sakai, all of whom are based in Japan. All have extensive experience in Japanese equity market investing, and have been with JPMorgan since 2004, 2006, and 2013 respectively.

Eiji, Naohiro and Michiko all sit within the wider JPMorgan Japanese investment team, and are able to draw on the research of a team of 14 analysts specialising in different sectors. Including all the portfolio managers on the desk, JPMorgan has 25 professionals on the ground in Japan and conducts over 2,000 company meetings a year. These provide excellent sources of information and ideas in a market with low levels of broker coverage, giving the managers an advantage in the post-MiFID II world.

Discount

JPS trades on a discount of c. 6.0% as at 30/01/2020. This has narrowed somewhat in recent months, in line with what can be observed across the sector as a whole as risk sentiment improved. However, as the graph below shows, JPS has consistently traded on a wider discount than the peer group.

The board is cognisant of the persistency of this discount, and in April 2018 elected to institute a regular dividend policy, paying 1% of NAV a quarter, with a view to broadening the appeal of the trust to investors looking for income streams. Historically the board has also proven willing to repurchase shares to narrow the discount, but it has noted its belief that the dividend policy may be a more effective tool for doing this going forward, without precluding further buybacks.

We note that there are four institutional discount players with notifiable interests (greater than 3%) in JPS. We note that aggregated, these holders were marginal net buyers of stock in 2019.

discount/premium

Source: Morningstar

Charges

JPS has an OCF of 1.1%, slightly above the 0.83% weighted average of the Japanese Smaller Companies sector. This includes a tiered management fee; thus, as net assets grow this should fall further. Management fees are charged at 1% on net assets up to £150m, and 0.8% on all assets above this level; presently JPS has c. £259m of net assets, giving a weighted average management fee of c. 0.92%, though clearly this will fluctuate in line with net assets.

The KID RIY figure is the lowest in the sector at 1.37%, relative to the sector weighted average of 1.46%, though we would caution that calculation methodologies vary.

ESG

JPS is managed by JPMorgan Asset Management (JPMAM). JPMAM is a signatory to the United Nations’ Principles of Responsible Investment, and therefore committed to the six principles encased therein, which aim to incorporate ESG criteria into investment processes and to promoting ESG disclosure.

The team are able to draw on ESG specialists within the wider JPMAM team, who are tasked with ongoing assessments on how companies deal with ESG risks and issues.

ESG factors, particularly those pertaining to governance, are very much a part of the investment analysis on an ongoing basis. As we discuss in the Portfolio section, governance issues are of particular interest, and the managers of JPS are actively involved with engaging with companies on issues such as board composition and structure, seeking to ensure external and independent directors are present.

Overall, the managers believe that companies that best address ESG issues are likely to be better placed to maximise future performance to the benefit of shareholders. As such, the managers engage on a range of issues, such as ensuring companies publicly disclose their greenhouse gas reduction targets or their policies surrounding cyber security and data privacy protection. Whilst not an explicitly ESG strategy, the investment process encompasses significant ESG considerations.

Related Research

Key facts

Investment objective

To achieve long-term capital growth through investment in small and medium sized Japanese companies

As at:

30/01/2020

Trust Name

JPMorgan Japan Smaller Companies

Ticker

JPS

Management Company

JPMorgan Asset Management Inc

Manager Name

Naohiro Ozawa; Eiji Saito; Michiko Sakai;

Association of Investment Companies (AIC) Sector

Japanese Smaller Companies

12 Mo Yield

4.3%

Dividend Distribution Frequency

Quarterly

Latest Market Capitalisation

£225,672,803

Latest Net Gearing (Cum Fair)

8%

Latest Ongoing Charge Ex Perf Fee

1.10%

Turnover Ratio

24.9%

Shares Outstanding

54,510,339

(Discount)/ Premium (Cum Fair)

-6%

Daily Closing Price

414p

Source: Morningstar

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.

Past performance is not a reliable indicator of future results. The value of investments can fall as well as rise and you may get back less than you invested when you decide to sell your investments. It is strongly recommended that if you are a private investor independent financial advice should be taken before making any investment or financial decision.

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