Disclosure – Non-Independent Marketing Communication
This is a non-independent marketing communication commissioned by Schroder Japan Growth. 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.
Schroder Japan Growth (SJG) invests in Japanese equities with a bottom-up process, aiming to generate long term capital growth. The trust typically has a bias towards value and currently has the highest exposure to this style of any trust in the AIC Japan sector.
The process centres on the identification of under-valued companies through superior fundamental research carried out by a team of 11 analysts on the ground in Tokyo, including three specialising in the under-researched Japanese small-cap market. The manager, Masaki Taketsume, is based in London, having taken over from Andrew Rose in July 2019. However, he had been co-manager since 2017 and previously worked in the analyst team in Tokyo from 2007, so there is total continuity of approach.
Although the process centres on valuation, a key differentiator from its peers, quality and growth characteristics are considered when the team build Fair Value Models for each stock. The trust also has a structural overweight to small and mid caps. Masaki believes that this exploits the advantage of the deep in-house analyst team at Schroders, which is a particular benefit in Japanese small caps given the low levels of sell-side analyst coverage.
The value bias has not helped the fund in recent years, and it has underperformed as growth and momentum-focussed trusts have done better. The portfolio has tended to be overweight in more cyclical areas of the market which have been out of favour relative to the steadier growth sectors, although Masaki has moderated the cyclical tilt in recent months.
In recent years the discount has been wider than the sector average, which we would attribute to the value approach being out of favour and, more recently, to the announcement of the change of manager. The discount has widened to 15.2% this year compared to a sector average of 6.2%.
The value tilt means the trust has a reasonable yield for Japan, which has traditionally been a low-yielding market. On the current share price the yield is 2.2%, with the trust having grown its dividend by 20% a year over the last five years. Dividend growth in Japan is being supported by improving corporate governance thanks to government-led reforms.
The company has structural gearing maturing in 2022 worth 12% of NAV at current levels. This increases the share price’s sensitivity to market movements.
SJG has a clearly defined approach, with a bias towards value, which has worked to its advantage over the long run. The current period of underperformance is the second significant one in the life of the portfolio, the first being between 2004 and 2008, when the value style was again out of favour for a prolonged time. Although changes in the market dynamics are hard to predict, with this Trust being on a discount of 15.2%, we think this could be an attractive long-term entry point.
|The discount is attractive relative to history and peers
||The departure of a long-standing manager
|The fund is biased towards out of favour value stocks, which could attract contrarians
||Structural gearing could magnify losses in down markets
|The locally-based analyst team give a stock-picking advantage
||The low interest rate environment globally could reduce the chance of a rebound in value stocks
Schroder Japan Growth invests in Japanese equities with a bottom-up strategy, aiming to generate long term capital growth. The trust owns a diversified portfolio of 70 to 85 stocks which are chosen on their fundamental merits rather than for their sector or industry exposures.
The trust has the greatest exposure to value stocks of any in the AIC Japan sector, according to Morningstar data. Stocks classified as value currently make up 43.8% of the portfolio, compared to a sector average of 16.4%. Growth stocks make up just 16.9% compared to a sector average of 59.8%. This is a very stable style bias: the exposure to value has varied between 40% and 60% over the past five years, and that to growth has rarely risen above 20%.
The manager, Masaki Taketsume, draws on the company research from a team of 11 analysts based in Tokyo, three of whom cover small caps. The process focuses on generating a Fair Value Model for the companies in their coverage and identifying anomalies with the potential to generate alpha. According to Morningstar data, the trust has tended to hold around 70% in large caps and a further 20% in mid-caps, with the remainder being in small-caps. Masaki believes that this structural overweight exploits the advantage of the deep in-house analyst team at Schroders, which is a particular benefit in Japanese small caps given the low levels of sell-side analyst coverage. That said, the current weight to small and mid-caps is at the lower end of the typical range as Masaki has taken profits on some positions which have benefitted from the previous strong run for Japanese small caps.
Analysts forecast the long-term earnings outlook for their stocks and combine this with qualitative analysis of the company to determine the long-run premium or discount at which they feel the stock should trade relative to the market. These qualitative factors include the quality of management, including track record and governance issues, and quality of earnings, including sustainability of the business model and diversification of the customer base.
The resulting Fair Value is adjusted to account for the net cash position of the company, which can be substantial in Japan. An adjustment is also made, where necessary, to normalise margins for companies with a high degree of cyclicality in their earnings.
At the heart of the process is therefore detailed analysis by the research team of individual companies and their long-term prospects. The analysts grade companies in their coverage from 1 to 4, with 1 (strong buy) reflecting particularly high-conviction views. A ‘2’ grade represents a buy recommendation while ‘3’s and ‘4’s are sells and strong sells respectively. Fund Managers and Analysts meet twice a week to discuss all new research and to debate the underlying assumptions which helps to ensure consistency of the research views across the team.
Sector positioning for the Trust is a result of the individual stock selection decisions taken by the Fund Manager. However, the process has evolved slightly in recent years to ensure that the value bias does not result in a disproportionate level of risk coming from a few particular sectors. This requires an acceptance of underlying reasons why many stocks in areas such as financials and autos could remain undervalued for a protracted period of time. Although the Trust does have positions in selected stocks in both these areas, Masaki regards many of the other sector constituents as potential value traps. In some cases there is an increased focus on relative value within sectors or industries to reflect this. A good example of this is the purchase of Fuji Oil, a food ingredients business, in 2019. Although on a current P/E of 18 to 19 times. The stock is relatively undervalued both within the sector and against its long-term earnings outlook. Masaki sees scope for the company to grow internationally following the acquisition of a US cocoa manufacturer, which has provided greater vertical integration and a more diversified customer base.
The trust’s top ten positions are well-diversified, with Japan’s largest company Toyota being the largest holding in the fund and a substantial overweight. The trust holds 5.4% in Toyota, compared to a 3.6% index weighting. The other largest picks are spread across different sectors, with notable positions in the railways and in financial industries (Sumitomo Mitsui in banks and Tokio Marine in insurance).
Top ten holdings as at 28 JUNE 2019
|Nippon Telegraph & Telephone
||Information & Communication
||Information & Communication
|East Japan Railway
The trust does not hedge currency exposure, so investors are exposed to movements in the value of the Yen. However, the currency exposure of the underlying portfolio, as measured by the aggregate level of foreign sales, is typically very similar to the currency exposure of the benchmark. This is a natural result of diversification within the portfolio and means the Trust’s performance relative to benchmark should not be unduly influenced by movements in the currency.
The company has structural gearing through a Y6bn loan worth roughly 16% of net assets at the current fund size (£274m) which matures in January 2022. It also has a one-year revolving credit facility which the manager has not made use of in recent years. Masaki prefers to avoid market timing but retains gearing levels in a steady range over time. As a result, gearing has been consistently in the 10% - 15% range, which has helped and hindered performance in rising and falling markets respectively. In theory the trust could increase gearing without seeking shareholder permission.
Over the past five years the trust has struggled relative to peers, primarily as a result of style factors rather than poor individual stock selection. Indeed, value strategies have tended to underperform globally, not just in Japan, while stable growth and momentum strategies have outperformed in an era of low growth and low inflation. As a result, the AIC Japan sector is dominated by trusts with a growth focus which have substantially outperformed the index and Schroder Japan Growth.
The second reason is that stock dispersion has been lower in the Japanese market. As the market has increasingly been driven by global macro and geo-political factors the contributions, both positive and negative, from stock picks have trended downwards. This lack of individual stock dispersion has hampered the trust given its focus on bottom-up stock selection. In the past, the trust was able to outperform the index even during short periods of value underperformance, thanks to stronger contributions from stock-specific risk. This has not been the case more recently despite the team’s batting average being consistent with the past. Masaki has responded by increasing the size of his active “bets”, so the alpha of successful stock picks are less likely to be swamped by style factors. As a result of these two influences, the trust has generated NAV total returns of 71% over five years, compared to a sector average return of 104.3% and 74.9% for the Topix.
Five year performance
The trust did actually outperform its peers in 2018, as its value approach was more of a benefit in a falling market, but this did not offset the large relative underperformance in 2017, when the trust outperformed the index but returns were around half those of the sector. The beneficial effect of being in value stocks in 2018, was partly offset by maintaining the gearing in a declining market.
So far in 2019, the growth and momentum strategies have bounced faster and further than the market, which we attribute to the more dovish policy expectations of the US Federal Reserve.
One year performance
Masaki tells us that the portfolio is not driven by views on where Japan is in the business cycle. The long-term structural trends in Japan are encouraging, while the risks at the moment mostly seem to be external. However, he has been taking profits on some cyclical and exporting stocks where he has less conviction in the company specific drivers or catalysts which would lead to a re-rating. This is a rational reaction to the low levels of dispersion in the market and a desire to increase the size of his highest conviction positions, rather than reflecting an overall view on the outlook for cyclical stocks themselves.
The trust’s objective is to maximise capital growth, and so Masaki does not necessarily target companies for their yield. Having said this, the trust has delivered strong dividend growth, and currently yields 2.2%. This is only slightly less than the 2.6% yield on CC Japan Income & Growth, which explicitly targets a high yield. Partly this reflects the value element to SJG’s style, which naturally leads them into companies with prospects for higher dividends. Increased pay-outs to shareholders are one result of the change in corporate culture in Japan which has seen 2018 deliver a record level of dividends and 2019 is predicted to beat this record once more – despite the cyclical slowdown in Japanese corporate earnings. The dividend per share on the trust has grown by 22% per annum over the past five years, and has been covered in each year.
The pay-out is once a year, and the last dividend was 4.08p. The policy is to pay out substantially all revenue as dividends, and there is no commitment to a progressive dividend. At 31 January, half way through the financial year, reserves amounted to 70% of last year’s dividend.
Masaki Taketsume took over management of the trust from Andrew Rose at the end of June 2019. The transition has been long in the planning, with the pair beginning to conduct regular conference calls since 2014, and Masaki relocating to London in August 2017 as co-manager. As such, there is total continuity in approach and any changes are evolutionary. Being based in London helps with client communication, while also ironically helping with access to some company management. As a large Japan investor in London, Schroders is targeted by senior corporate managements travelling from Japan on investor-related roadshows, while meetings at a similar level in Japan may be harder to arrange with some companies
Masaki joined the Schroders Japanese equity team as a technology analyst in 2007, the same year that Andrew took over management of the Trust. He has a total of 24 years of experience in investment, having previously worked for Nikko AM and Deutsche Trust Bank before joining Schroders. He manages both the £274m NAV Schroders Japan Growth trust and the open-ended, £1.9bn Schroder Tokyo fund. In London, he works closely with Nathan Gibbs, investment director for Japanese equities. Nathan, who relocated to London from Tokyo in 2016, contributes to portfolio strategy and debate, as well as interacting with Schroders’ investment resources in London. He has 35 years’ experience, much of it as a fund manager in Japanese equities.
Masaki draws on the research of a team of eight sector analysts and three small cap specialists in Tokyo. The average experience in the analyst team is 20 years. In addition to the London-based managers, Schroders has three fund managers in Tokyo running separate strategies and using the same local research team. At the end of December 2018, the combined team managed a total of £11.4 billion in Japanese equities.
The discount has widened out to 15.2% since the trust announced the change of manager in February, while there was little move in the average discount on the sector. We think this is unwarranted given the continuity of approach under the new manager. As a consequence, we have included the trust in our portfolio of discount opportunities.
The trust’s discount compares to a sector average of 6.2% and a five year average for the trust of 8.8%.
The board does have the authority to buyback up to 14.99% of the share capital, but it has not used it in recent years. The directors are obliged to hold a continuation vote at the 2019 AGM and every five years thereafter.
The OCF on the trust is 1%, which compares to an AIC Japan sector average of 0.95%. The management fee is charged at 0.75% on the first £200m of gross assets and 0.65% thereafter, which we calculate as equivalent to 0.72% at the current net assets of £274m. There is no performance fee. The KID RIY figure is 1.2% compared to a sector average of 1.45%, although we caution that methodologies vary.
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Fund History: Schroder Japan Growth
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