Funds investing in high-quality growth companies – particularly small and medium-sized businesses – have not had an easy time of it over the past year, no matter where they are based, as rising interest rates and the derating of highly valued technology businesses have undermined investor confidence.
Nonetheless, for the team running JPMorgan Japan Small Cap Growth & Income (JSGI), this is a really exciting time to be investing in just such companies in Japan.
There are two key reasons for their positivity, and both are country specific. First, as co-manager of the investment trust Miyako Usabe explains, there has been “very encouraging progress” in Japanese corporate governance in recent years, as a result of reforms introduced by former prime minister Shinzo Abe.
Improvements in Japanese corporate governance
Lack of oversight was one key issue. Latest data1 from the Japan Exchange Group shows that almost all company boards now have at least one independent director, and independent members account for at least a third of more than 70% of boards. The publication of annual and mid-term reports with detailed financial targets has also become much more widespread, Usabe says.
Additionally, much progress has been made in reducing the prevalence of cross-shareholdings (where one listed company holds the shares of another) and ‘parent-child listings’ (where the parent company lists its subsidiary). Both these longstanding features of the Japanese corporate environment have been much criticised by shareholders and regulators as potentially compromising good governance.
“Furthermore, corporate Japan has historically had an over-capitalised balance sheet, but we’ve seen a continuing trend towards increased shareholder returns, including share buybacks,” Usabe reports.
“Improvements in corporate governance are a multi-year positive trend for Japan – and importantly, the trend has not reversed under Covid.”
The second factor is the extent to which Japanese stocks are under-researched, despite the country being the world’s third largest equity market.
Fewer analysts research Japanese companies
Research from J.P. Morgan shows that just a third of members of Japan’s Topix index are covered by three or more analysts, compared with two thirds of FTSE All-Share companies and 99% of the US’s S&P 500.
“That trait is particularly prevalent among Japanese mid-caps and smaller companies, despite the fact that so many of the most innovative and attractive companies are in this space,” Usabe points out. “We believe that provides a great opportunity for active managers.”
Japan reopening expected to positively impact the economy
There’s a further short-term tailwind to bear in mind. After almost three painful years of Covid restrictions, the Japanese economy is still playing catch-up with western nations. The border restrictions around inbound travel were only lifted in October 2022, and face masks were obligatory indoors until a few weeks ago.
As Usabe observes: “We’re quite a few steps behind the west when it comes to reopening, and we can expect to see a delayed positive impact for the economy in coming months.”
So there are clear attractions to the Japanese mid and small-cap market in 2023. But it’s equally clear that this is a unique and idiosyncratic environment, and not necessarily an easy place for overseas investors.
JSGI is particularly strongly placed in that respect, with a team of more than 25 dedicated portfolio managers and analysts on the ground in Tokyo, doing the research needed to uncover Japan’s hidden corporate gems.
They are looking specifically for high-quality growth companies capable of producing sustainable compounded earnings for the long term.
As co-manager Xuming Tao explains, that mandate translates in practice into a high-conviction portfolio with a small valuation premium relative to the benchmark MSCI Japan Small Companies index – the payoff being a markedly higher return on earnings, and five-year expected growth almost a third higher than that of the benchmark.
2022 was a very difficult time for the growth-focused businesses held by the trust. JSGI underperformed the benchmark by 25% over the year, due to the Company’s preference for quality and growth stocks2. This focus means the portfolio usually differs significantly from the benchmark, which comprises many low-quality companies with unappealing growth characteristics. It is therefore to be expected that performance will also vary substantially from the benchmark, regardless of market conditions.
Growth stocks have been under sustained selling pressure in all major markets since the beginning of 2022, when the Ukraine war intensified investors’ fears about rising inflation and aggressive monetary tightening. A series of hefty interest rate hikes by the US Federal Reserve, the Bank of England and the European Central Bank, accompanied by hawkish rhetoric about the need for further rate increases, took a particular toll on quality and growth-oriented stocks. Japanese growth stocks were not immune to the change in sentiment, despite subdued Japanese inflation, an accommodative central bank and a positive outlook. The Company’s performance was therefore negatively impacted.
Given the Investment Managers’ conviction that good quality companies with strong growth prospects will always outperform in the long run, it is arguably more meaningful to assess performance over a longer timeframe.
Investing in Japanese stocks
The team are very much focused on finding companies with long-term attractions and aiming to hold them for the long term, rather than being swayed by short-term dips in sentiment.
One example of the kind of stock they seek is Meitec, an engineering outsourcing services firm. With its shrinking, ageing population, Japan has a structural shortage of labour, including engineers, which is good news for such businesses.
Meitec focuses on providing contractors for top-flight research and development projects, and has built a competitive advantage in hiring and training employees (mostly new graduates) as high-end engineers, carving out a market-leading niche for itself in the process. It’s highly profitable and has a strong balance sheet, and has committed to distribute up to 100% of net earnings to shareholders3.
Another leading name in the portfolio is dental handpiece-maker Nakanishi. Demand for dentistry is forecast to be fueled not only by Japan’s ageing demographic but also by the growing call for complex procedures, preventative and cosmetic work.
It’s already a leader in the Japanese, European and South Asian markets, but Tao sees opportunities for further growth in market share in China and the US. The company is also successfully leveraging its precision engineering skills to provide drills for cranial surgery.
There is clearly no shortage of high-quality, innovative enterprises among Japan’s mid-cap and smaller companies. JSGI’s extensive and highly experienced Japan-based team enables it to try and dig out the best choices for a robust long-term portfolio.
1 Japan Exchange Group, as at 30 November 2023
2 J.P Morgan Asset Management, as at Feb 2023.
3 J.P. Morgan Asset Management, as at Dec 2022
Net asset value performance data has been calculated on a NAV to NAV basis, including ongoing charges and any applicable fees, with any income reinvested, in GBP. * Geometric excess returns, returns over 1 year are annualized.
Past performance is not a guide to current and future performance.
The risk indicator assumes you keep the product for 5 year(s). The risk of the product may be significantly higher if held for less than the recommended holding period. In the UK, please refer to the synthetic risk and reward indicator in the latest available key investor information document.
To produce long-term capital growth through investment in small and medium-sized Japanese companies. Investment is permitted in Japanese quoted companies, other than the largest 200, measured by market capitalisation, emphasising capital growth rather than income. The Company has the ability to use borrowing to gear the portfolio and its current policy is to operate within the range of 5% net cash to 15% geared in normal market conditions.
- Exchange rate movements between the pricing currency of the underlying overseas investments held by the Company and sterling (the base currency of the Company) can cause the Company’s NAV (in sterling terms) to go up as well as down. For example, if sterling appreciates relative to Japanese yen, the value of the NAV in sterling terms will be negatively impacted; if sterling depreciates, the value of the NAV in sterling terms will be positively impacted.
- External factors may cause an entire asset class to decline in value. Prices and values of all shares or all bonds could decline at the same time, or fluctuate in response to the performance of individual companies and general market conditions.
- This Company may utilise gearing (borrowing) which will exaggerate market movements both up and down.
- This Company invests in smaller companies which may increase its risk profile.
- The share price may trade at a discount to the Net Asset Value of the Company.
- The single market in which the Company primarily invests, in this case Japan, may be subject to particular political and economic risks and, as a result, the Company may be more volatile than more broadly diversified companies.
The Company pays quarterly dividends without compromising on the objective of achieving capital growth, funded from dividends from investment holdings and capital reserves, equivalent to 1% of its net asset value, set on the last business day of each financial quarter.