Despite the uncertain global macroeconomic backdrop, Japan continues to offer an attractive combination of cash rich companies, low relative valuations and secular growth opportunities.

Rich pickings

There is a huge amount of companies in Japan - around 3,500 versus some 4,200 in the US. This is in part due to the limited amount of mergers and acquisition (M&A) activity and consolidation that occurred in the past. Another contributing factor is the dual listings of parents and subsidiaries in Japan, where the listed subsidiaries of large corporate groups such as Hitachi, Toshiba and Fujitsu account for 7-8% of total market cap.

The depth of the equity market combined with an affluent population of around 120 million means that there are many companies with a five-to-ten-year runway of growth in the domestic market.

Moreover, Japan offers rich pickings for bottom-up, active managers as many more companies, particularly in the mid/small cap space, are not widely covered by analysts compared to other developed markets such as Europe and the US.

In fact, the trust’s investments in under-researched names in areas such as educational software, and technology companies supported by a secular growth story have been among the strongest performers over the last 12 months.

Picking long-term winners

The core of the portfolio remains focused on market share gainers that are well positioned to come out of the current downturn stronger than their competitors. Key holdings such as Keyence, Yamaha and Misumi Group are prime examples.

We are continuing to maintain the technology bias in the portfolio, focusing on companies that will benefit from the shift to 5G and a new data-driven work from home cycle. We believe there is a good chance that these companies will lead us out of this crisis as demand for their products and services is likely delayed rather than foregone.

At the same time, we are also looking at domestic services stocks that are well positioned to recover and grow their businesses as restrictions are lifted. Companies in areas such as online services, ecommerce and educational software (including pre-initial public offering) that can benefit from changes in the way we work, shop and play look interesting.

Longer-term, there is likely to be a meaningful term impact on how companies do business and how their processes can become more resilient through, for example, the use of online and cloud computing. Japanese companies have generally been laggards in terms of building that resilience, and the current Covid-19 crisis is highlighting the need for them to enhance their digital capabilities.

Corporate governance improvements

Another area where Japanese companies have had to play catch up has been in corporate governance. However, over the past few years, there’s been significant progress on this front with the introduction of growth-oriented governance reforms such as the stewardship and the corporate governance code.

We are seeing a gradual shift in corporate mindsets with management now paying far more attention to profitability targets such as return on equity. In terms of shareholder returns, share buybacks have seen a decline in the first half of 2020 due to Covid-19, after reaching record levels in the past two years. Many companies have yet to make projections on payouts for the current fiscal period, although corporate management in Japan tend to favour stable dividend payments.

Additionally, corporate Japan continues to sit on large cash reserves, which has led to expectations for a resumption of buybacks and dividends once conditions stabilise. Moreover, many companies are considering selling strategic shareholdings to secure funds for capital expenditure.

In another sign of progress on the corporate governance front, we have also seen the increased number of companies that have announced consolidation of listed subsidiaries amid the uncertain business environment in a bid to improve their capital structure and business restructuring.

We believe there is a governance discount in Japan, which can be detected and exploited by active management. By working closely with our Sustainable Investing team in Japan, we are able to identify laggard companies that are implementing real change and moving up the governance scale.  For example, there are many Japanese companies that trade on an 5-10 times their earnings and as they move from a governance discount to a governance premium, we can capture significant upside potential.

There is a wealth of under-covered companies in Japan that represent a significant source of potential growth for investors that are willing to turn over enough stones and find the undiscovered or underappreciated gems.

In the current uncertain macro environment, our strong research and on-the-ground knowledge is invaluable when looking at the micro level and speaking to company management to fully understand the current dynamics. This puts us in a strong position to continue to identify mispriced winners which should create positive long-term outcomes for investors.

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