127. Exciting investment trends in Japan and the art of Nemawashi

15 April 2021 (pre-recorded 13 April 2021)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Chris Salih (CS): Hello and welcome to the Investing on the go podcast. I’m Chris Salih and today we’re joined by Andy Brown and Thomas Patchett, investment specialists for Japanese equities and product specialists on the Elite Rated Baillie Gifford Japan Trust. Thank you both for joining us today.

Thomas Patchett (TP): Thank you Chris.

[INTERVIEW]

[0:19]

CS: Thomas, starting with you, Japan has a reputation for being very slow to change. Has the pandemic changed that?

TP: Yeah, sure. I think COVID has definitely helped to accelerate some of those changes. Some of the changes that were, that were already underway in Japan – mainly by exposing some glaring shortfalls in Japan’s digital transformation, and some of the operational efficiencies as companies have scrambled to arrange flexible working conditions. However, some of the behavioural traits, so the art of Nemawashi, or consensus-based decision making, the sense of obligation and conformity, some of these traits, which are usually blamed for impeding some of the radical changes that we would otherwise see in Japan, I think they are fairly ingrained within organisational mechanisms within the corporate DNA and are culturally anchored to things such as the salary run cycle, seniority-based pay. And so those types of behavior will definitely take time to change.

However, that said, as with every country, within Japan there are companies that are at the forefront of change and our approach naturally leans us more towards more entrepreneurial, innovative and risk seeking type of business. Those that are willing to actually go against the grain and champion new technologies. And there’s a whole host of examples within the portfolio and I think a couple of relevant ones would be companies like Bengo4.com or GMO Internet, both of whom are helping Japan to abandon its addiction to the Hanko Stamp through their digitalisation, digitalised documentation service, or companies like SBI Holdings, a company that is pioneering financial disruption. So ultimately Japan’s infamously low and slow rate of adoption in some areas, we believe offers a ripe opportunity for innovative, nimble companies and of course our selective bottom-up approach.

[2:30]

CS: There’s a few trends that are sort of associated with Japan, one of which is its aging population. But the younger generations are becoming a bit more entrepreneurial. Could you maybe talk about what sort of opportunities this opens up for the region?

TP: Of course, yes, I mean, the unlisted market, which is probably a good gauge for entrepreneurial-ism is still dwarfed by what you see in the US and in China and that’s a product of several factors. However, things are beginning to change here too. So we’re seeing the breakdown of the rigid corporate structure, we’re seeing greater or growing access to risk capital for new businesses and obviously the success stories. So like Matsuyama-san inspiring younger generations, or in this case, homegrown hits like Mercari, which was Japan first ever unicorn – a company worth over a billion before listing- which is now worth over 7 billion. Companies like that make entrepreneurial-ism a more appealing pursuit of young professionals, incentivising them to kind of break from the mould, which I think is key in a country famous for conformity. And obviously as that happens, we’re likely to see new opportunities emerge in all areas of the economy. We found that founder-run businesses are often run by audacious characters, willing to embrace change and challenge the status quo. They also exist to achieve the founder’s often aggressive, but always long-term vision, so are invariably aligned with our long-term value creation.

[4:16]

CS: And Thomas, thinking about some of the other sort of more recent trends that are playing out now, the likes of digitalisation, robotics and women in the workforce. What do you think is the most exciting for investors?

TP: It’s quite a tricky question, I would say growing diversity is definitely, or definitely presents quite an exciting prospect for Japan over the long-term and likewise robotics is key and remains quite an important part or theme within our portfolio. But I think digitalisation, if forced to pick, would be the most exciting palpable kind of opportunity for investors. And that’s because Japan has lagged other developed markets in some regards when it comes to digitalisation. And it’s a low rate of e-commerce penetration and cashless payments amongst consumers, for example, or the use of incredibly inefficient processes and practices by Japanese corporates. So these things provide a lot of low hanging fruit and many domestic companies that we invest in, or that we are beginning to look at, are starting to capitalise on this huge opportunity.

And so, as a result, this umbrella term of digital disruption is playing out in so many different fields where online operators are using the scale and pricing power of the internet to upset and undercut some of the more traditional incumbents that exist. And again, a number of examples in portfolio, such as GA Technologies within the real estate industry or SBI as I previously mentioned in the finance sector or Raksul in printing logistics and advertising, so the list goes on. But given the exciting and huge run rate that this opportunity presents, I think it’s probably going to account for a much larger portion of the portfolio in the years to come.

[6:10]

CS: So Andy, just turning to you here, the stock market recently hit a three-decade high. Do you think it can continue to climb? And are you worried about the value rally in Japan, such as we have seen in other markets recently?

Andy Brown (AB): Yeah, Chris, it’s interesting that investors are focusing on this three-decade high. The fact that stock markets have only just got back to the level that they reached thirty years ago, you know, I think says quite a lot about where Japanese equity valuations are relative to other markets. For example, the US equity market is significantly higher and multiples of the value that it would have been 30 years ago. And I think when we look at Japan it’s worth reflecting on the fact that there have been quite a lot of improvements over the past 30 years. So Japanese corporate profitability is higher than it was. We’ve also seen great improvements in corporate governance standards and I suspect we’ll continue to see an improvement there.

And when we reflect on various valuation metrics, the Japanese stock market looks cheap compared to other markets across the world. So really this growth in share price that we’ve seen in Japan has come through earnings rather than to a rerating. There’s one measure called a “cyclically adjusted price earnings ratio”, which is widely regarded as the most accurate predictor of long term returns, and on that measure the Japanese market looks very favourable. Probably the last point I’d make in regards to this area is that the opportunity set is improving for Japanese equities. You know, we ourselves are finding more very interesting companies that offer a really exciting growth runway. And I think, you know, when we look at these sorts of companies, they do command lower valuations than similar businesses elsewhere in the world.

[7:47]

CS: Just lastly, you have Sumitomo Metal Mining in the top 10, is that linked to the move to renewable energy and EVs in any way?

AB: Yes, Chris that’s right. So really there are three aspects to the investment case for Sumitomo Metal Mining. The first is that they have exposure to nickel and copper extraction, and nickel and copper are of course key inputs into the electric car industry. So both in terms of the electric batteries and also the charging facilities to fill those batteries to work. And so Sumitomo Metal Mining first of all, has a major nickel and copper extraction business. And it benefits from a low cost process called HPAL, which stands for high pressure acid leaching, and this means that they can extract these two materials at a lower cost and with lower CO2 emissions than most of their competitors. So that’s the first aspect of the case.

The second is that they have a materials business, and this is where they make a component called lithium nickel oxide. And this feeds into the cathodes of electric batteries and major customers for this business are Tesla and Toyota. And this has fantastic growth prospects, we believe. Currently makes about 10% of Sumitomo Metal Mining’s profits, but the company believes it can get up to a fifth of their profits over time.

And the third aspect of the case is a bit less about electric cars and more just about balance. Sumitomo Metal Mining also has Japan’s most profitable goldmine. So this gives it a bit more of a sort of balanced exposure and in the event that we do have more inflationary pressures coming through, that offers us a nice hedge. So we believe all in all it’s an attracted investment for us.

CS: That’s great. Thank you both for joining us today.

AB: You’re welcome, thank you.

CS: And if you’d like to learn more about the Baillie Gifford Japan Trust, please visit fundcalibre.com and while you’re there, remember to subscribe to the Investing on the go podcast.