324. Diversification potential from robotics to digital payments

25 July 2024 (pre-recorded 16 July2024)

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]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. We’e focusing on the complexities of Japanese equities this week exploring everything from the market’s oscillation between growth and value stocks to recent corporate governance reforms and the weakening yen.

Chris Salih (CS): I’m Chris Salih and today we’re joined by Karen See, co-manager of the Elite Rated Baillie Gifford Japanese Income Growth fund. Karen, once again, thank you very much for joining us.

Karen See (KS): Thank you for having me.

[INTERVIEW]

CS: Let’s start with investment styles in Japan because it’s known for its wild swings between sort of growth and value markets. For listeners, maybe just explain where we are in the cycle at the moment, and are there any signs of what direction it might continue to take –  that’s the first layer – and then secondly, the implications for your fund.

KS: Yeah. So over the last 18 months or so I think it’s fair to say that the market’s attention has firmly been on the sort of large cap value stocks in Japan. Now, there a couple of drivers for this. One is quite a violent recovery for some of the cyclical stocks in the market. They tend to be quite large index constituents. We’re looking at sectors, sort of auto industries, transportation such as like shipping companies and mining companies coming out of the sort of covid disruption. It kind of caused some of these cyclical recoveries to be quite, as I said, violent over the last 18 months.

Some of it is caused by the weaker yen. The yen it currently is at its weakest in about three decades. Again, some of these sort of cyclical names, particularly exporters they’ve benefited heavily by having a very weak yen. So that has captured the market’s attention and focus. But there’s also one other thing that’s happened over the last 18 months, which is the head of Tokyo Stock Exchange came out and pretty much said companies with below one times price to book valuation, they need to do better, to create better values for shareholders. And if they don’t see any improvement, then they’re pretty much gonna go down the name and shame route, which is kind of a list of companies that they think is not doing good enough for the shareholders.

Now Japan has a very consensus driven culture. The last thing you want to do as a listed of company is to be picked out from the crowd, be labeled as bad. So what that means is there’s been a lot of focus put on companies that trade below book, as the head of Tokyo Stock Exchange has decided to use this metrics to sort of categorise whether you are doing a good or bad job. And there’s been a flurry of initiatives announced by management, sort of ways in which they can sort of air quote, rectify the low valuation. And we can see that in terms of more dividends paying back to shareholders and whining some cross shareholdings, buying back more shares, canceling treasury shares. These are things that have happened for a while now, but there’s just a lot more urgency behind these. So again, it calls that part of the market. So companies traded below books that again also happen to be sort of the larger constituents of the index. What we typically consider to be sort of value stocks to have done very well because people kind of just think that there is a lot of low hanging fruits that can be had in that space.

What it means for our fund. So for listeners that don’t don’t know us well, we are bottom up long-term growth stop pickers. So we typically go out and try to find companies that have a very exciting growth prospect in front of them and that they have the ability in terms of the edge of the business management quality, financials and resilience to really execute on that opportunity well. So a lot of the areas that have caught the attention of the market over the last 18 months or so, are really not what we typically would find attractive. And so this fund then as a result faced quite challenging period investment performance wise.

But what it has created over the 18 months of sort of focus on a lot of these value stocks is that we are now able to find growth stocks that we generally do think about and invest in at much more attractive valuation than before. And we believe that actually going forward over the next sort of three, five years, the sort of a symmetry of returns is much more appealing for us. We can buy them with lower multiples, the sort of structural growth story is still intact. So that’s where we are now.

CS: I’m gonna come back to the structural growth stories in a bit, but there was quite a lot in there that I wanted to follow up on. Firstly, you talked earlier on there about the yen, it’s been battered and a source of concern for lots of foreign investors. Maybe just explain where we are in the cycle in terms of the yen and do you see it stabilising and a bit of a view on that, please?

KS: Yeah so we don’t have any currency views and it’s not something that we spend a lot of time thinking about to be very honest. But one observation that I would offer, which is a very obvious observation, is as I said before, that the yen is at its weakest point in over three decades. So as a sort of generalist investor who don’t necessarily have that edge thinking about macro factors or to be able to predict when these things might change what we are thinking about is, well, if we are in quite an extreme position when it comes to the sort of yens valuation, how that has impacted various portfolio companies and also market constituents in terms of their profitability and the resilience of the business.

So you’re finding that if you have a business that profit has just like been shooting the lights out, but then a lot of that is because of a translational effect in the currency that that might not actually be something that you wanna put a lot of weight on. Whereas if a company, despite having quite a weak yen headwind they might be domestic player so they don’t really have much benefit in terms of exporting. The cost has increased massively because of the yen effect, but they’re still doing very well. And in some cases actually relative to their competitors, they’re in a much stronger position then that might actually catch our attention in terms of thinking harder about, well, when and if things do normalise in terms of the currency then that these companies might start to look quite interesting. We don’t know when that will happen. Wouldn’t really be making any predictions about that, but I guess it’s more sort of observing that it is at quite an extreme point at this particular point.

And I think a more sort of tangible sort of observation that when I was out in Japan the kind of prices that as a tourist you’d be paying for like a lunch is under 10 for two course lunch in century Tokyo. Now this is great for tourist, but for someone who lives in Japan earning a domestic wage, this is quite difficult reality in terms of how much the yen has weakened. So that might cause some kind of other effect in terms of domestic consumer. How much they can buy and how they will change the cons consumption habits as well. So there are a lots of sort of like second order effects they need to be thinking about. So those are the things that we are thinking more of.

CS: Okay. I wanted to touch again then. You mentioned on corporate reforms a bit earlier they’ve been ongoing for a number of years, but you talked about the one times book as an example of how things have changed more recently. Could you maybe give us an example of how those recent changes have impacted your portfolio specifically?

KS: Sure. So in our portfolio we have a few holdings in the sort of financial sector. It’s been great owning them because they have quite a strong run over the last 18 months. The investment case, this is not the only sort of investment case for some of these companies, but one part of the investment case is that actually some of these companies are sitting on a lot of cross shareholding, so long life insurers that we own in the portfolio. Because of the sort of corporate history in Japan, there’s been a lot of when you do business, you kind of own some shares in your customer’s company so that you kind of like deepening your sort of customer relationship and then you kind of have each other’s back when you do business. And that might sound good when you’re trying to win the business. But on a whole, what that has curated is quite sort of cozy corporate relationship where managers are not being held accountable for the corporate performance. Because if you have your mates basically assessing your performance even if you’re not doing a great job, they’re not really going to vote against you. So it’s not a very effective system.

So as part of the corporate governance reform one of the things that’s been really pushed hard on by regulators and actually they’ve come out and have mandated the unwinding of these cross shareholdings. What that has meant is that a lot of these cross shareholders has been sitting on the balance sheet as perhaps book value. They now have to be sold and unwind as a result and what the company then do with this huge amount of cross shareholding that they’re unwinding and is then interesting.

Now, they would go out and buy back some of the shares and then actually there’s been quite a few chunky share buyback announcements from our portfolio companies. They will increase the dividend payouts but also they would invest back into the business. So this is where picking the right one that can be quite important because you want the management to continue to think about where they can grow the business and actually allocate the capital effectively. And so we have seen a few of these financial holdings in our portfolio done quite well on the back of that.

It’s not just in the financial companies though. There’s been quite a few other companies that have not announced a share buyback in decades that have come out and announced that. And that would obviously have been good for the share price performance. So that would be an example.

CS: I was gonna ask, is there a good example of a company outside of the financials that’s done that, that you could think of?

KS: Well, so this one might be a bit controversial, but SoftBank is one that actually has done a huge amount of share buybacks over the last couple of years. And our core investment case in SoftBank is that we believe that Mr Song is actually one of the best capital allocators in Japan.

Now, many people have opinions about SoftBank, and this is actually one of the reasons why there is a potential investment opportunities here because people tend to focus on a lot of his investment failures, whereas the successes don’t really make the headlines as prominently as his failures. So people kind of look at him and think, look at the WeWork and all these other things that he has failed. But then what has really made SoftBank in terms of the value creation his bets on Alibaba and then he successfully sort of exited it and then kind of put money into AI.

I mean, more recently ARM [Holdings] has driven SoftBank share price I think to probably one of its its heights since listing, again, this is because Mr Song has been very shroud in terms of like thinking about the long term opportunity where to put capital. But because he’s such a true capital allocator, he understands when his business is undervalued and therefore he opportunistically do share buybacks. Not because the head of Tokyo Stock Exchange come out and tell him to do so, but because he believes that is the best way to use capital.

Now interestingly, sorry, maybe going slightly off topic, but one of the activist investors in SoftBank has recently kind of asked him to do some more share buybacks at this point, but then he actually quite straightforwardly kind of responded, no, actually at this particular point, I think more investment in AI would be, would generate more shareholder value in the long term.

And I think this is the kind of thinking that you want a management to be having, not doing share buybacks just for the sake of doing so, but because that is the best way for allocating the capital because your business is undervalued. Now if your business is not particularly undervalued and you go out and do share buybacks, that’s actually value destructive. So that is some of the worries that I have with some of these sort of blankets kind of go out and just sort of do all the paying out dividends and share buybacks regardless of whether it makes sense or not. It’s that actually sometimes the timing might not be right. You don’t want to kind of every year go out and buy shares that it’s not just gonna automatically increase shareholder value. So kind of having that understanding in management is very important.

And I think some Japanese companies, they might still not be thinking about it from that perspective, but it’s more from the wanting to protect their reputation and not wanting to be kind of called out and name and shame and therefore doing it that way.

But nevertheless, going back on track of the sort of the corporate governance reform, I think a lot of the low hanging fruits of being addressed by companies and the good thing that comes out from all of these reforms, and this is a very long time coming reform as well, it has hasn’t just happened over the 18 months, even though this is the time period in which people were sort of thinking or paying a lot more attention about corporate governance reform in Japan. It’s actually been going on for more than 10 years since the corporate governance code in stewardship code came into effect in Japan. And even before then, there’s been also efforts to try to improve a lot of these things.

So I guess my point is the more interesting change coming from all of this corporate governance reform is to do with how management changes the way they think about capital allocation and utilising the balance sheet well, and not just kind of running it. Because Japan has been in deflation for a very long time. So they haven’t had that prompt of, you need to make sure that you putting the money in the right place so that the value doesn’t go down. So they have kind of become quite lazy with balance sheet management and that’s changing now, which is good.

CS: I was just gonna ask you, I mean, you said that there. Let’s move on to the obvious question, which is how do they allocate? Obviously historically dividends has not been, how should we say, sort of fairly, you know, compared to a market’s mature of the UK it’s not sort of as sort of widely used as a tool, but that obviously has changed. You’ve got many more companies that do pay dividends. Could you just explain, has that change been steady, has it accelerated with the recent changes? I mean, maybe give us some numbers behind that. What sort of universe of companies do you now have now versus maybe, I don’t know, five years ago in Japan?

KS: Yeah. So it has been a gradual change. If I were to pull up a graph for shareholder returns in terms of dividends and share buybacks over the last sort of 20, 30 years, you would see a very steady sort of upward trend from sort of the bottom left to top right type thing. Even though there would be a bit of an uplift sort of over the last couple of years, that is to do with the TSE, sort of Tokyo Stock Exchange initiatives, sort of pushing that a lot harder.

But like I said before, this has been a long established trend. Definitely the regulator’s been kind of going quite hard at it for over 10 years. In terms of numbers though, I’m just trying to kind of see if I can read out anything. So the total amount of say dividends paid out to shareholders, sort of, let’s say we go back to around 2011/2012, it’ll be under 10 trillion yen. Whereas if we look at sort of the last year or so, the amount sort of being paid back to shareholders would be over 25 trillion yen. So that’s quite a magnitude of difference.

Now some of that has to do with companies were actually making more money, more profits, but then also in terms of the proportion of earnings coming back to shareholders in terms of dividends would’ve risen. But then a lot of that also comes from balance sheets, a lot of cash being sort of sitting on balance sheet, not really being utilised, that has been gradually paid back to shareholders as well.

CS: And is it fairly spread across the market cap or is it mainly the big players that contribute to that 25 trillion?

KS: Definitely the larger players will have more impact. And you tend to find that if you kind of the, it’s sort of just the mechanics of cash holding, if you’ve been around for longer and have a business for longer, that you actually have longer periods to kind of hold more cash so you can then unleash back to shareholders. When you look at sort of smaller mid-size companies, they tend not to have as much cash as the larger players. And in some cases, if you kind of think about a really large companies but don’t necessarily have avenue to invest for growth, then the obvious thing to do is to pay back more in terms of dividends. So I would think that the larger companies have also just a sort of logic that they will have a bigger impact in terms of moving the needle in terms of the total absolute amount of dividends being paid back to shareholders.

But for us, what is also important is finding companies that can grow that dividend streams. So it’s not about finding the ones that have a lot of cash on the balance sheet that can kind of pay out a couple of times. And then once you kind of get to the end of that, there’s nothing else for you to kind of be excited about. Whereas if you can identify a company that genuinely has a growing sort of earning stream and they also don’t need all the capital to continue to have to be reinvested into the business, then they can see the dividend stream coming back to shareholders actually rising over time. That’s more exciting and interesting for us.

CS: I wanted to touch on a couple of themes quickly. First one is that Japan is sort of well known for those sort of robotics and automation stories and, you know, market leading in a number of those areas. I mean, just maybe give us a bit of insight into that.

You have almost half the fund in the manufacturing sector, and I know that looks a bit different to what people might see here in terms of what that sort of includes, but maybe just give us a bit of insight into that. Is it all going towards AI? Is it quite a spread out story in terms of robotics and automation now?

KS: Yeah. So I’ll tackle the half of the fund being exposed to manufacturing question first. So the way that sort of the topics that the index sort of categorise different sectors sometimes it’s not very straightforward. So even though it might say manufacturing sector, but actually underneath that, it captures a lot of different themes and types of companies. So for example, within this 50% exposure to manufacturing sector of the fund, it captures companies that make skincare products, nappies, crisps, even sort of medical precision devices. So not all of that will be automation and robotic exposure, but automation and robotics, they are a key theme in our portfolio because we believe that actually going forward, the demand for robotics and also automation would only accelerate.

First reason for that is because if you look at sort of Japan’s demographics, they just need more automation in order for the society to function. And that has actually I think helped some of these automation companies in Japan to flourish over time because society as a whole, when you don’t have this debate over are they stealing out jobs, it’s much more easily and readily embracing of automation technology. Now they also, these automation companies historically have benefited from quite a strong auto sector in Japan, who then adopt automation technology.

But looking forward, we can see the automation being rolled out into other sectors as well. Not just cars or the making of cars. And Japan is in a quite interesting position sort of geopolitically if you kind of think about the experience of Covid how a lot of the sort of manufacturing companies even governments might be thinking about the resilience of their supply chain and what they might want to do in terms of bringing back some of that on shore. A Japanese automation company, you can see it’s quite straightforward as in if you want to automate the manufacturing facilities to be closer to home would you want to pick a robot that is made by a Japanese company or otherwise it’s quite an interesting play from that particular perspective about resiliency of the supply chain. So this is a key theme for us.

CS: You mentioned robotics automation. There a whole stream of things that sort of come to mind there, but perhaps one of the things that sort of slipped through the net perhaps when you think about this is digitisation. That’s perhaps not a story that you maybe think with the other sort of areas like robotics and automation that would come along as well, that’s perhaps the likes of, you know, e-commerce, cash payments, online banking, investing online – that has lagged when you think about, and it sort of looks a bit stark when you consider some of the other areas that Japan excels in, what is the underlying reason for that? Is that the demographics? Is that, are there any other reasons beyond the demographics for that and are you seeing that change and are there examples of companies that are sort of leading that change in your area?

KS: Yeah this is always a quite curious thing and also surprising thing as well for people that don’t know Japan very well, because people tend to think of Japan and think of these like robots and super technologically advanced. But actually it’s not even that long ago. I think it was five, 10 years ago, they were still using fax machines, you could go into a convenience store and they would have fax machines there in case you need to use that for whatever reason.

So I don’t know what are the precise reasons as to why they’ve been so slow with the digitalisation of various things. But it’s certainly something that is much more front of mind for companies and management now because of the labour shortage and how acute labour shortage is in Japan.

It’s not a question of it’s nice to have, we can digitalise this. It’s a we need to do this. We genuinely want to be able to continue our business because we don’t have enough people to continue doing accounting sort of like on paper. Or even a very basic Excel spreadsheet. We want something to actually get done as easily and with as few number of people as possible.

So from a growth investor’s perspective, Japan is quite an exciting place because it almost has been sort of it is sit inside its own little bubble in the sense it has all of these it’s certainly very wealthy country still. But then for whatever reason it’s not being heavily digitalised in terms of a lot of the functions whether it’s sort of within industries or just generally sort of how business operates. So you can see how you can see the trajectory in the adoption going forward, particularly when it’s underpinned by labour shortage as to why there will be a rise in demand for these things.

So we are seeing things like digital payment for example. That’s really the adoption for that really got accelerated during covid. And that is one of the investment themes in our portfolio. Whether it is looking at digital payment in terms of online digital payment or even just physically when you go to a shop, you are able to pay with a credit card, not having to walk around with a pile of cash anymore. Even though you might still have to if you go to more rural places in Japan, but it’s one of these things that is definitely changing in Japan.

Online banking is another one. Japan, historically the banking industry has been quite sleepy. There’s need to be more digitalisation happening in the back office to help kind of streamline some of these processes. Seeing opportunities also within the sort of e-commerce space a lot of these things that you can kind of just look around you say in the UK where actually e-commerce adoption is quite high, digital payment also, you kind of think about, well, why wouldn’t Japan kind of head towards this direction when they have such a structural issues when it comes to labour availability. So it’s an area we’re finding a lot of fruitful investment opportunity currently.

CS: I was just gonna ask just briefly, is there one example that you maybe you could give us of some of a company that in the portfolio that sort of is tapping into that digitisation trend at the moment?

KS: Yeah the one that I will be thinking of actually in terms of digital payment might be one of the more obvious trend would be Z-Holdings. It has a subsidiary called PayPay, which is a QR code payment thing. So if you think about when you go to your shop and you pay currently, you tend to have like a thing that you can tap your phone or your contactless card. But actually for some of the smaller merchants that might still be quite expensive. So having just a QR code where you can ask the customer to scan with the mobile phone and therefore able to transact that way is a easier lower hurdle in terms of adopting some of the digital payment methods. So PayPay is the leading player within that, pushing the digital payment story in Japan.

CS: I wanted to finish on outlook. A little earlier, you talked about some of the challenges and the structural growth opportunities that you you were seeing now. Japan’s obviously had a good 18 months in general. Maybe just talk about the opportunities you’re seeing for your perspective and then maybe just whether that run can continue or whether it sort of morphs into a run that sort of benefits you on your fund specifically.

KS: I certainly hope so! Well, so as we sort of discussed, the good run over the last 18 months, some of them were driven by quite specific macro factors. And while this fund has not benefited as much from these macro factors, we actually now are at a point where for the type of businesses that we sort of specialise in looking at and investing in, they are looking more and more attractive. The symmetry of returns is really looking very good if you don’t have to pay so much, but then you actually know that the growth story is still intact.

Now it’s very difficult to predict cycles generally, whatever cycle that might be. It might be the yen, it might be whatever industries these companies tend to operate in, but there are things that don’t change. And those are the structural trends we see in Japan. And those are the things that we spend a lot of time thinking about when trying to identify investment opportunities.

A lot we’ve touched on automation, digitalisation, opportunities that can be created by the labour shortage issue and demographic issues in Japan, those are not gonna go away. So these are the things that we continue to think very hard about to find investment opportunities over the long term. When the market’s gonna turn, I don’t know. But I think that given where the valuation is at the moment with a lot of these growth stocks that at times you don’t even, you hardly have to pay much premium for it at all is looking really rather interesting.

And I think also Japan in terms of as an asset class is also quite interesting because as it has demonstrated over the 18 months, it’s sort of, it’s driven by its own idiosyncratic drivers. It has its own stories. And so if you want to put something in the portfolio that’s a bit more uncorrelated to everything else, actually Japan is quite good place to look for now the drivers for the next sort of 18 months might be different to the last 18 months.

But then at least if you look at our fund, we kind of looking very specifically at this economy as a slightly different point as other developed markets facing its own issues and then therefore the set of companies that would benefit would also look quite different. So I think Japan continues to be a very interesting and fruitful place for people to consider and to think about. And I certainly hope that it will be a much easier time for growth investors over the next couple of years than we have experienced in the past couple years.

CS: On that note, Karen, thank you very much for joining us today.

KS: Thank you very much for your time.

SW: As discussed through this interview, the Baillie Gifford Japanese Income Growth fund aims to benefit from the improving corporate governance in Japan, as more and more businesses move towards a progressive dividend-paying policy. To learn more about the Baillie Gifford Japanese Income Growth fund please visit fundcalibre.com