327. Japan’s hidden investment gems: opportunities beyond the yen

22 August 2024 (pre-recorded 21 August 2024)

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. This week we’re discussing the recent volatility in Japan, opportunities for growth, and how changing global perspectives are impacting Japan’s economy.

Joss Murphy (JM): I’m Joss Murphy, today I’ve been joined by Richard Kaye, manager of the Comgest Growth Japan fund. How are you Richard?

Richard Kaye (RK): Very well, Joss. Great to see you.

[INTERVIEW]

JM: Great to see you as well. Well, Richard, the Japanese market has made a lot of headlines recently, perhaps for the wrong reasons. Can you explain what’s been happening, give listeners a bit of a background context to Japan?

RK: Sure. One of the things that’s been happening, Joss, is currency in Japan has been going crazy. Or maybe to put it a different way, the currency was going crazy for the last two years, and it’s been getting normal now. I’m sure you’ve noticed that the Japanese yen – and the listeners likewise – have noticed the Japanese yen has been at an all time low for about a year, and it’s been getting towards that low for the last two years.

And what happened just very recently is the yen suddenly “normalised”. It approached its multi-decade band and there were consequences from that in the Japanese stock market because yen sensitive sectors, things like banks and cars and commodities which had been massively bought by the incremental buyers in the Japanese market, those yen sensitive sense sectors were suddenly sold. And what I call more proper “normal” companies that just do a great job would’ve been eclipsed a little bit in the recent market flows. Those things got bought. And so those dramatic changes were all direct reflections of the movement and the currency. That’s what’s been going on.

JM: And is that all behind us now? Is Japan now, as you say, going to look a bit more “normal” going forwards?

RK: I actually don’t think it is behind us. In fact, I think that what we saw last week or two weeks ago is just a foretaste of more volatility to come probably. So you won’t get me on these podcasts again – you don’t want me to talk about more volatility coming – but I think that’s what’s going to happen.

I actually think that the yen is going to go back to a multi-decade average of maybe even 120 to 130 against the dollar. As a reminder, we’re looking today 146 and we were nearly 160 a few days ago. I think we’re going back to the multi-decade average, and that means more volatility to come.

But volatility is not necessarily a bad thing if you know where you are camped out, as it were, if you know where you want to pitch your tent, as it were. And we do want to invest in great companies that aren’t massively sensitive. They’re doing a great job. They’re speaking to shareholders. And we think that the folks who’ve been chasing those yen plays, the car companies, the banks and so on, are a little bit misguided. And those sectors are actually going to face a major reckoning in the Japanese stock markets as this volatility continues and the yen returns to its multi-decade average.

JM: So as you said, if the yen went back to around the 120/130 market against the dollar, do you expect the stronger yen to cause your growthier style to come more back into favour?

RK: Definitely. I think that the great companies that we have in Japan many of which are great even on a global comparison, they’re growing very strongly. They’ve got great return on capital. They speak shareholders language, but many of them are not properly understood. Many of those great companies have been significantly devalued during the last two years when the market is only focused on yen plays.

And I am urging investors strongly to wake up, smell the coffee, look at what’s basically the world’s second biggest, if I could put it this way, investible market, maybe the third biggest investible single country markets. Look at the companies that are doing a great job in that. Ignore all the noise about weak yen stuff and ignore a lot of the other commentary that I think comes out about Japan, or it’s all about governance change right now by bad companies because they’re going to get less bad. That’s not really the story.

Buy great companies, a lot of those are what, yeah, to use your expression, growthier companies, just companies doing a great job, growing their profits, great return on capital speaking investors language, engaging with shareholders, and they’ve been doing that from a long time back. And yes, I think those companies will come to the fore.

Forgive me for blowing my trumpet, but when we had those sort of black Monday type days two or three days ago, our fund had actually fantastic relative performance 60/70bps, 1% over, which is, you know, very unusual alpha for one day. As people I think started to look again for serious companies in in our markets.

JM: Richard, a recent commentary said, “biggest growth for the lowest price” was your watch word at the moment. [RK: Yes] Can you explain this and give your example of this today, please?

JM: Yeah thanks, Joss. We in our fund right now have the biggest profit growth for the cheapest price that we’ve ever been able to offer in this fund. We have an EPS aggregate growth across our portfolio of about 17% or 18%. I challenge listeners on this call to find other funds that are growing their profits in aggregate at that sustainable pace. And, by the way, the price earnings to growth multiple, and we think that’s a more meaningful thing than just naked PER or something. The price earnings to growth multiple is about one times, or it’s actually a little bit below one times, and we’ve done this fund for 16 years. It’s never been that cheap. So we are offering the biggest profit growth for the lowest valuation that we’ve ever done since the inception of this fund.

And again, I see even on a global comparison to folks who are looking at US stocks, European stocks, or emerging market stocks, I don’t think you can get a combination like that. The way that we can find it in Japan, again, Japan is not a small market. It’s a necessary global allocation, and that allocation has to be made in a sensible way, and that that’s how we’re trying to address our opportunity set.

JM: I know you’ve already touched on this a bit, Richard, but what are the overall valuations like for your companies at the moment? And have they suffered a de-rating of other styles have been more in favour?

RK: Yes, we are. The overall valuations have been in the last two or three years at multi-decade lows for many of our companies. I want to give the example of a company called ORIX which is a leasing and corporate finance company. It’s also Japan’s biggest renewable energy company. Everyone in the West is excited about renewable energy. Governments wanna support their tax benefits. Japan’s been onto that story for 20 years. Why? Because it’s got no fossil fuel. Oh, yeah, they tried to do nuclear and you know how that turned out.

And so ORIX, this company, has stepped up to the plate and said, yeah, we couldn’t do renewable energy. We will become the biggest solar farm operator in Japan. And they put investments in things like hydroelectric power and so on and so on.

That company offering great growth, is trading at something like six or seven times earnings. It is a discount to book value. They’ve got a lot of other very interesting businesses as well. They run an airport, which is obviously fantastic. If you live in Japan, you know how there’s an invasion of tourists going on right now. Well, that invasion of tourists into our country of Japan benefits directly ORIX because it runs Osaka or SAI airport [Kansai International Airport]. That company growing at a great pace, 14% 15% EPSE is trading at six or seven times earnings right now. It’s one example of a major valuation opportunity as that sector has just not been paid attention to.

We have a lot of technology companies that again, are significantly lagging their US or their European peers, despite giving much bigger growth. We have a little company called Dexerials, it’s a strange name. They make touch screen components for your iPhone. You will definitely have used them if you have a smartphone. But like a lot of Japanese companies, you wouldn’t be aware of them. But that thing is trading on 12, 13 times forward earnings for a very substantial high teens consistent growth rates.

These are just two examples, Joss, of companies that represent the broader theme of great companies at at record low valuations which our portfolio is really trying to catch right now. And we could just sort of sit back and say, well, this is financial theory, you know, it’s never gonna work. You know, who cares about cheap valuations? Just give me the momentum. Just give me Magnificent Seven in the US just give me banks in Japan, whatever is trading momentum. But that’s not what we do. You know, we think ultimately the herds and the momentum will get its comeuppance. And this radical move in the Japanese yen that we discussed earlier, and I think it’s going to be the trigger for that up as an opportunity for proper companies

JM: Going back to the invasion of foreign foreigners in Japan. I know that that’s been on the news a lot there. And I’ve been hearing that there has been some backlash from the Japanese people to that. How are both the people and companies kind of reacting to reforms and has there been a backlash?

RK: A little bit. I think it’s really important to distinguish like with a lot of Japan, the appearance and the reality. Japanese are great at making things look good and there’s a lot of reform that’s talked about, which looks good but is only unfortunately cosmetic. And nobody has a problem with cosmetic reform. Nobody has a problem with producing English language materials with great glossy printouts speaking a better language perhaps towards shareholder engagement. All of that’s gone down very well. My point is, it’s all nonsense. It doesn’t mean anything, it’s just cosmetic. And if I was allowed to and our legal people wouldn’t get angry with me, I could give you probably 13 companies without even thinking about it who do purely cosmetic reform. No problem with that. Yeah, we can do that.

What I’m interested in though is real reform companies that are actually changing how they operate. Companies that sort of wake up one day and say the last 50 years of destroying capital disregarding shareholders, doing dopey businesses, maybe for social reasons was all wrong. And that’s difficult. And, yes, there is resistance. And yes, there are employees or even labour unions, you don’t hear about that much in Japan, but they do exist. Who oppose that sort of thing. And there’s political engagement against that sort of thing, but there are companies who are doing it and some of them are victorious and some of them become great investments.

Hitachi is probably the poster child for that 30 years ago, which is pretty much when I started looking at Hitachi, I couldn’t even tell you what that company did because it did pretty much everything. Now it does two things renewable energy and a consulting business, and it grows very strongly with great capital return on both of them. That’s real reform. It’s been difficult. Not all companies are doing it, but if you can find it, that’s a great investment opportunity.

JM: Well, it certainly sounds exciting. And just finally, what does the future look like for the Japanese market, in your opinion, and what does this market offer to investors?

RK: Boy, where do I start and when do I stop? And I know you’ve got a limited time on this, so you’re going to call me against the stopwatch pretty soon, but I wanted to give you a couple of big things.

First up. A lot of people look at Japan and say, oh yeah, aging society, big sovereign debt problem, whatever, whatever. And I say, forget about that. Because we’re not actually investing in the country of Japan or the government of Japan right here. We’re investing in great companies that happen to be domiciled in Japan, but whose business is mostly outside of Japan. And a lot of the companies that we have in our portfolio have Asia, China, Greater China, as their major source of profit and major source of growth. Japan as a market offers you the chance to invest in the growth of Asia. Which I think anybody admits will be the next generation or several next generations main source of global growth. You can invest in that through Japan very cheaply because of the opportunities that our market gives you.

A second thing I wanna say real quick Japan’s going through a leadership change right now, changing the Prime Minister. I know for UK listeners, that doesn’t sound like a very surprising thing because it happens very frequently in the UK. When I started doing Japan was considered the place with infrequent leadership change. But we’re going through that right now, and whoever gets selected will probably be a very interesting person for investors. We’ve got probably two leaders running, first female leader potentially of Japan. We’ve got people with quite a radical view on deregulation, Japan’s need for greater energy independence. We don’t know who’s gonna be elected, of course, we’ve got no authority to comment, but whichever direction Japan goes under a new leader, it’ll probably be interesting for investors. And it’s worth checking that out.

The third major advantage that we have in the Japanese market is there’s a very large domestic investor base which is currently under allocated to its home market. And that investor base is moving as we speak, domestic large pension funds are increasing their allocation to Japanese equity. Many of these are the largest investors in the world, Japan government investment plan, Japan post bank. You may not think of these as dynamic investors, but they have huge pools of cash, which are currently mostly invested in Japan government bonds. That is a natural long-term incremental driver of the Japanese equity market. And we work with 23 of those institutions. We know something of what they want to do, and that is an opportunity which no other developed market can have. A large incremental returning domestic investor with serious intentions about investment. Those are the big opportunities of our market.

JM: Richard, I can’t thank you enough for coming on today.

RK: Thank you very much. Great to speak with you.

SW: Comgest Growth Japan is a concentrated portfolio of only 30-40 high quality long-term growth companies that are either head-quartered, or carrying out their predominant activities, in Japan. The team has an unconstrained approach and has demonstrated good active management in a region which has, in the past, made it difficult for managers to show their edge. To learn more about the Comgest Growth Japan fund please visit fundcalibre.com