Investing in Japan: from deflation to innovation

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Hello, I’m Chris Salih, investment research analyst at FundCalibre, and today I’m delighted to be joined by Thomas Patchett, investment specialist for Japanese equities and product specialist on the Elite Rated Baillie Gifford Japan Trust. Thank you for joining us today.

[00:15] Thank you very much.

Let’s start with what’s been going on in terms of the turnaround in Japan. A lot has been made of the improving corporate governance being a major factor behind its sort of change in fortune in recent times. Could you maybe tell us what has changed and how this affects both companies and investors going forwards?

[00:36] Yeah, sure. No, it’s a good question. It’s one that we’ve been asked quite a lot of recently. The corporate governance reform is an ongoing narrative that has been associated with Japan for decades now. Back to Koizumi, but then Abe, Prime Minister Abe, Abenomics and third arrow of structural reforms. There was the stewardship code, the corporate governance code, and their tri-annual revisions and more recently the TSE initiatives. And this is whereby the Tokyo Stock Exchange has requested that companies that trade below book value, and that’s almost half of the market, half of the TOPIX that trade below book value, they have been asked to come up with measures to lift their corporate value. And there’s a lot of low hanging fruit here within Japan for improvements because many companies have excess cash holdings, inefficient capital allocations and cross shareholdings that collectively dilute their returns and result in this low multiple. Now, the market has viewed this quite favourably because they see this action or initiative, as a catalyst that will help address the issues that have suppressed valuations of Japanese companies for so long. They are viewed as providing a catalyst to a rerating or will cause a rerating of Japanese equities.

I mean, obviously Japan for three odd decades has had concerns over the economy, Japan-ification amongst many other things. I mean, what has happened more recently is Japan has sort of finally moved from a deflation environment to one of mild inflation. Is this likely to be sustained? And, and essentially what are the benefits to the economy? I mean, inflation over here is not, obviously the levels we have are not that welcome. Maybe just give us an insight into what it is in Japan and perhaps why it’s more welcome and more sustainable there.

[02:41] Yeah, sure. I mean, it’s hard to tell just how sustainable it will be. It’s looking like it has become a little bit more ingrained within society. The headline inflation number, to put it in context, is about 3% versus I think 6.7% here. So it’s still low relative to other developed countries, but very, very high relative to their history. It would probably be a little bit high if it weren’t for government subsidies and a few other factors, but we’re still seeing wage inflation and lots of regulatory bodies pushing through requesting higher prices, higher wages for their members. I think if we were, if Japan as a country were to exit deflation, that could provide a huge boon to the economy, creating that kind of virtuous circle. Higher wages could result, should result in higher consumption; that would allow for higher price rises and greater corporate profitability, which could drive further higher raises in wages and the likes. And so you do have this kind of virtual circle.

So, looking to find of a balance of trying to find sort of mild inflation to sort of, to the point where the consumer is still engaged and doing well, accepts price rises, et cetera, but is sort of in a position that’s strong enough to still take those on board in terms of boosting the economy.

[04:04] Yeah, and it is an interesting point because there’s a book called The Price of Time by Edward Chancellor, and he argues that it’s not higher rates that that should cause concern or be an issue to worry about. It’s actually free or over easy money for too long, which is of course, what Japan has had for a lot longer than many other countries. And so shifting from that environment where the cost of cash is free to a much tighter environment could also cause some friction. And if you take mortgage rates, we’ve all experienced that here, where we’ve seen a huge bump in our mortgage rates from one month for the next with the same house. In Japan, you can still take out a mortgage for 20 basis points. So you know, deeply kind of negative real rates there. And so, if things were to shift, purses could have come under a lot of pressure.

I wanted to turn to a specific couple segments of the market, which was the more smaller mid cap sector, which is an area you guys sort of delve into to a strong degree. That hasn’t had the tailwinds that perhaps some of the larger companies have had. Maybe just talk me through the segment in terms of, you know, how cheap are they now? Are there any specific catalysts you’d look for for areas to start performing and, you know, are there a couple of companies that perhaps are outliers? Just give us a bit of a view on where, where you see those particular segments.

[05:34] No, I think it’s a good point. I think we have seen a lot of funds flow into Japanese equities from international investors, and the majority of those funds have gone into larger, more liquid names. Companies assume to be a better purer play on Japan Inc. and some of the broader macro narratives that are supporting the asset class at the moment, which is leaving whole parts of the rest of the market uncovered, unloved, under-appreciated. So we’re finding a lot of opportunities in a range of different industries of businesses that continue to deliver strong growth, yet are trading at multiples less than the market. So just to give you few examples there’s a company called GMO Internet, a one and a half billion dollar company that provides internet infrastructure tools, so hosting security finance, the brick bricks and mortar, the picks and shovels, if you like, for the internet within Japan. And it is a glue, it is a leader, it is dominant within that industry, yet it trades at one times price to sales, which is less than that of the market, despite the fact that it’s been growing at double digit rates on a compounding basis for the past five years.

There’s another example as well, which I think is particularly relevant given what we’re seeing in AI, a company called Cyber Agent this is slightly bigger, two and a half billion dollar company. Cyber Agent is probably one of the companies that is embracing artificial intelligence more than most within Japan. And they are doing so within online advertising, digital advertising, creating AI-generative banner ads which are tailored to the individual user viewing that particular website at any point in time. That technology could allow them to change the economics of advertising in an industry which is still predominantly offline. This company has been growing at an even faster rate than GMO Internet, it’s been growing at 15% compounded for the past three years, yet trades on a multiple that is half that of the market. And then the list goes on – I could come bore you for the rest of the day with other examples of Japanese companies that are doing pretty phenomenal things yet are unappreciated by the rest of the market! And given the growth rates that a lot of these companies are delivering, we don’t necessarily, or you don’t necessarily need the market to rerate these stocks in order to make a significant return. But of course a rerating, a higher multiple would obviously supplement that upside. When that will occur is difficult to tell, but I think once investors look beyond some of these macro factors and start to discriminate on an individual level, that’s when some of these companies should come to the fore.

So, just a couple of quick follow ups from that. Firstly, so you kind of answered the first one there in terms of being happy to be patient with these companies. Secondly, in terms of M&A activity is that a concern in Japan, like it is in other parts of the world with small caps that are sort of lowly valued?

[08:49] No, I think this feeds into the broader corporate governance piece if you like. Japanese companies are becoming more proactive, more willing to engage, and we’re starting to see a lot more activity in terms of M&A, so that could bring the opportunity to life a lot more so, and the government are far more open to this as well. So it’s becoming a very interesting market for activism and given the anomalous pricing that we’re seeing in terms of high growth rates from companies trading at very, very low multiples, Japan is now the second largest market for activism after the US. So it is within the target sites of a number of investors because of those really attractive characteristics.

It would be remiss not to look at some of the downsides that have sort of plagued Japan for the last 30 years. Obviously there are a few. Let’s, let’s talk about the most obvious one, which is demographics. They have hit long-term growth or have been a headwind for long-term growth in Japan in the past. Could you maybe just tell us through what the government is looking to do to tackle the challenges of demographics?

[09:59] I think this is a structural issue which is quite difficult for the government to address and deal with. I heard a stat a while back, this is quite a few years back, that every woman in Japan would need to have something like four children just to stabilise the population. So I don’t think this is clearly doable. The population is shrinking, and I don’t think that is going to reverse anytime soon. What’s important here though is that that issue does not pull away from the opportunity that Japan presents as an investment destination for clients. What is often an issue at the macro level can be transferred or transformed into an opportunity at the bottom up level, so there are a lot of companies which we as bottom up investors find, that are turning these economic headwinds into industry tailwinds. They’re turning threats into opportunities. And just one example to illustrate that point is a company called Nihon M&A which is an M&A advisory for the SMEs – small and medium sized enterprises within Japan. Every year by their assumptions, and there are other industry groups that back up these numbers, there are about 60,000 SMEs that need to be sold because they are being run by retiring founders in their 70s, 80s that don’t have any succession plan in place. Nihon M&A conducted about a thousand deals last year, so even if they are grossly overestimating that number, it still represents a significant addressable market, which is only increasing. So that is a wonderful illustration of how this demographic issue can be turned into a fantastic opportunity for some companies that are turning that around and profiting off of that economic issue.

I think there are a whole host of other examples within the automation and internet space as well that should also benefit, as their automated and / or online solutions provide an increasingly appealing alternative to what is becoming an expensive and shrinking pool of labour. So Japan is at quite an interesting pivot point where it’s labour market is becoming so tight and increasingly expensive, where the payback period for investing heavily into an automated solution or an online software provider becomes far less, becomes more appealing. So it is at a really interesting pivot point for the increasing acceleration of digitalisation and automation.

I mean, use the word pivot point. It feels like there’s a pivot point in a few areas in Japan at the moment, but maybe – and I appreciate you are more of a company by company type of investment house – do you have a view on where you think Japanese equities will be in 2024? Do you feel there’s certain sectors or markets that will be attractive in particular? Just a little bit of a view on that please, to round this off.

[13:07] Short term, it’s very difficult to forecast. What provides us with excitement lies further ahead into the future, and this is where I think Japan is incredibly exciting because there are a lot of structural growth opportunities that are probably more unique to the Japanese market than elsewhere. Two examples I would provide would be automation. Japan continues to lead globally in industrial robots. And there are a lot of trends which are accelerating their adoption, be it re-shoring, wage inflation in Japan, but elsewhere around the world, and the improving application of robotic tools that sees them being used far broader beyond the traditional application within the auto sector. And then the other I would give would be digitalisation within e-commerce, software as a service, cashless payments, and a whole host of other areas which remain in their infancy in Japan versus elsewhere in the world. And one example, just to illustrate that would be cashless payments. So in Japan, cash is still king, it still accounts for about 70% of transactions there or thereabouts, which is the polar opposite of the UK and most other developed markets. And there are a lot of companies at the forefront that are capitalising on that; one being LY Corporation, which is behind PayPay, Japan’s fastest growing QR payment provider. This app was designed, created four or five years ago and it already has 60 million users, almost one in two people within Japan use them. Within five years or within the time they’ve been operating, they’ve already to 10 trillion in terms of GMV (gross merchandise value). And I think that speaks to the opportunity here. They are still scratching the surface. They have 1% of the entire market and they are taking share from both cash and credit card, which is the main way people pay if not with cash.

So there are so many companies there that are benefiting from that nascency, from those low penetration rates, which means there’s a lot longer, a far longer run rate of growth opportunity available to some of these companies than there would be to some of their Western peers. That’s what makes us incredibly excited for what the growth holds, in addition to all of those structural growth opportunities as discussed in a previous question, a lot of these companies are now trading at a little to no premium to the market, which makes the upside case even more attractive.

On that note, thank you very much for your time today.

[16:03] Thank you very much.

And if you’d like to learn more about the Baillie Gifford Japan Trust, please visit FundCalibre.com.