231. How Japan’s car manufacturers got it all wrong

Published 29 December 2022 (pre-recorded 24 November 2022)

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.

[INTRO]

Darius McDermott (DM):

I am Darius McDermott from FundCalibre, and this is the ‘Investing on the go’ podcast. Today I’m joined by Matthew Brett, manager on the Elite Rated BG [Baillie Gifford] Japan Trust and the BG Japanese fund. Matthew, good morning. Thanks for taking the time to talk to us. It’s been a very interesting year in markets. Japan has not been immune to some of the difficulties that have gone on in equities and bonds. I just wanted to start, if we may, on what’s happening economically, particularly with respect to the BoJ’s [Bank of Japan] policy of suppressing the yen. How is that manifesting itself in companies and what are you doing about it?

[INTERVIEW]

Matthew Brett (MB):

Yeah, so I think it’s a really interesting time for Japan at the moment because like other parts of Asia, Japan is basically a bit behind where we are in terms of reopening from Covid. So, I went to Japan in September, and you know, everyone’s still incredibly cautious about Covid. But we can see how that closer to home has changed quite quickly. We’d expect that to happen and the economic activity to be picking up, and again, the tourists are only really allowed back into Japan from now. So, we should again see a pickup in activity coming from the tourists returning to Japan.

And in terms of that Bank of Japan policy, what is interesting about it is that when we go back in time, people used to be pretty cautious about the zero interest rate policy because they said, well, look without inflation, it doesn’t make any difference because if you’ve got you know, zero interest rates, but you’ve got a bit of deflation, you’ve still got a positive real rate and it doesn’t really make a difference.

Whereas what we’ve seen in recent times is, as there’s a bit of inflation in the system, that zero interest rate policy really starts to become very stimulatory. And so, in many ways, this is exactly the kind of situation that the Bank of Japan has been trying to get to for many years, of actually having some inflation and a negative real interest rate and starting to try and get the economy going.

Now, the interesting thing looking forward is going to be what happens when Mr. Kuroda’s [Governor of the Bank of Japan] term ends and that’ll be in the spring, and whether they’ll be having another look at that policy at that point and deciding, you know, do we want to keep going at quite this level?

DM: So that weakening of the yen, how’s that affected companies? I mean, imagine it’s good for exporters and the like.

MB: Yeah, I mean we see at the moment some, what to me seems slightly ill-thought-out comments around, you know, is a weak yen damaging to Japan? Because, you know, I invested through the global financial crisis, and at that time you had a strong yen, and it was really, really damaging to the Japanese exporters. And if we’re going into a kind of tougher economic environment, personally, I’d far prefer to be going into that with a weak yen and that’ll help all the manufacturing businesses and then that feeds through the rest of the economy. So, in many ways I don’t see the weak yen as a particular problem.

And the other thing we should probably say is that when we go back to that strong yen period, the yen was really strong against everything. Whereas at the moment, although we’re talking in terms of a weak yen, in some ways what we’re really talking about is a strong dollar. And so maybe the challenge will come look, if we have a tougher economic background, you know, actually is it going to be experienced by the US manufacturing sector rather than as it was the last time by the Japanese sectors? So, you know, time will tell, I guess.

DM: Time will tell. So, another phenomenon that’s taken place in 2022 has been [the] fairly dramatic underperformance of small and mid-sized companies, certainly in the UK, certainly in the US, certainly in Europe. Has that been the case in Japan? Because I know both your trust specifically, and the fund, does have access to mid and small companies.

MB: Yeah. You’re absolutely right. I mean, essentially the smaller, higher growth type of businesses, particularly anything that’s not reached profitability yet, have been the kind of things that have really been sold off quite aggressively. And I think that that is a pretty global phenomenon. The slight difference that we have in Japan, is the prices of a lot of these things didn’t go up before they went down to the same extent. So, when we look at the valuations of a lot of these small high growth things, you know, we’re pretty excited. And so, as a result, we’ve actually been taking the gearing on the Trust up a bit and buying more of these things at what we hope is a good time.

DM: And what sort of level have you taken the gearing to?

MB: Well, so the [Baillie Gifford] Japan Trust, the net gearing at the moment’s about 17.5%.

DM: Okay. So that’s sort of at the upper end of where you tend to get to. So that … I’m looking at an excited Matthew Brett here this morning, who sees valuation opportunities in some of those preferred names. So, you talk about some of the gearing there, but you appear to have been buying and selling quite a few names in recent [times]? Would you like to give us a little flavour, not necessarily by name, but by sector and which areas have been either leaving or reentering the portfolio?

MB: Yeah, so we’ve found, you know, amongst kind of high growth, small cap area, several different opportunities recently. So, for example, Oisix [Oisix Ra Daichi Inc.] is a meal kit, delivery type of company. We’ve also bought Demae-Can [Demae-Can Co.,Ltd] which does food delivery. So, in these kinds of digital transformation type of opportunities, a lot of those have been priced down quite aggressively. But we think they still have a great opportunity ahead of them.

We’ve also been buying and adding to companies in the cosmetic space. I talked at the start about how the reopening in Asia is behind where we are. And you know, tourism is a big part of those companies’ demand; Chinese tourists coming to Japan to buy skin cream and bring it back. And a lot of people buy cosmetics at airports as well. And all of that has just still not really got going yet. But when we take a long view, you know, it seems absolutely inevitable that those things will get going again and we should see the profits recovering. So those are two of the areas we’ve been finding opportunities in.

DM: And what about Nintendo, a very well-known stock to Western consumers? How … is that one that you currently own? Or is that one that you’ve added or in fact let go?

MB: Yeah, so Nintendo is one that we’ve held in the majority of [the] team’s funds for a long time. The [Baillie Gifford] Japan Trust has tended to have smaller gaming companies. But recently we decided to take a holding in Nintendo for that as well. So yeah, we own Nintendo across all of the larger cap funds that we run. We don’t hold it for [Baillie Gifford] Shin Nippon just because it’s too big. And I think, you know, with Nintendo, you know, the real excitement here is just the sheer quality of the intellectual property [ie.], you know, Mario, you know, their skills with the software side of things, which we think gives it a lot of durability

DM: That strikes me as being one of the companies that would’ve been a beneficiary of the ‘working-from-home-and-spending-more-time-indoors-and-less-time-outdoors’ part of Covid. So, I think is that a challenge they face … reopening? Will their product be used less, or are they such an engrained name within global gaming that it doesn’t make any difference?

MB: Well, I think you’re absolutely right. You know, all gaming companies had a bit of extra demand from Covid. The difference with something like Nintendo is because it’s mainly selling consoles and package type of software, what it means is that the question is: do people buy it or don’t they buy it? – once they’ve bought it, it doesn’t matter as much as for some types of gaming how much they’re using it. So, in that sense, although the covid, you know, has been a slight positive, and coming out [of lockdown] will be a slight negative, I think the bigger point with Nintendo is just the sheer durability of the software franchise and what they can do with that in the long run.

DM: Maybe that question might give it away that I’m not a gamer and <laugh> hence didn’t fully appreciate where Nintendo’s role [was] other than obviously a very, very high-profile brand. Let’s talk about car manufacturers. An area that you have been invested in in the past, but no car manufacturers today?

MB: This is quite a big change for us. You know, [in] the past 15- 20 years, we’ve never had more in car companies than the index as a whole. So, you know, in that sense we’ve never been huge fans of the car industry. It’s quite a tough industry. But we have found individual companies that we’ve liked. And those have included things like Subaru, which has the very good all-wheel drive type of technology, very popular in America and in snow areas. Also Mazda, which has had the sky active engine technology, which are high compression, very efficient engines. But basically, we’ve come to the view that the world is changing, and we need to take that into account. And what we’re seeing now is that pure battery electric vehicles are reaching, in our view, a point of adoption where we’re kind of at that J-curve point, where the adoption now could grow really fast.

And when we take a step back and look at those vehicles, we just see them basically as being a better option for many cases. I mean, they’re faster; they’re cheaper to run; they’re simpler to build in the end; and they don’t have any emissions out of the tail pipe because there isn’t one.

Now obviously the catches with them are, they do take a little while to charge up and you’ve got a range limitation, but both of those two problems are becoming increasingly diminished now. And we just think basically that the Japanese, because they focused – both Subaru and Mazda use Toyota Motors hybrid type of technologies – we just think that they have gone down the wrong technology path.

DM: So more around the hybrid path rather than the total EV [electric vehicle]?

MB: Exactly. And of course, they’re working now on bringing EVs to the market and they’ll succeed in doing that, but they’re now quite a long way behind where other people are. And in the UK of course, you know, we see a lot of Teslas around. And we see now a few MGs, which is now a Chinese brand. What we’ve not really yet seen is the sheer number of lower end electric vehicles being produced on scale now by Chinese companies. And some of those you’re able to get now a battery electric vehicle for equivalent of about five thousand dollars. And those have yet to kind of reach the European market. But you know, we just think all of this could be very disruptive and ultimately it could be a bit of a blood bath for the traditional automakers.

DM: It sounds like the choice of the hybrid route has been the real sort of … maybe mistake or error in judgment by the Japanese companies. I would’ve thought of them as very technologically advanced and at the forefront of some of these sort of high tech areas? That’s what I think about Japan.

MB: Well, and I think that’s right. And of course, what they saw beyond hybrid was fuel cell vehicles. But you know, hydrogen fuel cells, they do have some issues and particularly around the safety and so on of storing the hydrogen. And this is now looking like a technology – of course, it will be of value maybe for larger vehicles – but for domestic cars, it just looks like battery electric is going to be the future for quite a while. And unfortunately, yeah, we just think they’ve gone the wrong way there. And is perhaps kind of, it’s a bit like you know, in the past, we used to invest a lot in copier companies and when screens improved and connectivity improved, and everyone moved on to iPads…you know, it’s not that Canon doesn’t exist anymore, it’s just no longer got the growth profile that it used to. And we’ve not held that for years. And in the same way with the car companies, we’re not saying, you know, any of these companies are going anywhere soon, we just think we can do better in terms of growth elsewhere.

DM: So, just finally then, we’ve talked briefly about the gearing – and this is one of the differences between an open and a closed-ended product where you have that lever to pull where you see those valuation opportunities, and you’ve touched on that – but another function, I suppose, or an output of closed-ended companies is the ability of shares to trade slightly above the net asset value or indeed below, known as a discount. Not unsurprisingly in 2022, when most assets have been out of favour, the Trust has traded on a bit of a discount. Well, that appeared to have narrowed in October. Was that just a sentiment change, or has the board actively started buying back shares – another mechanism that the investment trust boards have to buy their own shares back for cheaper than they know the net asset value to be? And that is accretive to shareholders. Is that what’s been happening or is this just Japan’s back in favour and hence the discount has narrowed?

MB: Yeah, so I think it’s kind of in many ways…It’s all of those factors have been in play. So, you know, the Trust in the past has issued some shares when the Trust is traded at a premium to NAV [Net Asset Value]. And then more recently, as the Trust has been at a discount to NAV, the board has bought back some shares. But then over the past kind of month or so, effectively I think we’ve just seen, you know, more buyers than sellers. It’s not being driven by aggressive buying back from the board. It is being driven by effectively people being prepared to pay a higher price for the shares. And you’re right, that the discount is now closed into a kind of bold single digit type of discount, well under 5% at the moment.

And I think one of the features of the [Baillie Gifford] Japan Trust in particular is, it does have quite a stable shareholder base. So, actually, the amount of kind of turnover in the shares relative to its size, is not what it would be if it was a kind of more conventional listed company. And I think that also perhaps has had a bit of an effect, that the discount perhaps moves around more than you might think, you know, based on whether there’s slightly better sentiment or slightly worse sentiment. But yeah, currently you’re right, the discount has come in a bit. Yes.

DM: So, in summary then you’re pretty positive, [the] gearing’s at the upper end on the Trust, which suggests that you are seeing better value than on a normal year. And even though it’s been a tough year for equities, you think Japan’s well placed going forward?

MB: Yeah, I think that’s a good summary, and also the Trust is … the board’s decided to, to propose an increased dividend again this year from 6p up to 9p so, you know, a 50% increase in the dividend. And that just reflects the fact that, you know, the underlying holdings have been growing their dividends over time and that’s coming back to the shareholders.

DM: Matthew, thank you very much. If you’d like to get more information on the Baillie Gifford Japanese fund or the Baillie Gifford Japan Trust, please do visit FundCalibre.com.

MB: Thanks, Darius.

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 the time of listening. Elite Ratings are based on FundCalibre’s research methodology and are the opinion of FundCalibre’s research team only.