298. Why Japan is due for a review of investor perception

25 January 2024 (pre-recorded 23 January 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.

[NTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. This weeks interview provides a comprehensive and informed exploration of the Japanese market — including insights into the recent Tokyo Stock Exchange reforms, weak yen prices and what this means for investors in the year ahead.

Joss Murphy (JM): I’m Joss Murphy, research analyst at FundCalibre, today I’ve been joined by Richard Kaye, manager on the Comgest Growth Japan fund. Hi, Richard, how are you?

Richard Kaye (RK): Hi, Joss. I’m fine, great to see you. And thanks for your time today.

JM: Great to hear.

[INTERVIEW]

JM: The Tokyo Stock Exchange, Richard, is taking steps in the right direction on some long overdue reforms. Can you tell us more about these reforms and what it means for investors?

RK: Sure, thank you. As you correctly point out, the Tokyo Stock Exchange has been working actually for a number of years now to improve governance: things like the stewardship code, things like the governance code, things like new categorisations within the exchange, with the higher categorisations rewarding shareholder friendly companies. And then, most recently, the threats to de-categorise or even de-list companies, which, for example, have consistently low price [to] book ratios because of low return on equity. Those are various moves that the exchange has taken over a number of years. And I don’t think anybody could argue that that’s a “bad thing” – we all favour improved shareholder engagement.

I take a slightly different view, however, from the consensus on this.

I think that it’s difficult for an exchange to drive fundamental change. Markets do that anyway, that’s what markets are meant to do! They price down companies which don’t agree with shareholders. And of course that’s happened in the Tokyo markets, which happens in any stock market. We therefore think that you need to look for real change, which is probably driven from inside a company itself. Examples like Hitachi or Toyota Industries which is a great company making components for Toyota car company and has changed the way that it governs itself. Those are examples of real change driven by the company itself, not really by top-down elements.

JM: And, Richard, Japan has a long history of deflation and while we’re starting to see some mild inflation — it’s slowed for the second month now — do you expect to see this continue in 2024? What is the inflation story in Japan today, and does it present any opportunities?

RK: Thanks, Joss. It’s a super timely question because today — January the 23rd — was the Bank of Japan’s monthly monetary committee announcements. And sure enough, just as your question suggested the Bank of Japan says inflation is slowing, we’re not going to change monetary policy. They’ve been saying that for something like three years now, and yet you wouldn’t think it because an awful lot of strategists say, inflation is coming to Japan and monetary policy change is coming to Japan. And inflation stocks like banks and real estate have done awfully well in Japan for two years now.

As your question implies, inflation is slowing. The Bank of Japan knows that better than anyone. They said it again today. And in fact, the data that we look at from the companies we talk to on a daily basis suggesting that price hikes are awfully difficult in Japan, that wage hikes are actually not as big as the public data have often suggested, those data suggests that there is no structural inflation story.

We therefore think that the market leadership of Japan is set to change a little bit. All of these inflation-geared stocks which have driven the Nikkei index for an awfully long time, probably pause or even go down, and what I call “real companies” with “real earnings” that have been rather sidelined in the last few quarters, those things probably drive the Tokyo stock market higher, I humbly suggest.

JM: Certainly makes sense. And, Richard, what does a weak yen mean for investors? Is now the time for foreign investors?

RK: Unequivocally, yes. In fact, if there’s one thing I want to take from this discussion Joss it is that the yen’s situation is highly irregular. And it relates to three things.

One is what you just asked me about inflation and monetary policy, and specifically the sovereign yield gap — the difference between Japan government bond yields and primary US government bond yields — that difference has narrowed significantly in recent months. And that’s why the yen has actually stopped falling and even started to go back a bit. It’s a very important point I think for folks who are not yen-based investors, whether they’re sterling or other currency-based investors.

The second thing is that the weak yen obviously is a what the Americans call a ‘no-brainer’ reason to buy export stocks like car companies in Japan. But as soon as the yen goes the other way, those trades get difficult. Conversely, there’s a very strong statistical correlation between a strong yen and small caps in Japan, and we have over a 30% small cap weighting in our Japan fund for that reason. We think that the yen weakness will actually abate and reverse, and that’ll be terribly good for small caps whose stock specific story is often very strong.

The other thing to say about the yen is a lot of people assume the weak yen is good for Japan because they can export more televisions and cars and things. That’s actually wrong because Japan imports an awful lot of stuff, from oil to salmon, believe it or not. You think they have enough fish in Japan, but they import salmon to labour because a lot of production for Japanese companies is done overseas. And the weak yen has actually been a negative for the Japanese economy. Policy makers will fight against it.

So, for all those reasons, I expect a bit of a sea change in the yen. I think it’s an important point for people listening to this discussion. And of course people who are denominated in sterling for their returns, they can probably expect quite a nice lift for the reasons we discussed.

JM: Well, Richard, it seems like quite a sizeable opportunity then.

RK: I think so.

JM: Semiconductors and their role in AI have been hot topics in the last 12 months. You have exposure to semiconductors in this fund through Shin-Etsu Chemical and Lasertec. Have they seen a boost from AI or do they offer something else? Tell me about these please.

RK: Yeah, thank you, Joss, it’s a huge topic. In fact, you mentioned Shin-Etsu and Lasertec; we’ve actually got about seven semiconductor stocks in the fund. They represent something like 20% of the market cap of this fund. And it’s a story that keeps on giving!

Japan actually added more semiconductor capacity than any country in the world last year. People don’t realize that. They always think that semiconductors are all about Taiwan and TSMC [Taiwan Semiconductor Manufacturing Company Limited] or Samsung, or, of course, Intel. But actually no: Japan was the biggest semiconductor builder last year. Partly because TSMC is throwing up two factories in the south island, partly because Micron [Technology] announced a big DRAM [dynamic random access memory] memory factory in Hiroshima at the G-7.

But the point is, all that stuff is happening in Japan and the companies you mentioned, like Lasertec and Shin-Etsu and a bunch of other companies that we hold in this fund, make the stuff that goes in them from wafers to inspection tools. And a lot of these devices and materials, they are the only people in the world who can make it. And so they’re having a fantastic time right now.

Lasertec, for example, has had over a 50% absolute share price recovery in the last few months because of the orders momentum coming from this capacity addition. Yes, the semiconductor story is very much a Japanese story and yes, our fund is unashamedly exposed there.

JM: You mentioned you have seven semiconductor companies. Most people today associate this purely with AI. Is there more at play with these companies?

RK: Yeah, there is Joss and thank you so much for raising that. Seven sounds like a lot of companies to have in that one theme, but actually there’s a lot more going on than AI. There are very cyclical phenomena happening in the semiconductor market, which are also very important and which will support earnings for our companies over a number of years. Things like the recovery of DRAM memory prices, for example. Samsung has been very explicit on this.

Things like a recovery in semiconductor spending on the equipment, which, for example, TSMC in its Friday earnings was very explicit about. And, of course, semiconductors are used in things other than large language models; they’re used in cars, they’re used in iPhones and each of those end markets is also going through cyclical recovery.

But very importantly, the seven companies we have are doing unique stuff within all of that. They’re making inimitable technology. We have, for example, an inspection company that inspects something that nobody else can look at. They’ve got a particular light source and lens combination and algorithm feedback systems, which no one else has been able to copy in any country, and which is vital for designing the smallest type of chip. I could bore you with this in some detail because I’ve looked it for over 20 years, but Japan is replete with companies like this. And like I said, we’ve got seven of them in our portfolio, which capture these long-term trends, but do so in a very unique way.

JM: And Japan’s Nikkei was Asia’s best performing market in 2023, touching on 33-year highs. What led to this success and do you see that momentum continuing into 2024?

RK: Take the second question first. Yes, I see the momentum and I think it’s perfectly plausible that the Nikkei goes back above its all-time highs. Remember Joss, that Japan is the only market in the world — among developed markets, big ones — that hasn’t gone back to its all-time highs. We had the Lehman Crisis, which knocked down FTSE or S&P, but then they all came back again. Nikkei never came back after the 1990 crash, and now it’s coming back.

It’s a huge moment here in Japan and retail investors, we have a big presentation on Saturday to a bunch of retail investors actually, —yeah, we work on Saturdays in Japan — we don’t work other days! That’s all because of this focus on the Nikkei’s recovery.

What’s driving it partly is simply the volume of money, that we have one of the largest investor bases in the world in Japan itself, and most of that money is still in cash, in post office savings banks as a matter of fact. And that money’s coming in. It’s coming partly through just people putting their own money into tax-efficient stock accounts, but also institutional investors Joss. We work with over 20 Japanese pension plans that invest in our Japan fund that are typical of this movement of institutional investors back to their market driving this return to historic highs. And remember, this is not what they call a bubble market in Japan, it’s only 13, 14 times on earnings. A lot of great companies with sustainable growth, as we mentioned at the start, improving governance and capital returns, yes, I think it’s a story that we don’t see in any other major markets that we can enjoy in Japan right now.

JM: Well bring on 2024. The consensus I’m seeing is a bright outlook mid-to-long term, but fears of choppiness, should we see a slowdown. What are the benefits of high-quality, growth companies if markets are challenging in the short term?

RK: The benefits of companies like we hold, high-quality, high-visibility, of growth, speaking our language, speaking to us as shareholders in terms that we understand and often companies where the founding family is still important. You may think that’s a bit weird, a bit nepotistic or a little bit arcane maybe, but actually we found that companies with that sort of management often have a passion about their business because their name is on the label. And companies like that give us much greater stability in times of economic volatility than what I may call more standard cyclical companies. We’ve shown a much greater earnings resistance, I think, in the earnings of our fund companies, in economic downturns than the market average. And we expect that to continue.

There’s an additional kicker, we briefly referred to it in passing; The whole Japanese market for two years has been focused on what I call ‘brain dead’ inflation and cheap yen plays. If those things lose their lustre a little bit, the sort of things we hold, which have been rather sidelined in market attention, those things I think are due for a big review of investor perception.

JM: Richard, thank you very much for your time today.

RK: Thank 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. For more information on the Comgest Growth Japan fund visit fundcalibre.com – and don’t forget to subscribe to the Investing on the go podcast, available wherever you get your podcasts.