A guide to Baillie Gifford Shin Nippon

Baillie Gifford Shin Nippon Trust aims to provide long-term capital growth by investing in smaller companies listed on the Japanese stock market. Shin Nippon means ‘new Japan’, and this trust has historically focused on emerging or disrupted sectors, where the manager sees innovative growth opportunities.

The trust has a strong growth style bias with manager Praveen Kumar targeting companies which look to at least double their value over five years. The small-cap nature of the portfolio means it tends to focus on Japan’s domestic stories.

Praveen Kumar took over this trust in December 2015 – performance was exceptionally strong between 2015 to 2020, but has encountered a number of headwinds since 2021 which have seen small-cap growth stocks fall out of favour. We will discuss these further in the outlook and performance section.

Long-term growth by tapping into the challenges faced by the Japanese economy

Praveen aims to identify smaller businesses that offer above-average growth prospects. He targets companies with innovative business models and the potential to disrupt their industries; those that challenge traditional Japanese practices; as well as companies with strong overseas growth prospects. Sectors which have historically been of interest to the team include Japan’s emerging services industry, which is fast expanding due to government deregulation and corporate outsourcing, as well as technology and healthcare.

As mentioned, the target is for companies to at least double in value over the next five years. Praveen will hold companies that are unprofitable if he feels the sales growth and profitability runway is there in the future. Praveen has worked hard to widen the scope of the portfolio by increasing the focus on sectors where it has traditionally been hard to find growth, such as utilities and food services. A good example is SWCC, which was added to the trust in May 2023. This is a business which was traditionally a manufacturer of electrical wires and cables but has transitioned under new management to become more of an asset-light manufacturer and consultancy business. This is an area of extreme growth, with Praveen pointing to the growth of AI combined with the fact that Japan’s energy infrastructure has not been updated since the Second World War.

The final portfolio currently has between 40-70 holdings, with annual turnover of 19%*. Ongoing charges stand at 0.72%*.

Why now for this portfolio

• Japanese small-cap growth has been heavily out of favour since 2021 – the sector was hammered in the reflationary rally, while the recovery seen in 2023-2024 has been focused purely on large-caps.
• Japanese small-caps are now incredibly cheap – this is despite small-caps producing stronger recurring profits growth in both 2023 and 2024**.
• EV/EBIT on the trust is on a slight premium to the index (12.9 vs.12.5), but the three-year forward sales/earnings growth is well ahead of the benchmark (12.4 vs 8.0). Essentially you are getting faster growth from BG Shin Nippon at a similar price to the benchmark index***.

• Discount of 14.7% is well above the five-year average (-5.1%)****.
• The Yen has started to rebound after significant falls – something which has historically been a very strong tailwind for small-cap growth in the region.
• This sector of the market is helping to tackle some of the region’s biggest challenges – slow adoption of software technology, labour market demographic challenges and cyber security amongst others.

Manager’s View

“There is light at the end of the tunnel and we are confident that light is not an oncoming train! If not now, then when?”

Having seen strong growth from 2015 through to the early stages of Covid, the trust has endured a challenging time since 2021, as a series of headwinds have hampered performance. The largest of these being the fall in the Yen (it has been down as much as 30% versus the US dollar between June 2021 and 2024)^, which has been good for exporters such as large AI companies, electric vehicles, semiconductor related businesses and renewables. By contrast, high growth, small-cap companies have become almost untouchable for investors, despite many continuing to bring in strong sales and grow rapidly. Having been hammered in the reflationary rally, many of these companies have seen little change in sentiment.

Praveen acknowledges there has also been an element of laziness in the market. The desire for some of these aforementioned larger companies has been exacerbated by the growing themes of shareholder returns and corporate governance, which has seen value stocks attract a huge slug of capital.

The result has been the creation of an almost record high valuation gap between re-rated large-caps and de-rated small-caps. Praveen says the anomaly is that many of the latter are still growing at 20-30%, but this is not being reflected in valuations. However, Praveen believes sentiment is starting to turn.

“The last few months have seen things gradually come back into our favour. The US Federal Reserve has come out and said we think it is time to cut rates, while we’ve also seen the yen start to strengthen versus the US dollar. Headwinds are becoming tailwinds.”

Praveen has recently spent five weeks in Japan meeting all the companies within his portfolio. He believes there are three legs to a rally for stocks – the domestic retail investor, domestic institutions (wealth managers/large pension funds) and then finally overseas investors.

He says the key is to be as close to the domestic retailer as possible, as they tend to be canny and spot trends first – something he feels is starting to take place.

“There are two stark trends which stand out. In addition to the valuation gap between small-cap growth companies and large-caps having reached record levels, we also have to understand some of these larger companies are not in fast-growing industries and are primarily export-type businesses.

“There are semiconductor-type companies trading on 25-30x P/Es and it does not make much sense. These sorts of P/Es would apply to internet companies growing at 20-30% each year. You can’t expect that from semiconductors where there is more cyclicality and a capital-intensive structure. Large-cap is getting overextended and that is being noticed by the man on the street,” Praveen adds.

Despite small-cap stocks being heavily undervalued in the past three years, they are demonstrating higher profit growth expectations than large-caps going forward. This dichotomy suggests a misalignment in market valuation that could present lucrative opportunities for savvy investors.

EV/EBIT on the trust is on a slight premium to the benchmark (12.9 vs.12.5), but the three-year forward sales/earnings growth is well-ahead of the benchmark. Essentially you are getting faster growth from BG Shin Nippon at a similar price to the benchmark index***.

Praveen says the small-cap market is as attractive as he has known it in his time on the trust, adding that we are either “at or close to GFC levels in terms of valuations.” He says the trust has traded above 20x at its peak, with the benchmark closer to mid to high teens.

It should be noted that there are valuation gaps between most small-caps vs. large-caps across the globe. However, Praveen does not only believe the discrepancy is stark in Japan but, importantly, these small to medium-sized businesses are the ones facilitating change in the country – allowing them to tackle structural issues, such as software technology, labour market gaps and cyber security concerns.

Examples of small-caps the trust holds which tackle major issues in Japan

A recent acquisition by the trust, this firm does everything related to cyber security, ranging from training to preventative measures – with the exception of making software (which it leaves to its larger peers). In Japan, companies have generally underinvested in IT and that is now increasing at a decent pace – one area where that is stark is cyber security. This firm is targeting the SME market, where the desire is growing.

Praveen says: “No one is offering these types of solutions to SMEs. 80-90% of people are employed by SMEs in Japan. Global Security Experts goes into these firms and has some 200 or so white hackers (friendly hackers) who deliberately try and break your systems down and find the vulnerabilities you need to fix. They also do consulting work to find the best solutions (training, implementation and monitoring). It is a fast-growing business with a dominant position.”

SpiderPlus focuses on construction software. The construction sector in Japan is probably one of the worst in terms of labour shortages – the average worker is over 65 years old. SpiderPlus has their own app, built using its own software – this allows a site manager to track things like taking photos of progress, measurements and managing the whole project (this normally takes 4-5 people). Praveen says it is a simple example of a company which, in its own small ways, makes the construction sector less labour intensive.

Others include Bengo4 – which has created an online platform for those wanting legal advice. It offers free access to a lawyer for individuals (like a LinkedIn for lawyers – it shows cases, pricing and other tools). Another is Infomart. In the food market, when a restaurant owner orders food supplies, they have to deal with a network of almost 20,000 food suppliers and they are using phones and fax machines to do all the administration. This means costs are high and efficiency low. Infomart has developed a cloud-based system and software platform linking restaurants with suppliers. This allows them to check stock and order online, creating cost and efficiency benefits.

Successful companies priced to go bust and the software “knowledge” gap

Praveen believes the opportunities are not only attractive, but there are also certain examples where they simply make no sense. An example is GA Technologies. This is an online real estate company which automates the whole process, ranging from viewings to applying for mortgages through their platform.

He says the firm recently reported strong Q3 results, with sales up 23% and profits up around 75%. “What we are seeing is immense growth, but it is only 0.2x price to sales. I recently met the senior team, looked at the risk and balance sheet and I struggle to understand the 0.2x price to sales figure. The balance sheet is controlled with little debt. If rates go up (which is likely to be nominal) and people stop buying property, we must remember people are still making 6-7% yield in Tokyo (where the company operates). I struggle to see why GA Technologies would have a 44bn yen market cap – it should be closer to 100-150bn.”

Another is Oisix, which Praveen says is like the HelloFresh of Japan. They are on 0.3x price-to-sales despite strong figures. He says: “This is not a loss-making business, it has been consistently profitable for many years.”

Japan is often cited for being a leader in technological advancement, but Praveen says while this may be true for hardware, it has actually lagged behind on the software front. This is because Japan has been quite a closed economy since the end of World War 2, meaning many of the brands are purely domestic.

“You see the software gap when you go to meetings in Japan. Look at the laptops, they’re not slick, they look like clunky briefcases or weapons.”

Much of the software is custom-made and therefore not scalable, but with big players like Amazon and Google knocking at the door, changes are having to be made. He says the likes of cloud-based software tools are becoming more widely accepted and create tailwinds for the likes of Bengo4, Spiderplus and WealthNavi – a robo-advisory wealth management service designed to offer a way for investors to save (the Japanese introduced their version of the UK ISA recently). WealthNavi offers an avenue for savers, particularly younger ones aged 25-45, with a simple risk-profiling questionnaire and a handful of investing options. It has already caught the attention of the banks, with Mitsubishi UFJ Financial Group taking a $100m stake in the robo-adviser.

End of the golden era and slow rise of the yen

Praveen says the past three to four years have been a golden era for many cyclical, capital-intensive businesses in Japan (cars, resources, semiconductors), all of which have seen a boom in profits for larger companies. Ultimately, he feels these larger firms cannot sustain 30-40% growth in some cases, while less capital-intensive  businesses in the small-cap space, which target long-term issues in Japan, can sustain growth of circa 20-30%.

“The realities of life will catch up with these larger companies. Take Toyota as an example – it recently came out and announced record profits but added they expected them to fall sharply from here. The valuations are still tied to past profits.”

AI is a good example of the next phase; Praveen says we will move away from the mainstream winners to some of the enablers as the focus moves to picks and shovels – such as the aforementioned SWCC.

Portfolio activity

Although turnover has remained consistent in terms of underlying numbers (18.2% for the 12 months to 31 July 2024), the portfolio has seen a fair bit of turnover with five new names and 10 complete sales***. Global Security Experts has been joined by the likes of pet insurance business Anicom Holdings, and INFORICH, which is a cost-effective mobile battery provider for charging phones. Gift Holdings and Soracom complete the new buys.

Praveen says the sales have been due to the increased competition for capital in this opportune environment. There have also been some forced sales, through an MBO, poor management actions and a desire to push the portfolio towards proper domestic-focused stocks.

Examples of sales due to poor attempts to scale include recruitment business Outsourcing, which grew aggressively through acquisitions and had a number of accounting scandals which highlighted weak risk-management processes. Another was advertising technology company Freak Out, where Praveen says acquisitions side-tracked the business, turning “a simple growth story into a complicated one”.

Another sale was Snow Peek, a firm which manufactures high-end camping equipment. The firm boomed during Covid, but has since seen a severe slowdown as well as inventory issues.

Performance

Over the past three years, the trust has seen its NAV fall 47.8%, compared with a fall of 27.8% for the Association of Investment Companies Japanese Smaller Companies sector. From a share price perspective, the trust is down 56.1% vs. -33% for the sector. Both reflect the impact of having such a strong growth bias within the portfolio^^.

Longer-term numbers remain extremely strong, with the share price and NAV of the trust up 81.9% and 121.9% respectively over the past decade.

What else do investors need to know?

At 18%, the trust is almost fully geared (it can go up to 20% of the trust) – taking advantage of the number of opportunities and the low cost of debt in Japan.

As expected, the significant headwinds facing the trust have seen the discount widen significantly to 14.7% (it has had an average discount of 5.1% over the past five years)****. The board has introduced a performance tender of 15% of the shares (at a 2% discount minus costs) to be made if the NAV per share underperforms the index (MSCI Japan Smaller Companies) on a three-year view. This is designed to reinforce the board’s view that they remain confident in the trust’s investment style.

Outlook

Headwinds slowly become tailwinds and why you might not get a more attractive entry point

The trust has been through an incredibly tough period. This is through no fault of its own as markets go through cycles and we’ve now reached an excellent starting point from a valuation perspective. Praveen believes we are seeing the beginnings of a change in market sentiment with the yen starting to improve (a strong historical catalyst for small-cap growth) and domestic investors beginning to notice the extreme value on offer in the market.

Small-cap growth has been hammered but this may now be the perfect entry point, as when it rebounds it tends to do so fast and we believe Praveen and his team are ideally placed to take advantage of the companies designed to shape Japan’s future.

*Source: fund factsheet, 31 July 2024

**Source: Nomura Securities

***Source: fund presentation, September 2024

****Source: FE fundinfo, 17 September 2019 to 16 September 2024

^Source: FE Analytics, figures for Japanese Yen versus the US dollar, 31 May 2021 to 16 September 2024

^^Source: Association of Investment Companies