Japan Growth Q4 investment update

As with any investment, your capital is at risk. Past performance is not a guide to future returns.

Alison Henry (AH): Hello, and welcome to the Japan Growth Q4 update. I'm Alison Henry, an investment specialist, and I'm joined today by Donald Farquharson, head of the Japan team and lead investor on this strategy. Welcome, Donald.

Donald Farquarson (DF): Thank you.

AH: As a reminder, we take a flexible approach to investing in a concentrated portfolio of the best growth companies in Japan. The plan for today is to talk about performance, positioning, and outlook. But before we get into that, I'd like to ask Donald about the macro environment, as 2024 was an unusual year, reflecting the corporate governance reforms, an unprecedented wave of them, and also divergent monetary policy. So, Donald, what are your views on this, on this macro backdrop, and what implications does it have for the portfolio?

DF: Well, clearly, the backdrop was taken very positively in 2024. For the market, it was up about 20 per cent in total return. For a yen-based investor, for a dollar-based investor unhedged, roughly half of that was lost on the currency. But it was a strong year. For our strategy, it was good in absolute terms, but obviously not good or less good in a benchmark relative term. And that was particularly true in the final quarter of the year for reasons I hope we'll go into during the course of the call. The top-down factors, you've mentioned some of them. The weaker currency, that's continued to benefit some of the lower margin export-oriented businesses. Rising interest rate expectations with the Bank of Japan acting on a couple of occasions during the course of the year. And also, corporate reform. And I'd like to get the chance to highlight some of that as we see it played out in our portfolio.

AH: Moving on to stock-specific performance, the strategy underperformed over the quarter and Shiseido and Unicharm were two detractors. Is there any correlation between the two?

DF: Well, they're different businesses. Unicharm makes sanitary products. And Shiseido makes prestige cosmetics and skin care. But there is a common thread there. And that is that they both have significant exposure to China. For Unicharm, that's 10 to 15 per cent of sales. For Shiseido, it's bigger, it's about a quarter of sales. They face slightly different problems. In the case of Unicharm, it's actually been performing pretty well, taking share in most categories but had a weak period in a very competitive babies, nappies market. For Shiseido, it struggled a bit for some time. It's been a very difficult market in China. They're seeing consumer down trading and also suffering a bit from more competition. In terms of the action against that weakness, we added to Unicharm at the end of the period. And in terms of Shiseido, we had an update call with the new CEO and came away from that still convinced that they can recover their position in the prestige end of skincare and that they can also recover margins.

AH: Thank you. Another reason for the underperformance over the quarter was that we don't own the automakers and the megabanks. Any thoughts on their recent momentum? Is it sustainable?

DF: Well, for the automakers, there wasn't a lot of momentum up until the final quarter. In fact, the automakers had marginally underperformed up to the end of the third quarter, but ended the year with a very strong quarter. And Toyota Motor, the largest company in the market and the largest automaker, was the biggest single detractor of performance. And that's on the back of strong results, which I think in large part are fuelled by the weakness of the currency, but also by share buybacks that they are conducting. Now, with Toyota, we're concerned that it is a cyclical business and it is already earning the highest margins that it has generated ever. So, it is very, very profitable. We don't think that's sustainable. And we don't think that's sustainable because we're starting to see a lot more competition from the Chinese. They've established a very strong and leading position in battery electric vehicles, but they're also encroaching much more in some of the growth markets of the Japanese OEMs, most notably in Southeast Asia. So, that's the automakers. The banks, here we're seeing rising valuations on the back of rising interest rate expectations. And here we're quite cautious because if you look at the banks, loan growth has always been quite slow. We don't really see that changing an awful lot, largely because of very substantial, about a trillion yen of cash deposits on companies' balance sheets. So, there isn't strong loan demand. And in terms of margin expansion, because most banks have about twice the level of deposits as they do loans, it's quite hard for them to price aggressively.

AH: Now, we don't own the megabanks, but we do have financials exposure. And SBI was one of the top contributors over the quarter. I am interested in your comments on that and any other contributors of note.

DF: Yes, I think it's worth highlighting, as you have, that there is quite a lot of financial exposure within the portfolio. MS&AD Insurance and Sumitomo Mitsui Trust are two of the largest holdings. And in terms of the other financials, SBI Holdings is the largest one. So, SBI is Japan's largest online financial service provider. And interestingly, it owns two domestic banks. And in spite of what we think will be much higher growth than the megabanks are likely to deliver, they trade at about a 30 per cent discount to the larger banks. So, there's a valuation discrepancy in our view.

Another stock which performed very well over the period is Recruit. which is the world's largest online job recruitment and information website, Indeed and Glassdoor. Their performance has been extremely strong. They revised up their estimates during the quarter. And at the same time, they conducted a very large or have been conducting a very large share buyback, which was announced earlier in the year, $4 billion.

AH: And I know you reduced Recruit, taking some of the profits there. And you mentioned earlier that we added to Unicharm. Any other additions that you would like to comment on?

DF: Yes, you're right. So we added to Unicharm. That is probably at a 30 per cent discount now to its long run average. Shift was another company that we added to. It's an IT consultancy and software, business software assurance company. Here, the shares have been quite weak as it has gone through a period of restructuring. That restructuring seems to be successful as borne out by the most recent results. And it was gratifying to see that actually Shift was one of the best performing stocks and one of the bigger positive contributors to performance in the final quarter. And another company that we added a bit to where the shares have been weak was Money Forward, which designs cloud-based business software. And it continues to grow extremely strongly. And at the same time, we like the fact that it is restructuring its business and improving the focus onto the core cloud software.

AH: Interesting to hear about Money Forward in the context of corporate governance reform. It sounds like there's a lot to be excited about in Japan just now and for the Japan Growth strategy.

DF: Yes, and I think that the market has taken this idea of corporate reform as being only about poor businesses becoming a little bit better. And I think it is worth highlighting that a lot of the companies that we own in our portfolio are conducting reform, Money Forward being an example. Another would be Sony, which is going to spin out its financial services during the course of this year. So, corporate reform doesn't just apply to the weak. And also, when one thinks of capital management, greater capital efficiency, we're seeing that in terms of the share buybacks, the likes of Recruit, Sony and SoftBank are conducting [buybacks] and we're encouraging some of the other large cash hoarding businesses that we own also to conduct share buybacks. And I think we've made this point before - high growth businesses have devalued an awful lot and they are very receptive to positive surprise and so we are getting that coming through in the example of Shift that I made, but also in some of the bigger holdings like Rakuten. So there's a lot to be excited about, a lot. And I think that the sort of structural growth opportunities that we primarily are invested in have been overlooked during a period when cyclical growth has been quite strong. But as that diminishes, we're already starting to see that in terms of the prospective growth rates of our portfolio relative to the market. Earnings growth over the next three years is reckoned to be 1.5 times that of the market.

AH: Thank you, Donald. That's a very positive note to end on and thank you for your time. So, to recap the main points. The macro backdrop has been a headwind for the domestically orientated portfolio and it's helped boost large-cap cyclical names that we do not own. However, we believe a shift from these cyclical names into more structural growth is imminent so it's only a matter of time before share prices follow. We hope you found it helpful today. Please get in touch if you have any questions and we look forward to seeing you next quarter.

Annual past performance to 31 December each year (net%)

Annualised returns to 31 December 2024 (net%)

Source: Revolution, Japan Exchange Group. US dollars. Returns have been calculated by reducing the gross return by the highest annual management fee for the composite. 1 year figures are not annualised.

Past performance is not a guide to future returns.

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