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Going off benchmark for Japan returns

Investing in the asset class is different from investing in the Japan economy, according to an FSSA IM portfolio manager whose Japan fund has soared above its benchmark and sector.
Sophia Li, FSSA Investment Managers

Compared with the rest of the world, the Japan equity market has been underperforming, with the MSCI Japan Index returning just 35.06% on a 20-year cumulative basis, versus the 152.17% performance of the MSCI All Country World Index, according to data from FE Fundinfo.

“[Market underperformance] has a lot to do with the macro-environment in Japan. The Japan economy hit its peak during the 1980s, and after that GDP growth has been pretty anemic,” Sophia Li, Hong Kong-based portfolio manager at First State Stewart Asia (FSSA) Investment Managers, told FSA in a recent interview.

Because of the country’s macro characteristics, global investors often treat Japan equities as a macro trade, Li said.

“They buy Japan stocks when the yen is weak and when the global economy is good. That also explains why the asset class tends to be cyclical,” Li said, adding that the Japan index is also dominated by huge cyclical companies, which include banks and car manufacturers.

Away from the familiar

Li, who is the lead manager of the First State Japan Equity Fund, aims to invest in high-quality, non-cyclical companies that she believes should outperform the broader domestic market.

Her fund has far out-performed its benchmark and the category average over the trailing three years (see chart below), according to FE Fundinfo. Her top ten holdings are dominated by lesser known Japanese businesses.

“Japan has a deep and wide investment universe. What is important for investors to understand is that investing in Japan equities is completely different from investing in the Japan economy,” Li said.

According to Li, she avoids cyclical companies, such as the huge banks, car manufacturing firms, utilities and energy.


Top 10 holdings of the fund vs its benchmark

First State Japan Equity Fund

MSCI Japan

OBIC Co. 5.8 Toyota Motor 4.53
Kao Corp. 5.5 Sony Corp 2.62
Monotaro Co. 4.3 Softbank Group 2.16
Welcia Holdings 3.8 Keyence 2.1
Benefit One 3.8 Takeda Pharmaceutical 1.73
GMO Payment Gateway 3.8 KDDI 1.63
Keyence Corporation 3.8 Mitsubishi UFJ Financial 1.59
Recruit Holdings 3.7 Nintendo 1.49
Hoya Corp. 3.6 Recruit Holdings 1.28
Fast Retailing 3.4 Honda Motor 1.27
Source: Fund factsheets. As of 30 April 2020.

The high-quality companies she seeks have a dominant share in a niche industry, strong pricing power, invest heavily in research and development and have an asset-lite business model or little reliance on hard assets such as factories, she said.

An example is vision provider Keyence, which develops automation sensors used in factories and warehouses globally. At the end of April, the company accounted for 3.8% of Li’s fund, according to the fund factsheet.

“Even though it is classified as an industrial company, it does not have its own factory. What Keyence does is design the product themselves and outsource the production of the final product to third-party partners in Japan.

“Given that the business model has a low fixed cost burden, the company can heavily invest in R&D, which helps them become innovative in the industry.”

Entrepreneurship important

Li noted that she also prefers companies with entrepreneurial management teams who are quick at identifying mistakes and are willing to take risks when opportunities arise.

“This may be true across all markets globally, but it is really important in Japan, because most companies in Japan tend to be relatively slow and very conservative,” she said.

One example is Olympus, which was recently added to the Japan strategy, according to a recent client note. While Olympus is the largest medical equipment company in Japan, with 70% global market share in gastrointestinal endoscopes, the investment team was previously concerned about its management team.

“Despite its strong franchise, [FSSA] has been concerned in the past with its complacent culture and low profitability,” the note said. “However, we believe there are positive changes underway: Olympus has replaced the majority of its senior leadership team with externally-hired managers, which should bring fresh new perspectives.”

After the reorganisation, Olympus has been investing in China, where the overall penetration of gastrointestinal endoscopy is low, according to the note. China only has 22 endoscopist professionals per million people, compared with 250 per million in Japan.

Li added that she has started to invest or increase positions in Japanese companies that should grow despite the Covid-19 pandemic. They include e-commerce and digital payments.

While these sectors have become resilient during the outbreak, Li believes that they should also provide long-term opportunities.

“The e-commerce penetration is just about 6% in Japan, which compares with 25%-35% in the US.

“Japanese companies have historically been under-investing in IT and have a strong paper culture. But now, they are trying to catch up,” she said.

The First State Japan Equity Fund versus its benchmark and sector

Source: FE Fundinfo. In US dollars.

Part of the Mark Allen Group.