Fidelity Japan Trust plc (LON:FJV) is the topic of conversation when Kepler Partners’ Investment Trust Research Analyst Josef Licsauer caught up with DirectorsTalk for an exclusive interview.
Q1: Could you just tell us what Fidelity Japan Trust’s investment strategy is and how it differentiates from others in the Japan sector?
A1: Nicholas Price is the lead manager of FJV, and he employs a growth at a reasonable price approach to investing, so some investors may be familiar with that as a ‘GARP’ investment approach. Essentially, what this means is he is targeting companies with that potential for really steady earnings growth, and those whose shares are undervalued relative to that earnings potential. So, ultimately, the strategy is about taking advantage of opportunities where the market is under-pricing that future growth.
The portfolio really consists of Jaacpanese companies that Nicholas deems high quality and high growth potential, situated across the market cap spectrum and also in a plethora of sectors within the Japanese market. Nicholas, more recently, has been capturing opportunities in the upper end of that market cap spectrum, where he is seeing more undervalued opportunities, but also companies that are beginning to transition from value to growth.
However, where we think the Trust really starts to become differentiated is through Nicholas’s affinity with the under-researched small and mid-cap stocks in Japan. These stocks are particularly steep at a discount on the price to book metric, alongside being under-researched. So, for someone like Nicholas and his team, you have the tools and the on the ground resources, they can really add an edge in stock selection in that kind of segment of the market. In many cases, Nicholas and his team support the argument that a lot of these companies aren’t necessarily trading at cheap levels, because they are weak companies fundamentally. Of course, there are some, but rather many have actually had to just deal with those prolonged economic pressures, and this has led to multiple compression, essentially, making those companies look cheaper than they actually should be.
As such, he’s really taken advantage by adding a few of those new names to the portfolio but also topping up some existing ones because of that valuation dispersion and what he believes to be potential market mispricing.
Another one of the key differentiators in our view for FJV is Nicholas’s ability to allocate up to 20% or so of the portfolio to those unlisted or private companies. Now, Nicholas has seen firsthand that there’s been an uptick or an increase in the kind of entrepreneurial activity in Japan compared to, say, five or 10 years ago and that has really led to many new growth companies emerging in the pre-IPO market and thus creating opportunities for him to exploit.
Of course, investing in a listed company does bring with it high return potential and it provides Nicholas and the team with some real valuable insights into the emerging trends and its competitors. But it also comes and carries certain risks, and these can be anything from early-stage companies, which are more sensitive to funding costs, or those at high failure rates or typically shorter track records than some managers might be comfortable with. The Trust has approximately 6% of service portfolio invested in these unlisted companies so not quite near the 20% limit but the 6% invested in those companies really offers investors, in our view, a differentiating of sources of returns compared to other peers in the sector.
Q2: What’s the managers’ views on the current market backdrop in Japan?
A2: Japan, particularly in the first half of 2024, was spoken about a lot and I think that was primarily because of its stock market reaching record highs. But there are many other points to talk about and Nicholas has a few views on some of those.
Japan sitting at a bit of a pivotal moment with things like monetary policies normalising and structural shifts ongoing in Japan’s economy are really starting to drive long term opportunities that haven’t really been seen for many, many years.
We’ve also got to consider things like wage increases and domestic reflation, which is very different from other markets at the moment, west of Japan. Both of these factors are supporting consumption, which potentially is putting Japan on a bit of a track for improved GDP growth.
When we then look at something like a corporate governance impact that Japan have been going through at the moment with their reforms, the pressure and support that they’ve been receiving from the likes of shareholders and the Tokyo Stock Exchange, we’re really starting to see companies improve their capital efficiency. That in turn has sparked a bit of activity in share buybacks, mergers and acquisitions and this has created a widening pool of opportunities for managers to take advantage of. It paints a really interesting backdrop in Japan.
Despite such tangible progress being made over the last couple of years, Nicholas believes there is plenty more to come from something like the ongoing corporate governance reforms. They, of course, have led to a surge so far in buybacks and dividends and notable growth in some parts of the really deep, cyclical parts of the market but cash balances have continued to accumulate on corporate balance sheets. At present, the data suggests it’s just over 50% of listed companies in Japan are actually still in net cash, meaning there is much more potential for companies to do more with that cash. That could be expansion in their respective markets, that could be focusing a little bit more on buybacks or increasing dividends or even acquiring foreign businesses.
The latter point in particular is something that Nicholas has actually seen. He’s arguing that there is a clear increase in corporate activity through things like management buyouts, takeover bids and mergers and acquisitions more broadly.
Q3: So, with that in mind, do you think the Trust’s current discount presents an opportunity for investors?
A3: Well, I think the picture of the last five years is quite interesting, and I’ll put that into a bit of a quick narrative as to why we’re at the current level before answering that.
Towards the end of 2021, we really saw FJV’s discount begin to widen quite steadily, and this really is a reflection of an unfavourable market backdrop, in our view, for Nicholas’s preferred investment style. Around this time, the market rally was really driven and favoured more of the lower quality, more cyclical stocks, which gained traction and then outperformed their growth-oriented counterparts. This trend has persisted in the years that followed, into 2022, 2023 and also into parts of 2024 and it’s really, really boosted the value-oriented sectors like financials, which Nicholas and the team have much less exposure to.
When you then combine this with some kind of investment strategy being out of favour and an underexposure of those companies that are doing well, we also have the global equity sell-off, which really led to a significant de-rating of our growth stocks. So, it’s really unsurprising that FJV’s discount has widened, given these are his preferred investments.
You’ve then got to consider broader market factors. I think that’s really, really important and has put additional pressure onto FJV’s discount. Japan, for those long-standing investors, will be well familiar with its chequered past and I think when things look like they’re beginning to turn, investors react very quickly and run before they have to deal with the kind of endurance and the period that they went through when Japan’s economy bubble burst and the multiple false starts or false dawns that we’ve experienced since.
So, with that, I think there is a growing investor concern of some uncertainty in Japan’s economy at the moment and that’s its economic direction, that’s the yen’s weakness and potentially even some actions from the Bank of Japan themselves. Those factors are also weighing heavily, not only on investor sentiment, but FJV’s discount. So, that brings us to today, the trust is currently sitting around a discount of 12- 13% so wider than its five-year average and the ACI Japan sector’s average.
I think for those willing to accept that FJV is a higher risk, higher reward strategy, it really does present a potentially compelling entry point for them.
Many of the underlying holdings in the portfolio are growth-oriented businesses and this has resulted in its portfolio typically exhibiting high growth rates or higher return on equity relative to the index. Despite this, given the fact we just touched on the valuation metrics, so price to earnings, for example, of FJV’s portfolio is a much more comparable level to the index than it has been in previous years, especially when you’re considering those high growth potential on offer. With the discount being what it is, investors can really gain exposure to a portfolio of high-quality growth businesses in Japan that are offering significant upside potential at a wider-than-average discount, which we think is potentially attractive.
If that sentiment in Japan improves and the valuations subsequently start to expand, then that discount could narrow and in turn, act as a bit of a kicker, an extra kicker for returns for investors.
Q4: Can we just talk about performance? Why has it been a tough few years for Fidelity Japan Trust?
A4: I think it really has been a tough few years for Nicholas and the team and if we cast our eyes back further, long term performance has been strong, that’s come particularly during periods where growth investing has been involved. The manager and his team invest in those high quality, high growth businesses, but also have a slight tilt towards those under-researched small and mid-cap growth stocks we spoke about earlier and when that is in favour, the trust does very, very well.
Because of that preference, because of that tilt, it will not outperform in every scenario, particularly those periods where we’ve seen extreme value dominance, where those deep, cyclical, very cheap companies are doing very, very well. This is why I think FJV has really had a tough run over the past three years in particular.
Its small and mid-cap stocks have come under a lot of pressure and its positioning, stylistically speaking, has been massively out of favour. Unlike other markets globally, Japan continues to see those value-oriented businesses or sectors outperform the growth counterparts and it’s a trend that’s really persisted over the last three years or so. So, the growth-focused investment trusts in the sector generally have been hit very, very hard.
When we consider Fidelity’s approach and its tilt to those companies in the small and mid-cap growth space, it’s really been impacted quite hard, one of the most impacted in fact. Despite this allocation of small and mid-cap growth stocks hindering returns over the last three years or so, they have a much greater output potential than their larger counterparts and could rebound quickly given the right catalysts. And this is something we have seen in the past. It’s very much a long-term outlook rather than the short term, which some investors like to think so we really need to think with FJV as serving a specific role in a portfolio.
Now, it’s a high risk, high reward strategy that can up the balance of the global portfolio, particularly ones more weighted heavily to value strategies or even a portfolio that’s lacking high growth Japanese businesses. But what’s important to know is it will struggle amid a market-driven environment where low quality stocks and value style of investing is involved.
So, investors need to be aware of that and almost invest in a long-term investment horizon.
