JPMorgan Japan Small Cap Growth & Income Annual Report to March 2023

JPMorgan Japan Small Cap Growth & Income plc (LON:JSGIhas announced its final results for the year ended 31st March 2023.

CHAIRMAN’S STATEMENT

Investment Performance

Fears of inflation and rapidly rising interest rates generated significant volatility in major financial markets in the early part of the Company’s financial year ended 31st March 2023. However, subsequent signs of an easing in inflation pressures led to hopes that rates would soon peak, and this resulted in a rebound in global markets. The performance of the Japanese market was similarly mixed. It ended the six months to end September 2022 almost flat, before recovering in the following six months. In addition to the tailwinds provided by the improvement in global market sentiment, the Japanese market was also supported in the past six months by the lifting of Japan’s final COVID–19 related restrictions and China’s surprise abandonment of its crippling zero-COVID policies. Despite the Bank of Japan’s announcement in December 2022 that it was going to adjust the yield curve control range, which triggered speculation about the possibility that it would begin to reverse its ultra-easy monetary stance, the Company’s benchmark ended the financial year up 5.0%.

The Company underperformed its benchmark, returning -5.7% on a NAV basis for the full year, while the return to shareholders was -7.8% over the same period. This disappointing result was in part due to the Company’s bias towards quality and growth stocks. This preference means the portfolio usually differs significantly from the benchmark, which comprises many low-quality companies with unappealing growth characteristics. It is therefore inevitable that the Company’s performance will often differ substantially from the benchmark return. While the Company’s NAV total returns lagged the benchmark over one, three and five-year periods to 31st March 2023, the Annual total return  table on page 26 of the Annual Report shows that the Company outperformed the benchmark in six of the last 10 financial years. Shareholders will be all too aware of the market volatility over recent years and therefore the Board has extended the NAV performance Key Performance Indicator (‘KPI’) to 10 years as shown on page 28 of the Annual Report.

Over the past year, technology and other growth stocks came under pressure in all major markets, including Japan. A series of aggressive interest rate hikes by the US Federal Reserve, the Bank of England and the ECB, accompanied by hawkish rhetoric about additional tightening, adversely impacted growth stocks whose valuations are based on discounted future cash flows which diminish as rates rise. The Company’s exposure to many such stocks saw performance suffer accordingly. There were also a number of specific stocks which contributed to the underperformance during the year which are covered in the Investment Managers’ report.

However, the Board shares the Managers’ conviction that good quality companies with strong growth prospects will always outperform in the long run. The Company’s investment record and recent portfolio activity are explained in more depth in the Investment Managers’ Report. The Managers also outline the reasons for their optimism about Japan’s very favourable long-term prospects, and the positive implications this has for the Company’s ability to rebuild strong performance.

Dividend Policy and Discount Management

The Company’s dividend policy aims to pay, in the absence of unforeseen circumstances, a regular dividend equal to 1% of the Company’s NAV on the last business day of the preceding financial quarter, being the end of March, June, September and December. Over the year, this would approximate to 4% of the average NAV, paid from other reserves. This dividend policy has now been in place for five years. For the year ended 31st March 2023, quarterly dividends paid totalled 14.2p per share (2022: 20.3p).

The Company’s discount widened over the review period with an average discount of 8.2%, and ending the year at 9.8%, moderately higher than the 7.4% level at the same time last year. This widening is broadly in line with the experience of many other investment trusts over this period. The Company did not repurchase any shares during the year. However, the Board continues to monitor the discount closely and is prepared to repurchase shares in an effort to narrow the discount, when it considers this is appropriate, taking account of market conditions. At the time of writing, the discount is 9.9%.

A resolution to approve the Company’s dividend policy will be submitted to shareholders at the forthcoming Annual General Meeting (‘AGM’).

Gearing/Borrowing

The Managers seek, at times, to enhance investment returns for shareholders by borrowing money to buy more assets (‘gearing’), subject to their view on prevailing market conditions. The Company’s gearing is discussed regularly by the Board and the Managers, and the gearing level is reviewed by the Directors at each Board meeting.

The Company’s Yen 4.0 billion revolving credit facility with Scotiabank expired during the year and was replaced with a Yen 4.0 billion two-year revolving credit facility with ING Bank. This facility has a maturity date of December 2024 and the Manager will seek to renew or replace this facility, at the best available terms, on expiry.

Access to a credit facility provides the Managers with the ability to gear tactically within the set guidelines. The Company’s investment policy permits gearing within a range of 10% net cash to 25% geared. However, the Board requires the Managers to operate in the narrower range of 5% net cash to 15% geared, in normal market conditions. During the past 12 months the Company’s gearing level ranged between 4.5% and 7.6%, ending the financial year at 5.6% (2022: 6.1%).

Environmental, Social and Governance Considerations

As discussed in the Investment Managers’ Report, environmental, social and governance (‘ESG’) considerations are integral to the Managers’ investment process. The Board shares the Managers’ view of the importance of ESG when making investments that are sustainable over the long term and the necessity of continual engagement with investee companies throughout the duration of the investment. The Managers use their regular company meetings with potential and existing portfolio companies to discuss and challenge management on their adherence to ESG principles and best practice. The Board believes that effective stewardship of this kind can help to create sustainable value for shareholders.

Further information on the Managers’ ESG process and engagement is set out in the ESG Report on pages 16 to 21 of the Annual Report, and in the JPMorgan Asset Management 2022 Investment Stewardship Report, which can be accessed at https://am.jpmorgan.com/content/dam/jpm-am-aem/global/en/sustainable-investing/investment-stewardship-report.pdf.

Reporting under the Task Force on Climate Related Financial Disclosures

In accordance with the requirements of the Taskforce on Climate Related Financial Disclosures (‘TCFD’), JPMAM will provide product level reports for the investment trusts it manages, including your Company, in late June 2023 and annually thereafter. The report will be made available on the Company’s website.

Key elements of the report will include Scope 1 and 2 greenhouse gas (‘GHG’) emissions (i.e. emissions that are owned or controlled by the Company), total carbon footprint, weighted average carbon intensity (‘WACI’) and, from June 2024, Scope 3 GHG emissions (i.e. emissions generated as a consequence of the activities of the Company but which occur from sources not owned or controlled by it). The report will also include a scenario analysis of how climate change is likely to impact the Company’s assets under orderly, disorderly and hothouse world scenarios, and discussion of the most significant drivers of performance under those scenarios.

The Board and Corporate Governance

There has been no change to the composition of the Board during the reporting period.

Yuuichiro Nakajima, a member of the Board since April 2014, will retire from the Board following the conclusion of the forthcoming AGM in July 2023. The Board has benefited immensely from Yuuichiro’s contribution, especially his knowledge of the Japanese economy and investment environment. On behalf of the Board and the shareholders, I would like to thank Yuuichiro for his commitment to the Company since his appointment. The Board has a plan to refresh its membership in an orderly manner over time, and will, as part of its long-term succession planning, seek to recruit new non-executive Directors when appropriate.

In accordance with good corporate governance practice, all Directors, with the exception of Yuuichiro Nakajima, will stand for re-election at the forthcoming AGM.

Shareholders who wish to contact the Chairman or other members of the Board may do so through the Company Secretary or the Company’s website, details of which appear below.

Annual General Meeting

The Company’s AGM will be held on Thursday, 27th July 2023 at 12.00 noon at 60 Victoria Embankment, London EC4Y 0JP.

We are delighted that this year we will once again be able to invite shareholders to join us in person for the Company’s AGM, to hear from the Investment Managers, who will present at the meeting via video link from Tokyo. Their presentation will be followed by a live question and answer session. Shareholders wishing to follow the AGM proceedings but who choose not to attend in person will be able to view them live and ask questions (but not vote) through conferencing software. Details on how to register, together with access details, will be available shortly on the Company’s website at www.jpmjapansmallcapgrowthandincome.co.uk or by contacting the Company Secretary at invtrusts.cosec@jpmorgan.com.

My fellow Board members, representatives of JPMorgan and I look forward to the opportunity to meet and speak with shareholders after the formalities of the meeting have been concluded.

Shareholders who are unable to attend the AGM are strongly encouraged to submit their proxy votes in advance of the meeting, so they are registered and recorded at the AGM. Proxy votes can be lodged in advance of the AGM either by post or electronically: detailed instructions are included in the Notes to the Notice of the AGM on pages 90 to 93 of the Annual Report.

If there are any changes to the above AGM arrangements, the Company will update shareholders through an announcement to the London Stock Exchange and on the Company’s website.

Outlook

Despite the persistently uncertain global investment climate, unsettling geopolitical tensions and the near-term volatility these continue to generate, the Board shares the Investment Managers’ conviction that the long term outlook for Japan’s small cap companies remains positive. Japan is undergoing significant technological and structural changes and its innovative, entrepreneurial small cap companies are ideally placed to capitalise on the opportunities these changes generate. Small cap companies are already leading the way in a variety of niche markets. The Company’s Managers are extremely well-supported in their search for such success stories by JPMorgan’s extensive global and Tokyo-based research resources. The Board is therefore optimistic about the Company’s prospects, and we share the Managers’ confidence in its ability to continue delivering attractive levels of capital growth to shareholders over the long term.

Alexa Henderson
Chairman

23rd June 2023

INVESTMENT MANAGERS’ REPORT

Performance and Market Review

Over the 12 months to March 2023, JPMorgan Japan Small Cap Growth & Income’s benchmark, the MSCI Japan Small Cap Index (in sterling terms), produced a total return of +5.0%. The Company’s net assets underperformed the index by -10.7 percentage points over the same period, delivering a return of -5.7%.

Early in the year, the market performance was weak on the back of continued concerns over inflation and rising interest rates in major economies. These rate increases had an especially adverse impact on the valuations of technology and other high growth stocks in all major markets, as higher rates reduce the value of these companies’ future cash flows. Japanese technology-related and growth stocks were caught up in the rout, despite the fact that Japanese inflation remained relatively subdued.

The market started to rebound on anticipation of a peak in rate hikes following slower than expected inflation figures in the US. But this rally partially reversed as the Bank of Japan (BoJ) announced an adjustment in the yield curve control range in December, which came sooner than expected, and raised speculation about an eventual tightening of the BoJ’s ultra-easy monetary policy. Global concerns over the financial system were triggered by the collapse of Silicon Valley Bank in March this year, leading to a fresh bout of volatility. However, markets recovered towards the end of the reporting period following government and central bank interventions to support other struggling institutions and protect deposits. During the same period, the Japanese yen weakened against the US dollar and sterling. The Company’s underperformance over the year is in part the result of its bias towards quality and growth stocks, which were the stocks worst hit by last year’s market sell-off. This performance is very disappointing. However, our investment strategy looks beyond short-term market fluctuations and adopts a long-term perspective, based on the view that excess returns take time to accumulate, especially for smaller cap stocks. While the past year’s performance has dragged down average annualised performance over the past few years, over the 10 years to the end of March 2023, the Company has made an average annual return of +7.8% in NAV terms, outperforming the benchmark by +0.9 percentage points.

Performance attribution
Year ended 31st March 2023
%%
Contributions to total returns
Benchmark return5.0
  Sector allocation-3.7
  Stock selection-6.3
  Gearing/cash0.5
Return relative to benchmark-9.5
Portfolio return-4.5
Management fee/other expenses-1.2
Return on net assetsA-5.7
Return to shareholdersA-7.8

Source: Factset, JPMAM, Morningstar.

All figures are on a total return basis.

Performance attribution analyses how the Company achieved its recorded performance relative to its benchmark.

A Alternative Performance Measure (‘APM’).

A glossary of terms and APMs is provided on pages 94 and 95 of the Annual Report.

Spotlight on sectors and stocks

During the 12 months under review, both sector allocation and stock selection had a negative impact on performance.

The portfolio differs substantially from the benchmark, and this will, by definition, often lead to significant volatility in performance relative to the benchmark, as it has done over the past year. The most significant detractors at the sector level included our overweights to software & services and media & entertainment, sectors which came under particular pressure during last year’s sell-off. However, we believe that the trend towards digitalisation will remain a source of significant potential growth in Japan, considering the relatively low penetration of digital services such as e-commerce and cashless payments, so we remain overweight in these sectors. Our underweight to retailing also detracted, as this sector has done well due to the favourable impact of Japan’s re-opening. The main sector level contributors to performance included our underweight to real estate and food beverage & tobacco, and an overweight to consumer services. We maintained underweight in real estate and food beverage & tobacco due to a relatively lower level of conviction surrounding the long-term growth potential in both sectors’ companies. On the other hand, we continue to have an overweight in consumer services as we see market share gain potential amid domestic consolidation over the long term within the sector’s names. At the stock level, several names made significant positive contributions to returns, including CapcomYamato Kogyo and Medley:

•  Capcom develops and publishes video game software, including Street Fighter, Monster Hunter, and Resident Evil (Biohazard). The earnings of gaming software companies have stabilised over the past few years, especially for those with strong intellectual property. This is due to the consistent rise in the digital download ratio, which measures the download of games as a percentage of total sales from all sources, including via retail outlets. Digital downloads have higher per unit profitability thanks to the ease of distribution, and companies such as Capcom, with multiple popular titles, are benefitting from this shift.

•  Yamato Kogyo is an electric arc furnace (EAF) steelmaker producing construction steel using electricity to smelt scrap steel. Electric arc furnaces emit only around one sixth to a quarter of the greenhouse gases produced by conventional blast furnaces, and Yamato Kogyo is one of the largest Japanese steelmakers using this technology. Outside Japan, the company also has a globally well diversified business portfolio. It owns market leading operations in the US, and South-East Asia, including Thailand and Vietnam, through subsidiaries and joint ventures. We expect the shift towards more environmentally friendly methods of steel production to ensure the company enjoys a tailwind generated by strong global demand over the medium term.

•  Medley is a healthcare staffing platform and software solution provider. Given Japan’s aging population, the economy is experiencing a structural shortage of workers in healthcare, as well as in many other sectors. The ratios of job openings to job applicants for healthcare workers is significantly higher than the all-industry average, making healthcare staffing an attractive secular growth space. Within the industry, Medley differentiates its staffing service by charging a low, success-based fee which compares favourably with traditional players who charge either a 20-30% commission per hiring or a fixed posting fee levied regardless of the application or hiring outcome.

Unfortunately, the positive effect of these stock selection decisions was more than offset by the adverse impact of other stock positions. The largest detractors from performance over the period included ToshoMEC and Benefit One.

•  Tosho is a gym operator mainly targeting clients new to gym attendance. Before COVID-19, Tosho enjoyed the highest margin within the gym industry, thanks to its unique customer targeting and highly efficient operation. The company suffered a loss of gym memberships following the onset of the pandemic but has since streamlined its operations further and is currently in a recovery phase. Despite Tosho’s recent challenging period, we continue to hold this name, due to our confidence in the company’s long-term growth potential.

•  MEC manufactures advanced adhesion enhancer products used to produce printed circuit boards. The company is a global leader in this niche market. Its products improve adhesion between the wiring and insulating materials in semiconductors, preventing abrasion after long exposure to heat. This is an especially desirable characteristic in the production of miniature semiconductors. We anticipate MEC’s adhesion enhancers will enjoy rising demand and revenue growth as the trend towards semiconductor miniaturisation continues. MEC was the top positive contributor in the previous financial period, though its share price corrected during the global semiconductor cyclical downturn. Despite the correction, we still see great long-term potential for MEC, and we have maintained our holding.

•  Benefit One is Japan’s number one fringe benefit outsourcing service provider, following its recent acquisition of its competitor, the third largest provider, JTB Benefit. Japan’s structural labour shortage is encouraging companies to use fringe benefits as a means of attracting talent. Benefit One boasts close to 9 million members, but currently, less than 40% of the working population receives fringe benefits, so there is great potential for further growth in this market. Benefit One’s share price corrected in response to a longer than expected slowdown in topline growth due to the impact of the pandemic, but we continue to hold this name given its long-term growth potential.

Gearing stood at 5.6% at the end of the financial year.

About our investment philosophy

The Company aims to provide shareholders with access to the innovative and fast-growing smaller companies’ universe at the core of the Japanese economy. Our portfolio favours quality and growth, and we target companies (other than Japan’s largest 200) which we believe can compound earnings growth over the long term, supported by sustainable competitive advantages and good management teams. We especially like businesses that reinvest to capitalise on their growth potential. We believe the strong and durable market positioning of such companies will allow them to substantially increase their intrinsic value over time. At the same time, we avoid stocks that have no clear differentiation from competitors and that operate in industries plagued by structural decline and excess supply.

Our stock selection is based on fundamental analysis, local ‘on-the-ground’ knowledge and extensive contact with the management teams of prospective and current portfolio companies. The Company is managed by a team of three, supported by over 20 Tokyo-based investment professionals who possess an in-depth understanding of small cap businesses, which is a very under-researched and under-appreciated part of the market. This local knowledge thus provides us with a significant strength in identifying investment opportunities overlooked by many investors.

Within our bottom-up investment process, the starting point is the Strategic Classification framework, where we address the key question “Is this a business that we want to own?”. Through this process we assign a rating of Premium, Quality or Trading to each stock, based on the economics, competitive sustainability and governance practices of the business. We aim to maximise exposure to Premium and Quality companies, where we are most confident in the long-term outlook, and where possible, we aim to invest from an early stage, in order to benefit fully as companies realise their growth potential.

When investing in smaller companies, we believe it is important to adopt a long-term perspective, to give these companies the time they need to generate excess returns. Consistency on this point is key, so we continue to focus on quality companies with structural growth opportunities, despite the fact that the portfolio may struggle at times when value stocks are in favour. Having said that, the Company is not a ‘growth at any price’ strategy, and we always strive to invest at a reasonable price. To this end, we use a five-year expected return framework to consider whether a stock’s price is at an attractive level. It is also important to construct a well-balanced portfolio to minimise unintended risks, so the portfolio is invested in a wide range of sectors, including not only software services and technology hardware, but also materials, chemicals, construction, machinery, retail and restaurants, and consumer goods and services.

Trends and themes

While our decisions are based on company-specific factors, there are also structural, long-term trends and themes that underlie much of our stock selection.

Our investment themes include:

•  Demographic Change: It is no secret that Japan’s population is ageing and shrinking. While this is a difficult environment for the economy overall, there are areas that can profit from this trend. For example, staffing companies or businesses focused on improving labour productivity are benefitting from tight labour market conditions. The owners of family-run businesses looking to divest as they approach retirement provide opportunities for more M&A and consolidation, which can benefit larger industry players.

•  Digital Innovation: Although Japan is an advanced industrial economy, it lags other markets in the adoption of digitalisation. For example the penetration of cashless payments, e-commerce, and cloud software services remains relatively low. However, the direction of travel is as clear as it is around the world, and we anticipate sustained growth in the adoption of digital technologies over the medium to long term.

•  Industry Niches: Japanese manufacturing is world class, and the country is a leading global supplier of factory automation equipment, robots, electronics parts and materials. These present attractive investment opportunities for companies specialising in niche products and technology segments.

•  World Class Consumer Brands: Japanese businesses operating beyond Japan’s shores are in a very strong position to capture new customers in Asia’s dynamic, fast-growing economies. Demand for high quality Japanese goods and brands is likely to be particularly strong.

•  De-carbonisation: The environment is the subject of much attention in Japan, thanks to the government’s commitment to reduce carbon emissions to net zero by 2050. Japanese smaller companies have unique technologies capable of reducing emissions in many industries, including electric vehicles, solar and wind power generation, and other clean energy sources. We continue our efforts to identify companies well positioned to benefit from efforts to reduce emissions, and those with the ability to transform their business models to meet the government’s net zero target.

•  Corporate Governance: Japanese companies are making a concerted effort to improve governance standards via the appointment of more independent, external board directors and the adoption of other beneficial policies. These include enhanced shareholder returns, tighter internal controls and stronger disclosure rules to boost transparency. There is room for further improvement in the quality of corporate governance, and the market is likely to reward companies that upgrade their governance standards. We will therefore maintain an ongoing constructive dialogue with companies on this broad theme.

Portfolio Activity

Key new purchases during the reporting period included SangetsuPaltac and Kyushu Railway.

•  Sangetsu is Japan’s number one wallpaper producer. This is a mature market, dominated by an oligopoly of three companies, where the top player, Sangetsu, has been consistently expanding market share, and currently supplies over 50% of the market. The pricing environment has been improving recently, with the number two player following Sangetsu’s lead in raising prices. Sangetsu has a solid balance sheet with a net cash position, and a strong commitment to shareholder returns.

•  Paltac is the top wholesaler for cosmetics and other everyday items sold in drugstores, discount stores and other outlets. The market is fragmented, but Paltac has been consistently gaining market share, which currently stands at over 30%, with scope to rise further thanks to the company’s overwhelming scale and constant efficiency gains it is realising from the introduction of automation. Paltac has a solid balance sheet, with a net cash position, and we also sense an overall improvement in capital allocation.

•  Kyushu Railway is a railway operator in the Kyushu region. The company also has non-railway businesses such as real estate leasing and hotels. Railway companies were negatively impacted by COVID-19, although we anticipate steady growth over the mid-to-long-term, supported by the return of inbound tourism. Enhanced shareholder returns should also underpin the share price, while valuations are not demanding.

To fund these and other acquisitions, our largest divestments over the past year included SUMCOIriso ElectronicsMoney Forward and S-Pool. We sold SUMCO, which produces silicon wafers for use in semiconductors, and Iriso Electronics, another electronic components manufacturer, in favour of higher conviction ideas within hardware technology, including the acquisition of Fujimi and Japan Material. We also exited Money Forward, one of the top cloud accounting service providers for mid and small-cap enterprises. Competition in this industry is increasing, leading to higher-than-expected upfront marketing and R&D costs and less certainty about Money Forward’s financial prospects over the long term. A position in S-Pool, an employment agency focused on services for people with disabilities, was also closed due to the risk of regulatory pressures.

Our bias towards quality and growth means the portfolio continues to have a higher return on equity (ROE) and stronger earnings per share (EPS) growth than its benchmark.

Outlook and strategy

The external environment is uncertain, pervaded by geopolitical tensions, the risk of a global recession, and persistent concerns about inflation and interest rate hikes. Japan is also seeing signs of inflation, as rising commodity prices and a weaker yen have imported inflationary pressures although inflation levels are lower than in other major markets. However, as one response to Japan’s tight labour market conditions, some large corporates have started to announce generous wage increases, to attract and retain workers. These increases follow decades of stagnant wages, so this is very encouraging for the Japanese economy. On the monetary policy front, following the BoJ’s monetary policy tweak in December 2022, financial markets are awaiting further policy guidance from the BoJ’s new governor.

Regardless of these external and domestic events, we remain optimistic about the long-term outlook for Japanese small cap companies, and your Company, for several reasons. The average valuations of Japanese companies remain reasonable, and lower than both historical averages and valuations in most other major markets. Furthermore, Japanese equity markets will draw near-term support from Japan’s belated lifting of COVID-19 restrictions. Japan reopened its borders in October 2022, much later than most other developed nations, and just before China’s surprise decision to abandon its zero COVID-19 policies. So inbound tourism and a general reopening of the Japanese economy have only just gained traction in recent months. China’s reopening is also supportive for many Japanese companies.

However, in our view, the most important structural support for Japan’s equity market over the medium to longer term will be the ongoing improvement in corporate governance. The past few years have seen clear progress on this front, in large part thanks to the Corporate Governance Code introduced in 2015. We have seen notable improvement in areas such as board independence, and we expect more positive developments ahead, especially increased shareholder returns. Half of Japan’s listed non-financial companies still have net cash positions, so there is significant scope for this cash to be returned to shareholders over the longer term.

The pandemic has given added impetus to some other positive structural changes underway in Japan, especially the application of technology and digitalisation in many areas of economic activity. These trends will underpin growth, productivity and corporate earnings for years to come. In sharp contrast to other developed economies, Japan’s smaller companies are at the forefront of this innovation and change making them ideally positioned to prosper over the long term. However, the sell side coverage for such exciting mid- and small-cap companies tends to be thin, so many investors overlook the compelling opportunities available in this sector of the market.

In contrast, we have the support of a large team of Japanese equity analysts and fund managers on the ground in Tokyo, to help us identify these hidden gems. This puts the Company in a favourable position to capitalise on the long-term structural changes playing out in Japan. This, combined with our long-term performance track record, underpins our conviction that our investment approach is sound, and capable of weathering bouts of short-term volatility such as we are currently experiencing, just as it has done in the past. We are therefore confident the Company will deliver positive and sustained returns to our shareholders over the medium and long term.

Miyako Urabe

Xuming Tao

Naohiro Ozawa

Investment Managers

23rd June 2023

PRINCIPAL AND EMERGING RISKS

The Board has overall responsibility for reviewing the effectiveness of the Company’s system of risk management and internal control.

The Board is supported by the Audit Committee in the management of risk. The risk management process is designed to identify, evaluate, manage, and mitigate risks faced.

Although the Board believes that it has a robust framework of internal controls in place this can provide only reasonable, and not absolute, assurance against material financial misstatement or loss and is designed to manage, not eliminate, risk.

The Directors confirm that they have carried out a robust assessment of the principal and emerging risks facing the Company, including those that would threaten its business model, future performance, solvency or liquidity. The risks identified and the ways in which they are managed or mitigated are summarised below.

With the assistance of JPMF, the Audit Committee has drawn up a risk matrix, which identifies the principal and emerging risks to the Company. These are reviewed and discussed on a regular basis by the Board, through the Audit Committee. These risks fall broadly into the following categories:

   Movement from
Principal riskDescriptionMitigation/ControlPrior Year
Investment and StrategyAn inappropriate investment strategy, poor asset allocation or the level of gearing, may lead to underperformance against the Company’s benchmark index and its peer companies, resulting in the Company’s shares trading on a wider discount.The Company has a clearly defined strategy and investment remit, which is reviewed annually. The portfolio is managed by a highly experienced Investment Manager, with a defined investment appraisal process. The Board relies on the Investment Manager’s skills and judgment to make investment decisions based on research and analysis of individual stocks and sectors. To aid appropriate investment decisions, the Board has set investment guidelines and parameters for the portfolio managers to follow. The AIFM also monitors the Investment Manager against the Company’s investment guidelines.The Board reviews the performance of the portfolio against the Company’s benchmark index, that of its competitors and the outlook for the markets on a regular basis, with the portfolio managers who attend Board meetings. Where necessary the portfolio managers will take action following a review of the performance.The Board also reviews the level of premium/discount to NAV at which the Company’s shares trade and movements in the share register. The Board regularly seeks the views of its investors.   Risk has been heightened by the Company’s underperformance during the year.
MarketMarket risk arises from uncertainty about the future prices of the Company’s investments. This market risk comprises three elements – equity market risk, currency risk and interest rate risk.The Board considers the split in the portfolio between small and large companies, sector and stock selection and levels of gearing on a regular basis and has set investment restrictions and guidelines, which are monitored and reported on by JPMF. The Board monitors the implementation and results of the investment process with the Manager. However, the fortunes of the portfolio are significantly determined by market movements in Japanese equities, the rate of exchange between the Japanese yen and sterling and interest rate changes. This is a risk that investors take having invested into a single country fund. The Board recognises the benefits of a closed-end fund structure in extremely volatile markets. During times of elevated market stress, the ability of a closed-ended fund structure to remain invested for the long term enables the Manager to adhere to disciplined fundamental analysis from a bottom-up approach and be ready to respond to dislocations in the market as opportunities present themselves.   Risk has been heightened by inflationary pressures due to an adjustment in the yield curve control range announced by the Bank of Japan in December and market volatility caused by global concerns over the financial system.
Operational and CybercrimeDisruption to, or failure of, the Manager’s accounting, dealing or payments systems or the custodian’s or depositary’s records could prevent accurate reporting and monitoring of the Company’s financial position.On 1st July 2014, the Company appointed Bank of New York Mellon (International) Limited to act as its depositary, responsible for overseeing the operations of the custodian, JPMorgan Chase Bank, N.A., and the Company’s cash flows. Details of how the Board monitors the services provided by the Manager and its associates and the key elements designed to provide effective internal control are included in the Risk Management and Internal Control section of the Corporate Governance Report on pages 49 and 50 of the Annual Report.As an externally managed investment trust, there is a continued reliance on the Manager and other third-party service providers.The Board reviews the overall performance of the Manager and other key third-party service providers and compliance with the investment management agreement on a regular basis to ensure their continued competitiveness and effectiveness, which includes assessment of the providers’ control systems, whistle-blowing, anti-bribery and corruption policies and business continuity plans.The Manager’s internal control processes are monitored throughout the year and are evidenced through its Service Organisation Control (SOC 1) reports, prepared by an independent auditor. The SOC 1 reports, which are reviewed annually by the Audit Committee, provide assurance in respect of the effective operation of internal controls.Service providers are appointed with clearly-documented contractual arrangements detailing service expectations. The Audit Committee receives assurance and internal controls reports from key service providers on an annual basis.The threat of cyber-attack, in all its guises, is regarded as at least as important as more traditional physical threats to business continuity and security. The Board has received the cyber security policies for its key third party service providers and JPMF has assured the Directors that the Company benefits directly or indirectly from all elements of JPMorgan’s Cyber Security programme. The information technology controls around the physical security of JPMorgan’s data centres, security of its networks and security of its trading applications are tested by independent reporting accountants and reported every six months against the Audit and Assurance Faculty Standard.®Risk remains relatively unchanged.The operational requirements of the Company, including from its key third-party service providers, have been subject to rigorous testing. To date the operational arrangements have proven robust and key third-party service providers have not experienced significant operational difficulties.
Loss of Investment Team or Investment ManagersThe sudden departure of the investment managers or several members of the wider investment management team could result in a short-term deterioration in investment performance.The Manager takes steps to reduce the likelihood of such an event by ensuring appropriate succession planning and the adoption of a team based approach.®The Manager has ensured the portfolio is managed by a robust portfolio management team i.e. the portfolio is co-managed by three portfolio managers who are supported by a number of on-the-ground investment professionals.
Share Price Relative to NAV per ShareIf the share price of an investment trust is lower than the NAV per share, the shares are said to be trading at a discount.The Board monitors the Company’s premium/discount level and, although the rating largely depends upon the relative attractiveness of the trust, the Board has authority to issue new shares or buy backs its existing shares when deemed by the Board to be in the best interests of the Company and its shareholders. The Board is committed to consider buying back the Company’s shares when/if they stand at anything more than a small discount to enhance the NAV per share for remaining shareholders.®Risk remains relatively unchanged.The Board regularly reviews and monitors the Company’s objective and investment policy and strategy, the investment portfolio and its performance, the level of discount/premium to net asset value at which the shares trade and movements in the share register.
Accounting, Legal and RegulatoryIn order to qualify as an investment trust, the Company must comply with Section 1158 of the Corporation Tax Act 2010 (‘Section 1158’). Details of the Company’s approval are given on page 27. Section 1158 requires, among other matters, that the Company does not retain more than 15% of its investment income, can demonstrate an appropriate diversification of risk and is not a close company.Were the Company to breach Section 1158, it might lose its investment trust status and, as a consequence, gains within the Company’s portfolio would be subject to Capital Gains Tax. The Section 1158 qualification criteria are continually monitored by JPMF and the results reported to the Board each month. The Company must also comply with the provisions of the Companies Act 2006 and, as its shares are listed on the London Stock Exchange, the UKLA Listing Rules and Disclosure Guidance and Transparency Rules (‘DTRs’). A breach of the Companies Act 2006 could result in the Company and/or the Directors being fined or the subject of criminal proceedings. Breach of the UKLA Listing Rules or DTRs could result in the Company’s shares being suspended from listing, which in turn would breach Section 1158. The Directors seek to comply with all relevant regulation and legislation in the UK, Europe and the US and rely on the services of its Company Secretary, JPMF, and its professional advisers to monitor compliance with all relevant requirements.®Risk remains relatively unchanged.Compliance with relevant regulations is monitored on an ongoing basis by the Company Secretary and Manager who report regularly to the Board.
Political and EconomicPolitical changes in Japan and the resulting economic uncertainty may affect the Company, the value of its investments in Japan and capital allocation decision making. Changes in legislation, including in Japan, the US, UK and the European Union, may adversely affect the Company either directly or because of restrictions or enforced changes on the operations of the Manager. JPMF makes recommendations to the Board on accounting, dividend and tax policies and the Board seeks external advice where appropriate. Significant political events could impact the health of the Japanese or UK economy, resulting in the imposition of restrictions on the free movement of capital.The Company is at risk from changes to the regulatory, legislative and taxation framework within which it operates, whether such changes were designed to affect it or not. The Board monitors and receives advice from the Manager and other advisors on political and economic risks.®Risk remains relatively unchanged.Political risks have always been part of the investment process.
Global PandemicsThe emergence of COVID-19 has highlighted the speed and extent of economic damage that can arise from a pandemic. Evidence suggests that the likelihood of pandemics has increased over the past century due to increased global travel and integration, urbanisation, changes in land use, and greater exploitation of the natural environment.The response to the Pandemic by the Japanese and other governments may potentially fail to mitigate the economic damage created by the Pandemic and public health responses to it, or may create new risks in their own right.The Board receives reports on the business continuity plans of the Manager and other key service providers. The effectiveness of these measures has been assessed throughout the course of the COVID-19 pandemic and the Board will continue to monitor developments as they occur and seek to learn lessons which may be of use in the event of future pandemics.To date the portfolio’s holdings have not exhibited a long-term negative impact and have recovered as the containment measures eased.The Board is mindful that implications arising from future pandemics will vary and hence the ability to assess mitigation activities is limited. But the Board seeks to manage these risks through: a broadly diversified equity portfolio, appropriate asset allocation, reviewing key economic and political events and regulatory changes, active management of risk and the application of relevant policies on gearing and liquidity.®Risk remains relatively unchanged.The economic impact of the COVID-19 pandemic has been considered. There are always exogenous risks and consequences, which are difficult to predict and plan for in advance. The Company does what it can to address these risks when they emerge, not least operationally and in trying to meet its investment objective.
Geopolitical instabilityGeopolitical Risk is the potential for political, socio-economic and cultural events and developments to have an adverse effect on the value of the Company’s assets.The Company and its assets may be impacted by geopolitical instability, in particular concerns over global economic growth. The crisis in Ukraine has affected energy and commodity markets and may cause further damage to the global economy.The ongoing conflict between Russia and Ukraine has heightened the possibility that tensions will spill over and intensify geo-political unrest between other countries sharing a common border.There is little direct control of this risk possible. The Company addresses these global developments through regular questioning of the Manager and will continue to monitor these issues as they develop.The Board has the ability, with shareholder approval, to amend the policy and objectives of the Company to mitigate the risks arising from geopolitical concerns.   Although geopolitical risks are part of the investment process, this risk has been heightened by the recent Russia-Ukraine invasion.
Climate ChangeClimate change has become one of the most critical issues confronting companies and their investors. Climate change can have a significant impact on the business models, sustainability and even viability of individual companies, whole sectors and even asset classes.The Board receives ESG reports from the Manager on the portfolio and the way ESG considerations are integrated into the investment decision-making, so as to mitigate risk at the level of stock selection and portfolio construction. As extreme weather events become more common, the resiliency, business continuity planning and the location strategies of the Company’s services providers will come under greater scrutiny.   Risk has been heightened by rising temperatures fueling environmental degradation, natural disasters, weather extremes, food and water insecurity and economic disruption.

Emerging Risks

The Board is cognisant of emerging risks, which are characterised by a high degree of uncertainty in terms of probability of occurrence and possible effects on the Company.

Emerging risks are considered as they are identified and are incorporated into the Company’s risk matrix. The Board, through the Audit Committee, will continue to assess these risks on an ongoing basis. The following have been identified as emerging risks:

Emerging riskDescriptionMitigation/Control
Artificial Intelligence (AI)While it might equally be deemed a great opportunity and force for good, there appears also to be an increasing risk to business and society more widely from AI. Advances in computing power means that AI has become a powerful tool that will impact a huge range of areas and with a wide range of applications that include the potential to disrupt and even to harm. In addition the use of AI could be a significant disrupter to business processes and whole companies leading to added uncertainty in corporate valuations.The Board will work with the Manager to monitor developments concerning AI as its use evolves and consider how it might threaten the Company’s activities, which may, for example, include a heightened threat to cybersecurity. The Board will work closely with the Manager in identifying these threats and, in addition, monitor the strategies of our service providers. Furthermore, the Company’s investment process includes consideration of technological advancement and the resultant potential to disrupt both individual companies and the wider markets.

TRANSACTIONS WITH RELATED PARTIES

Full details of Directors’ remuneration and shareholdings can be found on pages 55 and 56 and in note 6 on page 74 of the Annual Report.

STATEMENT OF DIRECTORS’ RESPONSIBILITIES

The Directors are responsible for preparing the Annual Report and the financial statements in accordance with applicable law and regulation.

Company law requires the Directors to prepare financial statements for each financial year. Under that law the Directors have prepared the financial statements in accordance with United Kingdom Generally Accepted Accounting Practice (United Kingdom Accounting Standards, comprising FRS 102 ‘The Financial Reporting Standard applicable in the UK and Republic of Ireland’ and applicable law). Under company law the Directors must not approve the financial statements unless they are satisfied that they give a true and fair view of the state of affairs of the Company and of the profit or loss of the Company for that period. In preparing the financial statements, the Directors are required to:

•  select suitable accounting policies and then apply them consistently;

•  state whether applicable United Kingdom Accounting Standards, comprising FRS 102, have been followed, subject to any material departures disclosed and explained in the financial statements;

•  make judgements and accounting estimates that are reasonable and prudent; and

•  prepare the financial statements on the going concern basis unless it is inappropriate to presume that the Company will continue in business

and the Directors confirm that they have done so.

The Directors are responsible for keeping adequate accounting records that are sufficient to show and explain the Company’s transactions and disclose with reasonable accuracy at any time the financial position of the Company and enable them to ensure that the financial statements and the Directors’ Remuneration Report comply with the Companies Act 2006.

The Directors are also responsible for safeguarding the assets of the Company and hence for taking reasonable steps for the prevention and detection of fraud and other irregularities.

The Directors are responsible for the maintenance and integrity of the Company’s website. Legislation in the United Kingdom governing the preparation and dissemination of financial statements may differ from legislation in other jurisdictions.

Under applicable law and regulations the Directors are also responsible for preparing a Strategic Report, a Directors’ Report and a Directors’ Remuneration Report that comply with the law and those regulations.

Each of the Directors, whose names and functions are listed in Directors’ Report confirm that, to the best of their knowledge:

•  the Company’s financial statements, which have been prepared in accordance with United Kingdom Generally Accepted Accounting Practice (United Kingdom Accounting Standards, comprising FRS 102 ‘The Financial Reporting Standard applicable in the UK and Republic of Ireland’, and applicable law), give a true and fair view of the assets, liabilities, financial position and profit of the Company; and

•  the Directors’ Strategic Report includes a fair review of the development and performance of the business and the position of the Company, together with a description of the principal risks and uncertainties that it faces.

The Directors consider that the Annual Report and Financial Statements, taken as a whole, is fair, balanced and understandable and provides the information necessary for shareholders to assess the Company’s position and performance, business model and strategy.

For and on behalf of the Board
Alexa Henderson
Chairman

23rd June 2023

Japan income fundJPMorgan Japan Small Cap Growth & Income (LON:JSGI), targets Japan income without compromising on Japanese growth opportunities. This Japan income investing opportunity gives investors access to a diverse and fast growing sector managed by local managers.

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