Bet on Japanese corporate-governance reform and healthy small US banks, says David Stevenson.
Two of this year’s most intriguing investment ideas are a change in Japan’s corporate culture and the auspicious outlook for small US banks. The Japan Life Insurance Association has released a review aiming to improve stewardship among the top 300 companies by market capitalisation.
There was a heavy emphasis on better corporate governance with 48 companies identified as candidates for “improvement”. These are mostly very large businesses by market capitalisation, but changes are also happening at the small-cap level.
Japan Inc. is getting the message
Last October the Asset Value Japan Opportunity Trust (LSE: AJOT) listed on the London market with £80m of capital. The idea was to invest in smaller stocks ignored by the big funds. Today it is already 90% invested and has scored a corporate-governance win with a business called Nakano Refrigerators. The company’s share price has gone up 23% in sterling terms after the trust started engaging with the business.
Joe Bauernfreund, Investment Manager at Asset Value Investors (AVI), says Nakano had far too much cash: “at the time of our purchase, Nakano’s overcapitalised balance sheet meant that net cash accounted for 89% of the market cap and 58% of balance sheet assets”. The firm has announced a commitment to pay out 100% of earnings as dividends for the next three years.
There has also been positive news at the CC Japan Income and Growth Trust (LSE: CCJI). It recently announced its annual results (for the year to 31 October). Net asset value (NAV) rose 4.1% in total-return terms against a loss of 0.4% for the Topix, one of Japan’s benchmark indeces. Crucially, most of the performance uplift came from investing in mid- and small-sized businesses, where corporate governance is rapidly improving and dividends are steadily starting to increase as a result.
At the fund level, total dividends of 3.75p increased 8.7% from 2017. The managers behind this well-respected fund expect aggregate distributions from Japanese companies to hit an all-time high in the financial year ending March 2019. Japanese firms, it appears, are slowly but surely getting the message.
The broader macroeconomic backdrop sometimes obscures the positive governance picture. The economy’s reputation as a safe-haven market doesn’t help. Every time investors worry about the dollar, Trump, China, or populists, the yen appreciates and Japanese bond yields fall. In December, yields slipped and the yen rose to ¥139.95 per pound, the high for the year.
As risk aversion spread and the stronger currency threatened to undermine Japanese firms’ overseas earnings, investors reacted by selling Japanese equities. Over the last 12 months the Tokyo Stock Exchange first tier is down 8.8% and the MSCI Japan Smaller Caps index is down 10.3%. My own hunch, however, is that this sell-off represents a real opportunity, allowing smart managers at AVI and CC to buy quality companies at even cheaper prices.
US banks are in rude health…
There are fewer headwinds facing my other compelling idea: the rude health of US financials. US interest rates are still – for now – increasing and that’s good news for US banks large and small as profits increase. Financial regulation reform has also really helped smaller banks, who now have fewer burdens imposed on them by the regulators. Merger and acquisition activity has started giving smaller banks a fillip.
There are certainly plenty of takeover candidates: 5,700 banks currently operate in the US. On average, balance sheets are now in excellent shape, with leverage historically low. While regulators may be worried about wider corporate borrowing, they are sanguine about US banks and their balance sheets.
… especially small ones
This is the wider context that has helped boost the share price of a small, under-researched trust listed on the UK market called EJF Investments (LSE: EJFI). It focuses exclusively on lending to small, mostly local banks and insurers. It does so in two ways: either directly or through collateralised debt obligations (CDOs, pooled loans repackaged into tranches and sold to investors).
It invests in the so-called junior portions of the CDOs. This has advantages and disadvantages. EJF puts these structures together as a manager and collects a fee, so it must have a handle on the creditworthiness of the underlying borrowers. Yields are also higher at this end of the structure. However, as the higher yield implies, there is a higher risk of default in this section of a CDO.
But smaller bank balance sheets are strong and even if there is an economic slowdown in the US, losses are unlikely to be anywhere near the defaults currently being experienced by many investors in mainstream leveraged corporate lending. Overall, this niche seems to be generating solid returns for this fund, with a yield running at around 5.6% per year. The fund reported bumper returns last year – up 19%, with the share price up 10%.
Matters might prove a bit tougher in the current year and recent monthly numbers showed December’s NAV was down just over 1% because of a write down in two loans in its portfolio. But with the shares trading at a slight discount to NAV, a balance sheet full of floating rate loans (which become more valuable as rates rise), and a well-backed dividend yield of more than 5%, this is a fund adventurous income investors should look into.