Joe Bauernfreund: why Japan is an active investor's dream market

Merryn talks to Joe Bauernfreund of the AVI Japan Opportunity Trust about the opportunities for investors in Japan, a hugely under-researched market with plenty of value.


Merryn Somerset Webb: Hello, and welcome to the MoneyWeek magazine podcast. I am Merryn Somerset Webb, editor-in-chief of the magazine, and today we are going to talk about Japan. Long-term readers will know that Japan is one of our favourite markets, and has been one of our favourite markets for a very long time, possibly too long.

I get a certain amount of criticism for giving Japan an easy ride relative to other economies, other stockmarkets, because I just really enjoyed living there in my 20s.

That criticism may occasionally be valid. I suspect that if we were going to talk about this year, it wouldn’t be valid. Japan is about, we think, to have a moment, maybe another moment.

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So, with me today, I have Joe Bauernfreund, who is the manager of AVI Japan, which is a particularly interesting Japan trust, because it is very value orientated, which is not something we’ve seen that much.

Joe, welcome. Thank you for joining us today.

Joe Bauernfreund: Thank you very much for having me. Good to be here.

Merryn: Now, one of the things that people always say about Japan, and one of the things people said even in my 20s when I worked in Japan, and they’ve been saying ever since, is that you can’t really look at Japan as anything except for a global, cyclical market. It sways and moves around the place, with news on global GDP growth and with foreign exchange news, and that’s just about it. And if you think there’s more than that to Japan, you’re just kidding yourself. But there is more to Japan, isn’t there?

Joe: Of course, there’s more to Japan. There’s sushi, there’s sake.

Merryn: I was thinking more on financial terms, but yes.

Joe: Of course, there’s a lot more to Japan than just that. It’s a large economy. There are thousands of companies there. There’s a lot to say for Japan in terms of the domestic economy and the domestic demand, despite what we hear about all the problems, the demographic problems and the deflationary problems. There’s a huge number of very successful, high-growth, very attractive businesses in Japan, benefiting from the domestic economy.

Merryn: Joe, possibly one of the reasons why we don’t hear as much about Japan as we might about other developed markets, is that it is so under-researched.

This has happened, I know, since I was there during the Great Bubble in Japan. Everybody was looking at Japanese companies. It seems like a long time ago now, but nonetheless the aftereffects of that bubble collapsing, people leaving the market, remain. So, something like 73% of the companies in the Japanese market are covered by only one analyst, and an awful lot of them are covered by no analyst at all. If you’re an active investor looking for opportunities that other people haven’t seen, it’s a really great market to be in.

Joe: That’s absolutely right. As you say, hundreds of companies in Japan don’t have any research, and that really contributes to the inefficiency that exists in the market. We hear so much about the debate about active versus passive, and the ability, or questioning the ability, of active managers to outperform benchmarks.

In Japan, because it’s such an inefficient market, and because there is so little in the way of price discovery from other investors and from the sell side, there are so many opportunities, really, to be exploited. And it should be a great market for active managers to outperform.

Merryn: And there’s also something going on there in terms of corporate activity, isn’t there? And another thing we think about Japan is that it’s a very slow-moving market in terms of corporate activity, that companies don’t restructure, they don’t merge, that they don’t really work to produce shareholder value.

I know shareholder value isn’t very fashionable these days. Everyone talks about stakeholder values. But nonetheless, we have been criticising Japan, and when I say we, I mean analysts, etc, for the last 20 years, for not thinking about shareholder metrics and not really thinking about operational returns. But something has changed there.

In the last few years, we’ve seen the introduction of the Japanese Corporate Governance Code. We’ve also seen various tax changes that have somehow changed the way that works. So, we’re beginning to see a lot of M&A announcements, various bits of shareholder activism, discussion, corporate restructuring news, etc. Something has changed, right?

Joe: Definitely. As you say, five or six years ago, they introduced the corporate governance code and the stewardship code in Japan, and the idea behind that was explicitly to improve shareholder returns, to get companies to focus on shareholders as well as other stakeholders. So, it’s not about ignoring the other stakeholders, it’s just promoting the interest of shareholders, to boost returns on equity, to do more about depressed share prices.

And that really has led to, as you say, a change in attitudes towards shareholders and towards corporate activity generally. But things take a long time in Japan, they don’t happen as quickly as they might in other markets, and that does frustrate some investors. And some investors still look at Japan and say, if they were really serious about change, they’d do a lot more, and they’d do it a lot quicker.

But I think one has to have some sympathy for Japanese culture and the fact that it does take them a long time to change direction. And what’s very positive, to us, is that when you look at the various corporate governance metrics, such as independent directors on boards, such as returns on equity, such as dividend payout ratios, today they are in a hugely better place than they were five or six years ago.

And that does say that most companies in Japan have really started taking shareholder returns a lot more seriously, and it’s that direction of travel that is encouraging.

Merryn: Sorry, let’s just go back a bit briefly and talk about why the Japanese market has historically been different. Why has it been that this idea of shareholder value had not quite the same traction as it’s had perhaps in the US and the UK? There’s a very different type of capitalism at work there?

Joe: Yes, absolutely. I think that the attitude of Japan, and certainly after the Second World War, as they rebuilt the economy, was about creating big, large, successful companies, employing as many as possible, making a positive contribution to the nation.

And on top of that, if you throw into the mix the attitudes towards personal welfare they had in Japan, it was viewed as embarrassing to be wealthier than your friends, and similarly, to pursue more personal wealth.

It was much more about the collective attitude. And that really has led to this stakeholder focus, whereby companies are less interested in the bottom line, and they’re less interested in shareholders. And they’re much more interested in keeping as many people employed as possible, making sure that their pensioners receive their pension, and that they can have pride in their company.

Merryn: That’s so interesting, isn’t it? Because that’s one of the things that everybody wants in the West now, isn’t it? It’s a shift towards that stakeholder capitalism, but at the same time as we look towards Japan, you’re seeing a shift in the other direction there.

So, we’ve talked about that shift beginning. Let’s just talk briefly about what drove that change. If we look at Japan, you might say that system was maybe working perfectly well, so why bring in the corporate governance code? Why change the environment so that it becomes a more shareholder-friendly environment?

Joe: Look, it was working in the sense that people had jobs, but when you look at the economic growth, or, to be more specific, the lack of economic growth that Japan’s been plagued with, the deflation attitude, the lack of animal spirit, really, in Japan, I think that was something that the government under Shinzo Abe primarily wanted to address.

And that really led to the introduction of the various corporate governance codes and the promotion of shareholder interest.

And then, on top of that, this attitude, this conservative attitude, had also led to enormous build-up of idle cash on company balance sheets. And there was this attitude in Japan that you must have cash for a rainy day. You don’t to be caught out when problems hit. You don’t want to have to go to banks to borrow. You don’t want to have to go to your shareholders to raise capital.

So, always have cash on hand, and that cash really suppressed, as you can imagine, returns on equity and shareholder returns, consequently. And what the government felt was that you can almost kill two birds with one stone. You can get that cash used more productively. You can boost shareholder returns. You can boost wealth generally.

And if not, if the company can’t find anything productive to do with it, then if we encourage companies to give that cash back to shareholders, then those shareholders, in turn, will take that money and spend it and just fire up the economy in that way. And that really was the thinking between the two codes.

Merryn: So, what are the results? One of the first results there, of course, is that cash is beginning to be returned to shareholders. And one of the extraordinary things that we’ve seen over the last few years, something I thought I’d never see, is the launch of a couple of funds that are Japan income funds. That was one, Jupiter I think that was. Jupiter, that was the Japan income fund?

But now there are a couple of others knocking around this idea that you can actually invest in the Japanese market, to seek out dividends and get an income return you can live off, is a new and fairly extraordinary idea, right?

Joe: Absolutely. Japan stacks up quite attractively relative to the rest of the world when it comes to current dividend yields, probably slightly higher than the world on average. And in addition to that, companies are growing their cash balances, growing their profit on a year-by-year basis, and therefore have the ability to grow dividends quite attractively in the coming years.

Merryn: What is the yield on the market at the moment?

Joe: I think it’s just below 2%.

Merryn: That’s not bad, is it? It would have sounded awful a decade ago, but it doesn’t sound bad now.

Joe: That’s right.

Merryn: And valuation as a whole across the Japanese market?

Joe: You see, our area of focus is on the small cap, cash-rich companies, and there we see very depressed valuations. On average, on our portfolio, something like four and a half times EV/EBIT multiples, which is ludicrously low. Across the market as whole, valuations are somewhat higher, but the cash on the balance sheet distorts a lot of the multiples that people look at. And there’s a big difference between large cap and small cap, of course.

Merryn: So, we’ve got all these small, cash-rich companies knocking around, that nobody looks at, no one’s much interested in, you hold them in your portfolio. It’s a great story, and as we know, markets love stories, investors love stories. The history of investment, I think I wrote last week, is nothing but the history of stories. But a story needs a catalyst. And we’ll talk about what types of industries they’re in at the moment, but what takes all these small, interesting, cash-rich, cheap companies, and makes them not cheap companies anymore?

Joe: Corporate activity. The fact that you’ve got an environment in Japan where, on the one hand, you’ve got the regulators telling companies to do more about the depressed valuations, to focus more on shareholder returns. And then on the other hand, you’ve got the stewardship code, which tells shareholders really for the first time in Japan, to act like owners of these businesses.

And rather than always vote in support of the directors and the presidents of these companies that aren’t delivering for shareholders, you need to start flexing your muscles, and you need to start telling the companies to do more for shareholder returns.

And if you don’t, then part of this whole revision of the attitude towards the corporate governance code is to invite shareholders such as ourselves, foreign shareholders as well as domestic shareholders, to be much more active, to be much more engaged, because otherwise you’ll see companies start being taken over.

Japanese companies don’t want to be taken over by foreign investors, for the most part. And what you’ve seen since this has started, is an influx into Japan of not only activist investors, such as ourselves, focused on the stock market, but private equity investors as well. And the two really go hand in hand.

People like us put pressure on companies to do more for shareholders, and the solution for many may be to sell themselves or to partner up with private equity, and that’s certainly been the idea. And when you look back over the last five years, you’ve seen the likes of Hitachi and Toshiba, the big conglomerates, undertake a number of transactions whereby they’ve either sold subsidiary companies, or bought in subsidiary companies.

And often that has been done in partnership with the large global private equity firms, all of whom are expanding their presence in Japan, hiring teams, raising funds, and looking for transactions in Japan. Because, as we’ve said, it’s a cheap market and companies are undermanaged, I would say, and therefore there’s huge opportunity, not only on the valuation side, but also on the operational side as well.

And at the same time, we’ve seen the growth in the domestic private equity industry. So, Japan is behind the rest of the world in terms of institutional allocation to private equity and the number of private equity funds that exist, but it’s been growing in the last five years.

And particularly at the small cap end, there are more domestic private equity funds looking for opportunities. And collectively, activist investors and private equity investors hold the key to unlocking a lot of the value that remains trapped in the Japanese stock market.

Merryn: Joe, this is really interesting because it sounds like, like so many of the stories in the market, this Japan story is really a private equity story. It’s about the private market being able to see more value in a company than the public market. So, does it worry you that a lot of these small companies are going to end up being taken private, or is that just part of the value discovery process?

Joe: It absolutely doesn’t worry us. We say bring it on, because the whole idea behind the fund was that you have this collection of companies in Japan that had great businesses and that were so massively undervalued. And as you said, what is the catalyst for unlocking this value?

And the catalyst really is, either the companies do something about their undervaluation themselves by allowing the market to value them more appropriately, or somebody else comes along and exploits that undervaluation. And that really is what exists in most other markets around the world.

And what we’ve seen in Europe, the UK, and the US, private equity exploits valuation inefficiencies, valuation anomalies, and takes companies over at attractive prices if they can.

And Japan has been a bit closed on that front. It’s got this culture of cross shareholdings that protect incumbent management. It’s got this attitude that companies don’t want to be taken over, by not only foreigners, but also by domestic companies that have a different culture to their culture. So, it’s a very insular society, and protectionist in a sense. Lots of companies had poison pills in place to protect them from unwanted predators.

This is really the corporate governance code and the stewardship code, is removing all those barriers, inviting investors to be more active, encouraging shareholders to be more vocal. And if the companies can’t do it for themselves, then make the market open to other forms of corporate catalysts, corporate change of control, and private equity is at the heart of that.

Merryn: Based on what you’re saying, it sounds to me like the majority of the companies in your portfolio are going to be companies in more, say, old-fashioned industries. One of the big conversations that we’re having around the market at the moment is, the way that the pandemic has been a catalyst to productivity and to digitalisation. So, people are talking about the exciting growth in areas like, I don’t know, ecommerce and digital payments, and software, etc, space. But it sounds to me like these are not the areas in which you are invested.

Joe: It’s a mix, I would say. There is a lot of domestic demand focus, but there is also, in parts of the portfolio, certain types of company that actually tick some of the boxes that you’ve highlighted.

A big theme that we’re playing in the portfolio is digitalisation. Surprisingly to many, Japan was woefully unprepared for the whole work-from-home environment. A lot of companies have got decades-old technology, and companies simply couldn’t operate with employees working remotely.

And one of the big things, one of the big pushes that Suga San has implemented since he came into power is the digitalisation of the economy, promoting that. And we have a few software integration companies, software service companies, that are going to benefit from this big push and this big encouragement that’s going on in Japan, to improve their technological capability of Japanese companies.

Merryn: Should we talk about a couple of the companies in the portfolio that are particularly interesting?

Joe: Yes.

Merryn: Any that you’d like to highlight?

Joe: You mention the impact of COVID, and I think one very interesting company that we have in the portfolio, as a play on the recovery and the return to normal, is a company called Keisei Electric.

So, Keisei Electric is one of the railway companies in Japan, but it also owns a stake in Oriental Land, another listed company, that actually owns the Disney theme park in Tokyo.

On the railway line front, it owns the tracks that run from Narita Airport down into the centre of Tokyo, so if you can imagine, on both fronts, it’s been absolutely hit by the impact of COVID and the lockdown. There aren’t any people flying into Narita Airport, so there aren’t any people using their train tracks, so they’re not earning income from that. And of course, in a lockdown environment, Disney’s revenues have been whacked as well.

So, we see this as an attractive play on a very attractive valuation, to play the recovery. And given that Oriental Land is listed, and we can see the value of that in the market, it’s remarkable that Keisei Electric trades at about a 50% discount to the value of that stake in Oriental Land, as well as the value of the land and the railway line business as well.

Merryn: That’s interesting. And how will Japan’s reopening go? They’ve been very behind on vaccinations, right? I know they’re catching up now, but in a remarkably slow start, and cases in Japan rising. Is that reopening going to end up being significantly delayed, and what impact will that have?

Joe: I think it’s been delayed, and I think it was surprising to me, and to others, that Japan was so slow getting the vaccine rolled out, and they basically ended up at the back of the queue. And so, therefore, that’s probably one of the reasons why Japan hasn’t really participated in the rally that we’ve seen in markets since around October, November time, when news of the vaccine started to emerge.

What we’re seeing now is a massive ramp-up in the vaccine rollout. I think there’re over a million doses a day now, and probably by September, a big chunk of the population, and certainly a big chunk of the vulnerable element of the population, will have been vaccinated. And I think that’s what will allow a swifter return to some normality in Japan.

You’re right that cases are going up, but you have to remember that cases were always relatively low in Japan, relative to the rest of the world, and that’s both cases and fatalities as well. So, although we are seeing an increase, it is off a very low base.

Merryn: Let’s talk about a couple of other companies. What else is interesting?

Joe: We’ve spoken about corporate activity, and we haven’t got this in the portfolio because it was the subject of corporate activity, but it does provide evidence of some of the catalysts that we are looking for, and what some of the upside can be.

We had a company, up until about six weeks ago, called Secom Joshinetsu, and Secom Joshinetsu is a small company, £300 million market cap, that provides burglar alarm services and security services. And it’s an attractive business because it’s got maintenance contracts, and the maintenance contracts are very visible and provide uplift. Now, Secom Joshinetsu was controlled by a parent company called Secom, which is just the larger version of Secom Joshinetsu, and they own 51% of the company.

And this is a problem that exists in many companies in Japan, you have a parent and then you have a subsidiary. And the parent basically acts as a poison pill, it supresses the share price, it prevents anybody else from coming in and taking the company over. And this is one of the things that the corporate governance code is addressing, this problem of parent/child subsidiaries.

Now, Secom Joshinetsu traded very cheaply, it had 80%, 90% of its market cap sitting in cash, and it was a more attractive proposition than the parent company, but traded at a fraction of the multiple. And after a period of engaging quite intensely with the company, and coupled with the pressure from the regulators via the code to do something about these structures, the parent company made a bid for the child, Secom Joshinetsu, at about a 66% premium, as I say, a few weeks ago, to the prevailing share price.

That was accepted. We found that to be spot on where the company should be valued at. And that’s a sign of the potential catalysts that exist in this universe, and the upside that we expect to generate when these companies are the subject of this form of corporate activity.

Merryn: Okay, that sounds like an interesting one. Tell us a bit more about your portfolio. How many companies?

Joe: In total, there are 28 companies.

Merryn: So, it’s pretty focused.

Joe: It’s pretty focused.

Merryn: And you know all those companies very well?

Joe: Absolutely. At the top end, the largest positions are around 7% or 8% of the fund, so it’s quite concentrated at the top end. I think the portfolio’s probably got 20 core names and a tail of eight, a few names coming out, a few names being built up, positions. And we are focused, to some extent, on the less liquid part of the market, so it takes time to build stakes.

Merryn: And then you interact with management to a fairly large degree? And how does that work in Japan? Are you welcome?

Joe: Yes, we are welcome, and this is really one of the successes of the stewardship code and the corporate governance code, that Japanese managements have learnt that part of their job is to talk to shareholders, such as ourselves.

And actually, part of our job is to portray ourselves as one of the one good guys, not one of the very aggressive foreigners who are just interested in making a quick buck, and not that interested in the success, the long-term success of Japan. We are interested in that, we can be patient investors, we want companies to do well, and we want to work with these companies.

And I think both of those sides of the coin, really, have led to quite a productive relationship, in most cases. And engagement in Japan, how does it work?

It’s a very intense process. It takes a long time. You do have to be patient. You do have to write very long letters. You do have to sit in very long meetings. And that’s really why at AVI we’ve expanded our team.

We’ve hired four Japanese nationals to join myself and Daniel Lee, the senior Japan analyst, with whom we launched this fund a few years ago. And that really has enabled us, A, to have a presence in Japan permanently, but also to improve our efficiency and improve our ability to engage productively with companies.

Merryn: And of course, the risk here is you do all that productive engagement, and rather than the company is listening to you and you’re getting some traction, you suddenly find they’ve been taken over by private equity, and everything you did was pointless.

Joe: No, that’s part of the engagement, because if the way of getting the price up is that they get taken over, we are very open to that. There are plenty of other opportunities for us to focus on. We want to have a concentrated portfolio. As I say, there are hundreds of companies that are trading in Japan at ludicrously low valuations, and we can’t do all of them, and that’s why I welcome more activist investors such as ourselves. All of it helps.

It’s really up to Japan Inc to do what it can. If it wants to retain a listed market, then managers have to get the valuations up. But on that point, Japan has got too many listed companies.

I think there are over 4,000 listed companies in Japan, and many are very small, and it’s just an inefficiency that exists. It’s another reason for the lack of interest at the small cap end.

And there are reforms going on in the Tokyo Stock Exchange right now, that will make it harder for particularly small companies with limited number of shareholders to continue to exist in a listed form. And that is also driving some consolidation and some management buyout activity, all of which is good for us.

Merryn: Good. And the Olympics? Will you be going to the Olympics?

Joe: I don’t think anybody will be going to the Olympics.

Merryn: No one’s going to the Olympics.

Joe: Look, it’s very sad, of course. When COVID started and we weren’t sure how it was playing out, there was a lot of focus on, were the Olympics going to go ahead? Were they not going to go ahead? Unfortunately, the debate and the dialogue has moved on. The Olympics are going ahead, but in a form that nobody really is that happy about. And what was meant to be a great event for boosting Japan’s morale and boosting the popularity of Japan as a tourist destination, a business destination, really won’t come to pass, unfortunately.

Merryn: It’s very disappointing, but luckily, as you say, there are still many other reasons to be in the Japanese market, and many opportunities out there.

Joe, I think we have to leave it there. Thank you so much for joining us today.

Joe: Thank you for having me.

Merryn: Thank you very much, indeed, Joe. We will be hearing a lot more from Joe in the future, I’m sure. And I’m afraid, long-suffering readers, you will be certainly hearing a lot more on Japan from MoneyWeek over the years.

Now, if you want to hear more from us on all subjects, please do follow us on Twitter @MoneyWeek. You can follow me on Twitter @MerrynSW. You can follow John on Twitter at @John_Stepek. And of course, you can visit our website, where you can sign up for our daily newsletter, MoneyMorning, often written by John. And if you enjoy the podcast, please do leave a review on your podcast provider of choice. Thank you very much.