The veteran Japan investor tells Kyle Caldwell how he finds exceptional businesses and then holds on to them as long as possible, and explains why Abenomics has failed.
In life, three things are certain: death, taxes and investment experts tipping Japan as their star stockmarket performer at the start of every calendar year. The beginning of 2019 proved no exception, with investor enthusiasm even higher than usual on the back of Japan’s main stockmarket index, the Nikkei 225, tumbling into a bear market in late 2018, having fallen 20% from a peak at the start of October.
The cheaper valuations on offer are not the only attraction; optimism regarding Japan’s economy also remains high, due to a series of reforms being carried out by prime minister Shinzo Abe, dubbed ‘Abenomics’. The reforms are designed to stimulate Japan’s stagnant economy by boosting productivity, wage growth and consumer spending, and are being implemented through the ‘three arrows’ of improvements to corporate governance, the injection of fiscal stimulus and monetary policy.
Abenomics will take time to work
But veteran investor Michael Lindsell is not inclined to get swept up in all the hype. He points out that the core aim of Abenomics “has not worked”, as the country is still battling the deflation that arose after its debt-fuelled property and stockmarket bubble burst three decades ago. The Nikkei fell then from its 39000 point peak – a level it remains well below today, trading at just over 20000.
In order to address its economic malaise the Bank of Japan was set a 2% inflation target, which it was supposed to reach this year; but this has now been shelved, given that deflation persists. The latest inflation reading, for the year to October 2018, stands at a mere 0.4%.
Investor euphoria on the political front is therefore misplaced, Lindsell argues. “The governance changes for the companies we invest in happened many years ago, and in many ways they are run better than western companies. The reforms are a good thing, but they are not going to make a massive difference for some time.”
Moreover, he adds: “There are so many problems in Japan – there are too many old-economy businesses and over the next 20 years the population will decline. In addition, pressure on trade as economic growth in China slows, plus the impression that monetary stimulus has run its course with negative interest rates and intervention in both bond and stockmarkets, makes it difficult to see growth taking off.”
Lindsell’s nonchalant stance is refreshing, as fund managers love to ‘talk up an economy’ when investing in a particular region, as a means of trying to persuade investors to part with their cash. Instead, he prefers his track record to do the talking for him – and over the years the Lindsell Train Japanese Equity fund has not disappointed. Since Lindsell became lead manager in February 2004, the fund is up 306%, comfortably ahead of the Nikkei 225 index, which has doubled in that period. The IA Japan sector average has gained an edge on the index, up 133%, but trails way behind Lindsell’s fund.
His process is straightforward to describe, and involves constructing a portfolio of exceptional businesses – in essence the best of what Japan has to offer. Only a small number of companies display the sort of qualities Lindsell looks for in his search for businesses demonstrating long-term durability in cash and profit generation. The attributes he prizes most are strong consumer franchises built up over decades and valuable intellectual property. He takes a 20-year view, but ideally is looking for businesses to stand the test of time indefinitely.
“We view risk as the risk of losing money, which is why we focus on the best businesses rather than diversifying for the sake of it. We look for the ‘survivors’, the small number of companies that can endure for long periods of time. These businesses have the ability to compound cash flows at an accretive rate.”
Overall, there are 62 stocks in Lindsell’s investable universe, with only 22 held in the fund. He says “corporate governance issues” put him off having a bigger number of holdings. Indeed, he adds, he would cut the number of stocks if he had the option, but under the various Ucits regulations that aim to protect investors, it is difficult for the fund to become any more concentrated. The average age of the companies held is 89, with the top slot occupied by Nintendo. Beauty product firms Kao and Shiseido are among the largest holdings in the fund. Around half the portfolio is invested in consumer franchises. The rest is split between owners of valuable intellectual property or media content, and healthcare an pharmaceuticals – the latter a play on Japan’s ageing population.
Turnover is low, at 7% last year, with just one new holding – Square Enix, one of Japan’s leading video game publishers – added to the fund in 2018.
But while Lindell likes to ‘run his winners’, he does not rest on his laurels, and is increasingly devoting his time to the rise of technological disruption. “Technological innovation is a threat, but it can also enhance existing business models,” he says. “We spend a lot of time trying to understand what tech will do to our existing business models and working out which ones will benefit and which ones are vulnerable.” He points to Square Enix and Nintendo as two stocks that are both benefiting from advancements in technology. “Over half of all video games are downloaded on the internet. In turn, this cuts distribution costs enormously and boosts margins,” he adds.
In various industries innovative firms are attempting to eat the lunch of the old guard, but Lindsell says the “hurdles are higher” for a younger company meeting his investment criteria. “I have more much confidence in a company that has seen it all; some of our holdings have been through some hideous times, including the Second World War,” he says. However, he does not invest in the established industries that look most under threat from technological change, such as retailers and automakers.
As well as placing a big emphasis on the future growth potential of a business, Lindsell also likes to see a dividend paid, and at present all 22 stocks do return cash to shareholders. “Over the long term, dividends make up a greater proportion of the total return than I think people realise, so this is something we want to capture,” he comments.
Returning cash to shareholders
Over the past couple of years, the fund has benefited from upward revisions in dividend payments for a number of shares – an indication that corporate governance is improving. As part of the reforms, pressure has been put on Japanese businesses to be more shareholder-friendly and make more efficient use of their capital, including returning cash to shareholders in the form of dividend payments.
One way this has been achieved is through the creation of the JPXNikkei Index 400. To win a place in the index and receive investment from the Japanese government pension scheme, which tracks the index, firms are ranked using a number of measurements such as efficient use of capital and investor-focused management perspectives.
Lindsell, though, remains largely ambivalent. “Companies have raised dividend payouts and Japan companies are more income-friendly than they were, but for the overall market yields have only gone from 1.5% to 2% over the past decade.” The idea of running a solely income-oriented fund in the future therefore looks an unlikely one. “I do not like the idea of buying high-yielding grotty businesses,” he says. He does add that pushing businesses to become more efficient with their capital is ultimately a good thing, but stresses the reforms will not change the landscape overnight.
Lindsell’s focus on high-quality growth names has been a winning formula in recent years, and as the accompanying chart shows his fund has beaten the IA Japan sector average return by 62% over the past five years.
But in light of such strong performance, various experts have been tipping the value style of investing to return to form against a more volatile macroeconomic backdrop. Lindsell, though, does not see a distinction between the two approaches. “Value and growth are joined at the hip, with growth part of the value assessment of the share. For me, it is a misnomer to categorise value and growth separately.”
Instead, he argues that the shares he holds are attractively priced in terms of their intrinsic value, and look well-placed to continue standing out from the crowd – whether or not Japan’s ambitious reforms work.
Lindsell in six
1) My best investment was...Japan Exchange Group. it is one of the holdings that has contributed significantly to outperformance over the fund’s life. The position resulted from our longstanding holding in the Osaka Securities Exchange, which merged with the Tokyo Stock Exchange at the start of 2013 to become the Japan Exchange Group. We particularly like marketplaces such as stock exchanges. A dominant marketplace will draw customers through its provision of better liquidity and pricing, to the exclusion of lesser competitors. Market dominance is thus easier to sustain and can – as in the case of the Japan Exchange Group – lead to monopolistic market positions and returns.
2) My worst investment and lesson learned... investing in Japanese consumer finance companies. The lesson I learned was to avoid overly regulated industries.
3) Alternative career would have been…garden designer.
4) In my spare time I like to…read.
5) The one thing I would like to see change in financial services is.... the elimination of jargon.
6) Do you invest in the fund? Of course.