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he Japan Special Situations basket detracted -74bps from returns, driven by a decline in share prices and a weaker yen.

The annual AGM season promises to be interesting this year. To date, 18 companies have received shareholder proposals, three of which have come from AVI. We had originally targeted seven companies but withdrew proposals from four following announcements of improvements, including buybacks, board structure changes, and stock-based compensation schemes. This was encouraging, and highlighted the power of behind-the-scenes activism to effect change. For the three companies on which we have gone public – Tokyo Radiator, SK Kaken, and NS Solutions1 – we remain confident that pressure from shareholders, both at the AGM and thereafter, will lead to management and directors making the needed improvements.

The Japan Special Situations basket added 51 basis points to AGT’s returns, making it one of the largest contributors this month.

DTS Corp
Over a quarter of the contribution came from DTS Corp, an IT services provider. It may come as a surprise to some to learn that corporate Japan has chronically under-invested in IT infrastructure. This under-investment has prompted a warning from the Japanese Ministry of Economy, Trade and Industry that the economic loss from such under-investment could amount to 2% of GDP annually by 2025. With the formation of a governmental Digital Agency later this year, it is likely that the importance of updating legacy IT systems will become a priority item on many companies’ corporate agendas. Indeed, we are seeing more and more mid-term management plans that place heavy emphasis on IT investment and the digitation of processes. We believe that the whole IT sector, including DTS, will benefit from this increase in demand, which will be highly beneficial for sales and profit growth.

Since we initiated a position in DTS fourteen months ago, we have been engaging with the company in order to provide suggestions for improving corporate value, including sending a detailed 54-page presentation to the management team in June. To date, the company has been receptive to our suggestions: it has implemented a partnership with AWS, improved the speed of English-language disclosures, and evaluated a stock-based compensation scheme for directors. While individually these measures are small, collectively they can be quite powerful, and we hold out hope that they and other measures will help to create value for shareholders.

Despite these positive attributes, the market has rewarded DTS with a lowly multiple of 7x EV/EBIT, compared to peers which trade on a multiple of 15x. We do not expect this situation to persist if our expectations of improved profits and corporate governance prove correct.

Revised Corporate Governance Code
The third edition of the Corporate Governance Code (first edition published in 2015) was released just after the month’s end. The strictest measures will apply to companies that will be listed on the new “Prime” section of the Tokyo Stock Exchange, a designation that we believe the majority of our companies will qualify for. The key revisions to the Code include: increasing the number of independent directors; requiring listed subsidiaries to have a majority independent board, or a special committee to monitor conflicts of interest between the parent company and minority shareholders; disclosing a policy for promoting more diversity at the senior management level; enhancing climate-related disclosures; and disclosing a skills matrix for Board members.

The requirement for listed subsidiaries to improvement minority protections is encouraging, being the first time that it has been targeted by the Code. NS Solutions, a stock in the basket, is the listed subsidiary of Nippon Steel and will benefit from enhanced minority shareholder protections.

While some shareholders may be disappointed that the new wording is weaker than might have been hoped, we believe that the new edition of the Code is a significant improvement on its predecessors, and believe that the direction of travel in Japan remains highly encouraging.

Prospects for the future
2020 was a difficult year for the Japan basket, with the onset of COVID-19 effectively delaying our engagement efforts by a year. However, the important thing to note is that our efforts were delayed, not derailed; moreover, we believe that 2021 will set a record for shareholder engagement in Japan. Over the past year, we have been busy engaging with management and directors behind the scenes, sending 14 letters or presentations to 12 companies, of which 4 contained details of shareholder proposals to be submitted to their upcoming AGMs.

With a revised, more muscular Corporate Governance Code, a strong earnings recovery, and regulatory and governmental support, the corporate landscape in Japan is likely to change significantly over the coming years. We remain optimistic that the fourteen companies in the basket will deliver strong earnings performance and announce favourable changes to corporate governance.

A large proportion of the companies in the basket have now reported earnings for the quarter ending 31-Dec, with the results largely confirming our expectation for a strong earnings recovery. Despite the robust bounce-back in profits, the share price reaction of the companies in the basket has been muted, with the net result being even more undemanding earnings multiples and greater cash/market cap cover. In governance news, Japan’s Financial Services Agency held a meeting in January to discuss the upcoming revisions to the Corporate Governance Code. The key points discussed were parent-subsidiary listings, cross-shareholdings and capital efficiency, serving to highlight ongoing regulatory pressure on companies to improve corporate governance. The Tokyo Stock Exchange has, for the past year, been reviewing and restructuring its markets in order to improve structure and governance. One of its innovations has been to raise the minimum market cap required for a company to be listed on the new “Prime” or “Standard” market. In December 2020, it announced that shares held by insurance companies, banks or other businesses will not be included in the free-float calculation used to determine market caps – effectively meaning that companies with high levels of allegiant shareholders will be punished by having a lower market cap, thus reducing the odds of being allowed to maintain a listing on the more desirable Prime or Standard markets. This restructuring gave us the opportunity to engage with several companies in the basket who will be affected, including SK Kaken (doesn’t meet the minimum number of shareholders to list on the Standard market) and NS Solutions (free float of less than 35%). A variety of actions are open to these companies in order to avoid being caught by the stricter criteria, up to and including the option of privatisation. The Japan Special Situations basket continues to be an extraordinarily attractive opportunity in our view, as reflected by the 14% weight in NAV. With the majority of the companies posting strong earnings growth, low valuation multiples, and a tailwind from regulatory pressures to improve governance, it is fair to say that the probability of strong returns from here is as good as it has been at any point since inception of the basket over three years ago. Trading activity was relatively limited over the month. Gearing at the end of January was modestly lower at 5% of NAV.

The Japan Special Situations basket was the largest contributor to returns for the second month running, adding 136 basis points (bps). Returns were driven by a weighted-average share price gain of +5% and boosted by a 4% strengthening of the yen relative to sterling.

This month we would like to write about an important sub-theme within the Japan Special Situations basket – the issue of Japan’s aging IT infrastructure. Despite Japan’s reputation as a centre of technological excellence, the majority of government offices and companies in Japan still have fax machines: a hangover from the ongoing reliance on hanko stamps, which are used in over 11,000 procedures to sign official documents. Over the past few months, several high-profile events have brought the IT infrastructure issue to the fore, including the shutdown of the Tokyo Stock Exchange due to a series of technical glitches, and the Toshiba voting scandal. Toshiba’s voting system still has a significant element of postal votes which, due to a high volume this year, could not all be counted in time despite arriving before the deadline.

Recently elected Prime Minister Suga has made digitalisation of the economy a key priority; although still early in his tenure, he is already legislating for a new digital agency, has created a ministerial post for ‘digital transformation’, and appointed a veteran cabinet minister to the role of ‘administrative and regulatory reform’.

This trend in improving and updating IT infrastructure is expressed in AGT’s portfolio through positions in DTS Corp and NS Solutions, which account for c. 2% of AGT’s NAV and over 10% of the Japan Special Situations basket. DTS and NS provide IT solutions for corporate clients and will benefit significantly from the trend towards updating IT infrastructure. Compared to the US, Japanese companies rely more heavily on third-party service providers for IT (65% vs 28%).

The Japanese IT service providers we own are exposed to the same underlying growth trends of the market, yet, for reasons unrelated to their fundamental outlook, trade at steep discounts. They trade on EV/EBITs of 6x and 8x, compared to a sector average of 13x. Both companies suffer from inefficient balance sheets, poor shareholder communications, and weak corporate governance. Furthermore, NS Solutions’ valuation suffers from being part of a parent/child ownership structure, which results in a lack of incentives for management and poor protection for minority shareholders. We are engaging with management to address these issues and we believe if they can be improved in line with our suggestions and the valuation normalises, we could see upsides in the order of 50-100%.

Reversing its performance from last month, the Japan Special Situations basket was August’s largest contributor, adding 125 basis point (bps) to NAV. Japan, and the rest of the world, were surprised this month by the announcement of Prime Minister Abe’s resignation; while the deed itself had been expected, the timing thereof was sooner than anticipated. With a change of leader come, naturally, questions about policy continuity. Will the next Prime Minister retain the so-called “Three Arrows” programme? Will the clear trends towards improved balance sheets and corporate governance continue?

The latter question is perhaps the most pertinent for investors – and our answer to it is an emphatic yes.

While PM Abe’s programme of reforms was indeed radical at the start of his tenure, it has now become doctrine, and we do believe that the gravity of his leadership is no longer necessary to pull companies towards improvement. We draw confidence from our meetings with many managers and directors in corporate Japan: it is abundantly clear from senior-level executives’ comments that they are beginning to see the merits of the reforms and have no intention of reverting to the poorer practices of before. Furthermore, domestic institutional investors have begun to flex their muscle, providing significant “oomph” to the changes that we are seeing. Alongside domestic investors, we are encouraged by the increasing presence of other foreign activists, many of whose engagement with companies provides a powerful catalyst for change.

It seems clear to us that the trends we are seeing in corporate Japan are reaching a point of critical mass, such that the reform programme is closer to becoming self-sustaining. Although the pace of travel may not always be to our liking, we remain confident in the strategy, and note furthermore that the cash flow positive nature of the companies we own means that we are effectively being paid to wait. [Author’s note: At the time of going to press, it was announced that Yoshihide Suga had been voted in as Abe’s successor. Suga announced, prior to his election, that his predecessor’s policies would remain untouched – lending further credence to our view that the improving trends are intact.]

Fujitec was a particularly strong performer in the basket, accounting for over one-third of the 125bps of contribution. Since the launch of our public campaign in May (see here), we have continued our dialogue with the company, and are encouraged by improved communication, as well as the recent combination of the elevator and escalator business in China aimed at improving efficiency. While the steps may be small, they are inarguably in the right direction. The shares have risen +47% since the start of May, outperforming the TOPIX Index by 32% – we believe that this is due in some part to our public campaign, and the light it has shone on Fujitec’s business.

The Japan Special Situations basket was the largest negative contributor, reducing returns by -133bps. The weighted-average share price return was -3%, which compares favourably to a return of -5% from the TOPIX Small Index (both in JPY terms). Returns were further dampened by a -4% weakening of the GBP/JPY exchange rate.

Over the past month, the companies in this basket have been reporting quarterly earnings. We expect in sum that this quarter will be weak as a result of lock-down measures, although the degree to which companies are affected will vary. Quite often, quarterly earnings do not have an impact on the long-term appeal of a company, but can be useful when they result in mis-pricings that stem from the market’s sometimes-myopic focus on quarterly numbers. Two such instructive examples are DTS and NS Solutions, both of which are held within AGT’s Japan Special Situations basket.

It may surprise some to learn that corporate Japan has chronically under-invested in IT infrastructure, to such an extent that the Japanese Ministry of Economy, Trade and Industry has warned that the economic loss from such under-investment could amount to 2% of GDP annually by 2025. Currently, only 19% of companies in Japan use cloud-based accounting software compared to 53% and 35% in the UK. DTS and NS Solutions both help companies make this digital transition and are therefore well placed to benefit from increased levels of IT spending as companies upgrade aging infrastructure.

Despite this, both stocks have performed poorly following the release of weaker than expected quarterly earnings – while disappointing, we do not believe these results put a dent in the long-term attractiveness of these businesses, and we added opportunistically to the positions over the month. In addition to the attractive earnings profile, both trade on undemanding EV/EBIT multiples of ~6x and offer scope for engagement/improvement given their inefficient balance sheets, poor shareholder communications, and sub-optimal corporate governance. NS Solutions is also majority-owned by Nippon Steel, which investors view as an obstacle to change. In our view, these issues present the opportunity for excellent returns alongside the growth in earnings, as companies in Japan increasingly come under pressure to rationalise their balance sheets and improve governance standards.

The Japan Special Situations basket was co-dominant with PSH during the month, also contributing 137bps to returns although the weighted-average return (+6%) for the stocks in the basket lagged the TOPIX Small (+10%). Our thesis of a multi-year corporate governance reform programme in Japan continues to receive encouragement from the ongoing pace of buybacks and increasing dividend payout ratios, as well as evidence that shareholder activism is increasing (and has not been dented by the coronavirus pandemic).

Perhaps of more importance than monthly performance figures are the startling valuation metrics on which the stocks in AGT’s Japan Special Situations basket trade. At the time of writing, the net financial value2 is 97% of market value, and the EV/EBIT ratio just 3x. These are truly remarkable statistics for a basket of mature, profitable, cash-generating stocks with a history of consistent operating profit growth. We continue to believe that the prospective returns from holding a basket of overcapitalised stocks – coupled with a changing corporate environment which puts a higher emphasis on governance and balance sheet efficiency – should result in highly attractive returns for shareholders.

The Japan Special Situations basket was the largest contributor to returns in April, adding 126 basis points
(bps) to NAV. The weighted average total return for the stocks in the basket was +8% in JPY, which compares to
total returns of +4% from both the TOPIX and TOPIX Small indexes. The basket had previously been one of the
largest detractors from performance as Japanese equities sold off heavily during February. There has been
some recovery since then, but we note that the metrics in the portfolio remain compelling: the average stock in
the basket has 91% of its market cap covered by net financial value (net cash + investment securities), and the
average EV/EBIT is a derisory 3.2x. Although the economic outlook at the moment could charitably be termed
“unclear”, we struggle nonetheless to see the logic in applying such low multiples to businesses that are mature,
profitable and generating positive cash flows.

With the outbreak of coronavirus and the subsequent economic shock, the obvious question arises: will this halt
the tides of corporate governance reform in Japan, with management teams and directors now able to point to
the current crisis as justification for their “rainy day” cash piles? While we acknowledge that this economic
setback certainly makes a strong case for prudence in balance sheet management, we would argue that there is
still plenty of room to find a middle ground between the ultra-lean balance sheets seen in the US, and the cashreplete
ones of Japan. Many of our portfolio companies continue to announce buybacks and increased pay-out
ratios, giving us further confidence that our thesis is far from dead in the water.

Just after the month’s end, we announced a public campaign calling on elevator and escalator operator,
Fujitec (6406) (3% of AGT’s NAV), to address deficiencies in its corporate governance, business strategy and
capital efficiency. This campaign is a clear example of AVI’s long-term approach to activism in Japan, which
focuses on improving the business to the benefit of all stakeholders. A dedicated website for the campaign can
be found here.

The Japan Special Situations basket was AGT’s largest negative contributor, reducing returns by -220 basis points (bps). Japan has been near the epicentre of the viral outbreak, with the third-highest number of cases in Asia outside China or South Korea. The TOPIX has declined -21% from the start of February to the time of writing, and the Japan basket has fallen by -26%, in line with the TOPIX Small. As a result of the sell-off, there are now six stocks in the basket where net financial value (net cash + investment securities) is 100% of market value or greater, and three stocks have greater than 100% of their market value in cash. With such valuations, the market is implying a zero or negative value to the earnings of the underlying businesses. Even in times of distress, it is difficult to see the rationality behind assigning a zero/negative valuation to businesses which we believe, over the medium- to long-term, are capable of generating positive, growing earnings and cash-flows.

The Japan Special Situations basket was the single-largest detractor, reducing returns by 46bps. We estimate that the average stock in the basket declined by -3% which was broadly in line with Japanese equity markets – the TOPIX and TOPIX Small Indexes returned -2% and -4% in January as fears mounted over the impact of the coronavirus on Asian economies. The latest metrics for the 16 companies in AGT’s Japan Special Situations basket show that (on a weighted average basis) net cash is 46% of market cap; including investment securities brings this number to 89%. The basket trades at a lowly 4x EV/EBIT and the underlying businesses (stripped of excess capital) earn an average return on equity of 17%. Since inception in June 2017, the basket has returned +25% in GBP terms, significantly ahead of both the TOPIX (+10%) and TOPIX Small (+9%) over that time period. We continue to view the theme as our highest-conviction idea, with the basket accounting for 18% of AGT’s NAV, and total Japan exposure now at 28% of NAV.

During the month, we recorded a significant victory in Japan. We had submitted shareholder proposals to an undisclosed company, which we were content to subsequently withdraw when the company acquiesced to our demands and publicly announced key changes. While other companies in the basket have shown positive results and changing attitudes, this is the first company where management has directly confirmed that it was our engagement that sparked the discussion and shaped policy. We view this event as both confirmation of the trend in Japan towards improved corporate governance, and as a victory that confirms the validity of our balanced approach to activism in Japan. We typically engage behind closed doors via letters and meetings, avoiding the more brash and confrontational style of activism which is seen as anathema in Japan. That said, we are prepared to go public in the face of continued and persistent intransigence and believe our mix of the “carrot” and “stick” is bearing fruit.

On the latter, we have now initiated a public campaign to highlight the inefficiency of Teikoku Sen-I’s balance sheet, which is replete with cash and investment securities, accounting for 44% of market value. AGT has been a shareholder of Teikoku since March 2018, and we have engaged with management consistently over the past two years to highlight changing corporate governance practices and suggest ways to improve capital allocation. Despite this, Teikoku’s management has been recalcitrant and unaccepting of criticism, instead relying on a network of “group” shareholders to defeat AGM proposals aimed at releasing excess capital and rationalising the balance sheet. Further information on our campaign is available at www.transformingteikoku.com.

The Japan Special Situations basket added 113 basis points (‘bps’) to returns, with the average stock in the portfolio returning +7%, versus +2% from the TOPIX and +3% from the TOPIX Small. The strong performance was driven in the main by Toshiba Corp’s offer to acquire two of its listed subsidiaries, both of which were held within AGT. NuFlare Technology and Toshiba Plant received bids from their parent at significant premia to the prevailing share prices. Both Toshiba Plant and NuFlare have been successful investments for AGT, earning IRRs of +26% and +89% respectively.

We have been attracted to the “parent-child” subsidiary theme for some time, believing that listed subsidiaries would either be sold off, or bought in by the parent company. The Abe administration has been critical of parent-child arrangements, bringing government pressure on the companies involved.

Despite the strong performance of the Japan basket over the month, valuations remain compelling, with 91% of market value covered by net cash and investment securities, and an EV/EBIT multiple of just 4.4x. We see increasing evidence of excess capital being returned to shareholders in corporate Japan, as companies begin to focus more on improving balance sheets and corporate governance. Furthermore, with a free cash flow yield of 5% and a focus on quality businesses, we are being paid to wait for the evolution towards a more efficient Japan.

The Japan Special Situations basket was October’s second-largest contributor, adding 32bps to NAV. The 17 stocks in the basket returned an average of +7% (in JPY terms), outperforming both the TOPIX and TOPIX Small (+5% and +6% respectively) along the way. Notable performers in the basket include Fujitec (+14%), with strong upward revision in profit forecasts, and Sekisui Jushi (+5%) which announced a buyback of 7% of outstanding shares. The level of total buybacks in Japan has been increasing strongly, with JPY12 trillion of announced buybacks in 2019 (year to date), which compares to JPY6 trillion in 2018.

There was a negative note during the month, when the Japanese government published proposals that altered the ownership level at which foreign investors in protected industries need to seek regulatory approval. The proposals appeared, prima facie, designed to thwart foreign activism in the country; however, the Ministry of Finance later clarified that foreign investors will be exempted, provided that they do not seek a director’s seat or the sale of key assets.

Post month end, our thesis that parent-child listed subsidiary arrangements would come under pressure was confirmed as Toshiba Corp offered to buy in three of its listed subsidiaries, of which two are held in the Japan Special Situations basket: Toshiba Plant & Systems (52% owned by Toshiba Corp) and Nuflare Technologies (57%). Toshiba Corp offered JPY2,670 and JPY11,900 for Toshiba Plant and Nuflare respectively, representing increases of +27% and +45% from the undisturbed share price. Since the end of September, the tender offer from Toshiba Corp represents a rise of +48% and +55% for Toshiba Corp and Nuflare respectively.

We consider all these developments to be highly encouraging and interpret them as being confirmatory evidence of the changing regime in Japan, with corporations improving their capital allocation and governance policies to the benefit of all stakeholders. Furthermore, the government remains supportive of foreign activism to propel changes in corporate Japan.

The Japan Special Situations Basket was AGT’s single-largest contributor, adding +61 basis points (bps) to returns – marking a significant change from August, when the basket was the largest detractor. Japanese equity markets recovered from the sell-off in August, with the TOPIX and TOPIX Small both posting returns of +6% over the month. While the basket’s performance has been lacklustre over the past year – declining -2.7 in GBP% –we continue to believe that our investment thesis remainsintact. Business attitudes in Japan towards corporate governance and capital allocation are coming under pressure from the Abe administration, and we believe that this is increasing the probability that overcapitalised companies will begin to distribute excess capital to shareholders, or put it to more productive use. While the process is slow – as all evolutions are – we note that we continue to see evidence of changes in attitudes, including increased payout ratios, higher numbers of independent directors, better voting at AGMs, and more activist shareholders taking stakes in Japanese companies. Buybacks for the 6 months to September 2019 totalled JPY5 trillion – an increase of +96% over the same period last year. Our conviction in this theme remains high, as evidenced by the basket’s 18% weight in AGT.

The Japan Special Situations basket was AGT’s largest detractor, reducing returns by 101bps over the month, accounting for approximately one-third of AGT’s NAV decline. August was a difficult month for equities generally, and Japan specifically, with the country being hard-hit by the US-China trade war. Many of our companies suffered seemingly irrational declines in their share prices, which we believe is reflective of the illiquid and often inefficient nature of Japanese small-cap stocks. Following the turbulent summer months, the basket of 18 Japanese cash-rich stocks now trades on a 55% net cash to market cap ratio, and an EV/EBIT multiple of just 2.2x. To our mind, these metrics are remarkable and we have been adding to several names on weakness. As fundamental investors, it is imperative to remain focused on valuations and the long-term. Following the month end, there have been several encouraging signs: the TOPIX has increased by +8% since the nadir in late August (outperforming the MSCI ACWI Index), and foreign purchases of Japanese stocks turned net positive in the first week of September. We continue to believe that there is tremendous upside in this portfolio.

The Japan Special Situations Basket added 92 basis points (bps) to returns, making it the largest contributor. Returns were driven by a combination of share price increases and a 3% strengthening of JPY relative to GBP. July saw 8 holdings (out of 18 total) release quarterly earnings. Profits had been forecast to be somewhat weaker than this period last year, and this was indeed the case. Many companies are experiencing margin pressures and suffering from a general slowdown in economic activity. That said, the basket is skewed towards a domestic exposure, and our companies continue to generate free-cash-flow and add to their excess assets. Notwithstanding short-term volatility, we continue to believe that we are witnessing a secular change in how corporate Japan thinks about governance and capital efficiency, and a portfolio of cash- and securities-rich stocks should benefit handsomely from this trend.

The Japan Special Situations basket was the largest detractor over the month, reducing returns by 29bps. The single-largest detractor, Pasona, saw its NAV fall by -14% over the month as the share price of listed holding Benefit One (92% of Pasona’s NAV) fell by -10%. While the performance of the basket in June was disappointing – and trailed the broader Japanese market, which itself was a relative laggard over the month – we would point out that the long-term performance remains good. The Japan Special Situations basket has returned +14% since inception in June 2017, substantially ahead of both small- and large-cap Japanese indexes. The basket’s stocks have, on average, a remarkable 86% of their market cap covered by cash and listed securities. As we have stated previously, we believe that we are in the midst of a secular change in corporate Japan’s attitude to governance and capital allocation, and the resulting returns to investors who are positioned to benefit from this trend should be immensely attractive.

The Japan Special Situations Basket contributed 50 basis points (bps)
to returns over the month, making it the largest contributor to AGT in
May. Four stocks, out of a total of eighteen in the basket, generated the
majority of the returns. Fujitec (share price +5% in JPY) appointed
another new director to its Board, leading to a Board of Directors that is
now majority independent; another strong contributor, SK Kaken (+4%),
abolished its poison pill. For the other two major contributors (Kanaden,
Digital Garage), there was little major news over the month, although
Kanaden bought back 4% of its outstanding shares in February. Since
we initiated the Japan basket in June 2017, we have observed a
continuation of the trend towards increasing levels of dividends,
buybacks and shareholder proposals, which we interpret as
confirmatory evidence of our initial thesis – that corporate Japan is
undergoing a secular change in its attitude to governance and capital
allocation. We believe that the potential risk-adjusted returns from such
a shift in attitudes will be highly attractive.

The Japan Special Situations Basket was the largest contributor to
performance over the month, adding 56bps to returns. Four stocks, out
of a total of eighteen in the basket, accounted for the majority of returns,
during a period in which Japan Inc started reporting FY19 results.
During the month, Fujitec (share price +11%) published a three-year
management plan, highlighting ambitions to grow operating profits by
26%. Among the other top three performers, all had recent positive
developments (albeit all prior to the start of the month). Daiwa Industries
(+14%) announced a two-fold increase in its dividend, the second
increase since 1998; Kanaden Corp (+7%) bought back 4% of its
outstanding shares, in the process reducing its cross-shareholdings with
two major banks, and also cancelled all of its treasury shares; and
Tachi-S (+8%) cancelled the majority of its treasury shares and slightly
increased its dividend. As we have stated previously, we believe that
there is mounting evidence that corporate Japan’s attitude towards
governance is undergoing a seismic shift, with the attendant potential for
highly attractive risk-adjusted returns as companies improve
governance standards and enhance balance sheet efficiency.

The Japan Special Situations basket was by far the largest contributor
to BTEM’s performance in February, adding 91bps to returns. Five
stocks, out of a total of twenty in the basket, accounted for the majority
of this figure. Kato Sangyo (share price +17% in JPY) announced a
buyback of 2% of outstanding shares, which follows on from a 2%
buyback conducted in October last year; Daiwa Industries (+14%)
announced a two-fold increase in its dividend, the second increase
since 1998; Pasona Group (+16%) was the target of activist shareholder
AIM&R, which wrote an open letter calling for Pasona to either spin off
or merge with listed subsidiary Benefit One; and Kanaden Corp (+13%)
bought back 4% of its outstanding shares, in the process reducing its
cross-shareholdings with two major banks. This evidence at the
individual company level serves to highlight a trend: dividends and
buybacks have been rising in aggregate in Japan over the past several
years. This, inter alia, leads us to believe that we are in the midst of a
paradigmatic shift in corporate Japan’s attitude towards governance,
with the attendant potential for highly attractive risk-adjusted returns as
companies improve governance standards and enhance balance sheet
efficiency.

The Japanese Special Situations basket (comprised of 19 grossly overcapitalised
Japanese operating companies) outperformed the broader
Japanese market, led by our position in Fujitec (+13%) and Kanaden
(+11%). Fujitec is a top ten global elevator manufacturer with a strong
focus on the Chinese market which accounts for 30% of sales. Longdated
recurring maintenance contracts mean the underlying business is
attractive, and the company – which has net cash covering 46% of its
market cap – trades on a compelling valuation of just 6.7x EV/EBIT versus
global peers that trade at 17x. We believe the depressed rating is due in
part to anti-takeover measures adopted by the company several years
ago, which increasingly makes it an outlier in Japan given the large
number of companies that have removed such provisions in light of
increased scrutiny on corporate governance. We have engaged with
management regarding the removal of these defences which will be voted
on at the 2019 AGM, and are encouraging them to make greater use of
share buybacks and reinstate stock-based remuneration.

Kanaden’s valuation is one of the most attractive in the basket, trading on
a derisory 1.2x EV/EBIT multiple with nearly 70% of its market cap in cash.
The company is one of five wholesalers for Mitsubishi Electric, operating in
a sector ripe for consolidation. Margins can be improved by offering more
after-sales services, with the President highly motivated to improve ROE
as stock-based remuneration is based on achieving an 8% ROE in three
years (currently 7.4%). We have met management four times over the last
18 months, and have been encouraged by their increasing focus on
shareholder returns.

The Japanese basket, which consists of 16 individual cash-rich and overcapitalised
Japanese operating companies that are in aggregate our largest
holding, was our biggest detractor over the month as it fell in line with the
Japanese small-cap market. Such price moves serve to further highlight the
inefficiency with which these companies are priced as, given their cash backing
of 52% of market cap, the market is implicitly marking down their operating
businesses by significantly more than their less well-capitalised peers.

Over the long-term, our research does indeed show that these over-capitalised
companies outperform on average in down months, but irrationality is certainly a
feature over shorter periods which, of course, creates opportunities for
fundamental investors.

The Japanese basket performed broadly in line with a weak Japanese market
and thus detracted from returns, while Symphony International’s share price
(-7.7%) went in the opposite direction to its rising NAV (+2%) on some clumsy
selling. We note the management team have been acquiring additional
shares in the market on the back of this weakness.

The Japanese Special Situations basket provides an intriguing insight into
market (in)efficiency – all seventeen constituents were more volatile than the
broad Japanese market over the month despite having an aggregate net
cash level equating to 59% of market cap. We acknowledge liquidity and
size factors are making their presence felt here, but it also reinforces to us
the Japanese market’s tendency to overlook and undervalue asset backing.
With the changes in Japanese corporate behaviour we have discussed in
previous newsletters starting to take hold, we believe the mis-pricing is
unlikely to continue indefinitely. Indeed, we have already benefitted from a
pronounced re-rating of several of our investments in this area. Despite its
heightened volatility, the Japanese basket registered an above-market
return of -1.8% in local currency (+3.4% in Sterling) versus -3.1% for the
TOPIX Small Index.

Japanese Special Situations basket had a rare month where it
underperformed. Notwithstanding the setback in January, the basket has
outperformed the TOPIX by +13.6% and the TOPIX Smallcap by +8.0%
since its inception in Jun-17.

The Japanese Special Situations basket was again a significant contributor,
up +5% in aggregate to extend its run of very strong absolute and relative
performance. The share price performance of Pasona, a basket holding we
covered in our last newsletter, continued to impress with the stock up
another +32% in December.

The Japan Special Situations basket (which consists of 19 laughably overcapitalised
small-cap Japanese stocks) is in aggregate our largest position,
and continued its strong run of performance with a weighted average share
price gain of +6% in a month where the TOPIX and TOPIX Small-cap indices
were up +1.5% and +1.3% respectively. One of the larger positions within
the basket, Pasona Group, was the subject of attention from a Hong Kongbased
activist investor during November. Pasona’s 49% stake in listed
Benefit One, a provider of HR and employee benefit services, covers its
market cap 1.3x over and a huge amount of value could be unlocked were
this stake to be sold and the cash returned to shareholders. For what we
believe are tactical reasons, the activist’s proposals focused on improving
the weak profitability at Pasona’s core operating business but we see the
real prize as being the Benefit One stake. Pasona’s share price increased
by +8% in November, and is up a further +7% so far in December. Since
our first purchase in June, its share price has risen +96%.

There is a striking contrast between the US, where the S&P 500 exfinancials
index trades on a Price-to-Tangible-Book multiple of 19.2x, and
Japan where the multiple for comparable companies is just 1.9x.
Notwithstanding differences in sectoral composition that account for part of
this divergence, corporate Japan’s bloated balance sheets make for a
target-rich market for activists. Activism is on the rise encouraged by a
confluence of pressure from the government, shareholder advisory services,
and the National Pension Fund amongst others.

Our Japanese Special Situations basket, consisting of 17 individual
grossly over-capitalised Japanese small cap stocks that we believe
stand to benefit from corporate governance reform, and a greater focus
on capital allocation/returns on equity, was the fourth largest
contributor. It has been a strong performer – as at the end of October, it
had outperformed the TOPIX by 8.1% and returned 20.2% on an
absolute basis in Yen terms since its inception earlier this year.

The Japanese Net Cash basket was our next largest contributor. As
detailed in our last newsletter, this basket was established to benefit from
the expected positive impact of changes in governance and capital
allocation practices across corporate Japan on the valuations of a selection
of deeply discounted and ludicrously over-capitalised Japanese stocks. The
basket comprises 13 names accounting for 5.3% of BTEM’s NAV and all
share certain characteristics we find attractive: very high cash/financial asset
balances as proportions of market cap, high free cash-flow yields, and –
crucially – sound operating businesses. Since we initiated the strategy, it is
up +9.2% versus +0.5% for the TOPIX, +3.3% for the Tokyo Small Cap
Index, +2.5% for the Tokyo Small Cap Value Index, +1.6% for the MSCI
World, and +3.3% for the MSCI AC World ex-US (BTEM’s benchmark). With
a weighted average discount to NAV of 30% and compelling free cash-flow
yields, we see scope for further material gains.

We recently began building a basket of Japanese “net cash” stocks that
consists of 11 names and now amounts to just over 4% of NAV and takes our
overall Japanese weighting up to 16%. This basket has an aggregate level of
net cash that covers 55% of its market cap, with net financial value (including
cash) equal to 73% of market cap. Importantly, these are all sound businesses
as shown by the aggregate compound annual growth in operating profits of
6.3% over the last 10 years and operating margins of 6%. This is crucial as it
allows time to be our friend as value is not being eroded while we wait for the
latent value to be unlocked. We have already engaged with management and
boards of several of these new holdings to make our views clear, and will be
meeting with them on our next visit to Tokyo in July. The aggregate free-cash
flow yield of 7.3% on our Japanese basket is attractive in its own right, but the
potential for value creation is staggering when one considers that the freecash-
flow yield stripping out cash on the balance sheet (i.e., FCF yield on
enterprise value) would be 30.4% and that the aggregate EV/EBIT is just 2.7x.
It is difficult to conceive that a portfolio with anything like these characteristics
could be constructed today outside of Japan.