This week’s Investment Q&A is with Elite Rated manager Praveen Kumar of the Baillie Gifford Shin Nippon investment trust, who tells us about the welcome return and impact of ‘mild inflation’ to a country that has had more than two decades of deflation. Detailing the subsequent shift in mindset for domestic investors and how this is boosting the domestic equity markets, Praveen then gives us his views on the growth prospects for Japan – boosted by advances in the application of AI – and the impact of this on the fund’s own holdings.
(Recorded 1 August 2023)
Inflation is the buzzword in the UK, the US and Europe, and it’s a problem for us, but in Japan it’s perhaps more of a welcome phenomenon. Tell us more about inflation in Japan.
We are seeing what I would like to call ‘mild levels’ of inflation in Japan, currently around the 3% mark. And people are feeling the pinch.
Japan has had more than two decades of deflation, and that deflationary mindset is quite well embedded in people’s psyche. So, the current environment where we are seeing mild inflation is causing a bit of a shift in terms of how people think about prices. For instance, we are seeing a whole range of companies from different sectors raising their prices, which is causing consumers to recalibrate the way they think about pricing and their own spending decisions.
If inflation becomes sticky, then it could have a whole range of really interesting implications. The first one worth highlighting is just the sheer volume of cash-based transactions that still happen in Japan. Interestingly, along with Germany, Japan is one of the world’s largest users of hardcore cash.
We have bought quite a lot of online payment-related companies in our portfolio on the basis that this situation with cash will not be tenable in the long run and people will have to make that shift to online payment. And, in some ways, that shift is being accelerated by this whole inflationary environment. People are taking cash from their secret hiding places and are finding a home for it in various areas, one of which is the stock market.
Japanese domestic investors have notoriously under-invested in their own market and we are seeing a steady inflow of funds into the domestic market. One of the companies we own is Japan’s largest robo-advisory firm, called WealthNavi Inc. WealthNavi offers a very narrow range of 5 or so easy to understand products, most of which are focused on the domestic market, and they’re seeing quite considerable sums of money come in from retail investors which is one interesting result of this inflationary environment in Japan.
The other interesting development we’ve seen is companies across sectors are now aggressively raising prices, partly because their own costs have gone up, but also partly because they see the current environment as an opportunity to try and exercise some of their pricing power, which historically they haven’t had, and which has been one of our longstanding issues. This obviously has positive implications for their margins and for their returns in the long run. In addition, it reinforces this idea that the Japanese consumer’s mindset shift from a deflationary mindset to an inflationary mindset is likely to take root.
The IMF thinks that Japan will grow by 1.3% this year, which is better than the UK and Europe and pretty much level with the US. Is growth improving?
It is worth acknowledging that Japan is a very mature economy. Add to that, the fact that Japan has the world’s most rapidly ageing society, then the trend growth rate is generally around the 0.5%-1% range. We wouldn’t expect the economy over a long period to grow much faster than that.
The other thing worth bearing in mind is that there is very little empirical evidence to suggest any kind of correlation between economic growth and stock market returns. So if you are able to pick the right sort of companies that have a large growth opportunity, that have a very strong competitive edge and are growing quite rapidly at very attractive valuations as we are seeing today, for instance, then these companies – whether they’re domestic-focussed businesses or exporters – generally have the ability to grow irrespective of what happens in the broader economy.
Additionally, there are a number of positive tailwinds that the Japanese economy is likely to witness over the next few years. One of the big ones at the moment is obviously as a result of the friction between the US and China and the range of restrictions on high-end equipment exports that the US has placed on China. As the Japanese tend to have very high market shares in a lot of these niche equipment areas like semiconductors or industrial equipment, factory automation etc., they could end up benefiting from this whole trend of moving production from China to other areas. For example, if you’re putting in new factories in the US like TSMC, which is the world’s largest foundry. It will need a lot of equipment, a lot of tools, and Japanese companies are among the world-leading providers of those types of tools. So, you could potentially see new avenues of growth open up for these types of companies.
Equally, with an ageing population, there are additional pressures on the government. It has to consider how to manage healthcare, how to take care of this fast-growing base of very old citizens? That requires creative solutions and we’re seeing many healthcare companies coming up with robotic surgery-type solutions, for instance. Artificial intelligence is another emerging area of opportunity.
Overall, I would say the Japanese economy is almost in a bit of a sweet spot at the moment and whatever positive moves in the stock market we’ve seen so far, it’s mainly concentrated on some of these really old-style, traditional companies that are looking more to survive, so there are opportunities maybe from a shareholder returns angle. But these are not really the types of companies that are looking to grow; the big opportunity in the next few years is likely to be in growth companies which are currently at dirt cheap valuations.
We’ve seen an increase in dividends being paid to shareholders over the past couple of years, with greater pressure from the regulator more recently. Has it had an impact on any of your companies at all?
There’s been consistent pressure applied by the regulators, by the stock exchange and even by the government.
It started during the era of Shinzo Abe, the former Prime Minister of Japan who introduced ‘Abenomics’ with three key aims, or ‘3 arrows’ as it was called then. Since then, many of these reforms have become quite well-embedded within companies to date. But we are increasingly seeing companies do things like share buybacks, raising their dividends every single year, even if their earnings are quite weak. It’s become almost a well-known fact that this is the way to go, if you want to attract overseas investors or if you want to broaden your shareholder register base.
One of the other things we’re seeing is Japanese companies are increasingly benchmarking themselves versus their global peers. Historically, one of the issues with Japanese companies was that they were very much inward-looking because the domestic market itself was so huge that they didn’t really need to compare themselves globally. But, because of increasing competition from global peers and pressure from shareholders, this has been turned on its head now and we are seeing a strong, continuing momentum in terms of returning cash to shareholders.
As regards the stocks that we own, although we are operating at the smaller end of the spectrum where these types of moves are perhaps less pronounced, we’re nevertheless seeing a lot of our manufacturing-type businesses, for instance, significantly increase their payout ratios. We’re also seeing some significant share buybacks being announced. As an example, just a few years ago, one of our stocks is a gaming company called Akatsuki Games Inc., and they bought back around 17% of the shares, which is huge! That’s probably an extreme but I would say this move towards improved corporate governance and improved shareholder returns, is very much trickling down from the large to mid-caps, and now into the small caps.
Given Japan’s ageing population, the fact that they’ve got a decreasing workforce, and they’ve got a really strong history in machinery and electronics, Artificial Intelligence seems to be a perfect opportunity for Japan?
Yes, that’s very much the case. We’ve now reached the stage where virtually every other company is trying to work out how best to use the current AI-related tools that are available.
One of the things that Japanese companies or tech companies haven’t been good at – and I don’t think they will ever be good at it – is developing genuinely new software, like, for example, ChatGPT. Having said that, where Japanese companies have excelled themselves is in using existing tools, existing software packages, to develop some really relevant, interesting products and business models.
One example of this is a company we recently purchased for the portfolio which is a Taiwanese company that is listed in Japan. It’s called Appier Group Inc., and it’s run by a Taiwanese husband and wife team, both of whom have PhDs in computer science, and who have set up their base in Tokyo as well as the company’s HQ. It uses artificial intelligence to develop tools to help small and medium-sized businesses to better understand their customers as well as targeted marketing strategies. For example, they were doing some really clever marketing to consumers even when they’re not on the company’s website or if they’re just kind of walking down the road, sending information to their smartphones as they pass through a shop saying, ‘Look, this shop is offering this product for a 20% discount, would you be interested?’. That’s a very high-level generalisation but they’re actually doing so much more sophisticated strategies to try and increase the lifetime value of existing customers, and also to help retailers identify who are the potential customers that might end up buying their products. And all of this analysis is done by their in-house developed AI models. They’re a good example of a company that hasn’t created a new, fundamental software as such, but is using existing technologies to build these various products that are much more relevant for their client base.
Similarly, we are seeing the use of existing AI tools in the legal arena. We own a company called Bengo4.com Inc. which is an online legal website that matches people looking for legal advice with appropriate lawyers. Again, they’re using existing AI tools to create something called ‘legal brain’ which is a new suite of products that they’ve launched. This set of tools helps lawyers to not just source potential clients, but also helps them in terms of preparing for any upcoming cases and it helps them with managing their workload, basically scanning hundreds and thousands of past legal rulings and all the case work, picking out relevant bits of information that will be useful for the lawyers in preparing for a particular case. It’s a really clever application of existing AI tools and personally, I think this is likely to become quite a big area.
I suppose the trick is to find out which are the companies that have the best chance of succeeding by thinking about the competitive advantage, the whole sort of culture of the firm and some of these other softer factors because I suspect you will get quite a lot of companies in this space that promise a lot, but don’t deliver, so, you do have to be careful in terms of which companies you pick.
Tell us about I-Ne Co., Ltd., the cosmetic company and Spiderplus & Co. in the construction industry, two of your new holdings that you’ve got in the fund.
I-Ne is a fairly recent holding who I met in Japan a few months ago. To me, it feels very much like an AI based tech company that just happens to be in the cosmetics business!
Their model of product development and customer analysis is quite interesting, having built their AI model that basically aggregates consumer feedback data from a number of sources, both online and offline, bringing all of that information together to build a vast database of consumer-generated feedback. And the company basically uses this AI model to try and understand what kind of products people are genuinely interested in and what products that are already on the market that are not really serving the purpose that they were supposed to serve? They also try and work out what areas have the most complaints and what products might be needed to fill the gaps. Once this kind of really detailed, specific feedback is gathered, it’s passed on to the product development team and they then work on one or two products which they feel have the best chance of succeeding. They make their own formulations using domestically-sourced, unique, raw materials, develop the product and start test marketing.
The validation of this process of theirs lies in the fact that a couple of their star hair-care related products, which were launched 6-7 years ago, are continuing to grow at about 10%-15%. That is some serious staying power because for a cosmetic product to last that long, when you have new products on the shelf every other week and to be able to continue to grow at that rate is quite impressive. And the company is not interested in launching a product every week or every month, they’re very, very targeted and take a very disciplined approach to product launches. It’s a really interesting business, run by a young entrepreneur who owns quite a large chunk of the business.
Spiderplus is another one of these young up-and-coming software companies, which is trying to digitise the construction industry which is known in Japan as probably one of the worst, when it comes to the adoption of IT. It’s still very traditional, using the phone, fax, and a lot of paper, and so Spiderplus built a set of products that completely automates the entire process. So someone working at the site can easily create and upload drawings using a tablet that runs their products which they can then share with coworkers, who, in turn, can make markings, notes etc. It becomes very easy, and you can do multiple projects within that same software. I can’t see why this shouldn’t become the industry standard in 5-10 years’ time. They’ve already made significant progress in terms of getting some of the big construction contractors in Japan on their side and getting them to use their software. Again, quite an interesting business targeting an absolutely massive industry.
Listen to the full interview here:
