Baillie Gifford trust to offer escape route if performance doesn’t improve

Baillie Gifford Shin Nippon’s annual results make uncomfortable reading, but for investors willing to stay the course there are signs for optimism as suppressed valuations may well represent an overdone sell-off. 

In addition, if performance does not improve, investors will be offered an escape route, as the board announced in the results that it will commit to a one-off tender offer (of 15% of the issued share capital) if the performance of its underlying investments (the net asset value or NAV) fails to beat the MSCI Japan Small Cap Index over three years to 31 January 2027. The tender offer is subject to shareholder approval.

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Below is a review of performance over the 12-month period (to 31 January 2024), as well as an ii analyst view on prospects for Baillie Gifford Shin Nippon Ord (LSE:BGS).

Performance

Shin Nippon’s results sit against a backdrop of Japan’s Topix index earlier this year surpassing its previous all-time high after a 34-year wait. However, this performance was led by part of the market that Shin Nippon doesn’t invest in – established large-caps businesses. For nearly a decade Praveen Kumar has been the designated manager and decision maker on the fund. 

Shin Nippon focuses on the opposite corner of the style box, small-cap growth, which has hardly participated in the upside.

The trust’s results show a continuation of chronic underperformance, with further declines in share prices across the portfolio. Businesses with greater exposure to China’s economy particularly suffered. The decline in the value of the underlying investments, the NAV, through the year further hurt its five-year track record, which is below peers. Over five years (to 26 March 2023), its share price total return is a loss of -31.4% versus a loss of -14.5% for the Japanese Smaller Companies investment trust sector.

The numbers in detail (for the 12 months ended 31 January 2024)

Net Asset Value (NAV) Return:-14.9% (-21.2% vs index)
Share Price Return:-20.5% (-26.8% vs index)
Index Return: +6.3%
Discount:-14.6% (-6% vs Jan 2023)
Gearing: 18% (+3.1% vs Jan 2023)
Dividend: 0.8p (vs 0p in Jan 2023)

Outlook

Management highlight tentative prospects for the portfolio’s recovery. Should macroeconomic uncertainties abate, investor focus may shift from the greater safety of those large companies to the fundamentally strong, but oversold, smaller, dynamic businesses, the likes of which Baillie Gifford Shin Nippon seeks out.

Discount

At the end of January 2024, shares traded at a discount of -15%, which is 6 percentage points lower than the same point last year. The current discount (-17%) is the widest of its peers and marks a new depth versus the trust’s five-year average (near -3%).

Portfolio

The year saw five additions across a range of sectors and seven disposals, meaning a 12% turnover. Management reiterated commitment to its stock picking long-term approach, not succumbing to buying into rising sectors or being drawn in purely by low valuations. The trust retains its overweight to smaller companies, and underweight to more value-heavy exposures, such as traditional energy, financials and materials.

The results also provided an update on unlisted holdings, comprising four names and 3.7% of the portfolio. Overall, unlisted companies boosted performance, with the larger two positions each returning more than 20%.

Gearing

The board agreed an increase in borrowing, and subsequently gearing rose to 18%. While management do not leverage to take a view on the broader market’s direction, the increased gearing does reflect the fund manager’s optimism towards both new and existing opportunities presented by market conditions.

ii View:

The results reveal a continuation of disappointing NAV and share price performance, much of it due to a weakness in valuations of Japan’s small-cap growth businesses. Aggregate valuations of the portfolio (18x earnings) have now fallen closer to the levels of the trust’s benchmark, MSCI Japan Small Cap Index (15x), down from twice that level at the start of 2021 following a stellar 2020.

The picture was worsened by the trust’s aggressive gearing level, company-specific issues and the persistent widening of the discount despite frequent share buybacks.

A key point announced in the results is the trust’s introduction of a one-off performance incentive to buy back up to 15% of issued share capital at a 2% discount to NAV if, over the next three years, the trust underperforms its benchmark (subject to shareholder approval).

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While this may seem a marginal recompense to shareholders after what could then represent a decade of NAV underperformance (potentially more exaggerated still on a share price basis), it represents a positive incentive to rectify performance and continue to buy back shares going forward.

While there is no masking the torrid performance of recent times, there are some green shoots to speak of. While income isn’t a focus for Baillie Gifford Shin Nippon, the reinstatement of a proposed final dividend of 0.8p reflects a newfound surplus in the revenue reserve. It speaks to operational strength and a pick-up in distributions of portfolio companies, reversing the trend of a reserve deficit (and, by extension, no dividends) over the last few years.

Further, suppressed valuations may well represent an overdone sell-off, and we see reasons for optimism in the near-maximised gearing as management could use the facility to capitalise on investment opportunities.

Lastly, while the decade’s widest discount may appear bleak, it is worth remembering that the trust has recovered before from more profound depths, such as post-2008. Baillie Gifford Shin Nippon is one of interactive investor’s Super 60 list of ideas.