Fund Spotlight: former star trust now looks very cheap

An aggressive and differentiated approach to finding the best and brightest of Japan’s smaller companies finds itself trading at newfound low valuations.

Baillie Gifford Shin Nippon (LSE:BGS), managed by Praveen Kumar with support from a number of Japan specialists, seeks to grow capital over the long term by investing predominantly in Japanese smaller companies possessing substantial growth potential. 

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The trust looks for exciting and disruptive companies, run by dynamic entrepreneurs willing to take risks. Kumar wants innovative business models that are disrupting traditional Japanese practices. 

Due to the concentration of positive market returns in just a small number of companies, Kumar seeks to buy and hold winners over five to 10 years using a patient, low-turnover approach. This is an adventurous portfolio that looks completely different from its benchmark index (MSCI Japan Small Cap). 

Bear in mind that, as this is an adventurous strategy, its performance over the shorter and mid-term can be lumpy and prone to periods of underperformance. Therefore, investors need to be prepared to accept that the fund will, over short time periods, blow both hot and cold. Because of this approach, investors need to think long term – ideally 10 years.

What does the trust invest in?

The portfolio comprises 40 to 80 positions, with 60 names at present. Up to 10% of the portfolio may be invested in unlisted companies (currently near 3% of total assets). The top 10 holdings account for roughly 23% of the portfolio, with the largest three positions being Nakanishi (2.7%), Toyo Tanso (2.7%) and GMO Financial Gate (2.5%), representing Healthcare, Industrials and Technology exposure, respectively.

The trust has a bias towards Industrials (29%), Technology (18%) and Consumer Discretionary (16%), with the Industrials and Technology allocations being well overweight the benchmark (+5% and +7% respectively). 

Current positioning has seen new and innovative names (Appier, Vector, SWCC) added to the portfolio, as Kumar took advantage of depressed share prices to add to positions. 

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Further testament to management’s optimism and conviction in the long-term potential of the portfolio is the trust’s rising gearing level, which has increased to 17% of the trust’s net asset value (NAV). This level approaches the trust’s limit (18%) and makes it the most leveraged of its investment trust peer group. 

This means that, rather than shying away from a volatile market - contrary to many managers who see volatile periods as a time to deleverage and pause deploying capital - Baillie Gifford is raising its exposure via borrowing.

How has the fund performed?

The course of investing in small companies with as-yet unrealised future growth potential, never did run smooth. Long-term return figures still demonstrate outperformance and some fantastic examples of alpha-generation from individual stock selection. 

Over 15 years, the trust produced an annualised return of just over 13% on both a share price and NAV basis, versus benchmark returns of 9%. However, more mid-short term returns for the trust disappoint. A broader market downturn for growth stocks meant that BGSN’s underperformance in 2021 and 2022 has been sufficient to negatively impact the five-year return figure. 

In the 12 months to end of September 2023, the trust returned investors -17.1% (versus +8% for the benchmark index) and in the prior 12 months the trust returned -37.5% (versus -12.5% for index). This again reinforces the need for investors to have a 10-year investment horizon with this particular investment strategy. 

Source: Morningstar (Market Return) GBP to 30/09/2023.

When market sentiment is positive and macroeconomic conditions suit, shares valued on the basis of their future growth potential can see their prices reflect great multiples of the value of their earning streams and asset bases. When fear and uncertainty abound, sentiment towards these innovative but perhaps more speculative growth companies tends to dampen, and valuations follow.

The latter is the scenario in which the trust now finds itself in, and the latest set of interim results for mid-2023 made for hard reading. So far in 2023, spillover from weakening sentiment in China adversely affected the portfolio and has made for an environment better suited to more defensive and large-cap names. Short-term losses have been further exacerbated by a widening discount to NAV for the trust, which currently stands at over 13%.

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However, on the bright side, the declines in valuation for its holdings over the past three years mean that investors buying Baillie Gifford Shin Nippon today are buying a basket of investments at a cheaper price than usual. The portfolio is now priced at about 19x earnings, compared to a peak of nearer 34x earnings in early 2021.

In addition, its discount of roughly 13% is wider than usual, which may be viewed as an opportunity to buy low. Aside from a brief period at the start of the Covid-19 pandemic, this represents the deepest discount for a decade. Over the past three years, the trust’s average discount is nearer 3% and has occasionally traded on a small premium.

Why do we recommend this fund?

This fund is not for the faint-hearted, but its strategy is an option for those willing to accept the risks in pursuit of potentially higher long-term rewards, rather than follow a more balanced or cautious approach.

As is evident in the prevailing environment, the stylistic bias and leveraged approach can make for lumpy returns and contribute to periods of underperformance. 

However, amid favourable conditions bolstered by investor confidence, the trust has potential to significantly outperform. If sentiment towards portfolio companies recovers, and valuations normalise, this aggressive approach has potential to deliver upside to investors.

When sentiment turns is anybody’s guess. Japan has been a relatively unloved region for investors over the past three decades. Economic growth has lagged other developed markets, and deflation, domestic demand and demographic concerns have come to the fore. But higher inflation, governance reforms and fresh government stimulus packages could point to an end to some of these woes, to the benefit of the domestic economy.

Given the aforementioned positioning and risk profile of the trust, Baillie Gifford Shin Nippon is offered as an “Adventurous” option on ii’s Super 60 rated list.