Engaging Japan’s Hidden Gems

How a more personal investment approach could help uncover Japan’s small- and mid-cap “hidden gems.”

Today’s CIO Weekly Perspectives comes from guest contributors Keita Kubota and Kei Okamura.

There was a long pause.

It was almost too long for the normally well-spoken CEO, who had continued to grow the mobile telco business even amid numerous macro and regulatory challenges. Had our engagement on balance sheet reforms pushed him too far? Or had we hit a nerve over discussions on improving boardroom independence?

At last, he broke the silence.

“Sorry! I had the mute button on.”

Heated Discussions

During COVID-19, scenes like this have become all too familiar for us, as we manage our Japan Equity Engagement strategy. We are sometimes glad when a minor technical glitch offers some light relief from what can sometimes be rather heated discussions on capital management, boardroom independence or disclosure of material environmental, social and governance (ESG) risks.

Once we figured out how to work the mute button, our engagement was back on. The virtual meeting may not have been perfect, but we came away with strong conviction that the company’s fundamentals remain solid, as remote working had renewed demand for reliable voice and data communication. Just as important, the CEO welcomed our positive feedback on the company’s first-ever share buyback, but agreed that it was still a drop in the bucket of its bloated balance sheet, which continues to expand thanks to its highly cash-generative business.

Hidden Gems

This company is what our team often refers to as one of Japan’s “hidden gems”—a small to mid-sized firm with an exceptionally high-quality business model and the potential for long-term value creation, tucked away in the world’s second most liquid equity market.

They are often highly profitable businesses backed by strong balance sheets and robust cash flow profiles. We look for global market leaders in niche industries, survivors within consolidating industries or emerging technology disruptors, managed by capable and open-minded management that is willing to listen to long-term shareholders like us.

There are some special situations where we can potentially uncover “gems” like these with deeply discounted valuations. They often get overlooked due to the uniqueness of their products or preconceived notions of their industry and business.

Discovering them is no easy feat. This segment of the Japanese market remains largely under-researched by both sell-side and ESG analysts. So, our local team combs through public filings, media clippings and conversations with suppliers, customers and competitors looking for clues.

And that’s just half the work.

Once we’ve tracked down these companies, we have to piece together their business models and fundamentals based on the limited publicly available financial records, mostly available only in Japanese.

Our first meeting with a company like this is a bit like a first date. We don’t start with a deluge of questions. We take extra care to introduce ourselves, the history of Neuberger Berman, and our philosophy of investing for the long term. Then we seek to deepen our understanding of the business model and focus our attention on getting to know management and identifying the real players running the business.

In an age of high-frequency trading and passive exchange-traded funds, many forget that investing is a person-to-person business. This is particularly true when you are integrating shareholder engagement into your strategy. Our efforts would never bear fruit without management’s willingness to listen to us.

COVID-19

The global pandemic has tested the strength of our investment strategy. In January and February, rising uncertainty prompted us to double our communication with companies to keep up-to-date on the virus’ financial and non-financial impacts. We had conducted more than 140 company visits by the end of March and another 190 by the end of June, leading us to review our scoring model of business fundamentals and ESG factors, while adjusting our midterm earnings forecasts based on the post-COVID norm.

That gave us the confidence to look into opportunities in the market rout to top-up on existing quality businesses and introduce new “hidden gems,” while reducing exposure to high-valuation companies whose earnings visibility had suddenly become less clear.

The pandemic also renewed the focus on sustainable business practices—particularly on the “S” of ESG and how companies manage their employees. Japan has traditionally been a laggard in work-style reform and workplace digital transformation, but engagement with our IT services holdings suggests that COVID-19 has accelerated corporate Japan’s digital transformation by at least three or four years.

We think this trend spells opportunities for companies exposed to the digital transformation theme. However, it also creates sustainability challenges for other companies that don’t have blue chip-sized resources to fund the transformation. We will continue to engage with them, supporting management on sustainability best practices and encouraging timely disclosure based on the Sustainability Accounting Standards Board (SASB) framework.

Japan has witnessed a slew of crises in the last several decades, starting with the bursting of the economic bubble in the 1990s and taking in the financial crisis of the late 2000s, the March 2011 earthquake and nuclear meltdown and the current global pandemic. It hosts companies with high-quality, sustainable businesses that have risen up to those challenges and each time emerged stronger. We don’t believe this time is any different, and we will continue to seek out and remain long-term owners of businesses like these.