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Lose-now-win-later activist hopes to inspire investor interest in cheap Japan

14 February 2020

Joe Bauernfreund, manager of AVI Japan Opportunity Trust, describes the big goal behind his 15 months spent encouraging Japan’ s smaller companies to do something with their surplus cash.

‘The one thing Japanese companies are most fearful of with foreign investors is that we’re just short-term people, interested in a quick buck and ripping Japan off,’ says Joe Bauernfreund, manager of AVI Japan Opportunity Trust (AJOT ).

The £134m trust was launched in October 2018, after veteran activists Asset Value Investors (AVI) identified ‘a whole raft’ of undervalued Japanese companies too small for its £869m AVI Global Trust (AGT ), at the time called British Empire.

Teikoku target

The latest target in its sights is Teikoku Sen-I (3202.T), a 66.9bn yen (£470m) firefighting equipment manufacturer that typifies two features of the Japanese smaller companies it wants to persuade to change and how much work that can take.

‘Often in small companies you are dealing with directors who simply don’t get it,’ says Bauernfreund (above), who has around half of AJOT’s portfolio invested in companies worth under £500m. The current generation of executives began their careers during Japan’s bubble era in the late 1980s and have never got over the ‘rainy day’ mentality its spectacular collapse created.

AJOT has published a shareholder proposal ahead of Teikoku Sen-i’s annual general meeting at the end of March accusing the company of creating a ‘value destructive balance sheet’, with 70% of its total assets consisting of either cash or shareholdings in ‘completely unrelated’ businesses.

AVI is not the only dog in the fight. Teikoku has been the target of other activists including, unusually, a Japanese fund manager called Sparx Asset Management in 2018. Its proposal for the company to return some surplus cash by tripling the dividend was defeated when other shareholders rallied round Teikoku. However, in a lose-now-win-later pattern that has become familiar for activists in Japan, the company did later relent and modestly raise the payout.

Perilous error

‘The mistake that activists and foreign shareholders made in the past is to think that that cash is theirs, because they are shareholders,’ explains Bauernfreund.

‘That’s what you'd think pretty much anywhere else in the world. But in Japan you do so at your peril.’

When companies tend to react badly to aggressive, media-driven activist campaigns common elsewhere, the fact AVI’s ‘intentionally modest’ proposal for an increase in dividends and 3% share buyback has seen the light of day is a sign that covert engagement during three or four visits to Japan each year has failed.

Ultimately, the tailwind for AVI is pressure from the Japanese government itself under prime minister Shinzo Abe (main picture), as part of a push for Japanese companies to use capital more efficiently – AVI’s proposal is couched in such reforming language of ‘Abenomics’, designed to soften any impression Bauernfreund is just trying to get his hands on the cash.

Still, he estimates 30% of Teikoku’s share registry is made up of ‘allegiant shareholders’, companies who own each other’s shares and blindly support each other’s managements.

‘It’s a major uphill struggle to actually win this shareholder resolution, and it's not necessarily our expectation that we will,’ he says.

‘It’s more about putting pressure, making the argument.’

Because the process can be so incremental and AVI can’t be certain it will unlock value, it only selects ‘fundamentally attractive and cheap’ companies with strong earnings and the potential to grow. A company like Teikoku has high margins and, after a number of natural disasters in Japan, is in a growing sector.

Buybacks and acquisitions

Though this means any action from management is ‘the icing on the cake’, AJOT’s maiden annual results this week revealed share buybacks have been announced at 10 of its 30-odd holdings while three had been acquired by predators at substantial premiums.

Covering the period from launch to 31 December 2019, the results highlighted the trust’s strong start with a 14.3% rise in net asset value (NAV) against the 7.9% total return in sterling generated by its benchmark, the MSCI Japan Small Cap Index.

It is set to pay a dividend for the first time of 0.9p per share.
Although the company launched at a difficult time, with its initial public offer (IPO) raising just £80m of its £200m upper target, subsequent demand for AJOT saw its shares trade at a persistent premium to NAV, enabling it to issue 34.9m shares and grow in size to £128m.

Other prolonged campaigns have also started to pay off. AVI first invested in Tokyo Broadcasting System (9401.T) in January 2017 and has owned it in AJOT since launch. A high-profile campaign in 2018 did not bear much fruit but last week the broadcaster’s announcement it would sell some of its shareholdings in other companies saw its shares jump nearly 10%, before paring back gains.

Bauernfreund calls it ‘a great first step’ after the roughly flat share price over three years.

Other successes were Toshiba Plant Systems & Services and NuFlare Technology, both of which were majority owned by Toshiba (6502.T). Under pressure to either buy or sell the holdings, the electronics giant bid for both at premiums to their share prices, boosting AJOT’s NAV by 4.8% in the last quarter of 2019.

Teikoku sits in that half of the portfolio which has not benefited from share buybacks yet. Bauernfreund describes a two to three-year process – which began with some stocks in British Empire – of buying a stake, engaging with management and then, if nothing happens, making a public proposal, as with Teikoku.

First steps

That suggests it will be a busy year for AJOT, and a chance for investors to evaluate how much momentum there is behind the trend for Japanese companies to do something with their dormant assets and cash.

One of four companies in the AIC Japanese Smaller Companies sector, over a year AJOT’s shares have delivered a total return of 19.6%, second to the 26.5% gain of JPMorgan Japan Smaller Companies (JPS ), which is also the highest yielding at 4.1%. Atlantis Japan Growth (AJG ) is third with a 17.7% gain while Baillie Gifford Shin Nippon (BGS )’s shareholders are sitting on a 1.1% loss. The star performer has moved to a rare discount to NAV having delivered a whopping 622.8% gain over 10 years.

A fifth is now set to join the mix. Nippon Active Value (NAVF) has a near identical remit to AJOT and will be managed by James Rosenwald’s Rising Sun Capital. After a delay in its flotation over investor concerns on ESG credentials, the closed-end fund has announced it has hit its minimum raise of £100m and will begin trading on 21 February.

This all builds on more than 20 years of value investors crying that Japan is a ridiculously ‘cheap’ market.

‘There have been false dawns,’ admits Bauernfreund, but he argues small actions by companies could lead to wholesale re-ratings.

‘All of a sudden cash [on balance sheets] has got a value. You start to remove the justification for the discount in terms of valuation.’

‘And that’s really the theme that we want to get exposure to. You get capital flowing into Japan, you get big activist campaigns going on, with larger companies than Teikoku Sen-i. That’s when interest comes back.’


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