Royce International Micro-Cap Fund Portfolio Managers Jim Harvey and Dilip Badlani recently returned from their trip to Japan, where they were greeted with a sense of renewed optimism about the country’s economy and growth potential from the management teams they met.
At the end of the first quarter, Japan was the largest country weighting in Royce International Micro-Cap Fund‘s portfolio. What has been exciting about Japan?
Jim Harvey: When we run screens for micro-cap companies around the world, some countries will consistently show promising investment candidates, and Japan typically returns a lot of companies exhibiting the characteristics that we find attractive, the most important of which being valuation. Compared to some other developed markets, the valuations for many Japanese smaller companies look relatively low, and have been for some time.
So the challenging part is distinguishing a compelling value from a value trap. There’s no point in buying cheap companies if they don’t appear poised to grow, if there’s no enthusiasm in the economy, or if sentiment isn’t positive. Part of the reason why we are attracted to Japan today is that things are changing—there are lots of things going on in the country today; things that have not gone on for decades. While ultimately we are bottom-up stock pickers, there’s a renewed feeling of vibrancy on the ground.
Dilip Badlani: Japan has not seen significant growth since the late 1980s-early 1990s. Instead, it’s suffered from deflation and has been in a bear market for about 20 years. The political and economic landscape in Japan today is starting to change after decades of stagnant growth.
We’ve visited Japan a number of times over the years. In the past it’s been easy to observe the low enthusiasm from both investors and management teams. For the first time in a while, this is not the case. The policies that the Japanese government is putting in place and the stimulus efforts that the Bank of Japan (BOJ) is implementing feel like they’re having a bit of an effect on the economy.
JH: Just by their nature, Japanese management teams are very conservative—in fact, they are among the humblest, least promotional groups of management teams that we meet with around the world. But during our latest visit we actually heard a few of them expressing optimism and hinting that they are excited about the future. That has not really happened in our past visits, so it is definitely part of the reason why we think Japan is exciting today.
Jim and Dilip in downtown Tokyo near the Imperial Palace
What is your take on Shinzo Abe’s “three arrows”—monetary, fiscal, and growth strategies—and how do you think his policies will affect Japanese smaller companies and consumer behavior going forward?
JH: The first arrow was using the BOJ to pump massive amounts of money into the economy, primarily via the purchase of government bonds. The second arrow was similarly dramatic and came in the form of a fiscal stimulus package worth 10.3 trillion yen, or $116 billion. While we haven’t yet seen the effect these policies will have on the economy, the stock market certainly saw them as big positives.
DB: I think the most important of the three arrows is the third, which is ultimately structural reform. Stimulative monetary policy is what central banks are doing throughout the developed world, but I think the significant policy is structural reform, which can be a huge boost to Japan’s economy. It makes people commit to longer-term capital decisions, and I think when capital spending picks up a lot of these smaller companies are going to see their earnings shoot up as well.
We think it’s fascinating that over the last year Japan was one of the only markets in the world in which both earnings and the stock market have risen. Corporate profits have arguably come in a lot higher than what people expected them to be. So I think in the grand scheme of things, Abe has put policies in place that will turn things around.
Part of the reason why we are attracted to Japan today is that things are changing—there are lots of things going on in the country today; things that have not gone on for decades. While ultimately we are bottom-up stock pickers, there’s a renewed feeling of vibrancy on the ground.
JH: The Japanese stock market was up big last year. The question is, was the market reacting to the first two arrows or was the market discounting the third arrow, which has not fully unfolded yet? I think it’s a balance among all three arrows—and another key change that didn’t get a lot of coverage was Abe’s aggressive push to revamp the investment committee of Japan’s pension fund, which is one of the largest in the world.
The committee, which went from 10 members to eight members, now includes three who are in agreement with Abe in terms of shifting the allocation of the fund, which is currently about 60% bonds, 12% domestic equities, and 12% foreign equities. If he can succeed in influencing the investment committee to start placing more of that money into equities, that would be a real boost. That’s just a piece of what you can label as structure reform.
DB: There has been a lot of talk around labor market reforms, including hiring and firing practices, women entering the workforce, changes to the corporate tax rate, improved corporate governance, and creating lightly taxed, deregulated economic zones around the country. In terms of consumer behavior, the message we heard a lot in March was that people were pulling in purchases ahead of the 3% consumption tax increase in April from 5% to 8%.
Another major topic is a push for wage increases. Of course, this could be a double-edged sword—while it would prove helpful to consumers and hopefully increase spending, it could squeeze margins on small businesses that do not have pricing power. But in general we think these potential reforms will benefit the types of smaller Japanese companies that we typically invest in.
Jim and Dilip in a park in downtown Tokyo
JH: On our most recent visit to Japan, we met with companies in the transportation, industrial, pharmaceutical, financials services, and tech industries, in addition to a few other types of companies. So we do not have a specific focus in terms of importers, exporters, industry groups, etc.
What we’re looking for in Japan are the same things that we’re looking for in other micro-cap companies around the world—strong balance sheets and niche businesses run by capable management teams. Our biggest focus is on returns on invested capital (ROIC). Companies that have high ROIC are typically doing something right—there’s usually something about a business that’s good if it’s able to generate high ROIC over long periods of time.
DB: We do not have a specific mandate—we look at a mix of businesses. Our goal is to find companies that will hopefully no longer be micro-caps down the road. We look for companies with a dominant market position, a single-line business model, and the ability to generate high returns without leveraging their balance sheet.
Can you discuss a few names in the portfolio that exemplify your conviction in Japan?
JH: We recently met with a company called Zuiko Corporation, which makes specialty machinery for manufacturing disposable hygiene products such as diapers for babies and adults and feminine hygiene products. The company has been around for several decades and is the largest company in the world that makes equipment for diapers. The company has a strong balance sheet and we like that the sales volume for baby diapers is growing all around the world, especially in developing countries, which represent approximately 72% of the market.
Another advantage is that Zuiko has invested heavily in Asia over the last few years. Its customers like this because they’re setting up manufacturing sites all throughout this part of the world, and they appreciate the fact that these machines can be customized to fit their needs.
DB: Another company we own is Trancom, a logistics company. This is a classic case where a similar business would probably not trade at the multiple it does if it were based in the U.S. We love that it’s an asset light business. Started in the mid-90s, it’s also the largest truck-brokerage company in Japan.
Trancom has some solid customers. With approximately 8,000 trucking companies in Japan, it’s able to match the truck demand with truck supply. Drivers benefit because they get paid on both sides of the route; customers benefit because they receive lower pricing. The founding shareholder still owns a large chunk of the company, and much of the market remains underpenetrated.
In addition, Trancom has set up a contract logistics business where they can handle a company’s entire logistics chain. When you think about that, why should a manufacturing company handle its own logistics? It’s probably better to outsource it.
Many manufacturing companies would prefer to focus only on manufacturing as opposed to having to also think about transportation. We think Trancom will allow those companies to become better stewards of their own capital and think that it can continue to grow as their customers continue to outsource.
Our goal is to find companies that will hopefully no longer be micro-caps down the road. We look for companies with a dominant market position, a single-line business model, and the ability to generate high returns without leveraging their balance sheet.
Relo is a Japanese relocation company that we own. In the 1980s a lot of Japanese companies were sending their employees overseas. Relo would manage their houses and rent them out so the employees could earn an income while they were away. The company also had a huge base of business of employees moving within Japan.
What’s unique to Japan is that a lot of companies give housing as part of corporate compensation—it’s a tax benefit to the company, and it’s not considered a taxable income to the employee. Historically, a lot of these Japanese companies used to own the real estate, but as they went through the deleveraging process throughout the 90s and 2000s, many conglomerates began to outsource the service to companies that deal with property managers in order to get the apartments. It’s an attractive business because there’s a consistent earnings stream, as rentals are typically long-term leases.
The second attractive part of Relo’s business is its fringe benefits segment. This business combines the purchasing power of hundreds of small companies to give the employees at these companies discounts at places such as gyms, insurance, etc. The power of scale makes being a part of a big corporate network far more attractive than being on your own.
Jim and Dilip at the top of the Prince Park Hotel
JH: The last example is Nitto Kohki, which manufactures labor saving tools for a variety of industries. The company has been around for more than 100 years, consistently generates high returns on capital, isn’t widely covered, and occupies several interesting niches that are likely too small for competitors to pay attention to. The company has three segments that are somewhat difficult to link together in terms of their synergies, but we think they’re all good businesses.
The first business is the manufacturing of couplings. Couplings connect pipes that carry fluids, air, and gases. The product is used in a wide variety of fields, ranging from hydraulic/pneumatic equipment and semiconductor production equipment to hi-tech industrial devices. Its Cupla brand has the highest market share in the world. Couplings are the company’s highest-margin business and it accounts for roughly 38% of total revenues. And we learned something very interesting when we met with Nitto Koki, which is that coupling standards vary around the world. Nitto Kohki established the Asian standard for couplings, so it has a dominant piece of the market not just in Japan—where they have approximately 80% of their sales—but also throughout Asia. The company is now also expanding into Europe, and recently rolled out a new product called HHV Cupla, which is used to deliver hydrogen into fuel cell vehicles.
In Nitto Kohki’s machine tools segment, it manufactures hand-held drilling machines, electric screwdrivers, pneumatic types of equipment, grinders, etc. This segment also makes up about 38% of revenues. It has one big product called Atra, which is a drilling machine with a portable magnetic base. It’s a high precision type of machinery, and the nice thing about this tool is that there’s a consumable element that amounts to about 30% of segment sales and is another high-margin business. We believe that an uptick in capex will be a big driver for this type of equipment, and management feels that construction spending related to the 2020 summer Olympics in Tokyo should provide a boost to this business as well.
Nitto Kohki’s third business is door closers, which are built-in hinges that allow doors to open and close smoothly. This product line came with a machine tool acquisition the company made several years ago. Although this business shares few synergies with other segments, Nitto Kohki decided to keep it because it’s profitable and requires minimal capex. Like with its other segments, Nitto Kohki is a dominant player in this small niche. The business makes up roughly 6.6% of the company’s revenues and is tied to new construction, an industry that management expects will recover.