Japan’s overlooked disruptive tech sector

Japan’s technology index has easily beaten the US Nasdaq during the rebound from March lows. Rob Morgan takes a closer look at this often-overlooked market.

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  1. Rob Morgan

As we adapt to the new norms of social distancing measures and travel restrictions, the use of e-commerce, digital payments, remote healthcare, cloud services, virtual and online entertainment, and online education platforms have accelerated.

That’s been very obviously reflected in the valuations of shares in large technology-led businesses with the Nasdaq, the US index of high-growth companies, up around a quarter in 2020 so far. In Asia too the technology sector has dominated returns with Alibaba and Tencent, China’s e-commerce behemoths, soaring 17% and 45% respectively since the turn of the year, helping drive many Chinese and broader Asian funds in the process.

Yet what about the opportunities beyond these well-known giants of China and Silicon Valley? One compelling but lesser-known area, at least as far as UK investors are concerned, is Japan. The nation is home to cutting edge companies in areas such as robotics and biotechnology, and the trend of digitalisation is creating numerous growth opportunities for smaller businesses in a domestic market ripe for disruption. Somewhat counterintuitively, large parts of Japanese society are behind the curve compared with the rest of the developed world with around 80% of payments still made in cash.

Japan’s ‘hidden’ tech index

Few UK investors are aware of Japan's ‘Mothers Index’ of smaller, high growth companies. Japan is unusual in the developed world in that it hasn’t developed a significant venture capital industry that enables early-stage businesses to secure private funding from financiers or wealthy individuals. Instead, start-up companies in search of capital tend to come to the stock market, and when they do it is usually the Mothers Index where they first appear.

While most Japanese market indices are made up of the large manufacturing companies, financials and conglomerates, the Mothers is entirely different. Stocks are small-to-medium sized and often more domestically focussed on certain business areas. There is also a heavy bias to technology and healthcare with these two areas making up about two thirds of the index.

Recently, the performance of the market has been spectacular. The index's over 80% surge since March lows beats the Nasdaq’s 55%, although the US index held up better on the way down with the Mothers only 15% ahead in 2020 year to date versus the Nasdaq’s 25%. As with other markets, interest in the Mothers index, as well as Japanese tech businesses on other markets, has increased on hopes that AI-led digital transformation, cyber security and greater use of the internet of things (all accelerated by the coronavirus) will fuel growth for many of the nascent businesses.

There are concerns that spectacular short-term gains may be down to a sudden influx of excitable new investors and day traders. Volatility is therefore to be expected, but there are exciting new growth opportunities for dynamic, entrepreneurial and nimbler businesses in tune with changes to work and lifestyle habits.

For instance, the percentage of workers equipped with remote-working capabilities in Japan is currently below 20% and expected to rise substantially, leading to higher expenditure on technology-related goods and services. Some constituents of the Mothers index, as well as more established businesses listed on the more senior indices, could be poised to benefit.

Fund options for the ‘New Japan’

Broader Japanese investments such as Foundation Fundlist constituent Baillie Gifford Japan Investment Trust capture many of the growth areas available among Japanese corporates. This has been illustrated by recent strong performance from several of the Trust’s positions including M3 (provision of medicines through the internet), Advantest (test equipment for semiconductor industry) and Disco (precision tool maker).

However, its sister fund Baillie Gifford Shin Nippon has a more specific focus on innovative, disruptive business models representing the ‘new Japan’. The Trust’s portfolio will primarily consist of 40 to 80 listed companies held for the long term, although up to 10% of total assets is allowed in unlisted investments. Around 10% of the fund is invested in shares on the Mothers Index presently, with the bulk of the portfolio in more established businesses listed on the TOPIX Small and TOPIX Mid indices. There is a structural bias to the technology, healthcare, consumer service and industrials sectors.

Manager, Praveen Kumar, sees significant growth opportunities emerging as a result of the Covid-19 crisis in areas such as ecommerce and digitalisation, software services and healthcare. For instance, Bengo4.com offers online, digital contracts service which allows companies to eliminate paper-based contracts for employment, real estate and legal matters. Subscriptions have more than doubled over the past year and the company expects to maintain a similar pace of growth over the next year.

MonotaRO, Japan’s largest maintenance, repair and operations e-commerce platform, has also been a significant winner in the portfolio and has continued to gain market share. Kumar believes the company still has “a long runway of growth ahead” despite spectacular share price performance already, and that the pandemic will accelerate the shift towards online purchases.

Other holdings, including GMO Payment Gateway, Japan’s leading online payments processing company, and ‘virtual shopping mall’ Demae-Can are also emerging as major beneficiaries of the crisis as an increasing number of people opt to shop and transact online.

This tailwind extends to some of the Trust’s software companies too like Cybozu and Oro, which provide software that allows companies to automate and streamline a number of tasks in areas such as HR, payroll, marketing and project management. Meanwhile in healthcare, M3 and Noritsu Koki are beneficiaries of the increasing need online consultations, telemedicine and remote diagnostics.

Our view

Japanese smaller companies can be extremely volatile and sentiment-driven, so it’s important to take a long-term view when investing and be prepared for large ups and downs over shorter periods. However, some modest exposure could offer some diversification, as well as long term growth potential, to a broad portfolio for more adventurous investors.

The investment trust structure offered by Baillie Gifford Shin Nippon is appropriate for the area which can experience limited liquidity (the ease in which to buy and sell positions) but it does mean additional volatility, especially given the Trust can borrow to invest – current gearing is modest at around 7% of the portfolio value.

Past performance is not a reliable guide to future returns. This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus. If you are unsure of the suitability of your investment please seek professional advice.

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