2023-05-15 22:23:27 ET
Summary
- The abrdn Japan Equity Fund has trailed its benchmark despite a resurgence of foreign inflows in recent weeks.
- While there is an interesting governance reform story playing out in Japan, the high-quality JEQ portfolio is unlikely to capture much of the upside.
- With JEQ also exposed to an external slowdown and a further de-rating amid declining fwd earnings growth estimates, the fund's NAV discount could persist for some time yet.
Following a poor February/March, Japanese equities caught a bid in April, as the new BoJ governor all but confirmed an extension of the prior regime's ultra-loose policies; increased foreign interest following Berkshire Hathaway's ([[BRK.B]], [[BRK.A]]) trip to Japan also helped valuations. Over the long run, there is a developing corporate governance improvement theme at play as well - the Tokyo Stock Exchange ((TSE)) has stepped up corporate and investor engagement in recent months, presenting a potential governance catalyst ahead of the AGM season next month. But these reforms aren't as applicable to the large-cap constituents of the Topix index, which already offer dividend payout ratios above their S&P 500 ( SPY ) counterparts and typically have investor representation on their Boards. In the near term, the prospect of a deteriorating external backdrop remains top of mind for the export-heavy abrdn Japan Equity Fund ( JEQ ), while its exposure to FX downside is a concern as well. Valuations aren't cheap either, with Japanese large caps at ~13x fwd earnings despite a backdrop of negative revisions and sub-par consensus earnings growth forecasts. So even with JEQ's discount to NAV further widening since I last covered the fund, I would remain sidelined.
Fund Overview – Low-Cost Exposure to Best-in-Class Japanese Names
The actively managed abrdn Japan Equity Fund is an absolute return fund that benchmarks itself against the TOPIX index. In line with the broader abrdn group's philosophy, the fund maintains a fundamental stock selection approach based on its bottom-up, quality-focused research process. The fund held $88.8m of net assets at the time of writing (down from $90.6m prior), while managed assets (including borrowings) were also slightly down to $100m. Alongside the declining asset base, JEQ's expense ratio has increased to ~1% net (up from 0.85% prior). The relatively high active share of 72.7 is a positive, though, showing the fund isn't another closet indexer despite still being one of the more cost-effective Japan-focused investment vehicles. A summary of key facts about the ETF is listed in the graphic below:
abrdn
In line with prior reporting, the fund's sector allocation remains heavily concentrated on several key sectors. The largest sector remains Information Technology at 18.4% (up from ~17% prior), followed by Industrials at 17.7% (up from ~14% prior) and Consumer Discretionary at 14.3% (unchanged). Consumer Staples, formerly the second-largest allocation, has been cut to 13.2% (down from ~15% prior), along with Health Care at 11.0% (down from ~12% prior). On a cumulative basis, the top six sectors now account for a larger ~85% of the total portfolio (up from ~84% prior), with cash levels continuing to represent a small % allocation.
In contrast with the sector concentration, the JEQ portfolio is relatively well spread out from a single-stock perspective. Further reducing the diversification is insurer Tokio Marine's ( OTCPK:TKOMY ) ~2%pt decline, with tech giant Sony Group Corporation ( SONY ) now the largest stock holding at 4.7% (up from ~4% prior). Japanese real estate company Tokyu Fudosan ( OTCPK:TTUUF ) has also dropped out of the top-ten list (formerly ~3% of the portfolio), replaced by factory automation leader Keyence ( OTCPK:KYCCF ) at 3.9% (up from 3.1% prior) and Shin-Etsu Chemical ( OTCPK:SHECY ) at 3.3%. Rounding out the top-five list is the Japanese spirits, soft drinks, and food business Asahi Group ( OTCPK:ASBRF ) at 3.2%. Despite the portfolio reshuffle in Q1, the top ten holdings still accounted for ~ 33% of the overall portfolio.
abrdn
Fund Performance - Underwhelming Capital Growth as NAV Discount Widens
As of Q1 2023, the fund's YTD performance stands at a solid +7.6% in NAV terms, though the widening discount to NAV means investors are down -3.6% in market price terms (vs. its benchmark TOPIX index at +6.1%). The fund has underwhelmed relative to its benchmark across longer timelines as well – in market price terms, the fund has compounded at +4.2% over the last decade vs. the TOPIX at +5.2%. On three and five-year timelines, JEQ has compounded at +4.2% and -2.7% in market price terms, respectively (NAV at +3.4% and -1.5%), well below the index at +7.2% and 0.7%. Some of the recent underperformance can be attributed to the prolonged JPY weakness, though at +1.3% annualized since its 1992 inception (+1.9% in NAV terms), JEQ investors have not been sufficiently compensated for their risk.
abrdn
Since the 2021 peak, fund distribution has also declined, with the trailing yield from the recurring income portion (excluding capital gains) closer to ~1%. With the H1 2023 distribution also off to a dismal start at 0.023/share, the income portion of the yield is now on track to run below 1% this year. The low distribution and expense ratio also makes JEQ a fairly attractive funding option for investors looking to ride the USD/JPY uptrend (e.g., by combining JEQ with a hedged Japan equities fund to tailor FX exposure). With the current buyback authorization fairly limited in scope, I wouldn't be surprised to see the fund's NAV discount widening further (currently in the high-teens % range) before it narrows.
Morningstar
Limited Upside from Upcoming Governance Reforms
There has been an encouraging push for change by the Tokyo Stock Exchange in recent months as it looks to narrow the book value discounts of Japanese names relative to their developed market counterparts. At the heart of the proposed changes are corporate governance reforms such as improved disclosures and new index products, as well as a more streamlined 'TSE Prime' to improve visibility on higher-quality Japanese corporates. Alongside Berkshire's vote of confidence last month, Japanese stocks have attracted massive foreign inflows in recent weeks, suggesting investor sentiment on Japan has improved.
Man Group
The sustainability of the bullish sentiment is in question, however. While improved governance is a step in the right direction, implementation will take time; plus, it remains unclear how the TSE will address non-compliance. For large caps, expect comparatively less corporate governance upside as well - JEQ, for instance, already implements a governance filter in its stock selection process and is, thus, unlikely to benefit as much as the mid to small caps. With dividend payouts already on the rise as well for the large caps, there isn't as much low-hanging fruit here. Thus, investors looking to ride the corporate governance reform theme would do better screening for low RoE + low P/B stocks via a small to mid-cap Japanese fund. In the meantime, the MSCI Japan Index indicates large-cap valuations aren't cheap at the current low-teens fwd P/E, particularly against a backdrop of sub-par earnings growth (~4% estimated for 2023) and continued downward earnings revisions.
Yardeni
Conclusion
Coming off a difficult five-year run, it's hard to see things meaningfully improving for the JEQ fund anytime soon. The April bounce, helped by Berkshire Hathaway's vote of confidence in the Japanese trading houses, has boosted the YTD performance, but the setup remains challenging from here. On the one hand, the exporter-focused JEQ portfolio is exposed to the risk of a global growth slowdown; on the other hand, the new BOJ regime's commitment to ultra-accommodative monetary policy poses downside risk for the JPY (note JEQ is unhedged) despite offering valuation tailwinds. There is a compelling long-term reform story unfolding, though, led by a renewed push by regulators to improve corporate governance ahead of June's AGM rounds. But investors would probably be better off playing this theme via small to mid-cap names rather than JEQ's large-cap, multinational portfolio. And with fwd P/E valuations relatively pricey in the low-teens (vs. low to mid-single-digits % earnings growth this year), JEQ remains vulnerable to further downside.
For further details see:
Japan Equity Fund: Caution Warranted Despite The Record NAV Discount