Japanese stocks have rallied substantially since the start of the year with experts highlighting the Bank of Japan’s stimulus measures as one of the major reasons for the surge.According to FE Analytics, the Topix has returned 27.81 per cent in 2013 alone, making it the best-performing developed market index over the period.
However MacDougall, who runs the Baillie Gifford Shin Nippon IT and Baillie Gifford Japanese Smaller Companies fund, says investors should not fall into the usual trap of buying large caps as Japan’s new breed of entrepreneurs means smaller companies have much better prospects.
"Our approach to investing is to absolutely focus on growth," he explained.
"We have a long investment horizon and the average holding period in our Shin Nippon trust is six years. The first question we ask is can this company become much bigger or will it just chug along with the rest?"
"There are 3,500 listed companies in Japan, but there are only a couple of hundred that fit that category."
"Some investors may be using an ETF to get their Japanese exposure, but the index is diluted by companies that were listed for the wrong reasons – normally so the management team wouldn’t have to pay as much tax back in the 90s."
"By simply buying the market, you are getting exposure to a lot of poor companies."
"That’s why we focus on small caps, which have much higher growth potential and are led by management teams who are more in touch with the rest of the world. The majority have been educated overseas and are just more refreshing to work with," he added.
Although Japanese equities have performed strongly so far this year, it is the smaller end of the market that has shot the lights out.
Our data shows that the best-performing IMA sector this year by some distance has been Japanese Smaller Companies. It tops the tables over one, three, six and 12 months.
Performance of sectors over 1yr
| Name | 1m returns (%) |
3m returns (%) | 6m returns (%) | 1yr returns (%) |
|---|---|---|---|---|
| IMA Japanese Smaller Companies | 10.48 | 31.66 | 43.57 | 43.12 |
| IMA Japan | 5.71 | 20.32 | 36.48 | 34.49 |
Source: FE Analytics
MacDougall’s £72.7m Baillie Gifford Japanese Smaller Companies fund has been one of the main contributors to this performance, boasting sector-leading returns over one year.
The fund’s returns of 66.9 per cent over three years means it has been the best-performing fund over that period as well.
However, it is his Baillie Gifford Shin Nippon trust that has performed the strongest. So far this year it has made 66.42 per cent, while its MSCI Japan Small Cap index benchmark has returned 29.64 per cent.
Performance of fund vs index since Jan 2013
Source: FE Analytics
It has also been the best-performing investment trust in the IT Japanese Smaller Companies sector over one, three, five and 10 years. Due to the trust’s stellar performance, it is now trading on an 8.2 per cent premium to its NAV.
Shin Nippon translates as "New Japan", which McDougall says sums up what the trust is about quite nicely.
"We look for future global winners that have the highest growth potential," he said.
He adds that one of the major reasons for his funds’ success is the new entrepreneurial spirit in Japan which means the region’s small cap market should continue to boom over the coming years.
"In the late 90s at the height of the Japanese financial crisis, companies began laying off employees en masse," he said.
"Japan had had a job-for-life culture where graduates would join the oldest companies and spend their career there. However, when companies were laying off, many broke the cycle and thought they would try and build something themselves."
"There are a number of trailblazers now as two out of five rich people in Japan are self-made, having started up a company themselves. That has provided new role models for young entrepreneurs and it is now a lot more accepted to set up your own business."
"We have started to see an increase in IPOs and they have performed strongly, having attracted both domestic retail investment and foreign money," he added.
MacDougall expects small caps to maintain their strong run compared with their larger counterparts because there has been a change in dynamic in the flows pouring into Japan during this rally.
"It is an interesting question as to whether Japanese small caps can outperform large caps."
"In previous rallies, where the global economy has strengthened and the yen has weakened, large caps have outperformed and money would only go into small caps as the domestic economy picked up."
"However, this time the divergence hasn’t been so pronounced."
"Foreign investors have done their usual thing of buying larger companies, but domestic investors have been a lot more active than in the past and seem to believe in Abe’s policies and have a much rosier view of the economy."
"There is now an ISA-style tax-free way to invest in order to get that money out from underneath the mattress and get it flowing around the economy," he added.
MacDougall’s Baillie Gifford Japanese Smaller Companies fund has an ongoing charges figure (OCF) of 1.58 per cent and requires a minimum investment of £1,000. His trust has ongoing charges of 1.53 per cent and is geared at 5 per cent.