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How Japan is dealing with its “poison pill” problem

22 January 2020

AVI’s Joe Bauernfreund says shareholder returns used to come well down the list of priorities for companies in Japan – which is evident from the widespread use of “poison pills”.

By Anthony Luzio,

Editor, Trustnet Magazine

Japan has a “poison pill” problem – but addressing this issue could create another tailwind for a region that has been neglected by investors for far too long.

This is according to Joe Bauernfreund (pictured), manager of the AVI Japan Opportunity Trust. AVI as a group is interested in cheap, overlooked and inefficient areas of the market and Japan has long ticked all of these boxes.

However, the manager said it was the implementation of Shinzo Abe’s Abenomics programme, and specifically the third arrow, which focuses on corporate reform, that convinced the group to open the AVI Japan Opportunity Trust.

“The mechanism through which Abe deals with corporate reform is the corporate governance & stewardship code which was implemented four or five years ago,” said Bauernfreund.

“It specifically targets the idle cash sitting on companies' balance sheets, encouraging them to do something productive with it or return it to shareholders so that they can spend it and drive the animal spirits in the economy that way.

“Finally, it appeared to us that not only did you have a cheap market, but you had a catalyst in place to try and unlock that.”

Bauernfreund said an important aspect of the code is that it encourages foreign and domestic shareholders to engage proactively with companies to encourage them to implement among other things, a stronger focus on shareholder returns.

While it may sound strange that investors would need to ask directors to focus on shareholder returns, the manager said that this used to come well down the list of priorities in Japan.

“The objective of most companies in Japan was to build up a cash pile for a rainy day, so they never had to go through that existential crisis that they endured in 1989 to 1990 when that bubble burst,” he continued.

“It was also to employ as many people as possible and keep them in employment and pay them a pension when they retired.

“And it was to make a positive contribution to society so, as a nation, they could be proud of what they achieved. Shareholders came very last in that pecking order and Abenomics is about changing that.”

Bauernfreund said Japan has already made enormous progress, with return on equity ticking up, the majority of companies hiring independent directors and share buybacks doubling from 2018 – which was itself a record year.

Source: AVI

However, he said there is still plenty more to be done before companies in Japan reach the standards of their peers in the west, with the manager pointing to portfolio holding Fujitec as an example.

Fujitec is one of the world’s top-10 elevator manufacturers, selling to customers in Japan, China, south-east Asia, North America and Europe. Bauernfreund said the most appealing aspect of Fujitech’s business is the maintenance contracts that it receives after the installation of an elevator. These last for decades, producing steady, recurring profit.

The company has been the third biggest contributor to AVI Japan Opportunity’s performance since the trust’s launch and is expected to deliver 15 per cent profit growth for the year ahead.

Yet while its peers trade on EV/EBIT (enterprise value-to earnings before interest and tax) multiples of 20x, Fujitec is on just 8x.

“But if you look at its balance sheet, the reason becomes clear,” said Bauernfreund.

“One third of Fujitec’s balance sheet is allocated to low-yielding cash and investment securities, which account for 46 per cent of Fujitec’s market cap. These contribute little to profits and are valued at a heavy discount by the market.

“That creates this sort of impediment to full value realisation.”

However, Bauernfreund said there is “another sting in the tail” when it comes to the low valuation, which brings him on to the subject of the poison pill.

“Ten or 15 years ago, an American investor had a stake in Fujitec and wanted to take it over, so the company, like many Japanese companies, put in place a ‘poison pill’,” he explained.

“The poison pill essentially prevents anybody who is unwanted from making a bid for a company at risk of being diluted down to zero.

Bauernfreund said that poison pills have come under attack under the new era of more stringent corporate governance, with many companies eliminating them. However, Fujitec managed to win support from the majority of shareholders to keep it in place.

“Our angle with Fujitec is that you have a very high-quality business that is very undervalued because of its balance sheet, and because of the poison pill,” the manager continued.

“We are working with the managers in a constructive way to try and get the share price up to fully reflect the value – they fully appreciate that the company is undervalued.

“They don't want to be taken over by a foreign entity, they would rather not be taken over by a Japanese entity either.

“But they recognise that within the next couple of years, when the vote comes up again from shareholders, they are likely to come under increased pressure to eliminate the poison pill.

“So they have a job to do.”

Data from FE Analytics shows AVI Japan Opportunity has made 14.78 per cent since launch in October 2018, compared with gains of 11.73 per cent from its IT Japanese Smaller Companies sector.

Performance of trust vs sector since launch

Source: FE Analytics

The trust is trading at a premium of 3.56 per cent to net asset value (NAV) compared with 2.89 per cent from its one-year average.

It is 10 per cent geared and its management fee is 1.0 per cent of either the market cap or NAV, whichever one is lowest.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.