FE Alpha Manager Michael Lindsell has made a new addition to his high-conviction, low turnover five FE Crown-rated Lindsell Train Japanese Equity fund with Japanese video game publisher Square Enix.
Lindsell’s investment style is characterised by the in-depth fundamental analysis of the universe they invest in, which results in a low turnover and as such makes very few additions to the portfolio.
Indeed, the last time the high-conviction manager added a holding to the £216.4m portfolio was in November 2017, when he bought Calbee, a snacks food manufacturer.
Before Calbee, Lindsell’s most recent acquisition was Japanese media content owner Sotsu in September 2016.
The FE Alpha Manager said the team had been watching Square Enix since the original merger of companies Square and Enix in 2003 and decided to initiate the position following a 16 per cent fall in the share price year-to-date.
Performance of Square Enix over 1yr
Source: Google Finance
Lindsell, who has overseen the fund since 2004, said the investment case behind Square Enix is underpinned by its unique and rare collection of intellectual property, with the video game Final Fantasy standing out as one of the “top ten selling of all time”.
Other famous products by the game publisher include franchises Tomb Raider, Kingdom of Hearts, Just Cause and Nier: Automata.
Lindsell said the company will be able to benefit from structural shifts advantageous to the video game industry such as the shift from packaged software to digital downloads.
He noted the company’s digital download ratio is around 30 per cent and is meant to rise in the future, which will help the company expand internationally.
According to Lindsell, Square Enix will also be a beneficiary of the game’s industry digital shift away from a ‘units sold’ model to a ‘games as a service model’ based on users, engagement and digital monetisation.
“Square Enix has a rock-solid balance sheet, with net cash amounting to 120bn Japanese yen,” said Lindsell (pictured).
“Looking through this inefficient capital structure, which in 2017 recorded a return on equity of 11 per cent, returns on tangible capital have averaged 35 per cent over the last 15 years.”
“At the moment the company trades at an enterprise valuation of 1.7x sales, notably below Nintendo 5.1x, Electronic Arts 6.5x and Take-Two 5.1x,” he pointed out. 
The manager compared Square Enix to Lindsell Train Japanese Equity fund’s second largest holding, Nintendo, which has an 9.0 per cent weighting in the portfolio.
“It is, in our view, a great business model although arguably somewhat inferior to Nintendo’s as there is dependency on a series of platforms over which Square Enix has little control,” explained Lindsell.
Unlike Nintendo, where the majority of its video game software is played exclusively on its own hardware consoles, Lindsell noted Square Enix does not produce any hardware, with a software that is designed to be compatible with other companies’ hardware platforms.
“It may lose some of the profit margin but does not have the capital and technology risk of designing hardware and its platform neutrality gives it a multitude of outlets to distribute its Intellectual Property,” the Japanese fund manager noted.
“Historically Square Enix’s core competency has been in console games but it has also successfully moved into smartphone games,” he added.
“From financial year 2011 to financial year 2017 the revenue generated from their smartphone business has grown exponentially, from 13bn yen to 83bn yen.”
“The rise of smartphone games generally has helped grow the total addressable market for gaming from 100 million consumers in 1995 to 2.6 billion in 2017,” he said.
Finally, Lindsell noted the amusement segment of the business, which represents 17 per cent of sales and operates 140 arcades across Japan.
“This part of the business is inferior, lower margin than the core video game publishing business and has limited growth prospects but it can generate stable cash flows,” he said.
Lindsell added: “The global gaming industry has now surpassed $100bn of annual revenue and is growing at over 10 per cent per annum.
“Asia Pacific is the largest gaming market, worth an estimated 47 per cent share of global revenue and it is also growing the fastest.
“With famous intellectual property already resonant in Asia, Square Enix is in a strong position to capitalise on this opportunity.”
The Lindsell Train Japanese Equity currently has 26.5 per cent of the portfolio allocated to media including software stocks, although its largest sector allocation is to consumer franchises (45.9 per cent). Pharmaceutical and healthcare is another significant sector, representing 20.0 per cent of the portfolio.
The manager’s largest holding in the fund is chemical and cosmetics company KAO, which represents 9.2 per cent of the fund. Other notable holdings include software business OBIC Business Consultant, Astellas Pharmaceutical and personal care company Shiseido.
Performance of fund under Lindsell
Source: FE Analytics
Since Lindsell took over the strategy in January 2004, the fund has delivered a 337.01 per cent total return compared with a 159.96 per cent gain for the average IA Japan sector fund and a gain of 123.42 per cent for the TSE TOPIX index
It has also had a strong start to 2018, returning 12.40 per cent, compared with a gain of 2.62 per cent for the TOPIX and 2.13 per cent for the average peer.
Lindsell Train Japanese Equity has an ongoing charges figure (OCF) of 0.85 per cent.