Performance Review 2005Performance 2005 (since launch), in JPY: +24.70% vs +40.36% for the Topix TR index
Tom Mermagen: "The Oyster Japan Opportunities was due to be launched at the beginning of the year but was unfortunately delayed until the end of the first quarter. The fund manager enjoyed a very strong first quarter with other similar funds over 7% ahead of Topix and the Oyster fund missed out on the benefit of this strong performance early in the year. Towards the end of the year, the Japanese market enjoyed a strong rally as foreigners invested heavily particularly in large capitalisation stocks. The fund saw large inflows to the fund at this time which did take time to invest given a more mid- to small-cap emphasis. In December the fund manager did deliberately let the cash build up in the fund as it was felt that with valuations were getting quite high and the managers did not want to chase the stocks according to their value investment philosophy. Hence, a sizeable cash portion in the fund in an up market explains the fund underperformance."
Performance Review 2006
Performance 2006, in JPY: -1.74% vs +3.02% for the Topix TR index
Tom Mermagen: "The fund underperformed the index by -476bp in 2006. The managers’ approach of selecting stocks with low valuations and strong restructuring potential led to a strategic positioning towards domestically-oriented companies within the small-mid cap segment (over 80% of the portfolio). Unfortunately, in 2006, the small cap performed relatively poorly as it was partly affected by the Livedoor scandal and the subsequent demise of the activist Murakami fund. The yen also remained weak through the year which meant that more export oriented areas of the market continued to perform well during the year. It is worth noting that within the Japanese small-mid cap peer group, Oyster Japan Opportunities ranked no3 out of 22 funds."
Performance Review 2007
Performance 2007, in JPY: -13.87% vs -11.11% for the Topix TR index
Tom Mermagen: "In 2007 Japan was a disappointment to the managers. In spite of having relatively little exposure to the emergence of credit problems and difficulties in the US housing market, the Japanese stock market seemed to suffer nonetheless. The disappointment was apparent in the small to mid cap area which suffered a second year of negative returns. In 2006 it was exporters driving the market and in 2007 it was largely cyclical stocks, which did not meet the manager’s investment criteria (steels, metals and mining etc.) that outperformed the market.
Furthermore, the Japanese housing market was very weak in 2007 for very different reasons from the US. There was a change in the regulatory procedure for the approval of new houses which resulted in a dramatic fall in the number of newly built houses. The fund had exposure to housing stocks and these performed poorly during the year."
Performance Review 2008
Performance 2008, in JPY: -28.31% vs -40.62% for the Topix TR index
Tom Mermagen: "The market sold off heavily during the year largely because of selling by foreign investors. The fund’s strong outperformance resulted from low exposure to stocks widely held by foreigners and from a high exposure to financially sound domestic stocks which were less affected by the global financial turmoil. This result was almost entirely attributable to the quality of the bottom up stock picking as the fund generated a better performance than the benchmark in 7 out of the 8 invested sectors, and in each of the 3 market cap ranges.
For example the financial sector was one of the worst performing sectors and the fund had relatively little exposure to the sector. The stocks that it did own in the financial sector were the well capitalised regional banks which performed relatively well compared to the sector and the market as a whole. Overall the high weighting in small- and mid-cap stocks and the low weighting in large cap stocks was the strongest contributing factor to fund."
Performance Review 2009
Performance 2009, in JPY: +9.58% vs +7.62% for the Topix TR index
Tom Mermagen: "The fund ended the year on a positive note, both on absolute and relative terms. This performance came on the heels of an impressive outperformance in 2008. Towards the end of 2008 and at the beginning of 2009, some larger, more blue chip stocks had fallen back to valuation levels which the manager considered to be very attractive. The fund therefore purchased a number of such larger stocks which met the criteria in terms of strength of balance sheet and franchise but were also felt to have considerable recovery potential. This view came about because of the significant levels of restructuring implemented by may companies across many different sectors in response to the financial crisis. This strategy worked well, particularly in the first half of the year when a number of the stocks, notably those which had cut costs aggressively and those with high exposure to Asia, performed strongly
Once again the quality of the bottom up stock picking made the difference as the fund outperformed its benchmark in 6 out of the 8 invested sectors, and in each of the 3 market cap ranges."
Performance Review 2010
Performance 2010, in JPY: -1.61% vs +0.96% for the Topix TR index
Tom Mermagen: "There was little difference between the performance or large and small cap stocks and there was little obvious sector leadership during the year. For example, amongst exporters the auto sector performed poorly but electrical machinery performed well. The strength of the market was concentrated in the fourth quarter when companies reported interim results and most of them showed themselves to be well on track to meet or beat expectations for the full year. The better earnings picture gave many companies sufficient confidence to raise dividends or announce share buybacks. The fund performed well in Q4 and underperformance was concentrated in Q3. The main reason for the underperformance then was due the poor performance of two specific holdings (Fuji Media Holdings and Nippon Television Network), both of which were among the top 10 holdings. The two TV companies were and sold off on concerns about the prospects for advertising revenues. The fund added to both positions during the quarter which subsequently rebounded nicely in Q4."
Performance since 2006
Performance 31.12.05 – 31.12.10, in JPY: -33.43% vs -42.64% for the Topix TR index
Tom Mermagen: "The fund outperformed substantially over the period in question largely as a result of significant outperformance in 2008. In other years the fund marginally underperformed or marginally outperformed. In 2008 the fund avoided the worst of the financial crisis by holding domestic stocks with strong financial positions, which were less affected by the crisis. Following the crisis, the valuation of the overall market fell to well below book value presenting the fund manager with many new opportunities. The fund was able to capture the upside in the market by switching into some slightly larger domestic and global stocks with strong balance sheets and high quality franchises which recovered along with the global economy.
Although turnover was slightly higher in 2008 and 2009, the performance has been achieved with generally low levels of turnover and volatility. Over this entire time period the OYSTER Japan Opportunities fund ranks within the 6th percentile of its peer group in performance terms and within the 3rd percentile in volatility terms."
Investment Process and Strategy – How does the Fund Manager Invest?
Tom Mermagen: "Although the macroeconomic context in which a company is operating is a factor in their decision making, the stock selection process is entirely bottom up, rather than top down or macro driven. The investment universe comprises all the securities listed on the Japanese regulated stock exchanges which make up around 3’500 companies.
The narrowing down of the universe starts first and foremost with the balance sheet. The managers are looking for financially sound companies with strong balance sheets. All balance sheet items are scrutinised but particular attention is paid to cash & marketable securities, property, short and long term debts, pension funding and goodwill. The aim of the management team is to perform a thorough analysis of the risk held in the balance sheet and thus to make sure there are no black holes. Generally speaking companies with high levels of cash and securities and low levels of debt are selected for investment. The quality of the franchise is also considered at this stage.
The second part of the process focuses on valuation and the potential for upside, which can come from profit growth, asset sales, corporate restructuring, M&A or higher payouts to investors. The managers typically want a lower-than-market P/B ratio and a low EV/EBIT ratio (usually below 10x). Enterprise value is very important in the managers’ mind.
To assist them in their analysis the management team uses Pacific Data, a database of Japanese companies’ balance-sheet and P&L data going back to 1984. This database is updated on a quarterly basis. The management team then uses internally customized Excel spreadsheets to analyse these data.
Liquidity is an important element of the screening. The managers limit a holding to 1% of the company for each fund and a maximum of 5% across all the funds (i.e. at the group level). The managers will not buy a stock unless it can be a 1% position within the fund which therefore currently excludes stocks below a market capitalisation of Y50bn.
Simple screenings enable the investment universe to be reduced to around 200 to 300 companies. The manager endeavours to meet investment candidates and existing holdings on a regular basis. All the managers travel to Japan once or twice a year, regular conference calls are held with companies and many are seen in London. Qualitative criteria include management track record, disclosure, attitude towards shareholders, the company’s positioning, franchise and strategy. Following each company visit, a report is written and shared in a common database and discussed by the team. Each member of the team is a generalist and can look at or visit any stock in the portfolio.
The managers will then invest in those identified companies whose share price offer the potential to show significant growth over a period of up to 5 years. Every investment decision is taken on a consensus basis. All investments are based on the team’s own work. All the fund managers sit in the same room which provides an ideal setting for constant dialogue and communication for any investment idea. All prices are followed daily along with relevant news items so all of the fund managers are aware of the changing circumstances. Relevant company news pertains to earnings, share buybacks and dividends announcements, as well as general newsflow."
Tom Mermagen: "The Japanese economy recovered well in 2010. This was partly thanks to a healthier domestic picture which was supported by various measures to support consumption such as eco-points and housing incentives. It was also partly due to Japan’s exposure to Asia as a region which recovered strongly from the crisis. Nearly 60% of all Japanese exports now go to Asia and Japan is unusual in having a large trade surplus with China, its single largest trading partner. Although growth in 2011 is anticipated to be lower at around 1%, many of the drivers for growth – exports to Asia, consumption, capex and incentives – remain in place. More interesting will be the developments on the political side where a general election, which seems highly likely, could force a realignment of the political parties and a reassessment of growth strategies. Overall though, the government and the BOJ seem committed to tackling deflation and delivering growth.
More encouraging are the developments on the corporate side. In response to the financial crisis 2 years ago many Japanese companies undertook extensive restructuring by closing factories and laying off workers. Now that sales are beginning to recover, the benefits of restructuring are very evident in the recovery in profits. Interim and third quarter results have been very encouraging and most companies should comfortably meet their guidance for this year. In aggregate, companies should double their profits this fiscal year and are likely to show double digit growth next fiscal year as well. This performance is particularly impressive in the face of what has been a very strong yen. Low interest rates, restructuring and improving profits are also resulting in substantial cash generation as many companies also cut capex in response to the crisis. The cash generated can be used for investment or returned to shareholders and there is evidence that both are beginning to happen as capex intentions have increased within the Tankan (quarterly business survey) and share buy back announcements have increased noticeably in the last few months.
Given the unwinding of cross shareholdings in the late 1990s and early 2000s, ownership of the market has shifted to much more active shareholders. Management is under much greater pressure to deliver returns than at any time in the past. Increasing levels of M&A, including MBOs, and the recent establishment of a domestic activist fund by a leading blue chip investor are signs that his is likely to continue. Greater pressure on management should continue to drive changes in the corporate sector to the benefit of shareholders.
In spite of the improving earnings and corporate change, valuations for the market remain very low. The market trades at a small premium to book value, the PER is around 16x and the dividend yield is 1.9% which is considerably above 10 year JGB that yield 1.2%. The book value for the portfolio is considerably lower at around 0.8x. This is a reflection of the low level of sentiment, particularly amongst domestic investors, about the market. Domestic investors continue to have very high weightings towards bonds and cash. The historically low levels of the market and signs of on-going change within corporate Japan make us optimistic about the outlook for the market and the fund."