Fairlight’s approach to investing in Japan

Fairlight’s investment mandate is to invest in wealth-generating small and mid-cap businesses located outside of Australia. Provided there exists both a strong regulatory framework and a stable currency, we are generally agnostic about the country in which our businesses are domiciled in and, more importantly, operate. In practice, this results in Fairlight’s investible universe being the developed markets of North America, Europe, the UK and Japan. Since inception, the Fairlight portfolio has only invested in 2 Japanese businesses with mixed success. In this report we outline our cautious approach to investing in Japan and one new recent investment the Fund has made.

Over the past few years, Japanese equities have been attracting increasing interest from global investors. This interest has increased even more so in recent months, as demonstrated in Figure 1 by the outperformance of the Nikkei, the main tracker for Japanese equities, since the beginning of 2024.

Figure 1.

Despite our ongoing efforts (Fairlight Portfolio Managers have conducted 4 research trips to Japan in recent years), we have struggled to consistently find businesses in Japan that clear both our quality and valuation hurdles. As a result, the Fund has historically been less invested in Japanese equities than its benchmark (about 1% compared to 5% for the MSCI Global SMID Index). Notably though, our cautious approach to investing in Japan hasn’t precluded the Fund from achieving its investment targets since its inception.

While we continue to see better value in other markets, Fairlight has maintained a dialogue with the management teams of a number of high-quality Japanese businesses. This patient approach was rewarded late last year when the share price of MonotaRO, a leading distributor of industrial products in Japan, fell by more than 50% resulting in it trading at an attractive enough price to justify making it a small investment for the Fund.

Historically a difficult market

To understand why investors are becoming increasingly optimistic about the Japanese market, it’s worth considering its past history and what might be changing.

After the boom years of the 1980s, bursting asset price bubbles, a fragile banking sector and structural challenges, including an aging population, rigid labour markets, and resistance to reforms, all contributed to cause a prolonged period of economic stagnation, which arguably persists today.

While over the past decade the Japanese government has tried to revive the economy, most notably during the late former-Prime Minister Shinzo Abe’s term, uninspiring growth has only been part of the reason why, historically, quality-focused investors have found it hard to find value across the Japanese bourse.

For decades, the Japanese market has been littered with businesses featuring complex organisational structures, characterised by sprawling and often unrelated divisions, suboptimal capital allocation policies, disappointing execution and opaque governance. The better businesses, have then attracted ‘scarcity’ premia, making their valuations unappealing compared to businesses of similar quality available on other international exchanges.

Fear of missing out

So what has sparked the recent interest in Japanese equities? On a practical basis, Fairlight believes that the motivation for investors to seek larger allocations to Japanese equities has been twofold. Firstly, to reallocate funds to another liquid market in Asia, as geopolitical issues meant that Chinese equities are increasingly ‘uninvestible’. And secondly, to hedge the risk that Japan is, finally, on the brink of a sustainable move out of deflation.

Naming and shaming

Furthermore, the Japan Exchange Group, the operator of the Tokyo Stock Exchange, has been making more aggressive efforts to improve the quality of the Japanese stock market. From January this year, the Group will indeed start to publicly ‘shame’ those corporate leaders that fail to to enact proper governance.

Given the importance of pride and public reputation in Japanese culture, we suspect these initiatives will help. This may be another factor contributing to rising interest amongst those investors looking to capture a possible ‘rerating’ of the average Japanese business.

Quality and patience

At Fairlight, our process continues to emphasise quality and valuation-discipline above everything else. Over a number of years, we have built a watchlist of Japanese companies that we believe meet the hurdles of our investment philosophy. These high-quality businesses have a long history of generating high returns on capital and are run for the benefit of all shareholders. As mentioned earlier, these seldom trade at attractive valuations, however our most recent Japanese investment, MonotaRO, met both our quality and valuation criteria.

The company is the leading online distributor of MRO (Maintenance, Repair and Operating) products in Japan. Examples include screws, tools and lubricants. The business began operating in 2000, and has been able to compound EPS (Earnings Per Share) at an annual rate of 25% over the past decade, while paying shareholders growing dividends (Figure 2).

Figure 2.

While the broader MRO market grows in line with the Japanese economy, the online channel, which management estimate accounts for less than 20% of the overall market, should continue to grow faster. Given its current leadership and superior scale, Fairlight believes that MonotaRO has many more years of  profitable growth ahead.

The Fairlight View

While ‘index awareness’, ‘country rotation’ or ‘fear of missing out’ might explain the behaviours of institutional asset managers, they do not resonate with the Fairlight strategy, which doesn’t need to conform to index weights, nor depend on successful macroeconomic or geopolitical predictions. Furthermore, to minimise risk, our strategy focuses only on businesses which have had a long history of generating wealth and being run for the benefits of all shareholders. MonotaRO, unlike many Japanese businesses, does fit this profile and the Fund was able to purchase an investment at an attractive valuation in late 2023, due to a broader market sell off.

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