Nippon Active Value reports on initial success

Nippon Active Value Fund has published its first full set of results for the period from its incorporation in October 2019 to 31 December 2020. The shares started trading on 21 February 2020.

IPO subscriptions totalled £103m. By the end of the period, net assets had risen to £117m, representing a net asset value of 113.58p per share, a rise of 13.6% since IPO. The closing share price at the period end was 106.5p, a discount of 6.23% to NAV. At the period end, the company had invested approximately 85.0% of the IPO proceeds in 20 holdings. There is a 0.85p dividend payable on 30 April.

In Japan, the main Nikkei 225 index was up 16.01% while the MSCI Japanese Smaller Companies index managed 6.84% for the calendar year to 31 December 2020 (8.0% in sterling terms).

By period end, the 5% of outstanding issued share capital threshold, beyond which a filing is required by the Japanese Financial Instruments and Exchange Act rules (known as FEFTA), had been exceeded with respect to four of NAVF’s holdings: Ebara Jitsugyo, Sakai Ovex, Nihon Denkei and in conjunction with Earle 1927 LLC (a Special Purpose Vehicle formed specifically for this target), Intage Holdings.

They  have decided to sell two of the 20 portfolio positions that had been built up by end 2020, albeit for different reasons. The first is so illiquid from a trading perspective that it has proved impossible to assemble a meaningful holding. The second stock, although technically very inexpensive and offering tremendous potential for value to be extracted, is run by a management team that will, they believe, be immune to their blandishments to change direction.

Extract from the manager’s report

“Ebara Jitsugyo, Sakai Ovex and developments since year-end

The first few months of 2021 have been busy. We have continued to realise positions in the two stocks we decided to sell. The price of the more liquid counter has come down as we sold into the bid and we have decided to retain a 1% holding to give us the ability to ask questions and, perhaps, make proposals at the forthcoming AGM. Increasing sales proceeds coupled with a reasonable start to the year for the Japanese mid-cap sector, initially caused NAVF’s cash reserves to rise again to above 15% of the portfolio’s overall value. RSM’s Management Committee has continued to meet frequently and has resolved to accelerate the purchasing of several of the favourite targets, either by increasing the number of shares we intend to accumulate or by raising our maximum prices on those that have moved beyond our earlier limits. This has brought available cash back down to approximately 10% as of the date of this report and this will continue to fall as we put it to work. One lesson learnt early is that the efficacy of our approach to managements is in direct correlation to the size of NAVF’s holdings – the more leverage we have, the more we are taken seriously. It has been good to have additional firepower to deploy on our original ideas, most of which continue to offer undiminished promise and scope for capital allocation reform.

Two of the companies in which NAVF has assembled its largest positions, both over 6% of total equity capital, are Ebara Jitsugyo (EJ) and Sakai Ovex (SO). The managements of both have chosen to engage with us and hear our arguments, both written (SO has been the recipient of three letters, EJ two) and multiple meetings, whether over Zoom, or, in the case of my colleague Kazutaka Mizuochi’s visit to SO’s HQ in Fukui Prefecture, in person. The results have been mixed but encouraging.

EJ’s business has been performing well throughout the pandemic and this has allowed management to raise forecasts in its last two quarterly updates. In our letters, and given the Company’s manifest ability to afford them, we have been advocating increased dividends and share buy-backs. It is gratifying that, so far, the dividend has been raised from yen 60 a share, first to yen 100 and then to yen 110. We continue our dialogue with management and expect more good news soon. EJ is about to announce its future dividend pay-out ratio policy at the forthcoming AGM and, although we do not expect their complete acceptance of RSM’s recommendations (which should be put to the meeting), there can be no doubt that we have begun a journey together. Since NAVF was launched and we first started buying EJ, the stock is up almost 250%.

SO is even more gratifying. Our third letter to the Company in late November 2020 proposed SO undertake a Management Buy-out (MBO) to be organised by NAVF in conjunction with one or more of our Private Equity house friends. The suggested price was yen 2,350 per share, a 12% premium to the then market level. In response, Mr Matsuki, SO’s President, launched his own tender for the whole Company with the backing and advice of Mizuho Securities on 9 February 2021. The tender price was yen 2,850, though after the announcement of the intention to delist the Company, the shares traded consistently above this level, resulting in Mr Matsuki increasing the offer price to 3000. NAVF agreed to tender all its shares (6.06% of the market capitalisation) into the offer giving an approximately 38% profit against our average purchase price. On 24 March 2021, Mr Matsuki announced that his tender offer has failed, falling 3.5% short of the 67% target. RSM continues its dialogue with SO’s management and still expect to see developments in the company’s ownership in the coming months. RSM has recently sent first letters to another couple of target companies.

Below case studies have been provided for of both EJ and SO.

CASE STUDY 1 : Ebara Jitsugyo (6328 JP)

Ebara Jitsugyo (“Ebara”) manufactures pumps and other water handling equipment for industrial applications and municipal utilities. It is a very “green” business with growing sales in wastewater treatment and environmental remediation as well as a stable after-market niche in traditional supplies for plumbing and heating and ventilating systems. The company outsources much of its manufacturing to third parties and, as such, enjoys a very high return on invested capital because of its design capability.

Given its high return on capital and reasonable valuation, we began purchasing shares in Ebara Jitsugyo back in February 2020. With no debt and a large amount of surplus cash on the balance sheet (roughly equivalent to the company’s market capitalization of just under £90 million at the time), we felt Ebara could easily improve shareholder returns through one or more simple capital allocation decisions.

After a series of conversations with management, we proposed that they consider a buyout of the public shareholders. This would give public shareholders an exit at a price much higher than any that the stock had reached in recent years and would spread ownership of the equity across the employee base. In the event, the company’s management elected to remain publicly traded; but they agreed with us that they should do more to reward shareholders.

Last Autumn, they announced a substantial increase (more than 60%) in the annual dividend and this had an immediate effect on the share price. In addition, in the past month, the company has announced a further 40% increase in the dividend and committed to maintaining a consistent payout ratio.

Whilst we believe that there is still more the company can do to reward shareholders (it still retains a very large cash balance, for instance) we are gratified that the share price has increased dramatically (by more than 130%) and has now climbed to a level where the price is closer to reflecting the intrinsic value of the company.

CASE STUDY 2 : Sakai Ovex (3408 JP)

Sakai Ovex is a small-cap (£128 million) provincial company in the textile industry. The company provides finishing and dyeing services to larger textile manufacturers, engages in some textile trading and has a growing business in the manufacture of control systems for factories. More recently, it has started a joint-venture with its largest customer, Tokyo Rayon, to provide textiles to Chinese manufacturers, most notably the Chinese production facilities of Fast Retailing, which owns the Uniqlo brand.

We identified Sakai Ovex as a consistently profitable company that had accumulated significant financial assets on its balance sheet, had virtually no debt and no large controlling shareholder. (The Chairman, owning less than one percent of the equity, is the only employee with a significant stake in the business.) This is precisely the profile of the sort of Japanese company that NAVF believes is a candidate for financial restructuring to enhance value for all shareholders. With £57 million of net surplus financial assets on its balance sheet and stable profits of £13 million, it was clear that Sakai Ovex had multiple options that it could employ to improve returns for shareholders.

We began purchasing our stake in the company last Spring and engaged with the management through a series of virtual meetings followed up by letters with suggestions of how they might restructure the balance sheet, either through a large share repurchase programme or a one-time capital payout or a succession of enhanced dividends. We also offered to help them structure a management buyout of the public shareholders to provide equity ownership for all employees. This proposal was formalized and publicly announced in both London and Tokyo in late November last year.

Our recommendations were received politely, although it did not appear that we were making much impact on management’s thinking at first. Then, somewhat to our surprise, in December 2020, the Chairman contacted us with a proposal that he would lead a buyout of the company with the help of Mizuho Securities (a large Japanese investment bank). Rising Sun’s President, Mizuochi-sensei immediately went to visit the Chairman and helped him shape his proposed buyout. In exchange for our support, NAVF was offered the opportunity to participate in the new private company, Sakai Textiles, which would be the successor to the public company. NAVF, for a tiny investment, was offered preferred shares, convertible under certain circumstances, into nine percent of the new entity.

Unfortunately, the transaction was not fully subscribed, but we are hopeful that this experience will be the harbinger of other such opportunities for NAVF. Our engagement with SO would have led to a much higher stock price for all shareholders, would solve the problem that small companies in Japan face of possible demotion to the second section of the stock market, and would result in more members of management owning stock in the new private company, always one of our stated objectives. We feel that NAVF played a very constructive role in what should have been a successful outcome for all parties if the Company’s MBO proposal had been successfully executed. RSM continues its dialogue with SO.”