Portfolio opportunities in COVID-19 sell-off

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AVI Japan Opportunity Trust PLC ("AJOT" or the "Company")

Portfolio opportunities in COVID-19 sell-off

 LEI: 894500IJ5QQD7FPT3J73

These are unprecedented times with uncertainty creating a great degree of panic. The wide range of possible outcomes means there have been extreme moves in pricing across all asset classes. Rationality and fundamentals go out of the window and the urge to grab liquidity where it is available takes over. In this environment prices can diverge enormously from fundamental valuations.

Whilst impossible to call the end of the market rout and to time the bottom, it is useful for investors to understand the scale of the derating that has occurred in AJOT's portfolio. Readers will know that AJOT's strategy is to capitalise on improving governance in Japan by engaging with companies with excessive cash on their balance sheets. We have a long-term approach and the nature of investment trusts puts us in a strong position to enact our strategy.

The Japanese system is built on cash for a rainy day. While in AJOT's short life we have seen tremendous progress on the corporate governance front, returning cash to shareholders has been done in a measured way allowing companies to retain their financial stability. Japanese cash-rich companies can withstand better than most and will undoubtably survive the turmoil.

However, despite solid balance sheets our companies' share prices have suffered indiscriminate selling. The portfolio, on a weighted average basis, now trades with market caps 59% covered by net cash and 96% NFV¹, and on a 1.3x EV/EBIT multiple. These compare to figures of 46%, 82% and 3.4x as at the end of January. While our companies' profits won't be immune to any economic slowdown, the share price reactions have more than compensated for the weakened outlook.

The declines have opened opportunities for those with long-term horizons and capital to deploy. While we have no insight into how long the sell-off will last, the valuations of our companies are unsustainably low and, in some cases, have utterly disconnected with fundamentals. There are a record number of companies in our portfolio with net cash and securities covering more than their market caps, meaning at the current share price the underlying businesses can be purchased for free.

We believe companies in Japan are still committed to buying back shares and the underlying thesis of improving governance is still sound. Our current gearing is 14.6% with 2.3% of available cash, and we have been rotating positions to capitalise on the most exciting opportunities.  Three positions that we have been adding to are highlighted below.

[1] NFV = cash + listed investment securities + treasury share value - debt - net pension liabilities

King (2.7% weight)

King is a manufacturer of branded women's clothing. The core clothing business has consistently generated a profit and focus on cost control has led to margin expansion.

However, under the surface of its clothing business King has a real estate portfolio, consisting of hotels and offices, which generates as much profits as the clothing business. King's real estate alone produces free cash flow equivalent to 3.1% of the market cap, which underpins King's share price. In addition, there is net cash equivalent to 104% of its market cap and listed investments equivalent to 8%.

While King's shares are illiquid, AJOT has built a material stake and we are engaging with management to unlock the value. With net cash and real estate covering 147% of its market cap, in addition to its profitable clothing business, we conservatively estimate that King is worth 93% more than its current share price.

Fujitec (6.6% weight)

Fujitec manufactures, installs and maintains elevators and escalators. The maintenance business is a cash cow, with multi-year contracts to ensure the safety and reliability of installed elevators. The recent acquisition of Thyssenkrupps's elevator business by private equity at an estimated 19x EV/EBIT multiple shows the appeal.

Fujitec will have a tough quarter with its factory in China running at reduced capacity, but maintenance contracts will continue to generate solid cash-flow. Our thesis is predicated on Fujitec taking self-help measures to improve margins and, failing that, being taken over by a competitor. As one of the few, large independent elevator businesses, Fujitec offers an attractive target, trading with net cash covering 51% of its market cap and on a 4x EV/EBIT. Besides the valuation discount we believe there is significant margin improvement potential, offering further upside for a would-be suitor.

With 42% of Fujitec's shares held by foreigners and heightened M&A activity in the sector, Fujitec is feeling the pressure to avoid being taken over. Even without margin improvement, and assuming a 10% discount to where peers trade, we believe Fujitec offers 78% upside with a clear catalyst to realising the value. 

Secom Joshinetsu

Secom Joshinetsu is a 54%-held subsidiary of Secom, a security services company. It operates the same business model as its parent but limited to three prefectures in Japan. It charges annual fees for its alarm and security service both to commercial and residential premises. While not immune to economic slowdowns, it is resilient in downturns. In the global financial crisis, profits fell only -12% from peak to trough in 2007 before fully recovering by 2009.

Given Secom Joshinetsu's quality, its 0.2x EV/EBIT valuation is derisory. If Secom Joshinetsu were to be bought out at the 7x multiple at which Secom trades, we would recognise a +70% uplift. Secom Joshinetsu has 88% of its market cap covered by net cash and while we wait for a takeover by Secom, we benefit from a 3% dividend yield despite only a 40% payout ratio.

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We would like to thank shareholders for their continued patience and support.

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