Diversification - Japan

Geographical restrictions

Currently my portfolio is entirely invested in businesses listed in London, although they are mainly large international businesses, which have only a small proportion of their revenues from the UK. The list of companies I would be comfortable investing in is also drawn almost entirely from the London indices at the moment. I want to focus on quality businesses irrespective of their location, and am gradually adding to the list of potentials with some US based additions. Whilst I have some grasp of what's happening in the US and Europe, I'm less familiar with businesses listed on Asian indices. Since the US and Europe are potentially easier to purchase on my current ISA platform, and Asia more difficult, I’ll take a look at some alternatives to see if there are any attractive funds, investment trusts or ETF’s available. I’ll start with Japan.

Going passive

The simplest first option would be to put money into a passive tracking fund, something that simply tracks the performance of an index.

There are two indices of note in Japan – the Tokyo Stock Price Index, known as the TOPIX, and the Nikkei 225. The TOPIX is like the FTSE, in that it ranks it’s constituents based on market capitalisation, whereas the Nikkei ranks it’s 225 members according to price (using the Japanese Yen). The difference being that the Nikkei gives a greater weighting to higher priced stocks, whereas the TOPIX is influenced by higher capitalisation companies.

So what sort of easily accessible trackers are there for these indices? A quick rummage on the internet found a cheap Vanguard offering but tracking the MSCI Japan index rather than either the TOPIX or Nikkei. The MSCI provides a number of tools, analytics and (of most relevance here) - benchmark indices that institutional investors can use for measuring performance of their funds. According to the MSCI Japan Index documentation, the index is "...designed to measure the performance of the large and mid-cap segments of the Japanese market..." and covers around 85% of the market.

The Vanguard tracker accumulation fund has an ongoing charge of 0.23%, and according to the performance data they provide, over the last 5 yrs would have turned a £10000 investment into £16633 (in March 2019), a 66% increase, which is an annualised return of around 11%. I'll take this as my benchmark and see if there are other funds out there fishing in this pond that offer a better return.

Funds

There are more funds offering some sort of investment action in Japan than is sensible - 76 on offer from my current ISA provider. In order to restrict this a little I’ll take only the accumulation version of the funds (i.e. dividends are automatically reinvested into the fund), and only those with a rating from Morningstar (this tends to exclude newer funds). Based on the on the annualised return over 5yrs gives me the following 5 funds at the top of the list:

Fund name	5yr annualised return (%)	Ongoing Charges (%)
Legg Mason IF Japan Equity X	23.55	1.02
Bailey Gifford Japanese Small Co B	22.07	0.63
Lindsell Train Japanese Equity B	17.78	0.79
JPM Japan C	17.33	0.90
Bailey Gifford Japanese B	15.60	0.63

All of the above have a Morningstar rating of 5 stars, and all have a KIID risk rating of 6

If I make the assumption that the annualised returns and charges are going to remain roughly the same, I will subtract the charges from the annualised return to give a "Charge adjusted return":

Fund name	5yr annualised return (%)	Ongoing Charges (%)	Charge adjusted returns (%)
Legg Mason IF Japan Equity X	23.55	1.02	22.53
Bailey Gifford Japanese Small Co B	22.07	0.63	21.44
Lindsell Train Japanese Equity B	17.78	0.79	16.99
JPM Japan C	17.33	0.90	16.43
Bailey Gifford Japanese B	15.60	0.63	14.67

Quite a range of returns. Just for fun I’ll add in the total returns based on the charge adjusted figures:

Fund name	Charge adjusted returns (%)	Total returns (%)
Legg Mason IF Japan Equity X	22.53	176
Bailey Gifford Japanese Small Co B	21.44	164
Lindsell Train Japanese Equity B	16.99	119
JPM Japan C	16.43	114
Bailey Gifford Japanese B	14.67	98

So at the top of the table, Leg Mason would have turned every invested £100 into £276, whereas Bailey Gifford Japanese would have the same £100 into £198. Doesn’t take a genius to see which investment is preferable, so two funds moving into position as favourites.

The fund managers have been in charge for different periods too:

Fund name	Total returns (%)	Mgr start date
Legg Mason IF Japan Equity X	176	1996
Bailey Gifford Japanese Small Co B	164	2015
Lindsell Train Japanese Equity B	119	2004
JPM Japan C	114	2012
Bailey Gifford Japanese B	98	2016

I wonder if it is coincidence that that best performing fund has had the same manager for the longest period? The dates also suggest that the two Bailey Gifford funds have had a relatively recent handover, so any credit/ blame for the fund performance should be directed at the managers’ predecessors rather than current incumbents. A plus mark for Lindsell Train in that regard having been in charge of their fund for considerably longer.

And finally if I want to invest in an actively managed fund, I’m paying the fund manager to put my cash into the businesses that they see having the best return on investment both today, and going forwards. I’m expecting them to have selected a relatively small number of businesses – having a massive fist of different businesses doesn’t strike me as helpful – I might just as well get myself a cheap tracker fund and save myself some money on charges. I’m completely ignorant about the state of the Japanese economy, but I’d rather any funds I invest in are in more defensive companies, such as consumer goods, healthcare, and in tech, rather than, for example in highly cyclical companies or commodities. My preference would be for a fund to build it’s portfolio, then leave it alone for compounding to do the heavy lifting. Here's how the funds' portfolios breakdown across sectors:  

Fund name	Sectors invested (%)				Number of holdings
	Consumer Defensive	Healthcare	Technology	Total
Legg Mason IF Japan Equity X	17	18	24	59	44
Bailey Gifford Japanese Small Co B	5	11	35	51	71
Lindsell Train Japanese Equity B	41	21	24	86	23
JPM Japan C	16	6	25	47	53
Bailey Gifford Japanese B	3	9	12	24	39

Two funds clearly stand out here:

• Lindsell Train investing in only 23 companies, of which 86% of their fund is in Defensive/ Health/ Tech holdings
• Bailey Gifford Japanese are only invested 24% in Defensive/ Health/ Tech holdings.

Based on this bird’s eye view of these funds I’m losing three of them. JPM and the two Bailey Gifford funds. Leg Mason, and Lindsell Train have experienced managers at the helm; I don't consider the Leg Mason portfolio of 44 companies excessive in number and it’s difficult to argue with their returns. The portfolio structure of Lindsell Train appeals but it does lag Leg Mason, however, if either the global economy or the Japanese economy has a few wobbles, Lindsell Train would appear to have positioned the fund to cope. Whereas Leg Mason may require an amount of chopping and changing. Leg Mason has the highest ongoing charges, which would likely increase if there needed to be a bit of buying and selling, however, Lindsell Train have a cheeky 4% initial charge – so just buying into the fund would leave me down 4% (not taking into account broker fees etc.) – maybe not a big deal with a longer term investment horizon, but unnecessary in my view.

To return to the Vanguard benchmark tracker, the 66% return on offer doesn’t really stack up against the two above funds – Leg Mason making nearly 3x and Lindsell Train 2x the tracker returns.

Investment Trusts

The final area to check out is that of Investment Trusts, now I know the performance of some of the funds against which the Investment Trusts are competing, I can narrow the search a little more. Two offering higher returns are both run by Bailey Gifford:

Fund name	5yr annualised return (%)	Ongoing Charges (%)	Charge adjusted returns (%)
Bailey Gifford Shin Nippon (BGS)	25.35	0.76	24.59
Bailey Gifford Japan (BGFD)	19.13	0.73	18.4

Both trade on a small premium of around 4% (i.e. the cost of a buying a share in the Trusts is around 4% higher than the Net Asset Value (Assets – liabilities)). This isn’t massively different from the average premium for the last 12 months, so I’ll make an assumption that this is going to remain fairly stable and not impact any investment. So both Trusts look like they have put in a decent performance that is comparable to the funds above, outperforming the Lindsell Train offering for example, by putting in a total return over 5yrs of 200% for BGS, and 133% for BGFD.

The manager of the BGFD team retired in 2018, with her deputies now running the Trust which is invested in 70 businesses, whereas BGS has had the same manager in charge since 2015 and is invested in 74 businesses. Whilst I don’t really see the need for such a large number of holdings both teams have outperformed the tracker fund by some margin. Given my preference for more defensive businesses and tech over some other sectors, here’s how the two trusts fair:

Fund name	Sectors invested (%)				Number of holdings
	Consumer Defensive	Healthcare	Technology	Total
Bailey Gifford Shin Nippon (BGS)	6	13	32	50	74
Bailey Gifford Japan (BGFD)	2	8	22	32	70

Both Trusts would have been great investments over the past few years, but the change in management leaves me a little uneasy. On balance, I think I’d want to see the performance of these teams under the new management for a little longer before committing any cash. However, I’ll keep an eye on both, and should either develop a discount I may get tempted.

Conclusion

The two favourites for a bit more research are Legg Mason and Lindsell Train. Both have long standing management that have delivered a decent return, and significantly outperformed my tracker benchmark. Both managers appear to prefer a longer term investment horizon and preach patience over churning their portfolio. And both have fees that are unappealing in some regard. I’m off for a cup of tea and a ponder.

March Portfolio and Purchases

Slight pause on most things during March due to family illness, and wrecking my back. Now more or less back to normal...

So Brexit drags on into April with no more clarity as to what is going on. This, coupled with prices generally trending upwards left me mostly on the sidelines spectating during March. A few things are in buying territory, but most of what is on the shopping list still looks expensive.

Portfolio
March saw markets continuing the upward movement we've seen since the start of the year. The portfolio was up 2.6% compared to my chosen benchmark the Vanguard FTSE All Share Accumulation fund which was up 2.7% over the same period.

Best performer for March goes to Manx Telecom (MANX), +19% following a takeover bid from Basalt Infrastructure. This is both pleasing and irritating as it's nice to see such an increase, it has only been in the portfolio since January. The bid has been endorsed by the Manx Telecom board so likely to be agreed at the AGM. I would have been happy to keep the shares, but will hang on in case there are any further bids, at least for another couple of weeks. Worst performer was Fulcrum Utilities (FCRM) -22%, again a new purchase - this time since February, but badly mistimed. I should have looked at the longer term trend which was clearly downward, catching falling knives always a risky business. Still a couple of recent FCRM announcements including a trading update have been positive.

Crypto
Cryptocurrency markets look like they have stabilised and could be picking up, and some of the crypto portfolio is moving into the green, plenty still underwater but it is time to take some profits before it all goes pear shaped again. Some nice returns on Binance coin, plus a more modest effort with OmiseGo, are the whales going to dump Bitcoin again, or have we actually seen the bottom this time?

Finances
On the personal finance front, savings accounts have once again moved provider. As usual introductory rates on existing accounts dropped away, leaving virtually zero interest. So they migrated again. It's really irritating to be penalised for loyalty from a bank...

On the cash front, both Mrs Sleepy and myself have bonus payments, Mrs Sleepy has share options maturing from her employer which have been cashed in, and I also have a nice dividend payment from existing shares with my own employer. The shares awarded by both of our employers are not included in the portfolio, I'm happy to take the dividends from my shares for the moment and will sell the shares at some point in order to reinvest in the portfolio. I see these shares as part of a "ring-fencing" strategy for the portfolio, which along with the emergency fund should ensure I won't have to dip into it at an time when prices are unfavourable.

Bonus cash will be split between the portfolio, the mortgage, a few jobs around the house, and a treat of course.

Reckitt Benckiser

I rather like the owner’s manual that Terry Smith provides to investors interested in his fund, it gives a clear explanation of his approach to investing. I find myself attracted to this approach, and his results are impressive – according to the Fundsmith website, from inception in November 2010 to February 2019 the fund had generated a 302.5% total return, an annualised 18.2% growth.

I should probably invest in his fund and spend my time doing something else, but I rather enjoy the process of analysing stocks. Since I’m principally after defensive investments of the sort advocated by Mr Smith, I thought I would take a look at a FTSE consumer goods stalwart, and part of the Fundsmith portfolio – Reckitt Benckiser.

Reckitt Benckiser was formed in 1999 when the UK’s Reckitt & Colman merged with the Dutch firm Benckiser. Over the years they have repositioned their portfolio to focus on household, personal care and over the counter healthcare products, including well known brands such as Calgon, Finish, Durex and Strepsils (Thankfully in 2014 Reckitt Benckiser decided that the somewhat cumbersome naming would be known as simply RB going forward). In 2017, RB acquired the infant formula maker Mead Johnson and sold it’s remaining food brands to exit the food industry. It’s products are sold in around 200 countries.

It has certainly proven a sound investment historically, £1000 invested in January 2009 would be worth £2847 (including dividends) in January 2019, an average return of 11% per year. Since I like a dividend, I’m also pleased to see the dividends increasing by around 8% per year too, only 1 year out of the last 10 was the dividend not increased. The dividend has also been comfortably covered by free cash flow, averaging 2x FCF cover over the last ten years. This has fallen from nearly 3x cover 10 years ago to below 2x more recently, but I don’t see that as an issue, I suspect as the business has grown and future growth looks more difficult to come it makes more sense to pass the cash back to investors through the dividend.

Since the ceiling of any growth is revenues it’s good to know that these too have been pretty consistently grown – although in 2014 saw a 12% dip and 2015 they were flat, since 2009 they have grown from £7.7bn to £12.6bn, a total of 62% or an annualised growth rate of around 5%. Adjusted earnings have progressed at a similar rate, with adjusted earnings per share moving from 194.7 pence to 341.4 pence, a total increase of 75% or an annualised growth rate of around 6%.

So the headline numbers above show that RB tick a number of boxes, but before I invest some of my money into the business, I'd like to know how effective is the business at turning that investment into profits? To try to get a feel for this we should take a look at the capital invested, and the returns on that capital (ROCE – Return On Capital Employed). Taking a simplified view of capital as total assets – current liabilities we can see that from 2009 to 2018 capital increased from £5.7bn to £30bn, that’s a 421% increase, or over 40% per year. If we then take a look at their earnings before interest and tax (EBIT – the other part of the ROCE calculation) we can see that over the same 10 year period it increased from £1.9bn to £3bn, a 61% increase. So investment in capital has significantly outpaced returns, an ROCE of 32.8% in 2009 has reduced to 10.1% in 2018.

Return on capital employed

The chart above shows these ROCE components and we can see more clearly what has happened. From 2016 to 2017, assets rocketed whilst liabilities increased a little, with EBIT also showing a slight increase.

This coincides with the acquisition of Mead Johnson for $16.6bn (£12.3bn), which whilst contributing to earnings, has pushed up capital far more and therefore brought the ROCE down. RB’s average ROCE over the last 10ys is 22%, but that may not now be an accurate reflection of the business given the downward move in the numbers over the past couple of years. Whilst RB work through the Mead Johnson integration it’s probably reasonable to expect a hit to business efficiency.

Another metric I like to check is net profit margin – net profits / revenue, which effectively shows how much of every £ is actually profit, i.e. a 10% net margin tells me that for every £1 of revenue, the business has made 10p profit. Obviously a higher number is better, it is a useful indicator of a margin of safety should the business run into hard times – whether self inflicted or as a result of the broader economy. Slim margins could leave the business in trouble if they start to get eroded – nice fat margins would help the business ride out those downturns. These average 24% over the past 10 years, most years being in the upper teens.

As well as the Mead Johnson acquisition increasing assets as noted above, RB’s borrowings increased to fund the purchase:

	2009	2010	2011	2012	2013	2014	2015	2016	2017	2018
EBIT (£m)	1891	2130	2395	2442	2345	2164	2241	2269	2737	3047
Borrowings (£m)	136	2644	2508	3274	2767	2572	2420	2389	12861	11879
Borrowings vs. EBIT	0.1	1.2	1.0	1.3	1.2	1.2	1.1	1.1	4.7	3.9

Debt as a multiple of EBIT was around 10% of earnings in 2009, and tracked roughly in line with earnings until 2016. But by 2017, after the Mead Johnson purchase, had increased by £10bn and sat at a multiple of 4.7x earnings in that year. A year later the debt has had £1bn sliced off, hopefully new combined business will see increased inflows of cash which will enable the debt to be managed, rather than becoming a burden.

With the announcement of the retirement of CEO Rakesh Kapoor earlier in the year the share price dipped, and the business will undoubtedly be subject to a little more turbulence as his successor takes the reins and puts their stamp on the business. I’m hoping that as we approach the conclusion to chapter 1 of Brexit, in any stock market wobbles the share price of RB will take another dip. Working through it's acquisition of Mead Johnson, and managing it's increased borrowings has increased the risk of owning a slice of RB, but I think it looks like a decent long term investment. I'm off to learn more as it’s certainly on my radar.