AJOT Avi Japan Opportunity Trust Plc

AVI JAPAN OPPORTUNITY TRUST PLC

INTERIM REPORT 2024

LEI: 894500IJ5QQD7FPT3J73

Interim Report for the six months ended 30 June 2024

The Directors present the unaudited Interim Report for the six months ended 30 June 2024.

Copies of the Interim Report can be obtained from AVI Japan Opportunity Trust plc's website www.ajot.co.uk or by contacting the Company Secretary by telephone on +44 (0) 333 300 1950.

AVI Japan Opportunity Trust plc ("AJOT" or "the Company") invests in a focused portfolio of quality small and mid-cap listed companies in Japan that have a large portion of their market capitalisation in cash or realisable assets.

Dividend

An interim dividend of 1.00 pence per Ordinary Share for the period ended 30 June 2024 has been declared and will be paid on 8 November 2024 to Ordinary Shareholders on the register at the close of business on 11 October 2024 (ex-dividend date is 10 October 2024).

PERFORMANCE SUMMARY

[1] Since inception on 23 October 2018.

*For all Alternative Performance Measures, please refer to the definitions in the Glossary in the full Half Year Report.

CHAIRMAN'S STATEMENT

"AVI's unique brand of constructive engagement and high-quality research will allow for the unlocking of valuation anomalies that are unavailable in other global developed markets, with the potential for attractive absolute and relative returns."

Norman Crighton, Chairman

Performance and Introduction

Welcome to the fifth interim report for AVI Japan Opportunity Trust plc ("the Company" or "AJOT"), covering the period from 1 January 2024 to 30 June 2024. Since I last wrote to you, the Japanese equities market has continued to attract global attention, as regulators make further progress on the path to corporate reform. In early 2024, the Tokyo Stock Exchange intensified pressure on listed companies to improve capital efficiency and valuations by publishing a list of 1,115 companies that had made the required disclosures towards improvement, shining a light on those that hadn't. To 30 June 2024 this year, the MSCI Japan Small Cap Index has returned +12.9% (in JPY) and -0.2% (in GBP), compared to the MSCI Japan's return of +21.3% (in JPY) and +7.2% (in GBP).

Although small-cap Japanese equities have not fared as well as their large-cap counterparts during the first half of 2024, AJOT returned a positive +21.9% (in JPY) and a +7.7% (in GBP) well ahead of the Benchmark Index. Over the same period, AJOT's peer group of UK-listed Japan smaller companies investment trusts fell an average of -2.7% (in GBP but gained +10.1% in JPY). The Board believes AJOT's strategy is proving to be accretive and resilient.

The lack of research coverage of small-cap companies relative to large-caps continues to present us with abundant opportunities. Foreign investors have predominantly allocated their capital into larger companies with greater liquidity rather than taking time to uncover small-cap opportunities. This is likely to change going forward as investors seek out cheaper and more attractive hidden gems amongst small caps.

In this period, your manager, AVI, published a presentation to Aichi, a subsidiary of Toyota Industries, and sent private letters or presentations to a further eight portfolio companies. AVI's Japan team spends considerable amounts of time engaging closely with portfolio companies on matters including operational improvements, capital structure efficiency and corporate governance reform. The team routinely travels to Japan and has already conducted three trips in the first half of the year. It is apparent that, in many cases, Japanese management is becoming more appreciative of the team's constructive suggestions, particularly due to our engagement focus on operational improvements, a key point of differentiation from AJOT's peers.

In addition, and perhaps uniquely amongst our peers, I as Chair and Yoshi Nishio, one of the Company's Directors, travelled to Japan to attend the AGM of investee company SK Kaken, where we were invited to address the board and other shareholders directly. We asked questions of the board about the direction of the family-controlled company, its commitment to all shareholders, and, more broadly, its obligations as a publicly listed company. This was an important escalation of AJOT's interaction with SK Kaken, which we expect to lead to more dialogue and continued improvement in the share price.

The portfolio is more resilient than ever, with a greater focus on companies with high-quality earnings. This is reflected in net cash and securities accounting for 49% of the portfolio companies' market caps, which is marginally lower than in previous periods. Meanwhile, the portfolio maintains an attractive valuation, with an EV/EBIT multiple of 7.7x1. This underscores the significant discounts at which AJOT's portfolio companies trade relative to peers, largely due to their over-capitalised balance sheets and limited sell-side coverage.

On the macro front, earlier in the year the Bank of Japan finally put an end to its yield curve control policy, increasing interest rates to a modest +0.1%. Although this was only a marginal increase and was reasonably well flagged, it was a step in the right direction.

We are delighted that, despite the twin impacts of the general strength of the mainstream Japanese market in 2023, which has continued into the start of 2024, and the continuing weakness of the currency, your Company has generated strong outperformance.

Dividend

The Board has elected to propose an interim dividend of 1.00 pence per share. As stated in the Prospectus at the Initial Public Offering ("IPO"), the Company intends to distribute substantially all the net revenue arising from the portfolio and is expected to pay an annual dividend, but this may vary substantially from year to year.

Investment Strategy

AJOT listed in October 2018 to take advantage of the highly attractive opportunity to invest in under-valued, overlooked Japanese small-cap equities with strong underlying business fundamentals. We believed, and very much still do, that AVI's unique brand of constructive engagement and high-quality research will allow for the unlocking of valuation anomalies that are unavailable in other global developed markets, with the potential for attractive absolute and relative returns.

Discount and Buybacks

As of 30 June 2024, your Company's shares traded at a discount of -4.3% to net asset value per share. Over the period under review, this ranged from a -5.8% discount to a +1.2% premium. The Board monitors the discount/premium situation closely, ensuring investors are protected from the downside of a widening discount, while also taking advantage of the premium to grow the Company. Over the period, the Company bought back 135,000 of its shares at an average discount of -5.1%. All shares repurchased are held in treasury rather than cancelled so that they may be reissued if sufficient demand arises.

The total outstanding shares in issue was 140,301,702 at the end of the period, compared to 140,436,702 at the end of 2023.

Also during the period, AVI purchased 140,000 shares as part of its ongoing commitment to invest one quarter of its management fee in AJOT shares.

Debt Structure and Gearing

At the end of the period, AJOT had £14.4 million worth of Yen debt, with gross notional gearing standing at 7.4% of NAV. Taking into account the utilisation of total return swaps, net debt with the swaps marked to market was 2.1% (based on % of net assets).

Annual General Meeting

The Company's Annual General Meeting was held on 1 May 2024. All resolutions were passed with at least a 99% approval. The Board thanks Shareholders for their continuing support.

Closing Remarks

Your Board continues to have full confidence in the investment thesis and in the ability of the Investment Manager to execute it. However, wanting to lead by example, your Company stands by its commitment in our original Prospectus to offer Shareholders the opportunity to exit at close to NAV on a regular basis. The rationale behind including this clause was to ensure that if the original investment thesis did not generate the expected returns, or if circumstances had changed to make Japan unattractive, then Shareholders would not be penalised for wishing to exit.

I am very pleased to note that since the IPO neither of the scenarios mentioned above have materialised, and the Board and the Investment Manager firmly believe that the opportunities are now more attractive than they were when the Company was launched in 2018. Nevertheless, our broker, Singer Capital Markets, is canvassing opinion from Shareholders on the appetite for a redemption opportunity.

The Board would like to thank Shareholders for their continued trust and support. As always, if you have any queries, please do not hesitate to contact me personally (norman.crighton@ajot.co.uk) or alternatively speak to our broker Singer Capital Markets to arrange a meeting.

Norman Crighton

Chairman

16 September 2024

1 EV/EBIT figures are based on Last Twelve Months ("LTM") EBIT

INVESTMENT MANAGER'S REPORT

"The Japanese equity market continues to gain traction, amidst rising foreign capital allocation, corporate reform and a greater focus on shareholder returns. With these tailwinds, we maintain high conviction in our unique strategy built on constructive engagement, with more opportunities than ever for us to unlock substantial value across the small to mid-cap universe."

Joe Bauernfreund, Portfolio Manager

During the period from 1 January to 30 June 2023, your Company returned +21.9% (in JPY) and +7.7% (in GBP). This compares with a return for the benchmark index, the MSCI Japan Small Cap Index, of +12.9% (in JPY) and -0.2% (in GBP). Over the past six months, the Yen depreciated by -11.7% against the Pound, a significant headwind for sterling-based returns.

The Japanese equity market continued its strong performance from 2023, with large caps outperforming small caps. The MSCI Japan Index rose by +21.3% (in JPY) and +7.2% (in GBP). AJOT outperformed relative to its peer group of UK-listed Japan smaller companies investment trusts, which rose +10.1% (in JPY) and declined by an average of -2.7% (in GBP).

While we were pleased to see the Bank of Japan cease its longstanding yield curve control, the increased rate of 0.1% was too modest to curb the falling Yen. Nevertheless, this is widely seen as a positive sign of things to come, and after period-end, the Bank of Japan subsequently increased its benchmark rate to 0.25%, sending the Yen higher. This caused widespread volatility in global equity markets, particularly in Japan, however, the fundamentals of our portfolio did not change. During this period of volatility, we strategically added to existing holdings in our portfolio.  

Additionally, corporate reform amidst pressure from the Tokyo Stock Exchange ("TSE") has made Japanese equities even more attractive to foreign investors. The small-cap companies within AJOT's investment universe remain under-researched, presenting us with abundant opportunities. We anticipate foreign investors will allocate more capital to the attractively valued small-cap sector of the Japanese market. Tender offer bids ("TOBs") are becoming increasingly common in Japan, with four AJOT portfolio companies benefiting from TOBs during the period at premiums ranging from 19% to 194%. Since inception, a total of eight portfolio companies have been privatised.

Over the period, we added nine new names to the portfolio, causing the concentration of the top 10 holdings to fall to 65.5%, down from a near all-time high of 73.3% at the end of 2023. Maintaining a concentrated portfolio of 15-25 stocks allows us to complete in-depth research and dedicate the necessary time to constructively engage with portfolio companies on matters such as operational improvements, capital structure efficiency and corporate governance reform.

With greater attention from foreign investors, continued pressure from regulators, and increased focus on shareholder returns at the company level, all signs are pointing towards an extended period of positive performance for the Japanese market.

AVI shareholder engagement

Shareholder engagement remains a core component of AJOT's strategy. It is clear to us that management teams of our portfolio companies are particularly receptive and appreciative of our engagement efforts focusing on enhancing operational efficiency. While we prefer to keep our engagement private, shareholder proposals remain an important part of our engagement repertoire to drive corporate reform in companies that are lacking adequate management or strategic direction.

We filed shareholder proposals to two portfolio companies during the period, one of which we withdrew. In the case of SK Kaken, where we have now filed shareholder proposals for four consecutive years, AJOT Directors attended the AGM. This marked the first time a foreign investor attended as a speaker and the first time any shareholder had asked a question. Encouragingly, it was the most attended AGM and we were not the only shareholder asking probing questions about SK Kaken's woeful employee satisfaction track record and lack of strategic direction. Our presence and the questioning seem to have alerted the family who control the company. Yet again, our shareholder proposals achieved support from the majority of minority shareholders, and we will continue engaging until the company addresses the plethora of issues.

Alongside our public campaign with SK Kaken, we also prepared an in-depth, 60-page public presentation on Aichi, focusing on several constructive suggestions to enhance operational efficiency and corporate value, while addressing the parent/subsidiary relationship with Toyota Industries.

As mentioned, private engagement remains our preferred method for unlocking corporate value, and over the period we sent letters or presentations to eight portfolio companies. By maintaining private engagement, we can build mutually beneficial long-term relationships with management. Our significant focus on operational improvements is also far more effectively addressed through in-depth private engagement in collaboration with management, than simply via shareholder proposals. Over the period, we engaged on operational improvement 64 times in aggregate, across 18 portfolio companies. Capital efficiency also remains a core area of focus for our engagement and  share buybacks are becoming more frequent in Japan as companies demonstrate greater focus on shareholder returns, in line with the TSE's request.

We believe that the long-term focus of our constructive engagement assists management in building better businesses while enhancing shareholder value. A track record demonstrating our willingness to take engagement public enhances our credibility and adds another layer to our engagement.

Portfolio Trading Activity

With the team identifying plenty of new opportunities, annualised turnover was an elevated 74%. We exited six positions entirely and nine new companies entered the portfolio.

Sales

The largest sale over the period was Alps Logistics, which received a tender offer bid at a +194% premium to the undisturbed share price. We generated an ROI of +307% and IRR of +38% over the holding period.

Digital Garage was the second largest sale during the period, as we exited the longstanding position we had held since AJOT's inception. After publishing a press release in November 2023, at the end of the year, defiant to the trend of reducing cross-shareholdings, Digital Garage issued 5.3% of its treasury shares to Resona HD, with Resona HD committed to purchasing an additional 4.8% in the market. With a consistently underperforming and mismanaged business, along with the senseless issuance of undervalued shares, we have more promising opportunities to allocate our capital toward.

Turnover was boosted by two short-term holding periods in Yaizu Suisankagaku and Sun Corporation. We generated an ROI of +16% and IRR of +129% in our two-month special situation trade in Yaizu Suisankagaku, which was the beneficiary of a competitor buyout at a premium of +71% to the undisturbed share price. During the period we entered and nearly fully exited a position in Sun Corporation, during which time we benefitted from a +37% share price increase, delivering a +25% ROI and +406% IRR.

With an abundance of attractive opportunities in the small-cap market, we are focused on investing in high-quality businesses with management teams that are receptive to dialogue with shareholders. Whilst we have several tools to enact change and unlock value, we are willing to move on to more promising opportunities if management are unwilling to consider our constructive suggestions.

Purchases

The largest purchase during the period was Beenos, now the joint fourth largest position in the portfolio, which was added in late January. In the day following the announcement of our 5% ownership (which we have subsequently increased to 8.8%), the share price rose +17%. Following our declaration, another well-known engaged shareholder increased their holding to 9.8%. In less than six months, we have made a return on investment of +46%, for an IRR of +219%, and still foresee significant upside potential in the order of +70%.

In March, we initiated a position Raito Kogyo, which was the second largest purchase during the period, building it to 4.5% of AJOT's NAV. Raito Kogyo is a specialist construction company, with its 5.7x EV/EBIT1 multiple, compared to the peers' average of 7.9x, suggesting that the market views it as a cyclical low-quality construction company, which it is not. Raito Kogyo's core business is slope construction and ground improvement works, accounting for over 70% of the company's total sales order. Raito Kogyo is the market leader for both slope construction and ground improvement. With an inferior EV/EBIT multiple relative to peers, and net cash that accounts for 41% of the market cap, we foresee further +50% upside to the current share price.

We also added to new positions in Kurabo Industries and Aoyama Zaisan Networks, building both to be top 10 holdings in the portfolio by the end of the period.

Contributors and detractors

Alps Logistics (9055)

Alps Logistics, a provider of logistics services for warehousing and transportation, was the largest contributor, with a +247% share price increase during the period adding +392bps to performance.

In a takeover bid that reflects the true underlying value of the company and showcases the stark valuation differential between listed and private companies in Japan, KKR-controlled Logisteed paid a 194% premium to the undisturbed, pre-rumour price in February 2024 to privatise Alps Logistics. We were shareholders in Alps Logistics since AJOT's inception in late 2018, engaging with management on ways to enhance corporate value and addressing the parent/child subsidiary relationship with Alps Alpine.

It was a pleasing end to our investment, which generated a +38% IRR and +306% ROI. A total of eight AJOT portfolio companies have now been privatised since we launched the trust almost six years ago. They are a helpful way of realising the under-valuations in our portfolio companies, and there is no shortage of further privatisation targets in our portfolio. We are in regular dialogue with various private equity firms in Japan, which are quite familiar with our portfolio companies.

Beenos (3328)

Beenos achieved a share price return of +66% over H1 2024, adding +205bps to performance as the second largest contributor. We initiated a position in Beenos in January 2024, building our stake to 6.4% of AJOT's NAV, making it the fourth largest position in the portfolio.

Beenos operates in the e-commerce sector, deriving a significant portion of its profits from its Global Commerce platform. Beenos' business is primarily centred around a service called 'Buyee', which enables non-Japanese living abroad to purchase items from e-commerce sites popular in Japan, such as Yahoo! Japan, Mercari and Rakuten. Buyee's gross merchandise value has experienced robust growth at an annual rate of 31.3%.

Beenos trades at a 9.9x EV/EBIT1 constituting 55% of its market cap, including cash amounting to 32% of the market cap. We foresee a further +70% upside potential to the share price, and given an open shareholder register, we believe there is ample opportunity for successful engagement. Under the open shareholder register, investors' frustration is growing, evidenced by a rising number of shareholders opposing the CEO's reappointment. Additionally, the structure of the board of directors is favourable from a governance perspective, with a majority of independent directors, including a partner from Bain Capital and a former NRI Vice CEO.

Eiken Chemical (4549)

Eiken Chemical, a manufacturer of medical diagnostics equipment, was the third largest contributor, adding +142bps to performance as its share price rose +33%. Eiken Chemical holds a dominant market position in Colon Cancer Screening, with an overwhelming global market share in excess of 70%.

Eiken Chemical's share price benefited from a 7.3% buyback announced in January 2024, of which 2.7% was repurchased through an off-market transaction the following day. Our engagement with Eiken Chemical is in its early stages, but we are pleased to see that management have already taken steps to address its poor capital efficiency by buying back shares and improving disclosure to investors. However, we are disappointed with Eiken Chemical's profitability and believe that there is significant room for improvement on product optimisation and overseas distribution strategy.

Although the EV/EBIT¹ has increased to 10.5x from the 4.8x when we initiated our position, due to the increased share price and temporarily depressed earnings, we still foresee a substantial growth runway for the company, which if successfully executed by management, could unlock upside in the order of +120%. We're excited about Eiken Chemical's future and building our relationship with management.

¹ EV/EBIT figures are based on Last Twelve Months ("LTM") EBIT

JADE GROUP (3558)

Over the period, JADE GROUP ("JADE") (previously Locondo), an apparel e-commerce distributor, was the largest detractor, reducing performance by -157bps as its share price declined by -23%.

The share price increased +30% in the first quarter, propelled by the announcement of the acquisition of Magaseek, a leading fashion e-commerce platform owned 75% by DOCOMO and 25% by Itochu. The purchase is expected to double Gross Merchandise Value ("GMV") and profits by 2026. The shares then plummeted -41% in the second quarter, ending the period down -23% overall.

We invested in JADE in November 2021, after its share price had fallen -70% from a COVID-intoxicated high in August 2020. While JADE was viewed as a "growth stock", and not an obvious candidate for a value-driven engagement fund, it had become undervalued with a substantial net cash backing. We understood JADE's business model having had an indirect investment in Zalando, JADE's European equivalent, through our global fund. We watched in marvel as Zalando rolled out its partners programme across Europe and recognised a similar potential for JADE in the Japanese market.

Over the subsequent three years, led by President Tanaka and the newly appointed de facto CFO, Mr Shigetoshi, JADE continued its ambitious expansion. As the largest shareholder, we have actively supported management in pursuing its growth strategy. We agreed that the dividend should be scrapped to focus on M&A and share buybacks, and we sent letters highlighting JADE's undervaluation. Needless to say, it has been a busy period for management. They have made strides in improving IR communications, reduced the reliance on sales promoted by YouTube influencers, and successfully executed six acquisitions the most notable of which, prior to Magaseek, being Reebok Japan.

Having proven the model with numerous acquisitions, we believe the market is yet to fully comprehend how pivotal the Magaseek acquisition could be, and that the share price weakness was driven by myopic retail investors on non-fundamental factors. The share price weakness offered an irresistible opportunity to increase our holding by +44%.

We anticipate that as management better communicates the upside from the Magaseek acquisition in the coming months, the market will gain a better understanding of its significance and re-evaluate accordingly. When asked whether JADE is seeking to complete more acquisitions, management's response was unequivocal: "we absolutely want to do more." With JADE cementing itself as the #2  player in Japan's ¥2.4 trillion fashion e-commerce market, its ¥60 billion GMV still has a long way to go to catch up with Zozo's ¥574 billion, not to mention its valuation at 20x EV/ EBIT.

Shin-Etsu Polymer (7970)

Shin-Etsu Polymer, a producer of moulded plastics, was the second largest detractor over the period, reducing performance by -143bps as its share price fell -9%.

Shin-Etsu Polymer is a subsidiary of the chemical giant Shin-Etsu Chemical, where we have been engaging on ways to rectify their poor corporate governance and woefully low valuation (6.6x EV/EBIT). During the quarter, we met with Shin-Etsu Polymer's President in Tokyo, and while it was a pleasant and cordial meeting, we found it to be somewhat underwhelming. We did not get the impression that management had an ambition to grow corporate value nor that the company is taking adequate steps to address the conflicts and corporate governance shortcomings of its parent-subsidiary relationship.

We continue to believe that the parent-subsidiary relationship is harming Shin-Etsu Polymer's corporate value and that, as many listed subsidiaries in Japan have done already, it should be eliminated.

Takuma (6013)

Takuma, a waste treatment plant maintenance company, was the third largest detractor over the period, with its -6% share price decline reducing performance by -128bps.

The market was left disappointed by Takuma's underwhelming mid-term plan ("MTP") announced in May 2024, with the share price declining by -12.0% in the subsequent day of trading. Positively, the MTP demonstrated improved transparency around quantitative targets (such as orders intake and ROE targets), and, for the first time, disclosed a shareholder returns policy. This included a 50% payout policy, 4.0% Dividend on Equity target and the intention to buy back 3.8% of shares outstanding this year, with a similar amount during the following two years. However, the profit guidance for the next three years left much to be desired, with next year's operating profit conservative guidance (¥11.2billion) falling well short of consensus (¥13.4billion).

While we acknowledge that Takuma implemented some of our suggestions, management chose to ignore several of our most important points, such as unwinding cross-shareholdings and the divestment of non-core business segments. Having so far achieved an ROI of +17% in our just over one-year holding period, we will continue engaging with management on methods to enhance capital policy and improve operating efficiency. We see a further +70% upside, with Takuma's 6.4% weight in AJOT reflective of our conviction.

Outlook

The portfolio performed positively over the period, achieving a +7.7% return, compared to the benchmark, the MSCI Japan Small Cap Index, which returned -0.2%.  In local currency terms, the performance was stronger, with a toral return in 2024 of +21.9% during the period.  Overall, the portfolio trades at an attractive EV/EBIT multiple of 7.7x, with net cash and listed securities covering 49% of the market cap.

After period-end, July and August saw a period of heightened volatility in global equity markets, particularly in Japan. Some of this extreme volatility was attributable to the change in monetary policy by the Bank of Japan, which increased its benchmark rate by 15bps to 0.25% and caused strengthening of the Yen. The fundamentals of our portfolio did not change, and we used the period as an opportunity to add to existing portfolio names at attractive valuations.

The Japanese equity market continues to gain traction, amidst rising foreign capital allocation, corporate reform and a greater focus on shareholder returns. The seeds planted in recent years are beginning to come through, presenting us with abundant opportunities. We remain committed to selectively adding the most promising companies to our concentrated portfolio.

Joe Bauernfreund

Asset Value Investors

16 September 2024