12 Questions with nipponNuggets

This week, I reached out to the team behind Japan innovation-focused Substack nipponNuggets. To clarify, this is not a promotion. The idea behind these interviews is to pick other people’s brains about areas I personally don’t have much experience in.

Today’s topic is Japanese tech and innovation.

1. Could you tell us about yourself - your background, life in Japan, and what you’re focusing on right now? 

Mark and Rodney (or the nipponNuggets) are Japanese stock market veterans. We have both been in and around Tokyo and the Japanese equity market for going on 20 years. That journey has taken us through some highs and lows, but it has been a fun journey.

We set up Japan Company Visit Partners in 2020 to help foreign fund managers stay connected with Japan and help to engage with Japanese management.

We have a passion for high growth, small-cap companies that we believe will benefit from disruptive innovation over the next decade or so. Japan is an under-researched market, where our stock-picking skills can really add value.

2. How would you characterize the startup scene in Japan? What are the major success cases so far? 

Just starting up... small and behind by Silicon Valley standards but growing fast. From robotics to med-tech to SaaS business models, the start-up scene in Japan has become more vibrant in recent years. The Nikkei Asian Review reported that venture capital funding had increased to over $3bn, up over 50% YoY. Many companies such CyberAgent and SBI Securities have VC division that invests in burgeoning start-ups, mainly centered in Tokyo. Rather than a competition for capital, one of our recent company visits suggests that it’s a competition for projects that is the challenge.

3. What do you think has been holding back Japanese innovation? Do you see a shift taking place? 

In 2020, Japan stood as the world’s third-largest economy, underpinned by a top education system, leadership in sectors such as industrial and automotive manufacturing, high-quality infrastructure, as well as a professional culture that produces high-quality goods and services. However, Japan’s low levels of innovation and digital competitiveness are in stark contrast to the country’s economic strength. The country has produced just 5 out of more than 500 unicorn startups globally. Japan is falling short of its full potential.

Standing in the way of digitization is a risk-averse mindset; senior leaders focused on company longevity rather than productivity; limited exposure of some industries to global competitors; and most importantly, a deficit of more than half a million software-related engineers to build the software applications that will take the country forward.

There are success stories of course. Japan has pockets of strength in robotics, AI, biotechnology, gaming etc… Japan performs well in core research and ranks third in the world in terms of global patent filings. We have compiled a list of around 100 smaller companies in Japan, that are at the forefront of some of these trends. You can follow the names here.

4. What are the key trends in Japanese innovation that you think we should be aware of (digitalisation, EVs, etc)?

There are several important trends that we are following now. The most economically viable area right now is the digital transformation of the Japanese office environment. Companies that can offer cloud-based software are huge beneficiaries of a more fragmented, mobile and demanding workforce. In many cases, Japan is up to a decade behind the US in rolling out digital solutions for front and back-office applications. The Coronavirus pandemic has certainly helped to push companies to speed up the adoption of cloud-based solutions.

Looking further forward, we are seeing a lot of companies that are doing exciting work in the fields of AI, machine learning, computer vision and language processing. These are often surprisingly small companies with a handful of staff and limited revenues. But the technologies and potential applications just look really exciting.

E-commerce and digital marketing are already large markets that are growing rapidly. There are still multiple old businesses in Japan that will be disrupted over the next few years if they cannot transition quickly enough, whether that be in fast fashion, second-hand stores, auctions, payments, or delivery.

5. Which listed companies do you think are doing something truly innovative right now - something new and different?

For companies that are doing something really innovative, I would suggest looking into some of the AI players. Neural Pocket (4056) is using AI technologies to run Smart Cities. The company specializes in Image and Video recognition, while the key tech edge is the ability to process the data at the “edge” rather than in the cloud. This leads to much lower computing costs, lower latency and better privacy.

Kudan (4425) is involved in Artificial Perception, which is used in a broad barrage of industries from autonomous driving, robotics and mapping. The core SLAM technology is in effect, the “eyes” of the machine.

6. Are there any examples of “old school” Japanese companies that you think will be able to successfully reinvent themselves?

I think that there are quite a few examples of Japanese companies that are reinventing themselves. To be fair, some of it has been forced on the company, whether by responding to scandals or attracting the interest of activist investors. Other companies have simply had to change as the old business models became unprofitable and disappeared.

Hitachi is one example of a company that has been reinventing itself over the past several years. With more of a focus on capital returns, the company has taken the unusual step of disposing non-core assets and reinvesting cash flows into higher return business segments.

Nidec is another good example. With really fantastic management, the company has continually moved into new markets, all built on the strength of its small motor technology. It used to dominate the market for HDD motors, but as that market shrinks, Nidec has turned to supply motors and e-axels to automakers.

7. Curious to hear your take on Japanese auto makers’ approach to electric mobility (BEV / FCEV). Who do you think is best positioned?

Easy answer. Toyota is best positioned. The market is obviously excited by Tesla. But we see Toyota as the best and most innovative auto company in the world. Toyota has not come out with a bang in electric mobility like GM and VW. However, they have the technology and will soon roll out some cool products.

The Toyota Mirai hydrogen fuel cell sedan

It is no easy feat to balance the shift to EVs when you produce over 10mn cars per year which are still highly profitable and selling in high numbers. However, they do have a full suite of products and models to meet the carbon challenge. They have strategically tied up with other Japanese auto and truck makers as they roll out their zero-carbon technology.

8. A large part of the Japanese business world is still reliant on paper documents. Several new companies are pushing towards greater digitalization. Which of these companies do you like the best and why?

LoL – the infamous Japanese fax machine! They just will not go away.

Nevertheless, Covid-19 has been a wake-up call for companies. Spending on digitalization has surged as firms raced to enable staff to work from home and keep doing business. The establishment of a Digital Ministry to revamp government services has sent a strong signal to business leaders. Digitization and AI initiatives are not just nice to have, they are imperative if Japan is to lift productivity and regain its status as a center of innovation

As I alluded to above, there are a number of companies that are benefitting from the digital transformation of the office. The likes of Money Forward and Freee (accounting software), Rakus (expense management), and Bengo4 (digital signatures) all have good quality business models, large addressable markets and decent management teams.

9. How would you characterize the Japanese e-commerce market and the way it’s developing?

Opportunity is the keyword to describe the Japanese e-commerce market. For context, traditional retail in Japan is about $1.3trn annual turnover market size. From that, e-commerce still represents a mere $140bn, or just over 10% of retail. The e-commerce shift is just getting its 2nd wind as COVID-19 has added new impetus to the online shift. Competitive forces have taken hold with companies in the massive retail sector, realizing that business without an online strategy poses this shrinkage in the best case and bankruptcy in the worst.

Amazon, Rakuten, and Yahoo Japan are still the main players, but new companies such as BASE and Makuake are clocking high GMV growth.

10. How do you take into account corporate governance when you analyse Japanese stocks?

Corporate governance is particularly important in Japan. We believe that good governance is essential for long-term value creation. We try to identify companies that are capable of delivering outstanding long-term returns. This is best achieved by a management team that can run the business for the long term while considering the needs of society and other stakeholders.

For many of the smaller companies that we follow, the long-term value creation thinking often comes from the founder of the company. We want to see them generate significant value over the long term, rather than become preoccupied with hitting quarterly earnings estimates.

The composition of the board is also vitally important. For many of these companies, the biggest challenge is scaling the businesses. The transition from a small company to a large company is seldom easy, but a cognitively diverse board can certainly help - combining skills and experience that the internal management team does not have. Finally, we want to ensure that the remuneration policies are simple and reward for superior long-term performance.

11. Would love to hear your take on valuation multiples among innovation-focused Japanese companies? Where do you find value?

We take a different view of the valuations of these innovation-focused companies. Traditional metrics are useless for companies growing sales at 30-100%, many of which are yet to become profitable.

We are more focused on answering the questions such as:

• What is the size of the market?

• Does the company have a moat, and is it sustainable?

• Does the company’s management have the vision and strategy to execute?

• Are they incentivized to generate the kind of free cash flow in the long term that will lead to 5x or more expansion in enterprise value?

We put this assessment in our 4M framework, explicitly looking at Model, Market, Moat, and Management. When we visit companies, our questions are all geared at answering these questions.

12. Where can people learn more about you and nipponNuggets?

You can follow the nipponNuggets at jcvpartners.substack.com.

Simply put, it is a bite-sized look at Japanese companies that benefit from Disruptive Innovation. You can also follow us on Twitter @JCVPartners where we add to the general noise around Japan. For any institutional investors that would like to employ us for custom research requests, then further details can be found at www.japancompanyvisitpartners.com.