AVI JAPAN OPPORTUNITY TRUST

ANNUAL REPORT 2020

LEI: 894500IJ5QQD7FPT3J73

The Directors present the audited Annual Report for the year ended 31 December 2020.

Copies of the Annual Report can be obtained from the Company's website ("AJOT" or the "Company") www.ajot.co.uk or by contacting the Company Secretary by telephone on 01392 477500.

AVI Japan Opportunity Trust plc ("AJOT" or "the Company") invests in a focussed 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.

Portfolio Statistics as at 31 December 2020

Performance Summary

 ^{*For all Alternative Performance Measures, please refer to the definitions in the Glossary below.
†MSCI Japan Small Cap Total Return Index (£ adjusted total return)}

Overview

Company Objective & Strategy

AJOT aims to provide Shareholders with total returns in excess of the MSCI Japan Small Cap Total Return Index in GBP ("MSCI Japan Small Cap Total Return"), through the active management of a focused portfolio of equity investments listed or quoted in Japan which have been identified by Asset Value Investors Limited as undervalued and having a significant proportion of their market capitalisation held in cash, listed securities and/or other realisable assets.

AVI seeks to unlock this value through proactive engagement with management and taking advantage of the increased focus on corporate governance, balance sheet efficiency, and returns to shareholders in Japan.

The companies in the portfolio are selected for their high quality, whether having strong prospects for profit growth or economically resilient earnings. By investing in companies whose corporate value should grow overtime, AVI can be patient in its engagement.

Benchmark

The MSCI Japan Small Cap Total Return Index.

Capital Structure

As at 31 December 2020, the Company's issued share capital comprised 117,489,742 Ordinary Shares of 1p each and as at 15 March2021 it comprised 131,430,702Ordinary Shares. No shares were held in Treasury.

Annual General Meeting

The Board currently intends to hold the Company's Annual General Meeting ("AGM") at 10.30 am on Wednesday 28 April 2021 at the offices of Asset Value Investors Limited, 25 Bury Street, London, SW1Y 6AL. This may change at short notice due restrictions relating to the COVID-19 pandemic and Shareholders are advised to monitor RIS and the Company's website for changes. Shareholders are currently advised not to attend in person but to submit their vote ahead of the meeting or appoint the Chairman as proxy. Shareholders will be able to submit questions to the Board and AVI ahead of the AGM and answers to these, as well as AVI's presentation, will be made available on the Company's website. Please refer to the Notice of AGM for further information and the resolutions which will be proposed at this meeting.

Investment Manager

The Company has appointed Asset Value Investors Limited ("AVI" or the "Investment Manager") as its Alternative Investment Fund Manager.

Financial Conduct Authority ("FCA") regulation of 'non-mainstream pooled investments' and MiFID II 'complex instruments'

The Company currently conducts its affairs so that its shares can be recommended by Independent Financial Advisers in the UK to ordinary retail investors in accordance with the FCA's rules in relation to non-mainstream investment products and intends to continue to do so. The shares are excluded from the FCA's restrictions which apply to non-mainstream investment products because they are shares in an authorised investment trust.

The Company's ordinary shares are not classified as 'complex instruments' under the FCA's revised appropriateness criteria adopted in the implementation of MiFID II.

The Association of Investment Companies ("The AIC")

The Company is a member of The AIC.

Website

The Company's website, which can be found at www.ajot.co.uk, includes useful information on the Company, such as price performance, news, monthly and quarterly reports as well as previous annual and half year reports.

Chairman's Statement

Overview of the Year

2020 was for everyone a year of many unexpected challenges, opportunities and results. COVID-19 and the resulting global lockdowns altered daily lives, severely disrupted economic activity, and took many lives. We are unlikely to know for many years the longer-term impact that this modern-day pandemic is going to have on the world. AJOT has endured everything 2020 has thrown at it and enters 2021 in a better position now than at any stage since its inception in 2018, as explained below.

During the year, equities worldwide were of course highly volatile. The Spring saw sharp and fast, but brief, declines in all major global stock markets, followed by a similarly fast paced recovery. As is often the case, recoveries in stocks precede recoveries in economies, with varying time lags and trajectories. During this period a whole alphabet soup of possible recovery paths were put forward. As we head into 2021, with multiple vaccine rollouts underway, the most favoured V-shaped recovery for Japan appears in the offing with stronger synchronised global growth expected. This will undoubtedly benefit AJOT's holdings.

In addition to the macroeconomic factors, 2020 was a significant year for corporate governance activity in Japan. Prime Minister Abe's administration, the longest in the post-war period, came to an end but was swiftly and smoothly replaced by new PM and Abe protégé Suga, who has pledged to continue with and accelerate the reforms begun under "Abenomics". Against this favourable backdrop, it was perhaps to be expected that global investors have once again turned their focus to Japan after a decades-long absence, most notably in the form of accelerating activity by foreign private equity players.

At the individual company level, AJOT has now been joined by a steady stream of investors from around the world identifying and attempting to unlock often extreme value in Japan. While at launch back in 2018 we were in a small minority focussing on this opportunity, we now have many like-minded investors joining us, most notably Warren Buffett buying a portfolio of trading companies in the second quarter of 2020. The year also saw, in the form of Nitori Holdings and Colowide's respective bids for Shimachu and Ootoya Holdings, significant domestic hostile takeover activity that was unimaginable just a few years ago. And crucially, there was no regulatory or societal backlash; M&A has quietly become a legitimate and acceptable corporate strategy. Like the rest of the world, the pandemic and the consequent restrictions in travel have encouraged Japanese company managements to look inward, declutter cross-shareholdings and look for opportunities closer to home. This "Corporate Staycation" trend is set to continue and represents a very positive development and opportunity for our investee companies.

During the year, your investment manager, AVI, led two public campaigns at Fujitec and at Teikoku Sen-i, that were instrumental in those two stocks recording very strong performances during the period. Moreover, despite travel restrictions, AVI continued to hold regular discussions with investee companies, aided by significant additions to their investment team, including a senior team member based in Tokyo.

Performance and Dividend

As is sometimes the case however, the market did not reflect these improvements, overshadowed as they were by global events. So far, commensurate NAV returns remain elusive. We do not expect such a dynamic to last indefinitely, and as such have more conviction now, than at any time since inception, on the prospect of future returns for your Company. During the year, your Company achieved a net asset value ("NAV") per share total return of -1.4% in GBP. This compares to a return for the MSCI Japan Small Cap Return Index of +3.2% (also in GBP).

Your Company's largest holding, Fujitec at 8.1% at year end, was the largest contributor to returns, adding +340bps, and highlighting the power of constructive engagement. SK Kaken, 6.0% of NAV at year end, was the largest detractor (-220bps). A detailed commentary on your Company's performance by AVI follows on the pages below.

On 15 March 2021 (the last practicable day prior to publication of this document) the NAV per share was 108.06p, a discount of 0.29 per cent. to the closing share price of 107.75p.

The Company paid a dividend of 0.65p to Shareholders in October 2020. The Board proposes a dividend of 0.65p per share for the year ending 31 December 2020.

Investment Strategy

As you will recall, AJOT's raison d'etre is that Japanese corporate culture and governance is undergoing a revolution. For decades corporate Japan operated with little regard for shareholders, balance sheet efficiency or returns on equity. Extreme value was built up year after year on company balance sheets; yet the owners - that is, shareholders - were never able to access it. Under the Abe administration this started to change. The process is slower than some may like, but the direction of travel - as backed by politicians and regulatory bodies, and cajoled forward by increasingly vocal shareholders - is undeniable.

Your Company is set to benefit from the continuation of this trend, with significant ownership stakes in a concentrated portfolio of heavily over-capitalised and extremely undervalued companies. AVI will continue to engage actively with management and other shareholders to unlock this value.

Share Premium and Issuance

As at 31 December 2020, your Company's shares were trading at a premium of 2.2% to NAV per share. The Board monitors this premium carefully and manages it by periodically issuing shares. During 2020, we utilised the Company's authorised block listing facility to increase our shares in issue by 3,550,000. As at 31 December 2020, 117,489,742 shares were in issue, a pleasing increase from the 80,000,000 at AJOT's launch. Since the year end, the Company issued further shares through a placing and the blocklisting facility as detailed below and as at 15 March 2021, the Company had 131,430,702 shares in issue.

Debt Structure and Gearing

As described in the Prospectus, the Board supports the use of gearing to enhance portfolio performance. In March 2020 the Company increased its total debt facility from ¥2.93 billion, to ¥4.33 billion, an increase equivalent to approximately £10 million. The debt facility was renewed on 17 February 2021 and will mature on 16 February 2022. The gearing has been provided at an interest rate of LIBOR plus 0.95%

As at 31 December 2020, ¥2.2 billion (£15 million) of the facility had been drawn, and gearing was 6.8%, slightly below the targeted 10-15% range.

Outlook

Looking forward, like every other government, fulfilling the previously announced ESG obligations will remain a priority for the Suga administration. In last year's statement, we explored Japan's unique and historically well-established approach to the environment and sustainability of commerce. With a further, though somewhat modest goal of carbon neutrality by 2050, productivity improvements will be a tentpole policy of the coming decade. Central to this aim is the establishment of a Digitalisation Agency, to promote computerisation in all of its forms. In spite of its reputation for technological prowess, large parts of Japanese society still operate in the analogue era. Fax machines are still in widespread use, while pandemic-induced remote working revealed Japan's corporate Achilles heel in the anachronistic need for all documents - invoices, receipts, contracts - to be physically sanctioned with the application of a corporate seal, or hanko, a practice dating back five centuries to the time of the shoguns. Nationwide, digital reform will leave no industry untouched, creating a new class of Japan's own tech winners, some of which are discussed in the Investment Managers report below.

With the benefit of hindsight, 2020 was full of encouraging signs: the resilience of your holdings' business models during the pandemic; AVI's enhanced engagement efforts; continued evidence of changing corporate governance norms; and investor interest from both private and public equity institutions. All of these add to the mounting evidence in favour of owning a concentrated portfolio of lowly valued Japanese equities likely to benefit from the corporate governance revolution.

ESG Leadership

As you are aware, AJOT's investment objective is heavily focussed on improvements in G, the governance of the underlying investments in Japanese companies made on your behalf by AVI. The broader ESG approach is detailed in the Annual Report. However, there is no doubt that factors represented by these three letters will be playing an increasingly crucial role in all decision making, whether operational or investment, for corporates and individuals alike. In terms of corporate governance, your Company has adopted the very highest standards from the start, with measures in place to prevent value destruction caused by wide discounts to NAV, and directly aligning the interests of the Investment Manager with Shareholders, among other approaches.

Going forward, we will be turning our attention to the E and S issues, ensuring that your Company remains at the vanguard of putting these criteria at the core of what we do. AJOT, like every other investment trust with no premises and no employees, can have a limited direct effect on E and S issues. However your Board believes that you as Shareholders, our most important stakeholders, expect more from us as Directors. We therefore intend to take an increasingly proactive approach, and encourage our stakeholders to focus on their own mitigation strategies. We will start by asking all of AJOT's counterparties - the investment manager, broker, administrator, legal team, accountants and auditors, as well as major Shareholders and others, two questions:

(1) What ESG policies are implemented within your organisation?; and

(2) What ESG policies do you expect your stakeholders to follow?

The responses are likely to range from the very straightforward, "We recycle paper in the office" or "We buy electricity from renewable sources", to the more nuanced; "We use carbon offsets to mitigate business air travel made on behalf of our clients", which might lead us to ask "How do you calculate the most efficient offset program?" We might ask our Shareholders what additional cost they would be willing to incur to ensure AJOT's stakeholders adopt improved ESG measures, if indeed there are additional costs?  The information collected will form the basis of a full understanding of these priorities within the investment trust community. Although participation will be entirely voluntary, we anticipate a high level of engagement. Your Board will review the results, share them with the respondents and with refinements over time, develop them into a comprehensive Investment Trust ESG Policy. We are very excited to be launching this initiative and hope to have the first set of responses to share with you in the next Interim Report in six months' time.

Closing Remarks

Thank you for your continued support as Shareholders. I would also like to thank the other stakeholders in the Company: first and foremost, your Investment Manager AVI, N+1 Singer as broker, as well as Link our Administrator, who have all dealt with the unexpected issues of 2020 in their stride. If you have any queries, please do not hesitate to contact me personally (norman.crighton@ajot.co.uk), or alternatively speak to our broker N+1 Singer to arrange a meeting.

Norman Crighton

Chairman

17 March 2021

Investment Manager's Report

2020 was a most remarkable year. You are perhaps tired of hearing that, but there is simply no other way to put it. It will likely stand out in our collective memory for quite some time, whatever else future years may bring.

To recap the year for investors, the outbreak and spread of COVID-19 around the world in the first quarter of 2020 induced a short, savage bear market, erasing fully one-quarter of global equity values in a matter of just four weeks. I can say, without hyperbole, that the sell-off was breath-taking for its pace and severity.

Following the lows in March, markets began a rapid recovery as investors realised that monetary and fiscal support - policy tools honed during the previous financial crisis - would underwrite the worst of the economic and financial damage. At the time of writing, the MSCI ACWI Total Return Index, a proxy for global stock markets, has risen +44% from the March lows (in GBP), and returned +13% for 2020 as a whole: a remarkable achievement given the high wall of worry that markets needed to climb, and a testament to the near-insuperable optimism of humanity.

It has been no less an extraordinary year in Japan than elsewhere in the world. While the outbreak of, and fallout from, COVID-19 was managed better than in many other countries, the Bank of Japan's latest estimates nonetheless show a -6% contraction in GDP for 2020, highlighting the extent of the damage wrought by the pandemic. Against this difficult backdrop, the TOPIX Composite increased +9.5% for the year, the MSCI Japan Small Cap +3.2%, and your Company's NAV returned -1.4% (all figures total returns, in GBP).

These headline returns mask important trends: growth companies - in particular, technology or technology-enabled stocks - have delivered the most impressive performance as they have been natural beneficiaries of lockdowns. Cyclical, economically exposed stocks, on the other hand, have suffered and await a resumption of physical economic activity to return to full profitability. This dichotomy can be seen in the MSCI Japan Small Cap Growth Index, which returned +10.9% in 2020, against a return of -4.6% for the MSCI Japan Small Cap Value Index.

The environment in which your portfolio companies operate is exhibiting signs of a V-shaped recovery, which bodes well for a strong recovery in corporate cash flows and profits. To date, the companies in your portfolio have not relied on government furlough schemes nor raised additional debt or equity capital to fund operations, highlighting the resilience of their business models. Despite the demonstrated resilience and promising earnings profile of the portfolio, the stock market reaction has been, and remains, disappointing. The result of this is that the portfolio has gotten cheaper over the year and presents new opportunities. Although this experience has been frustrating, cheap valuations coupled with strong fundamentals lay the foundation, in our view, for strong future returns.

Corporate activity in Japan remains replete with potential, and since the Japanese economy exited lockdown, we have seen the return of animal spirits to capital markets. Buybacks and takeover activity returned to normal levels in the second half of the year, and foreign inflows turned positive in November and December. These inflows have been largely focused on large- and mid-cap names, but we believe that investor interest will in time turn to the small-cap segment of the market to which your portfolio has a significant exposure.

Large overseas private equity firms are showing significant interest in Japan, including well-known houses such as Carlyle, KKR, CVC and Blackstone. Many of these companies are raising large Asia- or Japan-focused funds, which will bring capital into Japanese markets searching for attractive deals. In a sign of the changing times, hostile takeover bids are no longer regarded as anathema, or the preserve of aggressive foreign firms.

The enhanced level of corporate activity and foreign interest in Japan, together with the supportive backdrop for corporate reform provided by the Suga administration, are very promising and the potential for the unlocking of shareholder value is increasingly compelling.

Overall, despite this year's somewhat disappointing NAV performance, we remain convinced that the portfolio's fundamentals are as sound as ever, and the valuations as compelling as they have ever been. Furthermore, the backdrop of corporate activity and supportive governmental policy provides a powerful catalyst for unlocking shareholder value. We comment further on an individual stock basis in the contributors and detractors section below, but we believe that your Company's portfolio is attractively positioned to benefit from all of the above, and the probability of strong returns from here is as good as it has been at any point since AJOT launched over two years ago.

Contributors

Fujitec

Fujitec was the largest contributor to AJOT's returns over the period, adding 340bps, after its share price appreciated by +29%. This was driven almost exclusively by an expansion of the EV/EBIT multiple from 8.4x to 12.3x, on what we think is at least in part attributable to our public work highlighting the undervaluation of Fujitec.

Founded in 1948, Fujitec manufactures, installs and maintains elevators and escalators ("E&E"). While it has a global presence, 90% of profits derive from Asia where it is well established, and over half of profits relate to sticky after-sales services.

At the beginning of May we launched a detailed public campaign¹ highlighting a multitude of issues at Fujitec, outlining how our suggestions could lead to improved margins and a higher valuation. We recommended to the board that they undergo a comprehensive strategic review, evaluate outsourced manufacturing, set out a transparent capital policy and adopt a three-committee style board structure. Our research for the presentation took around two months, and during that time we spoke to twelve experts within the field, including ex-Fujitec employees, peers, customers and suppliers.

Since we released the presentation, we met/had calls with management on eleven separate occasions. Pleasingly, less than seven months later, Fujitec publicly responded to our presentation with a new strategic direction for the company. Whilst we would have liked to have seen an explicit capital policy and a share buyback program, we were happy to see that the company will install a compensation and nomination committee, discontinue their anti-takeover measure when it expires in 2022, streamline their manufacturing process with a targeted operating margin of more than 10% (the highest since 1998) and focus on the more lucrative after-service business.

These were in line with many of the key points we outlined in our presentation and we applaud management for actioning not only ours, but other shareholders' views. We now plan to continue pushing for a rigorous capital policy, in particular a share buyback program, and will hold management accountable to their 10% margin target.

The share price reaction since the announcement has been lacklustre, +2.1% vs +1.2% for the MSCI Japan Small Cap. We think that the market is misunderstanding the substantial operational improvement measures and is too focused on short term initiatives such as a share buyback program.

Fujitec trades on a 12.3x EV/EBIT, which is undemanding considering that earnings have been temporarily impacted by coronavirus disruption and that peers trade on an average multiple of 24x. Despite the strong share price performance this year, we are optimistic about Fujitec's future performance, which is why Fujitec ended the period as the portfolio's largest position.

¹ The presentation can be found on www.takingfujitectothenextlevel.com

Pasona Group

Pasona is one of Japan's largest recruitment and outsourcing companies, with a 50% stake in Benefit One. Pasona added +199bps to returns over the period, making it your Company's 2nd largest contributor, with its share price appreciating by +32%, buoyed by a +37% increase in Benefit One's share price and a record-high quarterly profit.

Our interest in Pasona stems from its stake in Benefit One, which, remarkably, accounts for 287% of Pasona's market cap and implies a large negative value for Pasona's core operating businesses (-¥161 billion to be exact). Such a large negative value could be justified for a loss-making business, but Pasona's businesses excluding Benefit One reported an operating profit of ¥7.3 billion over the past 12 months.

Pasona is not without its imperfections. It is controlled by the 68-year-old Yasuyuki Nambu, who has proved resistant to shareholder pressure. He has expanded the business into some questionable areas, and to encourage rural living, converted part of Pasona's prime Tokyo headquarters into a farm - with livestock. While Mr Nambu has publicly stated that he will focus more on profits, as he is in control, the timing to cutting costs and increasing margins is firmly at his discretion. However, this is all well known and is why we are able to purchase a stake in Pasona at a 76% discount to its underlying value. What is more important is whether we can achieve an attractive risk-adjusted return considering these faults.

Pasona's most recent quarterly results showed green shoots of an improving cost structure, with corporate overhead costs falling 15% and its non-Benefit One businesses recording a 6.6% operating margin (the highest quarterly margin in Pasona's history). While part of the strong quarterly performance was due to temporary contracts to assist the Government in various coronavirus-related work, the higher margin continues a trend of improving profitability since 2017.

The most accretive outcome for our investment in Pasona is the spin out of its stake in Benefit One to shareholders (tax-free). Illustratively, and we do not believe it will take decades to realise Pasona's upside, even without an improvement in the value of Pasona's businesses, we can wait 15 years to realise the value of Benefit One and return a respectable 10% annualised return. More optimistically, if we assume Pasona's stake in Benefit One and its unlisted assets appreciate by 5% per year, we can wait 30 years (by which time Mr Nambu will be 98 years old and unlikely to be running the company) and achieve an annualised return of 10%.

Pasona's valuation is at such an extreme that a slight change in the market's perception could see a dramatic upward shift in the share price: returning to the 67% discount at which it started 2020, would result in a 35% gain. The staggering upside potential coupled with signs of improving margins leaves us optimistic about Pasona's future.

SoftBank Group

SoftBank Group ("SoftBank") was the third-largest contributor to returns over the period, adding 198bps. We initiated a position in SoftBank in February 2020, whose key assets include stakes in Alibaba, SoftBank Corp (a Japanese telecommunications company), the Vision Fund, Arm Holdings, and T-Mobile US. During our short ownership we have made an impressive return on investment of +44% and an IRR of +58%, in yen.

SoftBank is a well-known name, which has been plagued by negative headlines surrounding the Vision Fund and the tumultuous investment in WeWork. We felt that the publicity of these issues belied the fact that SoftBank's investment in the Vision Fund was simply not very material in terms of its economic impact, being far outweighed by the value of the stakes in Alibaba (65% of NAV) and, to a lesser extent, its telecoms holdings: Japan-listed SoftBank Corp (10%) and US-listed T-Mobile (5%); and had created an opportunity to acquire a stake in SoftBank at a remarkably wide discount to its underlying value.

Having acquired our initial position at what we believed was a wide discount to NAV (48%), the discount then widened to as much as 76% over the COVID-19-inspired market sell off, and we increased our position by nearly 40% at an average 64% discount and at prices 28% lower than when we first made our purchase.

A combination of pressure from shareholders (we wrote to the company outlining our recommended course of action) and the weak share price, led Masayoshi Son, SoftBank's CEO and founder, to announce unambiguously shareholder friendly measures. In March SoftBank announced a ¥500 billion buyback (an estimated 6% of market cap at the time of the announcement) followed by a thumping commitment to sell JPY4.3 trillion of assets and buy back a further ¥2.0 trillion of shares (26% of market cap) in addition to reducing debt. Since then, SoftBank has announced the appointment of new independent directors to its board and has improved transparency around the Vision Fund. This was welcome news for investors and, from the nadir in March, the share price has bounced back by +200%, and ended the period +40% above the pre-COVID price at which we initially purchased shares.

SoftBank has been an excellent investment for your Company. However, we believe that despite the strong gains, SoftBank still represents good value, a claim which we buttress with two observations. Firstly, the average discount of 40-50% that the market has applied to SoftBank in the past is no longer appropriate, given that it has shown itself willing to reduce leverage, improve capital allocation and tentatively embrace higher standards of corporate governance. Therefore, we believe there is further upside to the 41% discount at which SoftBank ended the period. Secondly, ongoing share buybacks generate risk-free, immediate, and certain NAV accretion for remaining shareholders. However, we are cognisant that a narrower discount reduces upside potential and towards the end of the year we reduced the position by -30%, bringing SoftBank's weight in the portfolio down to a more modest 4.6%.

Teikoku Sen-i

Teikoku Sen-i ("Teikoku")'s share price held up well over the period, increasing by +2.7% vs the MSCI Japan Small Cap return of +1.5%. The contribution to returns for your Company was bolstered as we reduced the position by 27% at an average price 8% above where it ended. Resulting in a total contribution to returns of 132bps.

Teikoku is a manufacturer and distributor of disaster prevention equipment in Japan. Its equipment ranges from emergency hoses to state-of-the-art rescue vehicles. Geographically speaking, Japan is precariously placed, and each year suffers from typhoons, earthquakes, and flooding. The Government of Japan is devoting significant resources to disaster prevention infrastructure as have private companies (particularly nuclear power operators).

Over the past two decades Teikoku has expanded its product lines to meet demand and this year announced a plan to invest ¥4.2 billion (c.£30 million) building a new factory dedicated to the production of rescue vehicles. This is a fantastic development for two reasons. 1) The current factory is split between fire hoses and rescue vehicles. By moving the production of vehicles to a new factory, Teikoku should be able to increase capacity of both fire hoses and vehicles. Moreover, we expect that dedicated factories and more automation should lead to cost savings. 2) Investing low yielding cash, which is heavily discounted by investors, is hugely accretive. ¥4.2 billion is not an insignificant investment and accounts for 20% of Teikoku's cash. A return on capital of 10% (reasonable assumption considering that Teikoku achieves a return on assets excluding cash and investment securities of 15%) could contribute ¥400 million to profits, or an 8% increase.

The second point is most encouraging, considering that in January we launched a public campaign titled "Transforming Teikoku"², highlighting Teikoku's inefficient capital allocation. We argued that with 70% of balance sheet assets held in cash and investment securities, Teikoku was harming corporate value, and this was the reason for its low market valuation. By adopting a balance sheet allocation in line with the average Japanese company, Teikoku could increase its ROE from a mediocre 7% to 20% - and with it the potential for a 120% share price increase.

We submitted two shareholder proposals for an increased dividend equivalent to a 50% payout ratio and a buyback for 3% of outstanding shares. Given the percentage of allegiant shareholders who have conflicting business relationships, it was not our expectation to win either proposal, but to draw attention to Teikoku's balance sheet mismanagement.

Encouragingly, despite the presence of allegiant shareholders, our proposal was supported by 25% of shareholders, with strong backing from Japanese institutions, and while hard to say, might have been a contributing factor in management's decision to utilise cash for capital expenditure.

While Teikoku has taken a positive step by investing cash into a new production facility, there is more that can be done, and we will continue to engage with management on Teikoku's capital efficiency. In the meantime, we hope to benefit from increased disaster prevention expenditure in Japan and from an improvement in Teikoku's modest 5.3x EV/EBIT valuation, as the quality of the business gets better reflected in the share price.

² The presentation can be found on www.transformingteikoku.com

Aichi

Aichi is a relatively new position for your Company, entering the portfolio in November 2019. This was a fortuitously timed purchase, as over 2020 Aichi's share price increased by +27%, resulting in a +36% gain on our position and a 107bps contribution to performance.

Aichi is a mature, cash cow business, selling two types of arial platforms: truck-mounted and standalone, used to repair bridges, install and upkeep telephone and electric wires, and maintain overhead train cables. It has a 30% market share in Japan and is the leader for its product categories. Its strong market positioning allows the business to generate an operating margin and return on invested capital in excess of 10%.

Our investment in Aichi was premised on its stable business, compelling valuation (3.2x EV/EBIT at the end of 2019) and it being a listed subsidiary of Toyota Industries. Listed subsidiaries and their controlling parents are coming under increasing pressure to ensure the protection of minority shareholders. Which we believe was part of the motivation for Aichi's unexpected announcement in March that it was going to pay out 50% of profits over the next three years (vs 33% average over the past three) and buy back up to 5.2% of its shares over the next three years (only the 2nd buyback in Aichi's history). Alongside these announcements Aichi have started to produce quarterly results in English - helpful for foreign investors.

With the more shareholder friendly outlook it was of little surprise therefore, that Aichi's valuation improved over the year from 3.2x to 6.4x driving its strong share price performance. We still believe Aichi is a buy-out candidate by Toyota Industries but given the improving shareholder returns and stable business, we can afford to be patient.

Detractors

SK Kaken

SK Kaken was the largest detractor over the period falling -21% and detracting 220bps from returns. SK Kaken's detraction was outsized due to its weighting in the portfolio, being on average our third largest position with a 7.0% weight. The share price of SK Kaken fell less than the market during the February sell-off, but disappointingly did not recover in the latter half of the year.

SK Kaken's share price suffered from continued selling pressure from a large foreign institution which experienced heavy redemptions, coronavirus-related profit weakness (-33% for the first six months of the year), and a falling EV/EBIT multiple from 5.2x to 1.2x. Remarkably, for a company of SK Kaken's size (£750 million market cap), net cash accounts for 88% of the market cap.

Headquartered in Osaka and listed on the JASDAQ with poor liquidity, SK Kaken flies under the radar of many investors. Its share price suffers from a prohibitively large minimum trading size of £27,500, preventing any retail investors from buying shares. This is quite easily rectified through a share split, something we have communicated to management.

Whilst on the surface SK Kaken's paints business might seem cyclical and low quality, our analysis shows that this is not the case. 75% of sales derive from paint replacement rather than new construction, and its focus on the niche segment of architectural coatings allows it to command a 52% market share and earn an impressive 27% return on capital. It is the only large paint company to focus predominantly on the domestic market, with Nippon Paint and Kansai Paint more exposed to China and India - both of whom significantly outperformed SK Kaken this year appreciating by 102% and 20% in 2020 respectively.

SK Kaken's lagging share price presents an opportunity for a rebound, as we do not believe that the fundamental outlook of the business has materially worsened. While we wait for a recovery, we are comfortable owning the shares knowing that the underlying value will continue to appreciate each year.

Tokyo Radiator

Tokyo Radiator was the second largest detractor, despite only an average weight of 2.1%. It suffered a -47% fall in its share price, with net cash now covering a preposterous 148% of the market cap. Tokyo Radiator is one of the few companies in the market whose share price has fallen since the lows of the February selloff, despite an improving business environment.

Tokyo Radiator's mainstay products are cooling radiators, used in trucks to avoid high temperature damage, and EGR coolers, which provide a mechanism to reduce harmful NOx emission by cooling exhaust gas. Most of Tokyo Radiator's sales are for commercial vehicles with less than 15% for passenger vehicles. This is important as the electrification of commercial vehicles is behind that of passenger, giving Tokyo Radiator time to develop products used in electric vehicles (batteries still need to be cooled).

It has been a difficult period for Tokyo Radiator which has suffered on multiple fronts. Its overseas business struggled amidst the US-China trade war resulting in slowed China sales, while the onset of COVID-19 saw weak commercial vehicle demand for Tokyo Radiator's key customer, Isuzu.

Last year Tokyo Radiator appointed a new President tasked with improving operations. He has focused on increasing R&D expenditure, expanding sales in China, outsourcing the production of some commoditised parts and modernising facilities. The effects of his efforts have yet to bear fruit, but the management team are confident about the outlook, particularly for their China business.

Trading with 148% of its market cap covered by net cash, Tokyo Radiator is undeniably cheap. Applying a very modest 5x EV/EBIT multiple to pre-COVID profits (which were already depressed), gets to a fair value of ¥949/share, 90% higher than the ¥500 share price at year end. In a meeting with management at the end of the year they commented that they too did not understand Tokyo Radiator's low share price.

We believe the crystallisation of Tokyo Radiator's undervaluation will be either through a buy-in by 40% shareholder Marelli, which is owned by KKR, or a management buyout funded by a private equity firm. Given the pressure on companies to collapse parent-child relationships and Tokyo Radiator's subpar corporate governance, we believe it is untenable for Tokyo Radiator to continue in its current form, especially given the reputational risk to KKR. Tokyo Radiator is poised for a rapid bounce in its share price and has one of the largest upsides in the portfolio.

Toyota Industries

Toyota Industries - the family controlled holding company of the Toyoda family - was also a detractor from returns, reducing performance by 120bps. The position was exited in the spring in order to reduce the portfolio's exposure to more economically sensitive areas of the economy, such as the auto industry, and so as to use the proceeds of one of the portfolio's more liquid names to invest in other areas where we felt valuations were more compelling. It was the timing of the sale that accounted for the detraction from performance, as we did not hold a position when markets rebounded.

The portfolio did, however, retain an interest in the Toyota nexus via Aichi Corp, the listed subsidiary of Toyota Industries. As we have communicated previously, we believe such structures are becoming increasingly untenable, and view Aichi as a possible take-out target.

We have long been attracted to Toyota Industries' world-leading forklift business, which has successfully shifted into warehouse logistics, and a beneficiary of the increased need for warehouse capacity to support ecommerce. It also manufactures parts used in electric vehicles, an attractive growth opportunity. Toyota Industries remains on our watchlist and at the right valuation could re-enter the portfolio.

Tachi-S

We exited our position in Tachi-S over the period and although it was a relatively small weight, its share price weakness caused it to detract 70bps from performance. From the start of the year to our average selling price Tachi-S' share price fell -37%.

Tachi-S is a manufacturer of seats for automobile producers. Uniquely, it is an independent operator without affiliation to one brand, producing seats for Honda, Nissan, Toyota and Mitsubishi. Our first investment in Tachi-S was at the launch of AJOT in October 2018. Tachi-S' valuation was compelling, with net cash and investment securities covering more than 100% of its market cap, and we had made positive inroads with our engagement - with management undertaking two separate buybacks. However, ultimately it is the business performance that drives returns and Tachi-S' business suffered severely from COVID-19, reporting a heavy loss for the first half of its fiscal year. Fortunately, we were cognisant of the cyclicality risks of the business and Tachi-S was never a core position in the portfolio, averaging a weight of only 2.1% over our holding.

Faced with a difficult business situation we think that management's focus should rightly be on stemming losses rather than considering how to enhance shareholder returns and rightsize the balance sheet. Confronted by business headwinds, we don't think that further engagement would be fruitful and that the recovery in Tachi-S' earnings could take some years to come through. We, therefore, felt it prudent to recycle the cash into more exciting opportunities.

Secom Joshinetsu

Secom Joshinetsu detracted 62bps from returns as its share price fell -8% with its illiquid shares indiscriminately sold during the COVID-induced sell-off and failed to fully recover. This, despite a respectable earnings performance during the period from 31 March to 30 September 2020, which encompassed the worst of the COVID-related social restrictions, where sales fell only -2% and operating profits grew +2%.

Secom Joshinetsu has a remarkably defensive business, providing security systems and security personnel. Its customers are on yearly contracts, but around 98% renew, resulting in sticky and stable revenues. Secom Joshinetsu is 54% owned by Secom and, with the support of Secom's systems and R&D, serves the prefectures of Gunma, Niigata and Nagano.

Secom Joshinetsu's close relationship with its parent shareholder opens a raft of potential conflicts of interest. 3 out of 8 board directors at Secom Joshinetsu previously worked at Secom; Secom Joshinetsu pays Secom a percentage of their sales to use Secom's trademark and to access other intellectual property; and almost all of Secom Joshinetsu's cash is deposited at Secom.

Given the multitude of potential conflicts of interest with minority investors and the inefficiency of Secom operating its business in three prefectures through a separately listed subsidiary, our thesis is that Secom will buy in Secom Joshinetsu. Management of Secom Joshinetsu have been receptive to our suggestions and seem cognisant of the governance issues. With a new President at Secom and some nudging from minority shareholders at Secom Joshinetsu, we think this process can be hastened.

A buyout multiple of 10x EV/EBIT would not be unreasonable for a business of Secom Joshinetsu's quality - implying 62% upside to the share price at the end of December.

Notwithstanding the optionality from a buyout, it is perplexing that for a business that proved its resilience during one of the most difficult trading periods in the past decade, its share price fell by -8%. Secom Joshinetsu ended 2020 on a derisory 1.3x EV/EBIT multiple with net cash covering 83% of its market cap. Considering this and the buy-out potential, Secom Joshinetsu presents one of the most compelling risk adjusted opportunities in our portfolio.

Outlook

At the time of writing, two quarters of earnings have been reported since the worst of the COVID-related disruptions. 19 of our 27 companies have shown not only a recovery in profits but have reported year-on-year growth. However, the rosier picture has not yet been reflected in the share prices of our companies. On top of that, we are confident that shareholder engagement activity that was delayed by COVID will return with rigour at the upcoming AGM season - indeed, we are preparing our own shareholder proposals for a number of companies. All this taken together reinforces our conviction in the potential upside of the portfolio.

Joe Bauernfreund

Asset Value Investors Limited

Top 10 investments*

1. Fujitec (8.1% of portfolio, 12.3x EV/EBIT)

A leading manufacturer of lifts and escalators with a global presence. It trades at a significant discount compared to global peers due to weak margins outside of Japan and a lower ROE exacerbated by a large cash pile on its balance sheet. In May we launched a public campaign highlighting Fujitec's underperformance and undervaluation. Management have started to address a number of these issues and we believe there is considerable upside from an improving margin and higher valuation.

2. Pasona (6.3% of portfolio, <0 EV/EBIT)

A staffing company providing dispatch workers and recruitment services throughout Japan. Pasona has a 51% stake in Benefit One, a provider of welfare agency services. Benefit One has grown rapidly in recent years and Pasona's stake in the company is worth 287% of its market cap. The listed subsidiary phenomenon is a problem particularly acute in Japan and one we have paid close attention to as it comes under increasing scrutiny and pressure.

3. DTS (6.1% of portfolio, 5.6x EV/EBIT)

DTS provides a variety of IT-related services to Japanese corporations. It is expanding its business in "DX-related" fields such as cloud, robotics and IoT ("Internet of Things"). Japanese companies have underinvested in their IT infrastructure, with antiquated processes and complex legacy systems. With support from the Japanese government to digitalise processes we believe companies will dramatically increase their IT expenditure - much to the benefit of DTS.

4. SK Kaken (6.0% of portfolio, 1.2x EV/EBIT)

SK Kaken specialises in industrial paints, commanding more than 50% domestic market share. It is a stable business with consistent earnings and margins but a low payout ratio has led to cash ballooning on the balance sheet. This capital inefficiency masks an otherwise high-quality business, that trades on an EV/EBIT multiple of only 1.2x.

5. Konishi (5.5% of portfolio, 6.3x EV/EBIT)

Konishi has two main business lines, household sealant products and a civil engineering business. Its core sealant business has a leading market share in multiple product lines in Japan with strong brand loyalty, while its civil engineering business is a beneficiary of increasing repair work due to Japan's ageing infrastructure. This year management increased the dividend payout ratio, bought back shares and started to disclose financials in English.

6. Secom Joshinetsu (5.4% of portfolio, 1.3x EV/EBIT)

Secom Joshinetsu, a regional subsidiary of Secom, is an example of the problems of parent-subsidiary listings in Japan. It operates in Niigata, Gunma, and Nagano prefectures providing security services. Despite having similar business characteristics to its parent, Secom, Secom Joshinetsu trades at a severe discount and an EV/EBIT multiple of only 1.3x. Ultimately, we believe Secom Joshinetsu will be taken private by Secom.

7. Digital Garage (5.4% of portfolio, 11.5x EV/EBIT)

Its three main business interests are in: card payment processing, online marketing, and venture investments. Digital Garage has a good track record of incubating young tech businesses in Japan and being at the front of digital innovation. It also has a large stake in the online price comparison site Kakaku.com. Its complex holding structure leads to a large discount as investors overlook the value in its growing payments business.

8. Teikoku Sen-i (5.2% of portfolio, 5.3x EV/EBIT)

Founded as a textile company, Teikoku Sen-i's main business now is in manufacturing disaster prevention equipment. It has a strong track record of growth with high operating margins. We submitted shareholder proposals to Teikoku Sen-i's March AGM highlighting its excessive cash. Encouragingly, management have undertaken a large capital investment program to build a new factory and expand production, using their cash more productively.

9. C Uyemura (4.9% of portfolio, 4.4x EV/EBIT)

C Uyemura produces plating and surface finishing related chemicals for electronic circuit boards. Although it has a long history of developing and manufacturing high-quality products, several years of hoarding cash have unfairly depressed its valuation. Its business should be a beneficiary of strong trends in the increased adoption of electric vehicles, 5G-enabled devices and the Internet of Things.

10.Daiwa Industries (4.8% of portfolio, <0 EV/EBIT)

Daiwa Industries manufactures commercial kitchen equipment, centred around refrigeration units, although it has been successfully expanding into other product lines. The business benefitted from increased tourism and restaurant expenditure, although a low-payout ratio saw cash build on the balance sheet, depressing its valuation. Remarkably, Daiwa Industries trades with net cash covering 103% of its market cap.

Portfolio Construction

The objective of AVI's portfolio construction is to create a concentrated position of about 20-30 holdings, facilitating a clear monitoring process of the entire portfolio. AVI picks stocks that meet our investment criteria and once we decide to invest a minimum position size of approximately 2% of the portfolio is initiated. In determining position sizes, AVI is mindful of liquidity and the likely timing of any catalysts to unlock value. A key consideration is the make-up of the shareholder register, a proxy for how receptive management might be to our suggestions. The portfolio is diverse in the industries within it but we are sector agnostic and select investments based on quality and value.

Portfolio Value by Sector

Equity Portfolio Value by Market Capitalisation