Morningstar: Martin Currie Japan Fund

Ash Kumar, analyst at Morningstar: We welcome the recent upturn but sustainability is needed to make this a strong choice.

After taking the reins from veteran manager Michael Thomas in mid 2006, current manager John Millar got off to a rough start, with the fund underperforming 85% of its Morningstar Japan Large-Cap Equity peers in 2007. To his credit, Millar has taken steps to address the issue, the main thrust of which was to initiate a change to the research methodology and screening tools.
The fixes led to the introduction of a quantitative tool to filter the Topix Index and formalised the team's approach to examining operating profit margins. They now have a more systematic way to detect improvements or deterioration in margin trends. Millar believes margin analysis is particularly relevant with manufacturing firms, which account for a large proportion of the index. He thinks it is vital to consider when earnings are sensitive to capacity utilization and that the market consistently underestimates operational leverage. That said, he admits the approach does not work equally well in all sectors and alternative research tools are at his disposal to analyse areas such as petrochemicals.

Millar's review also led the team to give up their generalist mode of research in favour of a specialist style, to help execute the process more efficiently. We think this will render greater accountability to the squad and he has also improved their working relationship with the firm's global analytical resource; he thinks investors ought to consider both overseas and local competition when making price comparisons among firms. The rest of the qualitative analysis conducted by the team has remained unchanged. So, when a positive change in operating margins is identified, the team then evaluates whether the firm is well run, produces strong top-line earnings and cash flow growth and trades at a reasonable price. Valuation tools they use include PE/PB/PCF ratios and discounted cash flows to stress test earnings.

The portfolio resulting from this process favoured, as at Dec 2008, domestic plays as the global economic slowdown meant bad news for export-orientated firms' margins. That helped the fund's annual return, which landed just outside the category's top quartile, but performance since Millar assumed sole charge in July 2006 lags both the Morningstar category and benchmark index.

While we acknowledge the recent strong results, it is too short term for us to draw any meaningful conclusions and its sustainability could be hindered by a few factors. We think some of this team's good work is being undone by the inordinately high portfolio turnover, which is 252% over 12 months to September 2008. At 1.7%, the fund's TER is already on the high side and trading costs (which are not included in the TER) from so much turnover can be significant. We think the fund is moving in the right direction and we think highly of Martin Currie in general, but this can't yet be counted among the category's best.

Strategy

The "root and branch" review instigated in 2007 led to the introduction of a proprietary operating profit margin analysis and sector screening tool, which is used to filter the Topix Index. This is in addition to the minimum liquidity ($2m average daily turnover) and market-cap ($430m) limits and the DSM quant model used companywide to filter the investable universe. The margin screen divides the index into 15 super sectors and pulls down consensus estimates, price changes and earnings upgrades and downgrades as well as several valuation measures to identify stocks worthy of further investigation. It uses improving or deteriorating margins data to detect either a positive or negative change in trends. The team then targets companies which are run by a well-incentivised management and show strong growth in top line, earnings and cash flows but trading at a reasonable price. Valuation tools include price-to-book, price-to-value and price-to-earnings ratios as well as discounted cash flows to stress test earnings. Company meetings are crucial to the process and the team meets or talks to nearly 1000 firms annually. Portfolio turnover has been high, which is a source of concern.

Management

In terms of sheer numbers and experience at the top-end, this Edinburgh-based team stacks up well, but it has experienced some disruption in the past few years. Most notably, veteran manager Michael Thomas stepped down in mid-2006. Millar did hire additional resources for the squad in 2007 following the manager's decision to adopt a specialist mode of research. Whie we view this as a positive, it can take time for a new team to gel: Claire Marwick, a DCF specialist, joined in August 2007 from UBS where she covered Hong Kong and other Asian equities; she covers machinery and materials. Eri McKenna, who started as a Japanese interpreter for this team, now covers retail services. Paul Danes replaced Kevin Troupe in September 2007 and he covers financials and telecommunications.

John Millar co-managed this fund with Thomas from April 2005 until July 2006 when Thomas retired, at which point Millar became lead manager. Millar joined Martin Currie in 2000 and has 16 years' experience, of which 14 are in Japanese equities. Keith Donaldson heads the six-strong team and the senior members (Millar, Donaldson and John-Paul Temperley) are experienced and have worked together at Martin Currie for over eight years. This team is further supported up by the firm's global analytical resource.