Part 2: Niche industries can provide a favourable competitive landscape for sector leaders

Despite the perception that there is little or no growth in Japan, our core portfolio holdings in the FSSA Japan Equity Fund have been able to adapt and grow despite economic headwinds, and have delivered sustainable earnings growth and attractive shareholder returns.

Throughout this six-part series, we aim to address some of the most common investor concerns about Japan equities and highlight the opportunities for sustainable growth in this market.

In chapter two, we look at how niche industries can provide a favourable competitive landscape for sector leaders. 

While the potential for outsized profits and strong sales growth usually attracts new entrants to an industry, our observations from spending time in Japan and talking to company management teams suggest that the younger generation prefer to work at steady jobs in large corporations rather than take the risk of launching new businesses. Due to the low growth economy, Japanese society has perhaps become even more conservative and focused on stability than ever before.

Additionally, the size of Japan’s venture capital industry is tiny (less than 1% of China’s) and there is little support for fledgling young businesses. As a result, new companies must build a profitable business model almost immediately to generate cash flow and sustain growth levels. There is no “free money”, which reduces the incentive to burn cash in order to capture a share of the market.

Negligible entrepreneurship, particularly in sectors where the market size is small (and thus potential rewards are lower), along with an underdeveloped private capital market, means that in niche sectors with just one or two dominant companies, the leading franchises tend to maintain their market position as there are no significant rivals to compete with. This can lead to sustainably high returns for investors in those companies.

In our Japan portfolios, we own a few companies, such as Benefit One and S-Pool, that benefit from this kind of competitive landscape – we refer to them as the only fisherman in a vast blue ocean. Benefit One is Japan’s largest provider of corporate welfare services, a highly scalable, recurring revenue business. The company has few competitors and generates an extraordinary 70% return on invested capital.

While fringe benefits are typically only provided to permanent workers in large corporations, we expect small-to-medium sized companies (which employ 70% of Japanese workers) to increasingly start offering them as well – thus expanding the potential market size. Benefit One aims to become a “one-stop shop” solutions provider to increase its value to clients, bundling together business travel management and healthcare programs with its core fringe benefit services.

Benefit One’s operating profit has grown 10x over the past 15 years. We believe this could accelerate further, as the company enhances its information technology (IT) systems, digitalises its services, scales the business and improves margins and profitability. As an asset-light business, Benefit One does not need much capital to grow, while its already-large size and the “network effect” acts as a natural barrier to other entrants.

Another company that fits into this category is S-Pool, which provides special needs employment services. S-Pool stands for Solutions, Systems, Staff, Society and Sharing, which represents the company’s core beliefs and corporate philosophy. The company leases and manages farmland where its client’s disabled employees can cultivate vegetable crops. Alongside the philanthropic nature of the business, S-Pool generates a healthy 39% return on invested capital, thanks to high barriers to entry and a niche market with few competitors.

In Japan, the law stipulates that 2.2% of most companies’ overall headcount must be filled with persons with disabilities. However, there are several challenges to meeting this quota. While people with physical rather than mental disabilities are easier to place into jobs, around 35% are already employed – which means a relatively smaller pool of candidates. On the other hand, only 6% of people with learning or mental disabilities are employed, but there are relatively few roles that are suitable – and as much as 50% of those that find work end up leaving within the first year.

As such, out of 90,000 domestic companies that are subject to the Act of Employment Promotions of Persons with Disabilities, around 50% are non-compliant. S-Pool’s long track record in the special needs employment sector places it at the forefront in this niche area. Its unique farming model is built upon years of accumulated experience, resulting in increased employee motivation and an extremely high 93% retention rate. Around 30% of corporate clients are recurring, which attests to the high level of client satisfaction too.

Similar to Benefit One in the fringe benefits sector, S-Pool faces no major competitive threat for its special needs employment services. Demand is defensive and both local governments and blue-chip companies have benefitted from S-Pool’s expertise. S-Pool’s model proves that companies that provide social benefits for the betterment of society do not necessarily need subsidies – and could even be attractive to investors if executed well.

Look out for chapter three of this six part series, as we continue to dispel some of the most common myths and misconceptions.