In a previous article, Quality Investing in Japanese Small-Caps, we introduced the use of Return on Net Required Operating Capital, or RORC, as a useful measure to uncover a universe of what we believe are cheap, quality businesses overlooked by investors that rely more on traditional metrics like Return on Invested Capital (ROIC). A variant of ROIC, RORC is defined as operating profits divided by operating capital. (Operating capital is the sum of net working capital and net fixed assets, excluding both cash and intangibles.) We use RORC because it compares a company’s operating profits against its operating capital, making it a better measure of the quality of business activity in isolation in our view.

We argued that this is particularly relevant when sourcing small-cap ideas in Japan, where companies are coming out of an era of deflation and economic stagnation with overcapitalized balance sheets. Strong balance sheets can mask the underlying quality of the business, resulting in valuation discounts. In this article, we introduce Zuken as an example from our current holdings in Royce International Premier Fund to illustrate how we try to identify undervalued quality businesses in Japan.

Zuken is a Japanese software vendor that designs and sells Electronic Design Automation (EDA) software. R&D and product engineers at more than 30,000 companies use Zuken’s software to design complex electrical components like PCBs, which serve as the “inner computing brain” of products ranging from automotive to industrial equipment. We are attracted to Zuken’s EDA software business because the software’s deep integration into the workflows of Zuken’s customers creates high switching costs that translate into high barriers to entry. Zuken’s EDA tools are often implemented across the customers’ supply-chains, making it extremely cumbersome to switch to an alternative vendor. The sticky relationships enable the company to maintain excellent pricing power and generate a predictably stable revenue stream, allowing it to build a strong market position over time. Today, Zuken enjoys a 65% market share in the domestic PCB design market and is one of the leading vendors within a global oligopoly.

We first purchased shares during 2022, when its RORC was trending north of 50%, but its return on invested capital (ROIC) was still in the mid-single digits. Although Zuken was perceived by other investors to be hoarding an excessive amount of cash, we recognized that its absolute cash position needed to be built up in order for the company to participate in attractive M&A deals. Following discussions with Zuken’s management, we became convinced that its capital allocation policy would have a realistic likelihood of closing the gap between high RORC and low ROIC over time. We felt that closing this gap would in turn create a significant reappraisal of its market value as more investors began to gradually recognize the potential ROIC Zuken’s underlying business could generate.

The Growth of Zuken’s Return on Net Required Operating Capital
2014-2024

Source: Bloomberg

While we believe that Zuken has significant scope to improve its ROIC, we are already seeing signs of improvement. The company conducted its first buyback in more than 10 years in 2023 and recently followed up with another buyback after its stock had temporarily fallen. Meanwhile, Zuken is currently generating synergies from its 2019 acquisition of Vitech, a U.S. software vendor that makes value-added engineering design software that can be upsold to Zuken’s existing customers. These measures, along with accelerating revenue growth, are driving invested capital turnover towards record levels, helping push up ROIC. We purchased our first shares at a forward capitalization rate of more than 20%. The shares have since re-rated to around a 10% earnings yield as of this writing—but still at a marked discount compared to global peers like Synopsys, which recently traded at a roughly 3% earnings yield.

The Historical Trend in Zuken’s Net Profit Margin and Invested Capital Turnover
2014-2024

Source: Bloomberg

The Historical Trend in Zuken’s Return on Invested Capital
2014-2024

Source: Bloomberg

Admittedly, identifying Zuken required that we navigate the nuances of Japanese capital allocation practices. One way to overcome this challenge is by identifying ‘kikikan,’ a Japanese term for a sense of threat, as too many Japanese companies are sheltered by domestic barriers that keep foreign competition out. In the case of Zuken, we understood from our due diligence research that the company had attracted several takeout offers, which we believe instilled a sense of urgency in its management team to address its low market valuation. As interest rates normalize and inflation returns in Japan, we suspect that more management teams will rediscover ‘kikikan’ and improve the efficient use of their balance sheets.

We want to make one final observation on the changes we see in Japan: while the country as a whole continues to lag the European and U.S. markets when measured by better known metrics like return on equity (ROE), we are seeing significant changes in the quality of the underlying business models when measured in RORC. Over the past 10 years, our investment universe has grown by 60% when screening for RORC. Meanwhile, although the absolute number remains small, the number of Japanese companies consistently generating ROIC at or above 20% has grown by 200%. Both trends illustrate to us that not only are the companies’ underlying business qualities improving, but the management teams are also beginning to understand the importance of using capital efficiently to generate profits. Underneath the hood, we are genuinely excited about the number of high-quality companies we have been finding in Japan.

A Decade of Change in How We See Japan’s Small-Cap Universe
A Comparison of Japan’s High RORC and High ROIC Universes, 2014 and 2024

Source: Bloomberg. The screening criteria are (1) market cap between $100 million to $10 billion, (2) profitable in the past five fiscal years, (3) 'High RORC' = Five-Year Geometric Mean Return on Net Operating Capital equal to or higher than 20%, (4) 'High ROIC' = Five-Year Geometric Mean Return on Invested Capital equal to or higher than 20%.

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