The signs have been looking good for Japan but can this positive trend keep going? Darius McDermott, managing director FundCalibre and Chelsea Financial Services, considers the landscape and where the opportunities for investors might lie going forward.
The first quarter of 2024 could well be the moment where hope turned into reality for those who have backed Japanese equities through the many false dawns of the past three decades.
Not only did the Nikkei 225 finally burst the previous high of 1989, but this news was quickly topped by Japan becoming the world’s last country to end its negative interest rate policy. Baillie Gifford Japanese manager Matthew Brett says the final trigger appeared to be unionised wage negotiations, which have resulted in the highest pay packet increase in 33 years of over 5 per cent*.
He says: “It is a potentially trendsetting level in the world’s only country where wage growth had effectively stopped for 30 years! This was considered a prerequisite to achieving the Bank of Japan’s 2 per cent target of domestic demand-led inflation.”
There is an argument Japan has been steadily recovering for the past decade, but 2023 seems to have been the year that investors started to take notice, with improvements to corporate governance and the ongoing shift to inflation from deflation.
The corporate governance improvements have centred around the Tokyo Stock Exchange’s (TSE) policy to push companies to focus on cost-of-capital management and capital efficiency in order to improve their value. The TSE’s ultimate objective is to encourage active dialogue between Japanese corporates and shareholders in order to improve corporate governance, returns on equity, and valuations.
As discussed, we’ve also seen inflation take hold after years of deflation. The impact of this is palpable because for the past three decades households and corporations alike have shown little appetite to consume or invest – with a low-risk attitude amid this deflationary cycle.
Since the beginning of last year, Japanese equities are now up some 23 per cent**. Warnings would typically be attached following such a period, but with a current PE multiple of around 15x***, the market does not look particularly expensive versus history or other markets, especially with interest rates so high.
I’ll put this into context, Japanese equities traded on a PE north of 50x*** during the bubble period. Japan also comfortably remains one of the major laggards in global markets since 1989 – with the S&P 500 and Euro Stoxx 50 up 1,334 per cent and 342 per cent respectively in that time****.
Scope for further gains
There are also plenty of reasons to believe this revival is sustainable. Firstly, the corporate governance changes were only the initial step. In October 2023, the TSE announced plans to publish a list of companies disclosing their capital improvement plans.
Lazard says while its focus has initially been on companies trading with a price-to-book ratio of less than one, the TSE is now urging even higher valuation companies to pay closer attention to their cost of capital and improve their valuations. Japanese company relationships with their listed subsidiaries – which have raised concerns about subsidiary independence and potential conflicts of interest – have also been targeted. The offshoot has been a steady uptick in share buy backs as a way to improve balance sheet efficiency^.
The other benefit for fund managers has been an increase in management buyouts, effectively taking companies private to avoid facing those higher standards. Names like drug maker Taisho Pharmaceutical and temporary staffing company Outsourcing are two such examples. These buyouts have typically come at a premium.
We’ve already touched upon demand-led inflation – triggered by wage hikes – allowing quality companies to increase prices and margins. A recent research note from Fidelity states that a “sustained improvement in returns on equity (RoE) would support a higher price-to-book (PB) multiple, and the economic trend towards moderate inflation supports higher earnings-based valuations.***”
Investors have remained noticeably underweight Japanese equities for a number of years (it currently accounts for 6.1 per cent of the MSCI World Index^^). In fact, international investors have only just started returning to Japan, with around $10bn of inflows between 2020-2024, this contrasts with $80bn of outflows between 2016-2019. It’s also worth noting the re-shoring efforts in Japan and the potential for the region to be an alternative to China amid its troubled slowdown.
There are reasons for caution. Schroders acknowledges the strong performance in the region has been heavily attributable to large-caps. The firm says while they may have ample liquidity, valuations of some larger companies in the Nikkei 225 have become stretched^^^. There are also some who would query whether the performance of Japanese equities has been slightly shrouded by the weaker yen, a strengthening of which could see it pull back from here.
Politics will always play a role and inflation concerns have seen Prime Minister Fumio Kishida’s approval rating fall to a level that has led to his two predecessors resigning; while long-standing concerns, like poor demographics still remain prevalent.
There is a belief that the sweetspot for Japanese equities could now sit in the small-cap market. Brett says Japanese small-caps now offer two appealing characteristics. He says: “They have been overlooked and ignored by the flood of foreign money coming into the country, they are now priced at little to no premium to the market. Furthermore, many benefit from structural tailwinds which are accelerating on the back of demographics and wage inflation.*”
Japan’s recovery has taken time, but many will say this is because the small steps started by Abenomics over the past decade have given them a greater chance of a sustainable recovery. Only time will tell, but the broadness of the recovery – coupled with the underlying themes and relatively attractive PEs – suggest there is scope for further long-term gains.
Three funds to consider
M&G Japan: Multi-cap approach
The team’s differentiated stock-picking approach aims to identify a large, exploitable gap between the price the market ascribes to a stock and its own estimated value of that stock, based on proprietary research. The fund has a slight value bias, with the final portfolio consisting of around 50 stocks.
Comgest Growth Japan: High conviction
This is a concentrated portfolio of only 30-40 high quality long-term growth companies. The team believes that markets fail to correctly price a company’s sustainable competitive advantage, which should help it generate above average earnings growth. To find these companies, the managers look for six factors to determine quality. These are the business model, financial criteria, organic growth, barriers to entry, sustainability of the business and quality of management.
Baillie Gifford Japanese Income Growth: Growing income
This fund aims to benefit from the improving corporate governance in Japan, as more and more businesses move towards a progressive dividend-paying policy. The fund is reasonably concentrated at 45-65 holdings, and will have a natural mid-cap bias. As the team has a total return mindset, rather than a pure income-seeking mandate, it does differentiate this fund and the stocks it will buy.
*Source: Baillie Gifford, April 2024
**Source: FE Analytics, figures in pounds sterling, 30 December 2022 to 4 April 2024
***Source: Fidelity, figures at 23 February 2024
****Source: JPMorgan, February 2024
^Source: Lazard Asset Management, April 2024
^^Source: MSCI index factsheet, 29 March 2024
^^^Source: Schroders, March 2024
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius’s views are his own and do not constitute financial advice.
