Has corporate call become a catalyst for change in Japan? There’s more to Japan than investors are giving the market credit for, suggests Darius McDermott, managing director, FundCalibre
Even when things are looking attractive Japan polarises opinion. It’s hard for people to forget this is a part of the world that has been out of favour for decades amid concerns over economic growth, corporate governance, and poor demographics. The result is an area which is under-owned by investors and under-researched by analysts.
There is an argument Japan has been steadily recovering for the past decade. You can date it back to when the late Shinzo Abe introduced “Abenomics” – his three “arrow” policy designed to break Japan’s long-standing deflationary cycle. The arrows are made up of quantitative easing, fiscal stimulus, and structural reforms. In a nutshell, companies were encouraged to make profits.
It’s been anything but a straight line in terms of a turnaround, and many would argue we have yet to see one! But I could make a case that foreign investors have missed a trick. In the past decade the market recorded a compound annual growth rate (CAGR) in earnings of around 12-13 per cent in local currency terms, even outperforming the S&P 500 index*. Yet surprisingly the P/E of Japanese companies fell in this period, a reflection of this poor sentiment*.
This brings us nicely on to today – Japan has been one of the leading performers thus far in 2023. The major equity indices, the Topix and the Nikkei 225, both hit their highest levels since 1989 in May this year**. The pessimists will be telling you “Another false dawn, don’t believe the hype” but there are some recent changes which may suggest things are improving for the longer-term.
Further corporate improvements lead change in outlook
The biggest drivers behind the recent performance are both structural and cyclical. The first is the Tokyo Stock Exchange (TSE)’s call earlier this year for companies to focus on achieving sustainable growth and enhancing corporate value. As part of its proposals, the TSE would, “require that management and the board of directors properly identify the company’s cost of capital and capital efficiency,***” especially for companies that have consistently traded below a price-to-book ratio of one (for clarity that is over 50 per cent of companies in the Topix)**.
The move is designed to put further pressure on Japanese management teams to address issues of capital inefficiency. One of the main reasons for these low P/B ratios is cash in reserve. According to Nikkei, reserves of listed companies, excluding financial institutions, had accumulated to about 100 trillion yen by the end of 2022****. Investors will be enticed by the idea of getting part of those reserves, while other portions will be directed towards initiatives such as investment in R&D (research & development) and human capital – both of which are designed to assist in sustainable growth, investment and restructuring of companies.
As a recent note by JP Morgan points out, weaker corporate governance has arguably been the single biggest reason for the persistent discount in Japanese equities. It states: “The trend of improving corporate governance could be a major driver of returns. Japanese companies have made notable progress returning cash to shareholders: combining dividends and buybacks, Japanese equities were yielding 3.7 per cent toward the end of 2022^.” Expect further inroads on this as a result of the TSE move.
The cyclical aspect is Japan has been late to re-open following the Covid pandemic, having only opened its borders in October 2022. There is plenty of scope for this to help service and consumption sectors from here, with consumption still yet to return to normal. According to the Japan National Tourism Organisation, the number of foreign visitors has only recovered to 66 per cent of 2019’s level, and Chinese tourists, previously the biggest growth engine of inbound consumption, are still down by 89 per cent compared with pre-Covid^^ – remember China was also late to reopen.
Digital transformation (DX) is also taking place at pace. This involves adapting processes and customer experiences via digital technologies to meet changing business needs. FSSA Japan Focus manager Sophia Li says awareness of DX has increased and the pace of investment should accelerate, making it one of the biggest secular drivers in Japan in the next 5-10 years – citing figures from International Data Corporation (IDC) which show the sector is expected to grow around 30 per cent^^.
Unlike other parts of the world – mild inflation is welcome in Japan following years of deflation and low growth, particularly as it gives companies the confidence to invest longer-term. Valuations also look attractive – as recently as March the Japanese equity market was trading at 12x earnings and 1.1x book value, which is close to the trough^.
Challenges remain, but big opportunities for active managers
Clearly, long-term concerns remain. Demographics are always a hard trend to overcome – as is the fact Japan has little immigration. Pessimists would also say that while the currency is cheap it’s hard to see it performing particularly well long term, given the massive government debt levels and a shrinking tax base.
But I would say you are being more than compensated for taking those risks. As I mentioned, Japan is vastly under researched, with figures from JP Morgan showing that about 50 per cent of the listed companies in Japan have sell-side coverage at all vs. 99% of the S&P 500^.
M&G Japan fund manager Carl Vine believes Japan could plausibly generate mid-teen compound total return in the next 5-10 years. He says prior double-digit earnings growth across the market was achieved without the complete institutional framework, which it now is.
He says: “This is why we believe there is still a lot more earnings growth to come. There is an abundance of low-hanging fruit to be picked, in our opinion – cross-shareholdings to be sold; too much cash on balance sheets; headquarter buildings that can be sold and leased back; and scope for productivity/margin improvement.”*
To me Japan is slowly overcoming a number of significant challenges to its economy. This, coupled with recent changes, give rise to greater potential for long-term growth for patient investors.
Funds to consider
Baillie Gifford Japanese
Matthew Brett has been on the management of this fund for more than 10 years and took the lead role in 2018. The largest portion of the fund is invested in secular growth, but the fund also has a portion invested in special situations and more cyclical growth. The fund also has a very strong bias to mid-caps.
AXA Framlington Japan
AXA Framlington Japan invests in Japanese companies of varying sizes but tends to have a slight bias towards smaller companies. The managers look for firms with long-term growth prospects which are independent of short-term news flow or what is going on in the wider economy. The portfolio usually contains around 100 holdings which limits the impact of any one stock on the portfolio.
FSSA Japan Focus
FSSA Japan Focus is a high conviction fund investing predominantly in large and medium-sized Japanese companies, with a heavy emphasis on quality. The team has regular discussions on potential new secular themes and new ideas are generated through more than 300 company meetings a year. Companies which are deemed good enough make it onto the fund’s watchlist which has around 120 companies.*Source: M&G: The Japan opportunity, period ten years to January 2023
**Source: Schroders: Japanese shares have hit 33-year highs – but why?, May 2023
***Source: Lazard Market Outlook Japan – Q2, 2023
****Source: Columbia Threadneedle – Japanese equities enjoy a surge in inflows
^Source: JP Morgan – Investing in Japan: Uncovering the opportunity in unloved Japanese equities
^^Source: FSSA -Japan equities: Renewed optimism after visiting companies – May 2023
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.
