To many investors the recent rally in Japanese markets looks like nothing more than one of the many so called false dawns Japan has experienced over the past couple of decades. Japan funds have experienced tremendous growth since late last year as markets rallied following the election of a new government which is implementing reforms to boost the economy. However, over the past few weeks Japanese markets have tumbled.
But before you initiate a sell trade on your Japan holdings, maybe you should consider the bullish outlook of a number of advisers and professional investors.
"Don't panic sell," says Jason Hollands, managing director at wealth adviser Bestinvest. "In fact, you might consider topping up your holding. Japanese equities have sold off in recent weeks after a stellar run when arguably they were looking overbought. In large part this was down to selling by domestic institutions, which reflects profit-taking by otherwise very risk-averse funds. At these levels, valuations of around 13 times forecast earnings look cheap compared with where they have historically traded and, importantly, there are tangible signs that Japan's 'shock and awe' therapy to kick-start the economy is having a positive recovery effect."
This is similar to the view of Gary Dugan, chief investment officer at private bank Coutts. "We remain overweight on Japanese equities and see the corrections as buying opportunities," he says. "We still see the Japanese equity market as attractive relative to other developed markets."
Simon Somerville, manager of Jupiter Japan Income Fund (GB00B0HZR397), believes the Japanese market looks undervalued and adds: "As the economic policies begin to work and we see inflation emerge in Japan and domestic economic growth pick up, then earnings will rise substantially. I expect corporate earnings to rise sharply this financial year to March 2014 on the back of a better domestic economy and significant benefits from the weaker yen. Japan's leading securities company, Nomura, has predicted the average earnings for companies listed in the first section of the Tokyo Stock Exchange to rise by 66 per cent in this financial year, assuming a yen per US dollar rate of ¥100."
Alex Treves, head of Japan equities at Fidelity, says that Japanese earnings per share (EPS) growth is currently leading the world. "Moreover, the average PE [ratio] for Japan equity is now cheaper than for US equity, in marked contrast with the past decade," he says. "Price-to-book measures are cheaper than those found in many other markets and dividend yield is the same as the US - with real dividend yield even better."
Valuation comparison
| 2013 Earnings per share (EPS) growth (%) | 2014 EPS growth (%) | 2013 price-earnings ratio (PER) | 2014 PER | 2013 price to book ratio (PBR) | 2008 PBR | |
| Japan | 68 | 18 | 13.7 | 11.6 | 1.24 | 0.86 |
| US | 11 | 8 | 15.1 | 14.1 | 2.41 | 1.52 |
| Europe | 9 | 12 | 13.8 | 12.3 | 1.92 | 1.01 |
| Asia ex Japan | 12 | 15 | 12.4 | 11.2 | 1.56 | 1.23 |
Source: Fidelity, Toyo Keizai & GS Global ECS Research
Meanwhile, GDP growth is estimated to be running at an annualised rate of 4.2 per cent, underpinned by increased consumer spending and exports that have risen on a materially more competitive exchange rate. New nuclear plant safety rules have been agreed this week, paving the way for the reopening of facilities which should reduce energy costs for business. "The prime minister's domestic popularity is high and we therefore expect his government to get a boost in next month's Upper House elections, which should strengthen his mandate for pushing ahead with reforms - for example, by paving the way for a cut in corporation tax," says Mr Hollands.
Government action to boost the economy should also create opportunities. "The primary beneficiaries of Abenomics lie in domestic sectors," says Nicholas Weindling, co manager of JPMorgan Japan Smaller Companies Trust (JPS). "The improved outlook for export companies thanks to the weaker yen will feed directly through to the domestic economy in the form of higher profits and, in turn, higher wages. Real estate companies will benefit as the improved economic outlook pushes down vacancy rates and drives up rents. Eventually, we expect wages to rise as the economy improves, which should in turn increase demand for discretionary goods. We also have investments in companies that will benefit from the new government's plan to increase public works spending."
"Japan is one of the largest developed equity markets globally and home to many leading international companies in industries such as motor such as Toyota and Mitsubishi manufacturing, of which there are none on the UK stock market," adds Mr Hollands. "There are also manufacturers of world-class consumer goods such as Sony, Panasonic and Nintendo."
Bears and risk
But not everyone is convinced.
"The potential volatility created by the introduction of aggressive policy stimulus was aptly demonstrated by this month's significant sell-off in the Japanese market," says Neil Veitch, fund manager of SVM World Equity Fund (GB00B0KXRB86). "Our recent decision to significantly underweight Japan will likely remain until we see greater signs of structural reform."
"Let's not forget that Abe was prime minister of Japan before and was an unmitigated disaster, or that while there is fiscal stimulus Japan has government debt of 240 per cent, the highest in the developed world," says Patrick Connolly, a certified financial planner at Chase de Vere. "Or that while a weak yen makes Japanese exporters more competitive, it increases import costs such as energy and raw materials and reduces returns for overseas equity investors."
Mr Somerville believes that the key risk remains prime minister Shinzo Abe. "If he becomes mired by constitutional reforms or if he has to step down for any reason, I think this will dramatically weaken Japan's recovery story," he says. "His policies might also encourage a raft of opportunist fundraising by companies that do not need to raise funds. We have already seen a small number of these. Fundraising could absorb any increase in demand for equities and hinder the progress of the stock market."
If growth falters Japan will be left with a large debt burden and a lack of wage growth to offset inflation, strangling consumer confidence. Exporters could suffer if yen weakness reverses.
And Max King, portfolio manager and strategist at Investec Asset Management, believes that while Japan offers a "noteworthy contrarian" opportunity to add value, short-term caution is warranted. "It is tempting to buy into the current setback," he says. "But tread carefully. A sustained bull market requires revenue and earnings growth beyond that handed to companies on a plate by a weak currency. More innovation, better returns on capital, higher dividend payout ratios and more investor-friendly behaviour by companies should be visible in due course, but we would welcome more evidence."
Given the volatility, Mr Hollands says drip-feeding rather than investing a lump sum is a sensible approach across most markets in the current environment. But Adrian Lowcock, senior investment manager at Hargreaves Lansdown, adds that although Japanese equities are an opportunity for long-term investors, they should allocate no more than 5 to 10 per cent of their portfolio to this market.
