As market analysts and advisers wheel out their predictions for the year ahead, one area seems to be getting wide approval - Japanese equities. This may seem surprising as the country constantly attracts attention for its economic problems. Most recently this has been because it has slipped back into recession despite two years of 'Abenomics' - Prime minister Shinzo Abe's pro-growth, pro-inflation economic policy, which he described as the three arrows of fiscal, monetary and reform measures. But if you are investing in an equity fund it is important to remember that you are buying into private companies rather than directly into the economy itself.
"Despite lacklustre gross domestic product (GDP), Japanese corporate profits have been quite strong in the past 10 years," argues John Vail, chief global strategist at Nikko Asset Management. "Indeed, in the last two quarters of this supposed recession, Japanese corporate profits have surprised sharply to the upside and grew about 10 per cent year on year - hardly an indication of crisis. Of course, the weaker Yen played some role in this, but service sector profits, including among banks, also surprised to the upside."
Data from Mitsubishi shows that, in the first half of the fiscal year, sales grew by 5 per cent and recurring profits by 11.2 per cent (ex-financials), and in aggregate companies had reached almost 52 per cent of their full-year profit forecasts.
"Given this robust performance through a tough six months, companies' full year forecasts for sales and recurring profit growth of 3.6 per cent and 4.6 per cent continue to look conservative," says Paul Chesson, head of Japanese equities at Invesco Perpetual. "With the central bank and the government both focused on supporting growth in the economy, coupled with resilient corporate earnings, we remain positive on the outlook for the Japanese equity market."
The consumption tax hike from 5 per cent to 8 per cent in April caused a sharp decline in consumer activity, so the government has delayed the planned increase to 10 per cent, scheduled for 2015, to April 2017. "The recent expansion of an already massive quantitative easing programme and the delay of the sales tax hike should provide a major boost to the Japanese market," says Tom Stevenson, investment director at Fidelity Personal Investing.
There are also a number of positive reasons why advisers and analysts like Japanese equities.
"The case for Japanese equities is simple: most other developed markets look fully valued by comparison," says Darius McDermott, managing director at broker Chelsea. "Japan is an exception: shares trade at a 1.3 price to book ratio, less than half that of US stocks. The stocks are cheap relative to their own history. Japan's stock market currently has a price-earnings ratio that is only 37 per cent of its 10-year historical average. The unprecedented flow of quantitative easing is also a tailwind for the Land of the Rising Sun."
The weak Yen should help export-orientated companies, while domestic stocks should receive a strong boost from a change in investment policy at Japan's Government Pension Investment Fund, which is to increase its allocation to Japanese equities to 25 per cent from a current target of 12 per cent. Due to its massive size - more than ¥1 trillion - this increase could be significant.
This year saw the launch of a new index, the Nikkei 400, and criteria for admission include having the highest three-year return on equity (RoE) record. So some investors are hopeful that Japanese companies will try to improve this and their behaviour towards shareholders, as it is now regarded as a badge of honour to be included in this index.
There have already been relatively high levels of share buy-backs this year and dividend payouts have also been robust. Standard Life Investments says that growing management focus on RoE and plans to cut corporation tax are supportive of Japanese equities, and it maintains a 'heavy' asset allocation stance towards these.
"It has taken a long time, but Japanese companies have recovered their balance sheets and capital expenditure is on an upward trend," adds Chisako Hardie, manager of AXA Framlington Japan Fund (GB0003500179). "Although usually seen as cyclical, the trend could last longer, considering the fact that companies procrastinated over capital expenditure for a long time."
Along with longer-term trends such as the detailed publication of voting at Japanese annual general meetings, there has also been much more emphasis on the appointment of independent external directors to boards, increasing dividends and a greater exposition by the authorities about the need for all companies to make more in profits than their capital costs, according to Sarah Whitely, manager of IC Top 100 Fund Baillie Giffford Japan Trust (BGFD).
"Beyond the large international Japanese businesses, there are numerous under-researched companies, many of which exhibit the rare combination of decent growth characteristics and low valuations," adds David Jane, fund manager on the Miton multi-asset team. "Additionally, Japan retains its world-class competitive advantage in technological expertise and innovation."
And economically there are some positive signs, too: tourist spending is picking up ahead of the 2020 Olympics and Japan is a net importer of energy so should benefit from lower oil prices, if this continues.
Read more on the fundamentals for Japan
Risks
Despite the positive market outlook there are still a number of headwinds facing Japan. Public debt to GDP is still around 230 per cent and the Japanese economy contracted at an annualised rate of 1.9 per cent in the third quarter, with the country recently falling back into recession.
"Near-term investor sentiment and economic momentum have improved," says Michael Stanes, investment director at Heartwood Investment Management. "These accomplishments have been achieved through a unilateral strategy of yen weakness, but this tactic alone won't be enough to improve the longer-term growth rate. Essentially, Japan needs to revive domestic demand. However, that remains contingent on implementing significant structural reform, part of Prime Minister Abe's third arrow framework."
This will depend on Mr Abe winning an election scheduled for 14 December, although opinion polls at time of writing have indicated he will.
Not raising the sales tax will help consumers in the very short term, but will do little for growth further out, according to Mark McFarlandon at private bank Coutts, which also highlights slow progress with Prime Minister Abe's reform programme.
Japan's working-age population is falling by about 1 million every year whereas the retired population is growing.
Japanese companies might lose their motivation to improve their RoE despite the creation of the Nikkei 400 Index.
David Coombs, head of multi-asset investments at Rathbone Unit Trust Management, says they remain overweight Japan equities, but this is driven by valuations rather than the country's fundamentals. "The political situation looks less stable and the economy is creeping back into recession," he says. "Ultimately, this means a murky visibility of earnings. We are sticking with Japan for now, but will not hesitate to reverse our decision if earnings start to deteriorate."
Funds
A major dent in UK investors' returns from Japan has been the strength of Yen against Sterling, and the impact of more quantitative easing will be further Yen weakening, according to James Dowey, chief economist at asset manager Neptune. Since January 2013 it has been far better to be hedged than unhedged in Japan, as we reported recently, and wealth managers such as Tilney Bestinvest are advising that investors in Japan funds stick to currency-hedged share classes of Japan funds.
Exchange traded funds such as iShares MSCI Japan GBP Hedged UCITS ETF (IJPH) and IC Top 50 ETF db X-trackers MSCI Japan Index UCITS ETF (DR) GBP Hedged (XMJG) have done much better in 2013 and to 31 October 2014 than their unhedged versions.
Mr Coombs argues that, as the boundaries between long-term structural problems and more cyclical ones may become confused in Japan, experienced stock-pickers are crucial. So if you agree and want an active fund we count GLG Japan Core Alpha (IE00B665M716), which offers a hedged share class, among our IC Top 100 Funds. This has performed more strongly than its unhedged version.
Read our latest update on GLG Japan CoreAlpha
We also recently tipped Aberdeen Japan Investment Trust (AJIT), which has a partial currency hedge - currently just under half its net assets are hedged through forward contracts.
The trust's manager and board set the levels of the hedge periodically to reflect the perceived net exposure to yen risk not already mitigated by the proportion of revenues and earnings derived from outside Japan by its portfolio holdings. Since it changed its investment strategy to do this just over a year ago it has done well, and it is the top performing trust among its sector peers over one year.
