Japan: all over again?

"The market was aided by so-called 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," explains Simon Somerville, manager of Jupiter Japan Income Fund (GB00B0HZR397). "The 2013 rally was mainly the result of yen weakness and the first two arrows, as the Abe administration implemented supplementary budgets to support the economy, while the Bank of Japan introduced a massive asset purchase programme in April 2013."

Consumption concerns

But this year investors have been concerned about the effect of a consumption tax rise from 5 to 8 per cent in April, and the failure of inflation to show a considerable increase, although it is now positive. They are concerned that Abenomics and the policies of the Bank of Japan are not working as well as they should. A recent survey by ING Investment Management of institutional investors found that only 9 per cent see Japanese equities as being the most attractive in terms of risk and return over the next six to 12 months.

Click here for The Trader Nicole Elliott's views on Japanese equities.

Click here for Chris Dillow's warning on how Europe is copying Japan's mistakes

However, a number of advisers and investors argue that you should still consider an allocation to Japan.

Valentijn van Nieuwenhuijzen, head of multi asset at ING Investment Management, warns that investors could be missing out because Japanese equities are currently attractive, and ING is overweight Japan.

"Japan remains attractive due to lowered expectations, high earnings growth, attractive valuations and investor positioning," says Mr Van Nieuwenhuijzen. "Japanese nominal gross domestic product (GDP) has embarked on an upward trend which should prove to be sustainable due to Bank of Japan policy, which at the same time should keep a lid on Japanese Government Bond yields. All of this is vital for sovereign debt sustainability and it will also help address the lack of sustainable wage growth."

Despite the increase in the sales tax the International Monetary Fund (IMF) is still predicting 1.6 per cent GDP growth for Japan over 2014, just below 1.7 per cent for US.

Russ Koesterich, global chief investment strategist at asset manager BlackRock, recently commented that while Japan is still facing several headwinds, much of the bad news is already reflected in market pricing. "So despite lingering economic headwinds, relatively cheap valuations have been attracting buyers, a trend we would expect to continue," he says.

"While it is not in what we would call bargain territory, investors buying in today are still doing so at below the long term average valuation on the market, and momentum is positive," adds Laith Khalaf, senior analyst at broker Hargreaves Lansdown. "Corporate earnings have been rising too, and our long term valuation analysis suggests Japan is actually still the cheapest developed market - even given the rises seen to date."

Valuation opportunity

Recently, Japanese equities have started to recover.

"Some of the easiest money has been made," admits Darius McDermott, managing director at discount broker Chelsea Financial Services. "But there is still a big opportunity in Japanese equities for reasons including their valuation. Japanese individuals are also under invested in equities and the new Japanese version of the individual savings account (Isa) should encourage them to put their money into these. This is not a short term boost, but could take effect over the medium-term."

Tim Gregory, head of global equities at Psigma Investment Management, argues that "Japan represents one of the best equity market investment opportunities available. We are not necessarily positive on a Japanese GDP recovery as Abenomics is a bit slow in coming, but Japanese equity valuations are very cheap relative to other markets and Japanese companies' balance sheets are generally strong."

Mr Gregory and a number of other investors are hopeful that Japanese companies will try to improve their return on equity (RoE), which historically has been materially below that of companies globally. Over the last five years total payouts as a proportion of operating cash flow came to just 12 per cent in Japan, well behind the US (89 per cent), Europe (42 per cent) and even Asia (19 per cent), according to Dan Carter, fund manager at Schroders.

"This has left companies' balance sheets bloated with cash: some 49 per cent of Topix companies are running net cash positions compared to just 26 per cent for S&P 500 constituents and 19 per cent for MSCI Europe excluding financials," he says. "As a result, the market's average return on equity (ROE) has consistently lagged global comparators, not once exceeding 10 per cent in the last decade, whereas neither US nor European market returns have dipped below that number aside from a brief period at the height of the global financial crisis."

But this year saw the launch of a new index, the Nikkei 400, and criteria for admission include having the highest three year RoE record. It is now regarded a "badge of honour" to be included in this index.

"This will focus companies on taking a pro-active stance in managing their RoE, which will include: streamlining their business, for example disposing of non core assets; conducting share buy-backs; increasing dividends and margins; and focusing on growth," says Mr Gregory. "This should all help to improve the returns companies make and is a big shift for Japan. While we expect a continued and gradual improvement in Japan's economic performance, we believe that the behaviour of corporate management towards shareholders will become far more important to investors, rather than the obsession over the decimal points of short-term inflation data and GDP growth."

An example is machinery manufacturer Amada which for many years had made little or no effort to improve returns to shareholders, and was excluded from the Nikkei 400 due to its low RoE. In response the company rewrote its management plan aiming for 100 per cent payout of earnings split equally between dividends and buy-backs.

"Amada may be the best example of this kind of change in management mind set but it is far from the only one," adds Mr Carter. "A number of blue chips including mobile phone company NTT DoCoMo, trading house Mitsui & Co and Toyota Motor have all announced share buy-backs in recent months and buy-backs for the first half of 2014 have already exceeded those in the whole of 2013 by more than a quarter."

Japan's Government Pension Investment Fund which is more than ¥1 trillion in size is looking to increas its weightings in Japanese equities, and due to its massive size even a slight increase should be significant. "An enormous amount of money is being reallocated to equities over time," says Mr Gregory.

The fund has around 12 per cent in domestic equities but it has been reported that this may increase to 20 per cent.

Tom Stevenson, investment director at Fidelity personal investing, says Japan, "still a manufacturing power house, is one of the best ways of playing a global economic recovery. Company earnings growth has been pretty robust despite the macro economic concerns. The results for the April to June quarter were generally a bit better than expected. Expectations are low, which means that any improvements in, for example, corporate governance or companies' focus on shareholder returns will come as a pleasant surprise.

The government and Bank of Japan are determined and working together - more stimulus will follow if needed. So cheap and out of favour - for contrarian and patient investors - Japan still looks attractive."

Risks

Although the Japanese market has risen around 80 per cent over the last two years, because of Yen depreciation this has meant only 30 per cent gains for sterling investors.

Japanese companies might lose their motivation to improve their RoE, despite the creation of the Nikkei 400 Index.

If there is uncertainty in global markets Japanese equities could experience volatility and it is likely the Yen would strengthen, which would be detrimental to Japanese exporters, though Sterling investors might see a better return on their investment. And the weaker yen has not played its usual role in boosting Japan's exporters because so much Japanese manufacture now takes place offshore.

Although prices have started to rise as the yen has fallen, wages have not followed leaving Japanese people poorer in real terms and disinclined to spend more. "One reason for this bad inflation has been the way in which, post-Fukushima [nuclear power station accident in 2011], Japan has become a net importer of energy so a weaker yen hurts," adds Mr Stevenson.

Japan's working age population is in decline: the working age population is falling by about 1 million every year, whereas the retired population is growing. "Japan's economic growth needs to be measured accounting for this headwind," says Mr Khalaf.

Abenomics may not succeed. "We are still waiting to see the outcome of Abenomics and the sales tax increase which is weighing on consumer activity," says Peter Walls, manager of fund of investment trusts Unicorn Mastertrust (GB0031269367), an IC Top 100 Fund.

"We maintain neutral on Japan," adds Luca Paolini, chief strategist at Pictet Asset Management. "Valuations look reasonable but indications are that the Japanese economy is stalling. While the Bank of Japan has indicated that it would add to its massive stimulus programme, the timing is still unclear. In addition, the third arrow of structural reforms that forms part of Mr Abe's pro growth plan has so far failed to deliver the expected results.

In spite of this, the case for Japan is positive over the medium term thanks to the combination of a weaker yen, improving corporate governance and prospects for an institutional rotation into stocks. Thus, we await a catalyst to turn tactically more positive."

Funds

Mr Gregory says you could put up to 5 per cent of your portfolio in Japan funds if you have broad global equity exposure and a long-term perspective. "You should be able to take a buy and hold strategy if necessary because Japan is not immune to short-term volatility," he says.

Mr McDermott says investors are typically under invested in Japan funds and medium risk appetite equity investors could look to put around 5 per cent of their assets in this area, and high risk equity investors could put in at least 10 per cent. But he doesn't think Japan equity funds are suitable for low risk investors.

Mr Khalaf suggests IC Top 100 Fund GLG Japan Core Alpha (GB00B0119933) for reasons including its long-term track record.

GLG Japan Core Alpha also offers a hedged share class (IE00B665M716). Hedging has been relevant due to recent weakness of the yen resulting in lower returns for sterling investors, though if the yen strengthened against sterling you could miss out on returns.

"The direction of foreign exchange markets is unpredictable and hopefully over time this will even out," says Mr Khalaf. "Companies are in a globalised market, and trade with and have revenue from other countries."

A strong performer is Legg Mason Japan Equity Fund (GB0033507467) which makes the top return in the Investment Management Association (IMA) Japan sector over five years, and is among the top performers over one and three years. It also beats the Topx index by a wide margin over these periods. It has a bias to small and mid-caps which its manager thinks offer the best growth prospects, but can be more volatile.

"The Legg Mason fund has done extremely well over the last five years but it has been a real rollercoaster ride for long term investors," says Mr Khalaf. "We prefer the steady-eddie approach of GLG Japan Core Alpha which has still rewarded investors handsomely over the long term, but without the stomach-turning drops in value."

Another downside to Legg Mason Japan equity is its high ongoing charge of 1.94 per cent for the retail share class, though if you buy funds from a platform you should be able to buy a cheaper institutional share class.

GLG Japan Core Alpha's manager has achieved his outperformance primarily through stock selection. "Our analysis shows that 30 per cent of his outperformance is attributable to his investment style, whereas 70 per cent is attributable to his stock selection," says Mr Khalaf. "Legg Mason Japan Equity's outperformance has also largely been generated by stock selection: 10 per cent is attributable to investment style and 90 per cent is attributable to stock selection.

The significance of this is that investment styles can go in and out of fashion, whereas in our view stock selection is a skill which lasts for the long-term."

Mr McDermott suggests Neptune Japan Opportunities Fund (GB0032076043) which seeks quality large-cap multinationals its manager thinks are under valued. "These are supported by the weak yen, and in addition the manager is short (bets on the value falling) of the Yen," he explains.

But this means the fund could underperform if the yen strengthens, although Neptune Japan is among the top five performing funds in its sector over one and three years.

Mr McDermott also suggests Baillie Gifford Japanese Fund (GB0006010838) which seeks well-managed businesses with a strong competitive advantage that are not over-priced. "This is growth orientated and stable," he says.

This has a very strong track record placing it in the first quartile of the IMA Japan sector over three and five years.

Suggested Japan funds

Source: Morningstar & *fund company

Performance data as at 4 September 2014

We also include two investment trusts in our IC Top 100 Funds, Baillie Gifford Japan Trust (BGFD), run by the same managers as Baillie Gifford Japan Fund, and Baillie Gifford Shin Nippon (BGS) which focuses on smaller companies.

Baillie Gifford Japan Trust is well ahead of its benchmark, the Topix, over one, three and five years, as well as the Association of Investment Companies (AIC) Japan sector average. It has an ongoing charge of 1.14 per cent against 1.55 per cent for the retail share class of its open-ended equivalent - though if you buy funds from a platform you should be able to buy a cheaper institutional share class. It currently trades on a slight premium to net asset value (NAV), although this is lower than its 12 month average.

Baillie Gifford Shin Nippon is well ahead of MSCI Japan Small Cap Index and its sector peers over one, three and five years, but trades on a 3.47 per cent premium to NAV, albeit tighter than its 12 month average of 5.33 per cent.

Suggested investment trusts

Source: Morningstar, as at as at 1 September 2014

Investors can also invest in Japan via passive funds such as exchange traded funds (ETFs), which have the advantage of having very low costs. But there are not yet any London listed ETFs which track the Nikkei 400 high RoE index of companies, and with divergences between companies there is an argument for a good active manager to pick out the better ones.

"If you are willing to review your investments regularly then you could go for an active fund, as there are managers who outperform the indices in Japan," says Mr Khalaf. "But because managers move on, things change and you need to review this. If you just want an allocation and are not able or willing to review it, then go for a tracker."

We include three Japan funds among our IC Top 50 ETFs.

These include Vanguard FTSE Japan UCITS ETF (VJPN) which has one of the lowest costs with an ongoing charge of 0.19 per cent. It aims to track the performance of the FTSE Japan index using physical replication.

db X-trackers MSCI Japan Index UCITS ETF (XMJG) tracks MSCI Japan monthly GBP hedged index, which provides exposure to the MSCI Total Return Net Japan Index as adjusted by transactions whose aim is to reduce the effect of Yen/Sterling exchange rate fluctuations (currency hedging). The ETF replicates the index by a fully funded collateralised swap and has a TER of 0.6 per cent. It reinvests the income so is suited to investors looking for capital growth.

Click here for The Trader Nicole Elliott's views on Japanese equities.

Click here for Chris Dillow's warning on how Europe is copying Japan's mistakes