During November I caught up with events in Japan having last revisited the market with readers during the summer of last year ('Defying the doomsters', 4 July 2014). Reassessing one's assumptions, even to the point of doubting oneself, is an important discipline. Having done so, I am even more positive about the outlook and have, accordingly, added to existing positions in both portfolios.
Having introduced Japanese exposure to the portfolios upon the election of Prime Minister Shinzo Abe at the end of 2012, the market had a strong run in 2013. Since then, performance has been more pedestrian. The doomsters and cynics have broadly held sway - convinced that factors such as high debt piles, demographics, an anaemic economic recovery and consumers haunted by decades of deflation will be too much for the equity market to bear.
This is despite government efforts to boost the economy and inflation, partly by weakening the yen, to raise consumer wages and spending, and to make structural changes to the labour market and tax system as part of a longer-term plan to reduce government debt. Parts of the plan have been successful, others less so.
The yen has weakened significantly and this will help to deliver earnings growth of at least 20 per cent this year. Twice-yearly bonuses linked to corporate earnings should help lift consumer spending over time. Yet last year's increase in VAT has hit confidence and, after two decades of stagnation, so far there is little sign of inflation or spending increasing markedly. Meanwhile, the economy splutters on.
But the gloom is overdone. There are many positive signs that policies are working. Employment and industrial production figures are strong. Indeed, we risk underestimating the potential of the corporate sector's bounce-back. A decade of cost-cutting and efficiency drives, partly in response to an appreciating currency, has left businesses both lean and mean. Meanwhile, lower corporate taxes will provide a positive backdrop.
We should also remember that Japan is a world leader in a range of sectors, including robotic technology and medical equipment. It also spends more on R&D than almost any other country. Meanwhile, structural reform is ongoing, and this includes paving the way for more immigration to compensate for a shrinking workforce.
The slowdown in China remains a concern for some, particularly the weakness of the yuan, given it is Japan's second largest export market. But Japan's exports account for less than 3 per cent of GDP - so exposure needs to be kept in perspective.
Furthermore, regular readers will know I am very positive about the changes being undertaken in China, which will, over time, make for a better quality of earnings even if at a somewhat slower rate of growth. This will be to Japan's long-term advantage.
In addition, there's firepower left in the government's armoury. Relative to the size of its economy, Japan has been embracing quantitative easing (printing money to buy bonds) at twice the rate of the US. The Bank of Japan could step this up - although it has declined to do so for now.
Finally, the stock market looks cheap relative to its peers on a range of measures, but particularly when considering price-to-book ('break-up' value). Cheap markets need catalysts for value to be crystallised. A number are now at play, including a new Isa-style account to help encourage Japanese households to embrace domestic equities - as they are underweight relative to elsewhere.
But attempts by government to encourage Japan's large pension funds to embrace equities could be more significant. GPIF, the world's largest pension fund, has only 25 per cent of its $1 trillion assets in equities - decades of stagnation has imbued a preference for bonds. By contrast, the largest pension fund in the US has a 65 per cent exposure. Even a partial shift into domestic equities could result in purchases worth $150bn-$200bn - not insubstantial.
Meanwhile, companies are being encouraged to be more shareholder friendly by way of better corporate governance and improved dividend policies - a new high-profile index for dividend payers is now up and running. Given the constituents of Japan's Topix contain net cash balances of nearly $100bn, compared with less than $10bn for the FTSE 100, the potential for both shareholders and the market to benefit remains huge.
In short, the Japanese equity market could be the best performing of its peer group next year - investors should be positioned accordingly.
JPMorgan Japanese
Step forward JPMorgan Japanese (JFJ), which I have added to within both portfolios. Catching up with manager Nicholas Weindling in Tokyo recently, he reminded me of a number of other positives, including the tightest job market for years, the recently signed Asian free-trade agreement, which should prove good news for the region in general, stable politics and a credible BoJ.
JFJ focuses on the larger companies and pursues two broad themes. The first relates to those companies benefiting from 'Abenomics', including selective banks (lending) and retail companies (spending) - sectors that can be further assisted by government intervention if necessary.
The second and larger focuses on longer-term 'mega' trends. These include: e-commerce, where penetration rates of 6 per cent are well behind those in the UK, which stands at 15 per cent; an ageing population, given there are winners and losers; robotics and factory automation, given wages globally are rising; and tourism, assisted by a depreciating currency, with Japan being the 27th most popular country in 2013 and forecasts suggesting 20m visitors in 2016.
JFJ has reduced its gearing somewhat, to 107 per cent, in recognition that over half of Japan's exports go to Asia, which is slowing. In addition, significant further yen weakness is deemed unlikely in the absence of unforeseen events. This suggests a slightly more domestic focus, which tallies with the second theme.
Since Nicholas took over JFJ five years ago, the performance has improved markedly - handsomely beating the TSE 1st Section. The portfolio is a little more expensive than the market in general, but its earnings growth and cash flow is superior. The rating could easily be lowered by increasing exposure to sectors such as commodities and cars, but these are not liked. Standing on a 10 per cent discount when topped up, JFJ is worth tucking away for Xmas.
Other portfolio changes
During November, I sold the Growth Portfolio's holding of Biotech Growth Trust (BIOG) and reinvested some of the proceeds in the portfolio's existing holding of International Biotechnology Trust (IBT) while standing on a wider discount. BIOG remains an excellent trust and is held in some of my website's other portfolios.
I will be reporting on the portfolios' 2015 performance in next month's column but, touching both wood and head, it is looking another good year. Meanwhile, I wish readers a Merry Christmas.
ABOUT THE AUTHOR:
John Baron waives his fee for this column in lieu of donations by Investors Chronicle to charities of his choice. As these are live portfolios, he has interests in all of the investments mentioned. For more portfolios and commentary please visit John's website at: johnbaronportfolios.co.uk
