Look to Japan for cheap valuations and dividend growth

Gavin Haynes, managing director at wealth management company Whitechurch Securities, says: "Japan hasn't been the fastest-growing economy for a long time, but growth now looks reasonable and robust, and inflation is positive, which is good. Japan has been a historically low-yielding market with not much to get excited about dividend-wise. But very low interest rates mean Japanese investors have been suffering income starvation and that seems to have resulted in companies paying out more dividends to satisfy investment needs, which in turn has improved their share prices."

The growth in dividend payouts is part of a wider improvement in Japanese corporate governance which has seen more independent directors added to boards and companies commit to reducing cross-shareholdings - shares held by listed companies in other listed companies. Improving corporate culture was one of the three areas that Japan's Prime Minister, Shinzo Abe, committed to when he was first elected in 2012. His 'three arrows' of reform also included fiscal stimulus and quantitative easing (Q

Although corporate reform has happened more slowly than the government's action on quantitative easing and fiscal stimulus through infrastructure spending, it might prove to be the most sustainable of these measures.

Jason Hollands, managing director at Tilney Group, says: "Japanese companies have huge scope to raise dividends compared with most other markets. While UK companies paid out 90 per cent of earnings last year, Japan has one of the lowest payout ratios of all, at 35 per cent, while also being the major market that has the highest proportion of companies with net cash on their balance sheets. Change is already happening: in dollar terms, during 2016 Japanese companies paid out 24.4 per cent more dividends than they did in 2015 - the biggest percentage increase of any region - and the positive trend of dividend growth has carried on into the first quarter of 2017."

The continuing accommodative monetary policy and low borrowing costs are also supportive to risk assets like equities, he adds. 

Government attempts to address Japan's well-known demographic challenges are starting to bear fruit, with more women joining the workforce. Female labour participation has moved up from 59.6 per in 2000 to 66.7 per cent in 2015.

"Competition for employees is up, although wage growth is still lagging," adds Sam Lees, head of research at FundExpert. "A pick-up here could go some way towards solving a number of Japan's ailments, including its demographic challenges, as rising wages making it easier to plan for and afford a family."

Even though there is a risk that Japan's ageing population could slow growth, it also opens up investment opportunities in areas such as healthcare and care home providers, argues Darius McDermott, managing director at research company Fund Calibre.

He adds: "Value stocks in particular look more attractive than growth ones over the longer term: as in the UK and Europe in recent years, these types of company have lagged behind and only experienced a mini rotation in 2017."

Trouble ahead?

Although Japan's ambitious reform package has so far been beneficial, it is still early days and it could run into trouble in a number of ways. 

"QE has been a big experiment all around the world, but the scale of it in Japan is much greater than anything done elsewhere," says Mr Hollands. "The Bank of Japan (BOJ) has pretty much tripled its balance sheet in size since 2012, buying government bonds and other assets. Does this harm the BOJ itself given that it expanded its balance sheet so much? And how does it unwind it?"

The hoped-for improvements in corporate governance and dividend payout growth may stall. "The issue with Japanese corporates and larger companies is that they can be very slow to change as they tend to have strongly embedded cultures," says Mr Haynes. "If companies don't move quickly [on achieving corporate reform] investors could lose patience."

And despite recent steady growth the economic recovery is fragile - especially as the government's attempts to weaken the yen to boost competitiveness have not been that effective.

"The constant risk in Japan is the currency," explains Mr McDermott. "The yen has weakened a little, but could do with coming down a lot more to help competitiveness. That's unlikely to happen, though, so it's a headwind for exporters. Japan is also the most cyclically sensitive economy, which means if global growth slows, so will Japan."

The problems with currency exchange rates have also been complicated for UK investors by uncertainty over the strength of sterling, especially now that negotiations with the European Union are under way. If you expected sterling to strengthen against the yen, you might consider hedging your exposure to protect you from the fall in the value of the yen, and benefit from the rising stock market that typically comes with a weaker yen.

But it is difficult to predict what the sterling/yen exchange rate will be, so Mr Hollands thinks it is best not to hedge your exposure just now.

Japan funds for different opportunities

Schroder Tokyo Fund (GB00BGP6BR86) for core exposure to this market. This fund uses Tokyo-based in-house research to identify attractively valued companies, whose share prices appear low relative to long-term profit potential. It is in the second quartile of the Investment Association (IA) Japan sector in terms of performance over one, three and five years.

The fund is run by Andrew Rose, who also runs Schroder Japan Growth (SJG) investment trust, which is trading at an 8 per cent discount to net asset value (NAV). But the trust has an ongoing charge of 1.12 per cent, compared with Schroder Tokyo's ongoing charge of 0.66 per cent.

CF Morant Wright Nippon Yield (GB00B2R83B20) for investors looking to benefit from the potential increase in income from Japanese companies. This fund aims for longer-term income growth, while preserving and growing capital value. It yields 2.5 per cent.

"This fund is run by a small fund management boutique wholly focused on Japan," says Mr Hollands. "It invests right across the Japanese market, including in medium-sized and smaller companies, with a strong emphasis on identifying ones that its managers believe are available at attractive valuations and can grow their dividends. They look beyond the big names to stocks that aren't on the radar of other [investors]."

CC Japan Income And Growth Trust (CCJI) also focuses on companies with the scope to raise their dividends. It aims to invest in undervalued Japanese companies with strong balance sheets and business franchises that can offer a return to shareholders from either dividend yields or share buybacks. This investment trust has a yield of around 2 per cent. IC Top 100 fund, Baillie Gifford Japan Trust (BGFD), which is run by highly regarded manager Sarah Whitley, has a strong record of outperformance. Over five years, for example, it has returned of 261.6 per cent - more than double the return made by its benchmark, the Topix index, of 111.5 per cent. But it is trading at a 4 per cent premium to NAV. "In terms of performance, it's ahead of the pack by a meaningful margin," says Mr Cockerill. "We look for consistency of performance and we've seen that with this [and Baillie Gifford's other Japan funds]. "These include Baillie Gifford Japanese (GB0006011133) of which Ms Whitley is co-manager with Matthew Brett. This fund is also well ahead of the Topix index over one, three and five years and its ongoing charge of 0.68 per cent is lower than Baillie Gifford Japan Trust's of 0.88 per cent.

But Baillie Gifford's Japan funds tend to have a growth-focused investment style, so if markets become more value-orientated their performance could suffer. Value-focused options include Man GLG Japan CoreAlpha (GB00B0119B50), which is in the first quartile of the IA Japan sector over one and five years, over which periods it also beats the Topix index. "This fund looks for out-of-favour areas of the market, taking a value-driven approach," says Mr Haynes. "If we continue to see reflationary pressure come back in Japan, then the companies that this fund invests in, such as banks, should be well positioned." Man GLG Japan CoreAlpha is overweight banks relative to the Topix index by 13.8 per cent. Japanese smaller companies are also on cheaper valuations than other markets, cash-rich and remain under-researched, according to Mr Lees. He likes to get exposure to them via M&G Japan Smaller Companies Fund (GB00B7FGLY29), which has beaten its benchmark, Russell/Nomura Mid Small index, over one, three and five years. It aims to deliver capital growth over five years or more by investing at least 80 per cent of its portfolio in the shares of companies that make up the bottom valued third of publicly listed companies in Japan, in terms of stock market value. Tim Cockerill, investment director at Rowan Dartington, likes Baillie Gifford Japanese Smaller Companies (GB0006014921). Its managers, Praveen Kumar and Felicia Hjertman, look for attractively valued smaller companies that offer good growth opportunities. Over five years the fund was the top performer in the IA Japanese Smaller Companies sector and very well ahead of its benchmark, MSCI Japan Small Cap index, but this is largely due to its previous manager. Mr Kumar and Ms Hjertman have run the fund since December 2015 and January 2017, respectively.

Mr Kumar also runs a Japanese smaller companies investment trust, Baillie Gifford Shin Nippon (BGS). Shin Nippon means new Japan and this Baillie Gifford trust focuses on emerging or disrupted sectors, where the manager sees innovative growth opportunities," says Mr McDermott. "The team delve into the small-cap area of the market where many other firms fear to tread, giving them ample opportunity to uncover hidden gems. But Baillie Gifford Shin Nippon is trading at a premium to NAV of around 3 per cent and has a higher ongoing charge than Baillie Gifford Japanese Smaller Companies, at 0.96 per cent.

So Mr Cockerill thinks that at the moment it may be better for investors to buy the fund. He says: "If you think they can maintain that outperformance then paying that premium to NAV might not be such a bad deal, but you could pick up something cheaper instead."