Is the Japanese equity market faltering?

There are several aspects to consider. One is that the structure and expected return from Japanese equities has changed from what investors might associate with the country. Japan was formally a hunting ground for investors seeking innovative manufacturing and exporting companies. But now fund managers speak of a ‘new Japan’, where they invest in companies that are not focused on auto and electronic goods exporting, but on serving domestic needs, Asian consumers, being embedded in the global supply chain, business models matching successful companies in Europe and the US.

But even this is not simple. Domestic consumers are at the mercy of the Japanese economic recovery, which has been confusing at best. In the first three months of 2018, Japan recorded negative GDP growth. In the second quarter, growth returned, so over the 12 months to the end of June, Japan’s economy grew 1 per cent.

Positively, inflation, and more importantly wage inflation, are picking up. According to Capital Economics, a research agency, consumer prices index (CPI) inflation will be 1 per cent this year, rising to 1.8 per cent in 2020. This is significant given Japan’s efforts this century to drive the economy away from deflation. None of these figures are stellar, but they are at least positive and relatively stable.

Capital Economics expects GDP growth of 1.2 per cent in 2018, but this falls to 1 per cent next year and 0.3 per cent in 2020. So where does that leave investors?

Land of the storm clouds?

We must also understand why the market is down thus far in 2018. A lot of this is due to general jitters with equities – net selling of Japanese stocks by investors outside of Japan is higher this year than it was in 2008. The Topix is the worst-performing major regional equity index in 2018, against the US, UK, Europe and emerging markets. But only the S&P 500 index has risen over 1 per cent in local currency terms. Markets globally have been weak.

“Japanese stocks have struggled. Concerns over a global trade war, emerging markets and global growth have created significant headwinds,” says Tadashi Shirai, a multi-asset investment manager at Fidelity International.

There is another factor, too. The yen has strengthened in 2018. It rose as much as 7 per cent against the dollar, before the dollar strengthened and pegged this back to 2 per cent. It is up 6 per cent against the pound, 5 per cent against the euro and 7 per cent against the Chinese renminbi. China is a major export market for Japan and a stronger yen negatively affects exporting companies as it makes their products more expensive to overseas buyers.

“The yen caused concerns [among investors] that companies would forecast weaker full-year earnings growth for March 2019, which they did,” says Alex Lee, a Japanese equity portfolio manager at Columbia Threadneedle.

“Such heightened geopolitical tensions and the threat of a trade war have also led to worries around the global growth outlook. This is a key risk for the Japanese market, which has high exposure to the global economy,” he says.

Capital Economics' senior Japan economist Marcel Thieliant says the current level of tariffs imposed by the US and China on each other could knock 0.2 per cent off Japan’s GDP. This is because Japan provides intermediate goods, items that are used in the production of other goods sold by China and the US. “Japan participates more in global value chains than most: nearly a third of all exports are intermediate goods. The country’s long-term growth rate may also be driven lower if trade barriers were raised globally,” he says.

Sunny spells

Despite all of this, some analysts remain sanguine on the risks facing Japanese companies. Mr Shirai and Mr Lee both believe companies were over cautious when reducing their earnings expectations – thus share prices have fallen too far relative to fundamentals.

“The recent earnings season was better than expected. Japanese companies delivered double-digit profit growth of around 5 per cent, and around half saw both sales and profits increase,” says Mr Shirai.

“Earnings growth has turned positive after trending downwards for the past six months or so, and companies are likely to upgrade their forecasts at the next interim stage.”

In addition, there seems to be less concern surrounding the country’s economic woes. Mr Shirai believes the rest of the year will see moderate but above-average economic growth. However, this is assuming Japan does not get caught by direct US trade sanctions and the spat between the US and China does not significantly worsen.

Mr Lee adds: “There are plenty of reasons to be cheerful about the Japanese economy, both in the second half of the year and over the medium to long term. Japan’s economic policymakers remain committed to invigorating the economy and company earnings should also remain firm.”

Chern-Yeh Kwok, fund manager of the Aberdeen Japan Investment Trust (AJIT), says the rising currency could aid investors to sort out the wheat from the chaff, as strong companies can prosper irrespective of the yen.

“A strong yen can present a big threat since it hurts the competitiveness of Japanese products, but the medium-term prospects of well-run companies will not be harmed. A strengthening yen will only expose weaker firms,” he adds.

More reasons to be cheerful

Others believe there are grander structural reasons to be positive on Japan, and investors should ignore the short-term noise.

There is a changing culture among Japanese companies to consider. In 2014, the Japanese authorities designed a new corporate code, aimed at shifting businesses away from traditional structures towards one that benefits shareholders. Progress has been slow, but is taking place. Average return on equity is now close to 10 per cent, as companies reduce costs and focus more on efficient capital allocation.

JPMorgan Japanese Investment Trust (JFJ) manager Nicholas Weindling says his conversations with company executives have changed for the better, paving the way for better shareholder returns in future.

“Historically, companies have lacked that all-important focus on providing value for investors,” adds Mr Lee. “[But] returns on equity are improving. If companies which are already providing great products focus on returns, they become excellent investment opportunities.”

Marcus Brookes, head of the fund of funds team at Schroders, says the positive GDP growth and inflation figures might be mundane compared with the US, but relative to what Japan has experienced for almost 20 years, it is a sign of long-term positivity and shows it is back on track. Rising wages should create a stronger economy and outlook for companies, he says.

“Many are congratulating the US for achieving sub 4 per cent unemployment for the first time since the 1970s. Japan achieved that in 2014 and the current rate is forecast to hit 2.4 per cent by the end of 2018,” he adds.

The relative valuation of Japan also remains attractive, with the Topix currently trading at a price/earnings (PE) ratio of 13.2 times and forward PE of 12.3 times, compared with long-term averages of 15.5 times. The US currently trades at a PE of 18 times and forward PE of 16.3 times.

“The market is cheap and within it there are significant sectors that offer good value without having to compromise on the quality of the company,” says Mr Brookes.

Funds to invest in Japan

Many analysts believe the best is yet to come from Japanese stocks, so investors should be prepared for a long ride. Given Japan’s exposure to the global economy, the ride may also be bumpy, so consider how much you want to hold: around 10 per cent in a growth portfolio is sensible.

There is also a debate to be had on the growth style of investing versus value. The former focuses on buying companies that are growing with the share price hopefully following, while the latter focuses on companies that are mispriced by the market due to negative sentiment. Globally, growth has been in favour for some time, but given where valuations are in Japan versus the long-term average, there is an argument for value to work.

Legg Mason IF Japan Equity (GB00B8JYLC77)

This high-octane growth strategy has been the top-performing fund in the Investment Association (IA) Japan sector over three and five years, returning almost triple the sector average and Topix index. The fund has been run by Tokyo-based Hideo Shiozumi since 1996. He focuses on domestic businesses, generally in the mid-cap space and invests in themes, such as the country’s ageing population. The manager’s style is not for the faint hearted. He takes large bets on a small number of companies, and combined with his penchant for smaller stocks, returns are volatile. Nonetheless, Mr Shiozumi’s long-term track record is exceptional. It has an ongoing charge of 1.02 per cent.

Man GLG Japan CoreAlpha (GB00B0119B50)

This fund has been run by Neil Edwards and Stephen Harker since 2006 and they were joined by Jeff Atherton in 2011 and Adrian Edwards in 2014. The fund’s recent performance is not something to shout about, however, this is because of the deep value strategy implemented by the managers. The fund focuses on finding mispriced mega-cap and large-cap stocks, that will revert to fundamental value over time. The fund’s holdings have an average forward PE ratio of 11 times compared with the long-term average of 15.5 times. Over 10 years, the fund is one of the best performing, but this strategy’s potential will only be seen when value comes back in style. It has an ongoing charge of 0.9 per cent.

Lindsell Train Japanese Equity (IE00B7FGDC41)

If it is a large-cap buy-and-hold fund run by an experienced manager with a great track record, then this is probably the right fund. The manager, Michael Lindsell, has run the fund since 2004 and operates the strategy his firm Lindsell Train has become famed for: buying large-cap companies that will steadily grow over time providing excellent long-term returns. Over 10 years the fund has returned 224 per cent versus 136 per cent and 134 per cent for the sector average and index. The fund focuses on cash-generating companies, and holds 41 per cent in consumer defensive stocks. It has an ongoing charge of 0.85 per cent.

Baillie Gifford Japanese Smaller Companies (GB0006014921)

This fund invests further down the market cap spectrum and has over 80 per cent invested in medium and smaller companies. It has been run by Praveen Kumar since December 2015 since when he has returned 107 per cent, versus the 76 per cent IA Japanese Smaller Companies sector average return and 58 per cent from the MSCI Japan Small Cap index. In the same period, the Topix only rose 47 per cent so there are returns to be made from small caps if investors can tolerate the risk. Mr Kumar favours a growth strategy with a strong bias towards nascent technology and industrial stocks – which includes robotics companies. The fund also has 20 per cent allocated to consumer businesses. It has an ongoing charge of 0.63 per cent.

Fund performance

Source: FE Analytics, as at 3.09.18