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Look beyond Japan's economy for strong returns

Japan's economy isn't doing well but its equity market can deliver strong returns
May 23, 2019

Japan's economy and stock market had floundered for decades, but since 2013 the ‘three arrows’ policies of Prime Minister Shinzo Abe have improved the country’s economic fortunes. However, Japan’s economy has still not experienced significant self-sustaining growth, so many investors are still deterred by a relatively stagnant economy, torpid corporate culture and unappealing demographics.

Economic data from Japan is erratic: it had a lengthy period of expansion following early growth measures, but has tipped back towards recession in recent months. Industrial output fell in the first quarter of this year at the fastest pace in almost five years as the country’s exporters found themselves in the crossfire of the China-US trade war.

Japan's government debt burden is around 2.5 times the size of the economy and the highest in the world. The country has a rapidly ageing population, thanks to a low birth rate and low immigration. The number of people aged 65 or older accounts for over a quarter of the country’s 127m population, up almost 4 per cent on five years ago. This is shrinking the tax pool and putting a greater burden on the state. 

The government is planning to hike the sales tax, but when it last did this in 2014 Japan went into recession. Although there are doubts as to whether the government will implement this because economic data has weakened in recent months, it remains a potential headwind for the economy. So a surge in Japan's economic growth seems unlikely in the near future.

However, Japan's domestic economy is not its stock market, so despite economic problems the country has proved a reasonably good place to invest in recent years. Over the five years to 17 May, the Investment Association (IA) Japan fund sector average total return is 76.7 per cent, ahead of the returns of all UK and European equity sectors. The IA Japanese Smaller Companies sector has done even better over this period, with a total return of 108 per cent – making it the second best performing sector. 

The funds within the IA Japan sector have delivered a broad spectrum of performance over the past five years, demonstrating that this is a market in which skilled active managers can excel. For example, the top two performers – Legg Mason IF Japan Equity (GB00B8JYLC77) and Lindsell Train Japanese Equity (IE00B7FGDC41) – have made returns of 230.1 per cent and 146.5 per cent, respectively, while the fund that made the lowest return – Neptune Japan Opportunities (GB00B3Z0Y815) – only returned 23.7 per cent.

Nevertheless, Japan has a reputation for having an intensely hierarchical corporate culture, which rewards longevity rather than merit. People get ahead by toeing the company line, which makes corporate change difficult and slow. And companies are often run to support social goals such as ‘jobs for life’ rather than for shareholders.

These ingrained governance habits were the target of Mr Abe’s third ‘structural reform’ arrow – the others were monetary and fiscal policy. The country has had its new corporate governance code in place since 2015 and it has started to influence corporate behaviour, albeit slowly. 

Joe Bauernfreund, manager of AVI Japan Opportunity Trust (AJOT), has based its strategy on this shift in corporate governance standards. He thinks that there are lots of companies sitting on significant piles of cash. Historically, management teams have tended to hold high levels of cash for a ‘rainy day’, given Japan’s history of economic weakness. However, the new governance code and increasing shareholder pressure are forcing these companies to use their cash more efficiently, to invest in the business or pay dividends.

Mr Bauernfreund says: “Since the bubble burst in 1990, Japanese people have saved, believing they must hold no debt and increase their cash. Among companies, there was a view that the cash belongs to them rather than shareholders. These cash piles were allowed to build up without anyone questioning it.”

This problem has been exaggerated by poor corporate accountability in Japan. Cross-sharing holdings were common among Japanese companies and directors grew used to having their proposals waved through. However, shareholder activism has increased, particularly as international investors have come into the market, and among domestic shareholders as the Japan Pension Association has taken action. Cross-shareholdings have been unwound and slowly management teams are being pushed to change.

“There are 900 companies with over 40 per cent of their market capitalisation in cash,” says Mr Bauernfreund. “Some, admittedly, are ‘zombie’ companies – weak businesses that have been allowed to continue because they have this pile of cash. Nevertheless, we have found companies that are growing their earnings and have good free cash flow, but low payout ratios. They have the scope to pay higher dividends.”

Dividends in Japan have been growing for some time, admittedly from a low base. FTSE Japan index has a yield of around 2.5 per cent, which puts it slightly ahead of the US and slightly behind the eurozone. CC Japan Income & Growth Trust (CCJI) was launched in 2015 with the aim of tapping into Japan’s growing income market. Coupland Cardiff, the company which manages this trust, says that management behaviour and regulation, and the introduction of new indices such as JPX Nikkei 400 and Nikkei High Dividend Stock 50, have supported and encouraged this change in behaviour.

Japan's markets also look relatively cheap compared with global peers. Graham Campbell, co-manager of TB Saracen Global Income and Growth Fund (GB00B3XPLG55), says: “Japanese companies historically had high price/earnings (PE) ratios. But they have materially de-rated and some sectors appear particularly lowly rated compared with their global peers.” 

When selecting stocks, Mr Campbell screens for characteristics such as cash flow, yield and valuation, and more Japanese companies are coming up than ever before. He says that while ‘cheap and Japanese’ is not a good criterion in itself, it is possible to pick up high-quality companies at a good price. He points to beer company Asahi (2502:TYO), which should be a key beneficiary of the World Cup and Winter Olympics due to take place in Japan, and is on an attractive rating.

“The economy hasn’t grown in 20 years and that is unlikely to change," adds Mr Campbell. "The Japanese are savers rather than spenders, which limits the prospects for domestic growth. However, among the exporters we see some opportunities. We find high-quality businesses, with good global prospects.”

Praveen Kumar, manager of Baillie Gifford Shin Nippon (BGS) and Baillie Gifford Japanese Smaller Companies Fund (GB0006014921), sees a similar phenomenon among Japanese smaller companies. “What sets Japan apart is less to do with the nature of the businesses, it is the perception of those companies among overseas investors," he says. "For some time, the Japanese market has traded at a discount, stemming from the false notion that to get a strong investment return, you need a strong economic recovery. There is limited academic research to support that conclusion.”

Smaller companies have been a more exciting area in which Mr Kumar has found plenty of fast-growing companies used to operating in tough domestic and overseas markets. “Japan has a multitude of problems," he says. "There is a lack of transparency in pricing, for example. Companies tend to have a multi-layered system of middlemen and contractors, which means that getting, say, an MOT can require people to go through multiple layers. There are a range of issues across a number of sectors.”

Smaller companies may avoid some of the more pernicious aspects of Japanese culture such as the ‘jobs for life’ expectation. Mr Kumar likes companies run by young entrepreneurial founders who may have been educated in the west and observed how western businesses are run, so bring a different perspective. But it can be like tiptoeing through a minefield. “Quite a lot of small to medium-sized enterprises still face a labour shortage, so we avoid those companies completely,” he explains. 

There is an argument that companies that can thrive in Japan are some of the toughest in the world. Many have operated in a slow-growth world for decades so don’t need a supportive environment to improve earnings.

 

Funds for exposure to Japan

If investors can overlook the lacklustre economic backdrop, and believe that corporate governance changes can bring about an improvement in company performance, they could consider an allocation to Japan. They should also have a high risk appetite and a long-term investment horizon. "Japan is in the foothills of a historic shift, but investors shouldn’t expect instant results," says Mr Bauernfreund. "Everything moves more slowly than expected in Japan, but it may hold more interest for investors than it has done for some time."

The main Japan equity indices have exposure to the country’s largest companies, among which some of the worst governance problems lie. But active funds' managers should be able to avoid the worst offenders. 

Options include Baillie Gifford Japan Trust (BGFD), run by Matthew Brett with Mr Kumar as deputy manager. The trust has a strong long-term performance record, but much of this was achieved under its previous lead manager, Sarah Whitley, who retired at the end of April 2018. However, Baillie Gifford's funds are run very much via a team approach rather than relying on one manager, with investment ideas generated from a number of sources including other areas of the company. This means the process via which the trust is run is unlikely to change much. 

And Mr Brett and Mr Kumar are fairly experienced, having worked at Baillie Gifford since 2003 and 2008, respectively, with considerable experience of running funds before assuming the management of this one. 

A downside to this investment trust at the moment is that it is trading at a premium to net asset value (NAV) of over 4 per cent. So a better option could be open-ended fund Baillie Gifford Japanese (GB0006011133), which has been run by Mr Brett since 2008. 

Lindsell Train Japanese Equity is run by highly regarded manager Michael Train and is among the top-performing funds in the IA Japan sector over, one, three and five years. Mr Lindsell aims to construct a concentrated portfolio of “exceptional” companies, with a focus on sustainable business models and/or established, resonant brands. He prefers companies with a record of long-term durability in cash and profit generation.

CC Japan Income & Growth Trust's manager, Richard Aston, looks for dividend growth from companies with the ability and willingness to increase the return to shareholders over time. He also favours companies that offer a steady dividend yield in excess of that of the market and special situations which have the potential to change the way they treat shareholders.

The investment trust only has a yield of about 2.6 per cent, but this could increase over time. And over three years it has made a NAV total return of 56 per cent – ahead of the Topix index and most of its sector peers. 

 

Fund performance

Fund/benchmark1-year total return (%)3-year cumulative total return (%)5-year cumulative total return (%)10-year cumulative total return (%)*Ongoing charge (%)
Baillie Gifford Japanese-6.1263.61107.35230.020.63
Legg Mason IF Japan Equity-3.8442.12230.1668.141.02
Lindsell Train Japanese Equity-1.0170.73146.47237.280.79
Neptune Japan Opportunities-19.9820.623.7354.170.87
Baillie Gifford Japan Trust share price-6.1573.68137.4494.39**0.73
CC Japan Income & Growth Trust share price-10.4542.74NANA**1.09
Topix index-5.9539.8781.73125.42 
IA Japan sector average-7.4939.2276.69123.52 
Baillie Gifford Japanese Smaller Companies-3.2764.12178.75471.210.63
Baillie Gifford Shin Nippon share price-8.5580.54216.45854.33**0.76
MSCI Japan Small Cap index-9.3939.4797.37180.65 
IA Japanese Smaller Companies sector average-10.9744107.99245.04 

Source: FE Analytics as at 17 May 2019. *Fund providers  **Association of Investment Companies