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Japan – anything but quiet

John Baron explains why now may be a good time to increase exposure
July 4, 2019

Financial commentary about Japan has been somewhat light of late. There has been little meaningful to report. The economy has been somewhat erratic, the stock market has drifted, and the country has just enjoyed a 10-day holiday to mark the ascension of Crown Prince Naruhito to the Chrysanthemum Throne, following the abdication of Emperor Akihito.

Yet investors would be wise to look beyond the lack of headlines. Sometimes it is the quieter markets that need watching. And it is the reforms to improve the country’s corporate culture and governance that risk not being sufficiently recognised by a market that still looks cheap both historically and when compared with others. 

 

The tea leaves

Overseas investors were net sellers of Japanese equities last year, in part because of frustration about the lack of progress to stimulate the economy. The market has been lacklustre. In fact, Japan’s market peaked in the first year of Emperor Akihito’s reign in 1989 and is now around half the level it was then after decades of protracted deflation.

The Japanese market is cheap when measured against a range of metrics. Some estimates suggest a trailing earnings figure of 13 times versus the global average of 18. The cyclically adjusted price/earnings (CAPE) ratio has proved a reliable indicator of returns over the long term and suggests the market has only been cheaper in two of the past 25 years. It also looks cheap on a price-to-book basis. 

Such valuations underrate the economic, fiscal and corporate reforms introduced by Prime Minister Shinzo Abe. The latter are focused on changing the country’s hierarchical and ‘closed’ corporate culture. This has tended to conserve cash and reward long-term and unquestioning service, which has made corporate reform difficult and directors difficult to hold to account. Shareholders were considered the poor relation. 

The government’s new corporate governance code, introduced in 2015, is pressing companies to achieve a better balance. For example, some estimates suggest nearly 1,000 companies still have 35 per cent of their market capitalisation sitting as cash. Cash was considered the preserve of directors. This is now changing. The new code and shareholder pressure are pressing companies to use this cash more efficiently by way of investment or dividends. 

This welcome development is being reinforced by further reforms. In the past, poor corporate accountability has been assisted by cosy cross-shareholdings, which have shielded managements from unwanted change. Companies are now being encouraged to unwind irrational holding structures and put the released cash to better use.

Investment is now hitting new highs, while aggregate distributions by way of dividends are thought to have hit an all-time high in the first quarter of 2019. The market now yields around the same as the US market, having yielded less. And reform is being given added momentum by shareholders, often led by international investors, who are more expectant and vocal.

Meanwhile, the country’s huge domestic institutions are under pressure to play their part. The Japanese Life Assurance Association has recently announced a review to improve stewardship among the top 300 companies and highlighted 48 companies where improvement was needed regarding corporate governance. 

Furthermore, the government is addressing the investment community’s preference for bonds courtesy of the country’s deflationary spiral in recent decades. Institutions such as the Post Office pension fund are being encouraged to reverse their traditional underweighting of domestic equities. This is important given the monies involved.

No one is suggesting the improvement in corporate culture will be rapid, but it is slowly happening and bearing fruit. Higher profitability and investment, better dividends and strong overseas patent numbers are helping to build on the corporate sector’s traditional strengths. And shareholders are no longer considered an afterthought.

Meanwhile, there are encouraging signs that the government’s economic and fiscal policies, which are focused on breaking the country’s deflationary spiral and mentality, are beginning to work. Quantitative easing and inflation targets are part of the mix. Better labour market and immigration policies, given the low unemployment rate, should assist. 

The pick-up in wage growth bodes well given consumption accounts for nearly 60 per cent of gross domestic product (GDP). Consumer confidence appears to be on the rise. A nation of savers is slowly changing its habits. Yet market sentiment remains poor at this pivotal moment when the world’s third-largest economy appears to be making a gradual transition from overseas to domestic consumption.

The financial headlines often enthuse about the emerging middle class in developing countries, and yet Japan’s transition warrants almost no comment. It has certainly not entered the investment mainstream, and market valuations reflect this. What could be the catalyst for change? 

Perhaps the inverted yield curve may encourage investors to reassess the country’s relative prospects and strengths. A resolution of the trade talks between China and the US would help sentiment, even though Japanese exports only account for one-sixth of GDP. Events such as the Rugby World Cup and Winter Olympics will do no harm. 

Whatever it may be, reform is taking hold and a transition is under way. The path will not be smooth – the effect on consumer demand of the proposed 2 per cent increase in sales tax in October will be closely watched, while increased tensions affecting oil flows through the Straits of Hormuz would have an impact. However, patient investors who quietly increase exposure will be more than amply rewarded.

 

 

Portfolio changes

During June, the Income portfolio added to its holding in JPMorgan Japan Smaller Companies (JPS) at a price of £3.79, while the Growth portfolio sold its holding in Woodford Patient Capital Trust (WPCT) at a price of £0.56.

JPS has a good track record and management team based in Tokyo, and has committed more resources to what is still a very under-researched part of the market by the investment houses – some estimates suggest nearly half of all Japanese small and medium-sized companies are not actively covered by analysts. The company has introduced an enhanced dividend policy, which equates to a yield exceeding 4 per cent given the current discount. 

The suspension in trading of LF Woodford Equity Income unit trust has warranted a reappraisal of WPCT. Given the extent of common holdings between the two funds, the fact unquoted companies comprise most of WPCT’s portfolio and the inability to gauge how retail investors will react when the unit trust reopens, WPCT is now better suited to higher risk/reward portfolios.

 

 

Corporate action

Regional REIT (RGL) is hoping to raise around £50m by offering shares at a price of £1.06½. A 7.7 per cent yield still looks attractive despite RGL’s recent run. However, despite remaining positive on the company, the Income portfolio will not be taking up its entitlement because it is already overweight the sector and the existing weighting is deemed sufficient.