Look beyond the Olympics to long-term value in Japan

It’s been a disappointing year for Japan. Questions linger over the Olympics which is due to start on 23 July, after Tokyo was placed under a state of emergency in April amid rising Covid-19 cases. A poll in May found that 60 per cent of the Japanese public did not want the games to go ahead, foreign spectators have been ruled out and domestic spectators capped at 10,000 per venue. The number of Covid-19 infections in Japan has been rising at the same time as the situation in the US and Europe has been improving, and Japan is significantly behind other developed markets with its vaccination programme.

These factors have led to the Japanese stock market lagging others during the recent rally in cyclical stocks. For example, over the past three months MSCI UK index is up 7.5 per cent while MSCI Japan is only up 1 per cent. 

Rob Morgan, chief analyst at wealth manager Charles Stanley, adds that if inflation picks up more it could become a problem for some companies with rising input prices causing margin pressure and supply shortages of, for example, semiconductors for the auto industry. “These will affect various companies and sectors in different ways, but for those exporters with high input costs and relatively small margins it could be a significant issue,” he explains.  

Looking forward

Despite a rocky few months, there are reasons to be optimistic about longer-term investment opportunities in Japan. Companies that would have benefitted from the Olympics, such as those in the tourism sector, have already had bad news factored into their share prices. And although the vaccine rollout has been slow Tomo Kinoshita, global market strategist at Invesco Asset Management, says that the government has now contracted enough supply to speed up the roll-out, which he estimates should raise the vaccination rate to 50 per cent by September.

“I see an upside for domestic demand-oriented stocks,” says Kinoshita. “I also think that Japan’s capital goods sector stocks will outperform as capital investments are likely to pick up globally due to pent-up demand, and demand for digital transformation and digital carbon emission controls.”

Jim McCafferty, head of Asia (ex Japan) research at Nomura, says that another short-term factor which could boost the stock market is that earnings season in Japan has been increasingly “crowded” with many companies reporting on 14 May in particular. He thinks that investors have been unable to fully digest the fact that results have been robust owing to this unusual overcrowding in reporting timings.

While a pick up in inflation is a concern for many equity investors, particularly those holding long duration growth stocks, many companies in Japan could do quite well if and when inflation picks up there. Sectors such as machinery can benefit from a pickup in global inflation if there is an uptick in capital expenditure. McCafferty says that Komatsu (JAP:6301), a global manufacturer of construction, mining and utility equipment, is an example of a firm that could do well.     

Simon Edelsten, co-manager of Artemis Global Select Fund (GB00B568S201) and Mid Wynd International Investment Trust (MWY), says companies such as Nippon Telegraph and Telephone (9432:TYO), which has not been able to raise telephone charges for 20 years, might benefit from modest inflation. But despite a pick up in US inflation and a bounce in commodity prices Japanese inflation remains low at 0.96 per cent. 

Japan also has lots of financials which could benefit from a buoyant global economy, and its large auto industry is well placed to benefit from a revival in global trade and capital spending. However, Morgan points out that companies with limited pricing power, perhaps because they have less of a technological edge, will find it harder to pass on rising input costs. So an inflationary ‘roaring 20s’ scenario is unlikely to be good for all companies. 

The longer-term reasons to invest in Japan remain. Valuations of Japanese equities are attractive relative to the other markets: for example, MSCI Japan Index's forward price to earnings ratio is 16.37x compared with 19.73x for the MSCI World and 21.96x for MSCI USA indices.  

Japan is also attractive for those looking for a reliable income stream. More than half of Japanese companies have net cash on their balance sheets versus 10 to 20 per cent in western developed markets. Although MSCI Japan's dividend yield on is quite low at 2 per cent, Japanese dividends only fell by 5.6 per cent last year while UK dividends fell 40 per cent, according to the Janus Henderson Global Dividend Index. On average, Japanese businesses are only paying out a third of profits as dividends so there is significant room for payouts to grow over time  

Japanese corporations have been viewed as set in their ways and not sufficiently prioritising shareholder returns, but Morgan says that “this is slowly changing.” The number of activist funds in Japan seeking to extract hidden value is on the rise which should help shareholder capitalism. However, a damning recent investigation into Toshiba (JAP:6502) which showed the government intervened to help its management fend off investor challenges has thrown the credibility of Japan’s corporate reforms into question. 

Funds for Japan

For investors looking to play the prospect of a recovery in cyclical stocks, Morgan suggests Man GLG Japan CoreAlpha (GB00B0119B50). This fund applies a value-led, contrarian approach to the Japanese market where some of the lowest developed markets valuations can be found. It has a concentrated portfolio of stocks in unfashionable areas which have underperformed but are still resilient companies.

The fund is not suited to all market environments, such as when investors prioritise certainty of earnings rather than cheap valuations, a reason why it has underperformed the TOPIX index over the past five years. However, with over 30 per cent of the fund in banks and transportation equipment, it has significantly outperformed over the past year as value investment styles have been more successful. 

Morgan says: “over time backing good stocks in the least fashionable areas has been very successful, and the managers have a very consistent, patient and robust process surrounding this, which is vital. It would blend really well with a fund that targets more growth-orientated areas because they would have little or no overlap in terms of underlying holdings.”

Baillie Gifford Shin Nippon (BGS) is a good way to get exposure to fast growing, disruptive Japanese smaller companies. The investment trust holds 40 to 80 stocks across a wide range of industries. The trust's benchmark, MSCI Japan Small Cap Index, includes about 900 companies. But Baillie Gifford Shin Nippon's managers only look at about 200 companies because they think that the others are not sufficiently liquid or in mature industries without enough growth potential. 

Although Japanese smaller company valuations are significantly higher than those of Japanese large-cap cyclicals, they are still lower than those of smaller companies peers in other markets. Baillie Gifford Shin Nippon's manager, Praveen Kumar, adds that Japanese small caps are under researched giving his team extra opportunities to spot long-term growth possibilities. 

The trust has a fantastic long-term performance record but has not done so well recently as the market environment has turned. However, this has resulted in a narrowing of the premium to net asset value on which it trades. This hit double digit levels last year but was only 0.3 per cent on 17 June.

If you’re looking for one core Japan fund, Lindsell Train Japanese Equity (IE00B7FGDC41) provides exposure to some of Japan’s biggest and best companies. For example, its 10 largest holdings include Nintendo (JAP:7974) and Takeda Pharmaceutical (JAP:4502). The fund is managed by Michael Lindsell and concentrated, with typically only 20 to 35 holdings in companies with sustainable business models and established brands. Lindsell looks for companies with long-term durability in profit generation which tends to lead him to  to consumer branded goods, internet, media, software, pharmaceuticals and financials companies. While the fund has not performed well over the past six months its long-term performance is excellent.