Should you follow Buffett into Japan?

The Sage of Omaha recently announced that his company had built up stakes in five of the country’s largest trading houses totalling a chunky $6.3bn, and Berkshire Hathaway suggested it could increase this exposure over time. Mr Buffett’s style of buying good stocks when they are unloved is likely to bring other investors' attention to the value to be sought in Japan.

While the Japanese stock market has not risen by as much as the S&P 500, it has been the second-best performing developed market since outgoing prime minister Shinzo Abe took the reins in late 2012, in sterling terms. Data also suggests that such gains have been driven by company fundamentals, rather than frothy investor sentiment. Tokyo’s main index, the Topix, has a price to book value ratio of just 1.2 according to FactSet data, compared with 3.8 for the S&P 500 and 1.4 for the FTSE All-Share.

Beyond low relative valuations, improving corporate governance, cash rich companies and secular growth opportunities also provide a compelling investment case. Mr Abe’s corporate governance reforms – which introduced a new stewardship code, helped women in the workplace and encouraged more companies to pay dividends – have made Japanese companies more mindful of their shareholders and attractive to foreign investors. 

These reforms have driven up profit margins in Japan which John Vail, Chief Global Strategist, at Nikko Asset Management, sees offsetting the problems of an ageing workforce. According to the World Bank, 28 per cent of Japan’s population are over the age of 65, the highest of any country it has data for, while the fertility rate is low at 1.4 per woman (2.1 is needed to maintain population levels).

While Japan has never been a high dividend paying country, its stock market has a dividend yield of 2.4 per cent – not to be ignored when interest rates are so low. And thanks to a culture of prudent capital management among Japanese corporates, dividend cuts have been on a much smaller scale this year than in the UK and Europe. According to Janus Henderson’s Global Dividend Index, Japanese dividend payments dropped by 4.2 per cent between in the second quarter of 2020. UK dividends dropped by more than 50 per cent over the same period.

Rob Morgan, investment analyst at Charles Stanley, says 55 per cent of Japanese companies now have net cash on their balance sheets, against just 13 per cent in the US and 15 per cent in the UK. Despite the Japanese economy being severely affected by the pandemic, companies could be well placed to endure difficult times. 

But investors must not ignore Japan’s problems. Before Mr Abe took office for the second time in 2012 Japan was churning leaders, with five prime ministers in the space of five years. While it is widely believed that reforms brought in by Mr Abe are likely to be continued, the risk of returning to a state of political paralysis could prevent further meaningful reform.

Japan is also a global manufacturer and exporter, so it is relatively exposed to the fate of the global economy. As some companies are likely to be heavily affected by the slowdown in the economy, other companies – such as those focussed on the digitisation of Japan – are facing a bout of demand.   

Japan has always had extremely high national debt levels, but these have been stoked by the coronavirus crisis. Mr Abe issued a stimulus package worth 40 per cent of Japanese GDP, which has brought national debt to 225 per cent of GDP according to FactSet data - much higher than in any other developed country. 

Such a large debt burden stifles Japan’s attempts to grow the economy. That said, Japan has been grappling with enormous debt levels for decades while the stock market has seen some good performance. Junichi Inoue, head of Japanese equities at Janus Henderson Investors, argues that profit more than doubled at Tokyo Stock Exchange-listed companies during Mr Abe's tenure, while the market’s total return has been 13 per cent per year since the end of 2011.

How to invest in Japan

Darius McDermott, managing director at research company FundCalibre, recommends that for a global equity investor, it might be sensible for Japanese equities to make up about 10 per cent of your portfolio. Similarly, if you invest in global equity funds it is worth checking how much exposure you have to Japan already in your portfolio.

Interestingly most global funds tend to be underweight Japan. According to data on FE analytics, funds in both the Investment Association and the Association of Investment Companies’ global sectors typically have a lower weighting to Japan than the MSCI World index. This may be because managers are wary of structural problems in Japan, or because they lack specialist knowledge of the area. 

You are likely to benefit from investing in Japan with an experienced fund manager who has specialist knowledge of the country. The best returns are likely to come from managers who can identify which stocks are most undervalued, or buy into growth opportunities such as technology. Japan is traditionally quite behind in technological innovation, so the pandemic has created upheaval for companies who have had to learn to adapt. Mr Morgan says this is creating “numerous growth opportunities for smaller businesses in a domestic market ripe for disruption”.

Fund options

Baillie Gifford Shin Nippon Trust (BGS) is well placed to take advantage of Japan’s scramble to digitise, as it invests in small- and mid-sized companies and is overweight areas such as e-commerce, software services and healthcare. Praveen Kumar, the trust’s manager, says people tend to have an outdated view of Japan but he has invested in a host of fast growing businesses at very attractive valuations compared with the US.  

The trust has significantly outperformed its benchmark over one, three and five years, with a share price increase of 166 per cent over five years to 4 September, compared with a return of 68 per cent from the MSCI Japan Small Cap index. Although the trust often trades at a premium, recently it has been trading at a discount as Japan seeks to recover from coronavirus. 

Moving into the larger-cap space, Fidelity Japan Trust (FJV), managed by Nicholas Price for the past five years, has significantly outperformed the Topix by being overweight the technology sector and underweight financials and machinery. Mr Price says he has been focussing on companies that will benefit from the shift to 5G and a new data-driven work-from-home cycle. Key holdings include electronic components makers Murata Manufacturing and TDK. On 4 September the trust's shares traded at a 9 per cent discount to the value of underlying assets. 

Mr McDemott recommends First State Japan Focus (GB00BJVQNH77), a relatively small fund with only 42 holdings that has had very good performance since it launched in 2015. He says manager Martin Lau is well supported by First State’s experienced Asian equities team and generally invests in companies with a market cap over $1bn. The fund has an ongoing charge of 0.9 per cent and has grown by 147 per cent from inception to 30 June 2020, compared with 52 per cent for MSCI Japan. 

If you want to tap into the value opportunity, Mr Morgan suggests Man GLG Japan CoreAlpha (GB00B0119B50), which has a contrarian strategy of investing in exceptionally cheap, but fundamentally sound businesses in the expectation valuations will eventually recover. It had around a fifth of its assets in banks at the end of July, for example. While the fund has severely underperformed its benchmark over one, three and five years, Mr Morgan says it “could benefit from greater interest in value stocks as well as the more incremental process of corporate reform in Japan that promises to gradually unlock greater shareholder value”.

To access Japan’s income story consider Jupiter Japan Income Fund (GB00B6QC0Z69), which has had strong performance and has a 2.3 per cent dividend yield, paid out twice a year. The fund is a concentrated portfolio of 38 stocks, the largest positions being Toyota, Sony and telecomms operator KDDI. While the yield may fall as companies protect themselves from this year’s crisis, Japanese companies prior to the crisis only paid out one third of profits (compared with 88 per cent in the UK), and some experts think Japanese dividends will grow over time.