Only certain sectors are poised to capture the strong recovery in Japanese markets, according to fund manager Nathan Gibbs (pictured)
, who says investors in this sector need to be selective rather than blindly chasing returns through a tracker fund.
There has been renewed optimism surrounding the region in recent months, following the new government’s announcement that it intends to reflate the economy following years of stagnation.
The Topix has outpaced other developed markets in the recent equity rally; according to FE data, the index is up 22.51 per cent over six months, compared with 14.67 per cent from the S&P 500 and 11.04 per cent from the FTSE 100.
Performance of indices over 6 months
Source: FE Analytics
Gibbs, who runs the Schroder Japan Alpha Plus
fund, says that while investors are right to be optimistic about Japanese equities, only certain parts of the market are poised to benefit from reflationary measures, and points out that valuations are stretched in certain areas.
"We are optimistic, but we have been for a long time as the market appeared significantly undervalued all the way through 2012," he said.
"The catalyst to spark the rally has been the reflationary rhetoric of the new prime minister [Shinzo Abe], but we still need to be careful about the amount which we are prepared to pay for individual stocks."
"While we feel the market still has significant potential, some stocks have already run well on the back of foreign buying over the last three months."
"Rather than chase this momentum, we are now more inclined to look for laggards where the change in outlook is not yet reflected in the stock prices," he added.
The manager says this is why he has raised his exposure to more consumer-focused cyclical stocks, which have not participated in the rally so far.
"The 'reflation' of Japan has been a major driver of stock prices in the last few months and this is reflected in holdings in financials, housing and real estate in particular," he said.
"We are also finding opportunities in many domestic areas of the market where we think companies will be able to regain pricing power if Japan moves from a deflationary environment to mild inflation."
"This idea is reflected in current positions in speciality retailers, services and transportation stocks, for example."
Gibbs counts both East Japan Railway and electronics company Yamada Denki as top-10 holdings.
He has run the £60.2m Schroder Japan Alpha Plus fund since its launch December 2000.
Over that time, the fund has returned 66.29 per cent while the IMA Japan sector and its benchmark – the TSE Topix 100 – have returned 27.82 per cent and 18.88 per cent, respectively.
Performance of fund vs sector and index since Dec 2000
Source: FE Analytics
However, the fund has tended to be more volatile than both the sector and the index over this time.
While Gibbs’ long-term record is strong, Schroder Japan Alpha Plus has lagged its peer group in the shorter-term, which in part prompted the FE Research team to remove the fund from the FE Select 100 in the recent rebalancing.
The fund has fallen short of its sector and benchmark over one and three years, with returns of -0.42 and 5.37 per cent, respectively.
Performance of fund vs sector and index over 3yrs
Source: FE Analytics
However, Gibbs says he is confident that the fund is well positioned to benefit from the impending inflationary policies.
"Many of the stocks now seen as reflation plays, such as real estate, were already in the portfolio, because they looked undervalued last year," he said.
"Nevertheless, it has also been important to recognise the potential for a long-term trend change in areas such as banks and autos, and the portfolio weightings in these areas have been increased where we can still do so at reasonable valuations."
"This has also meant a slight increase in the weighting in large cap holdings at the expense of mid caps," he added.
Schroder Japan Alpha Plus has a highly concentrated portfolio of just 30 holdings. Its largest sector weighting is to industrials, which make up 34.4 per cent of the portfolio.
Gibbs is a fan of Abe’s policy to make Japan a more globally competitive market; however he says these words need to be turned into actions.
"The new administration has made very positive statements and has the benefit of timing, with the appointment of a new Bank of Japan governor who is more aligned with the government's stated policy," he said.
"We would expect this positive news-flow to continue through to the Upper House elections in July."
"Beyond that, however, we need to see some real delivery on the policies outlined so far."
"In particular, we will need to see a stronger commitment to structural reform in order for a more aggressive monetary policy to be translated into a higher rate of trend growth," he finished.
Schroder Japan Alpha Plus has an ongoing charges fee (OCF) of 1.7 per cent and requires a minimum investment of £1,000.