Manager of the £3.1bn CF Ruffer Total Return fund Steve Russell believes there is between 30 and 50 per cent upside in Japanese equities over the next three years, insisting that the rallying market is even cheaper than it was two-and-a-half years ago. 
Russell (pictured), who recently won “Best in Bear Market” at the FE Alpha Manager of the Year awards 2015 with co-manager David Ballance, predicted just over a year ago that he expected 50 per cent from Japanese equities by March 2017.
The Nikkei 225 and Topix are already up 29.17 and 31.09 per cent respectively since his prediction and, speaking exclusively to FE Trustnet, he believes 50 per cent was too conservative.
“There’s only 10 per cent to go from my initial expectation, but given what we’re seeing I’d actually upgrade my expectations. There’s certainly more to come, and remember it’s the most attractive equity market out there by a long way,” he said.
“I hadn’t expected that the government would make so many changes so quickly and I didn’t expect the yen to fall so far and fast.”
Performance of indices since March 31 2014
Source: FE Analytics
“Moreover, Japan is one of the very few markets that is a beneficiary of cheap oil as it’s a net importer, and so a lower price is good news for corporate profits. This has had an interesting impact on inflationary policy – a lower oil price is actually disinflationary, so if anything it’s made the inflation target harder to hit, giving the authorities an extra incentive.”
While many investors may be tempted to take profits from the rallying Japanese market, Russell argues that it’s actually cheaper now than when the rally started back in late December, following the news of Shinzō Abe re-election.
He adds that a number of macro and fundamental drivers have still yet to play out, making the market even more attractive.
“Since Abe came in the Japanese equity market is up 60 per cent or so, but reported profits have actually risen by more than this. It’s therefore cheaper on a price-to-earnings point of view,” said Russell, who also runs the £343bn Ruffer Investment Company.
“This can’t go on forever of course, but we see significant upside. We are seeing a combination of a long-term cyclical upswing which has been happening since just before Abe came into power. Then we’ve had the government stimulus through QE, extra QE and tax cuts. We finally have a government that are standing behind the desire to get asset prices and inflation – particularly wage inflation – rising.”
“The final element we’ve had which we have certainly not seen in other regions such as the eurozone is a dedication to improving corporate governance. The authorities are really pushing for a higher return on equity from corporations.”
“Over a three year view I would say there is between 30 and 50 per cent upside to come.”
Performance of indices since Dec 2012
Source: FE Analytics
While there has been growing interest in Japan from some global managers including Schroder MM Diversity’s Marcus Brookes and Neptune Global Alpha’s Robin Geffen, Russell says its remains an unloved market overall. If this were to reverse, he says Japan would get an even bigger boost.
He adds that Japanese pension funds’ plans to increase their allocation to equities in favour of government bonds will provide added support. Three Japanese public pensions announced that they planned to shift more money into equities last month, following a similar move by the nation’s $1.1trn government pension fund – the largest in the world.
Russell says the bulk of his Japanese equity exposure in the Ruffer Investment Company and CF Ruffer Total Return fund is through banks and other financials, which he views as traditional re-inflationary trades which generally take benefit from improving corporate confidence.
“We also have exposure to companies that are reinvesting their cash reserves through buybacks and dividend growth via our holding in the CF Ruffer Japanese fund,” he added.
Japanese equites currently have a 20 per cent weighting in the Ruffer Investment Company and 18 per cent in CF Ruffer Total Return. In both cases its Russell’s largest asset class weighting, and both positions are larger than they were this time last year.
Whereas Russell’s confidence in Japan is going from strength to strength, his outlook for more in-vogue markets such as the US, UK and Europe are deteriorating.
“So far this year we have been cutting down our exposure to the US and UK, largely on valuation grounds,” he said.
“We don’t think they’re outrageously expensive on a relative point of view, especially given we have 0 per cent interest rates and bond yields on the floor. However we are struggling to find any outright bargains at the moment.”
“We’ve seen money flooding into the eurozone recently which has a Japanese-style stimulus programme. It may work for them, but I think this is based more on hope than anything because valuations have moved well ahead of earnings. I think a lot of the money going in is ignoring that,” he added.
Russell views the UK general election as an added headwind to UK equities, and it has contributed to his decision to both scale back on FTSE exposure and avoid other sterling-denominated assets.
He commented: “We’re watching [the election result] with a lot of care. The principle impact it will have on the portfolio is through our exposure to sterling.”
“We have recently scaled back our US exposure from 20 per cent to 5 per cent but we haven’t used the proceeds to boost our sterling exposure. I see no good outcome of the election for the economy and wouldn’t want to increase any allocation at this point. We have instead boosted our yen exposure to around 15 per cent.”
“The consensus play at the moment is to be long dollar, but given the strong run it’s had I think the more likely economic surprise will be going the other way.”
“The most important reason why we have scaled back our exposure is because we were using the dollar as a protection asset. In the past three months it’s been positively correlated to equities, so it’s usefulness as a protection asset has gone.”
Performance of indices over 5yrs
Source: FE Analytics
UK equities currently have a 7 per cent weighting in the Ruffer Investment Company, while the US and Europe make up a combined 14 per cent. He has a further 3 per cent in Chinese companies, but he says emerging markets are unlikely to make up a big portion of his portfolio.
“We’ve long been sceptics of investing in emerging markets but a year ago we felt China looked interesting. It was unloved, cheap and the government was just about to add some real stimulus to the stock market. That’s worked quite nicely and we’re happy to have 2 or 3 per cent and ride the wave a little further, but it will never be a significant part of the portfolio,” he explained.
While getting the Japanese market-call spot on, it been far from plain sailing for Russell and Ballance in recent years. Both the Ruffer Investment Company and CF Ruffer Total Return are highly diversified portfolios which prioritise capital protection above all else, and are geared up for a number of different macro outcomes.
Russell’s belief that inflation is likely to be a direct result of central banks’ desire for negative real interest rates has led him to a hefty allocation to inflation-linked bonds and gold. The former has performed very strongly of late though suffered badly during the 2013 taper tantrum, but gold has had an all-round miserable three years or so.
Ruffer’s limited exposure to equities and the US in particularly has also hurt performance. FE data shows the Ruffer Investment Company has returned 23.73 per cent over the past three years, putting it slightly behind its IA Mixed Investment 20-60% sector.
The managers don’t follow a benchmark, but draw on a composite benchmark split 50/50 between the FTSE All Share and gilts. It’s returned 27.81 per cent over the period.
Performance of fund, sector and index over 3yrs
Source: FE Analytics
Longer-term performance is much stronger, thanks to a particularly good 2008 when the fund managed to deliver 20 per cent in spite of the FTSE falling almost 30 per cent. FE data shows CF Ruffer Total Return is up 128.74 per cent over the past decade, putting it well ahead of the composite index and top quartile of its sector.
While not strictly an absolute return fund, the Ruffer fund has made money in nine of the last 10 calendar years, only losing 2.76 per cent in 2006.
CF Ruffer Total Return has a clean ongoing charges figure of 1.23 per cent, while their closed ended fund is currently trading on a 3.5 per cent discount to NAV, isn’t geared and has a total expense ratio of 1.18 per cent.
FE Trustnet will report Ruffer’s views on inflation, gold and asset class bubbles in two articles next week.