Last year’s growth/value rotation is likely to continue for years to come, according to Man GLG’s Stephen Harker (pictured), who believes defensive stocks have reached “preposterous multiples”. 
Harker, who has headed up the top-performing Man GLG Japan Core Alpha fund since its launch in 2006, says unloved sectors in the Japanese market such as iron & steel and banks are being unfairly shunned for “dull and low-growth” companies.
As such, his hefty overweights in these sectors remain unchanged, despite a number of investment professionals warning that the aggressive mean reversion from growth to value has run its course.
“Most of the value stocks that we have been holding, we still have in the portfolio because they’re so incredibly cheap. We think this is a multi-year event,” the manager said.
“The stocks that were winning for 10 years up until 2016 were low-volatility companies such as food, retail and pharmaceuticals. Defensives, essentially.
“Those stocks have not gone back into the portfolio because they’re still too expensive in our opinion, even though they have underperformed quite a lot over the last eight months. We still don’t think it’s an appropriate place to be putting money over a long-term view.”
Harker’s research – as shown in the graph below – depicts the price-to-book (P/B) ratio of the Nomura Large Cap Value index divided by the P/B ratio of the Nomura Total Market index.
It shows that value stocks haven’t been at such a big discount relative to the broader market for more than 30 years, with the discount only coming close to levels seen over the last eight months at the peak of the dotcom bubble.
Performance of index since 1980
Source: Man GLG
“Our view is that the price-to-book ratio of large-cap value would be in that range of 5 to 15 per cent discount to the market, in which case there’s enormous potential for the outperformance of value relative to the rest of the market,” the manager said.
On a sector basis, Harker has an 11.97 per cent overweight to banks and 7.76 per cent overweight o iron & steel relative to his TOPIX benchmark.
One of the potential reasons that Japanese financials – chiefly banks – are currently unloved is that ultra-loose monetary policy in Japan is keeping interest rates unusually low, which tends to squeeze banks’ profit margins.
“Both the national and regional banks have been benefitting from dramatically reduced credit costs from bankruptcy and other provisions they’ve had to make,” Harker argued.
“In many cases, the provisions have been positive rather than negative and have added back to book values, and that’s true across the whole banking system in Japan.
“We’ve had a very benign situation ever since 2003 with a little blip at the time of the Lehman’s shock.
“The key point is Japanese banks have been underperforming since 2007. If you look over the longer term, the banking sector peaked in 1987 so we have just come up to the 30th anniversary of the banking cycle’s peak.
“It’s been underperforming now for 30 years which is one of the longest periods any sector in the world has underperformed for. They’ve reached P/B ratios which are preposterously low in our opinion so we’re overweight.”
Not only this, the manager says banks now account for just 10 per cent of the TOPIX index compared to a 40 per cent weighting in 1987. He believes this is far too low and points out that this is reflected in the valuations of financial stocks.
In terms of his iron & steel overweight, Harker says this is also an area of the Japanese market that is trading on very low valuations relative to history.
“We’re looking at the steel price index against the food price index with one divided by the other - it’s a cyclical divided by a contra-cyclical,” he explained.
“Over the last 50 years, the market bottoms for steel have become lower and lower and the market tops for steel have got lower and lower, but the trend is insignificant. What is really important is the cycle.”
Performance of indices over 50yrs
Source: Man GLG
As shown above, the valuation of the TOPIX Iron & Steel Sector index relative to the TOPIX Foods Sector index is the lowest it has been for almost 50 years. Not only this, Harker’s research shows that food stocks have consistently outperformed iron & steel stocks for more than a decade.
“If you look at the relative valuation of steel versus food stocks, it’s off the charts. We think that steel is the right place to be and that’s why it’s our biggest sector overweight. Foods are really quite dull, low-growth companies and they are on preposterous multiples,” he continued.
“That’s why we’re overweight in financials and steel and we’re underweight in food, pharma and retail.”
Another unsustainable market trend, according to Harker, is the outperformance of Japanese small-caps relative to large-caps.
While many Japanese equity funds in the Investment Association focus on companies that are further down the cap spectrum, the manager believes the trend of Japanese small-caps’ outperformance is likely to mean revert.
“Looking at the share price of top-caps in the Russell Nomura index, 1981, 1987, 1997 and 1999 were really significant periods of large-cap outperformance,” he said. “In terms of where we are today, it’s at a record for this whole 37-year period.
“The last time we had a top-cap event was in the latter part of 1999, which was a long time ago. This is the longest sequential cycle of small-cap outperformance that we’ve seen at any time in stock market history.
“The same thing applies to the UK and the US. The world has seen 17 years of small-caps winning and its unsustainable. It’s only a question of time in our opinion before there is a reversal and top-caps are winning.
“This is predominantly why we set up Japan Core Alpha, to exploit what we thought was an undervalued top-cap opportunity.”
Since the fund’s launch in 2006, Man GLG Japan Core Alpha has returned 156.64 per cent compared to its sector average and benchmark’s respective returns of 50.98 and 68.31 per cent.
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
It has also been within the list of top-three performers in the IA Japan sector over one, five and 10 years.
Man GLG Japan Core Alpha has a clean ongoing charges figure of 0.9 per cent.