Continually improving corporate governance, attractive valuations and a weakening yen are some of the reasons investment professionals are becoming increasingly positive on Japanese equities.
This comes following somewhat of a dry spell in terms of enthusiasm for Japan, with European and emerging market stocks seemingly overtaking in the popularity stakes.
Year-to-date, the MSCI Europe ex UK and MSCI Emerging Markets indices are up 14.66 and 16.89 per cent respectively, while the Nikkei 225 is trailing in the dust at 3.33 per cent.
Performance of indices in 2017
Source: FE Analytics
Emerging market equities were the ‘darling’ investments of 2016, with geopolitical risk across many developed market regions pushing investors to buy elsewhere.
Then, following the reduced political risk in Europe and relatively cheap valuations, investors have now piled back into the country year-to-date, with many investment professionals already acknowledging that it is a consensus trade.
David Shairp, head of research at Prudential Portfolio Management Group, said the firm has a mildly positive bias towards equities and, alongside Europe, is particularly positive on Japan.
“Within equities, our bias is very much towards the late cycle markets. We like Japan and we like it all the more given that the yen is maybe starting to look like a weaker currency,” he said.
“If you look at correlation between Japanese equity returns and the dollar versus the yen over time, it is persistently and consistently negative. So very crudely, weaker yen, stronger Japanese equities. That has been a great trade on and off since 2012 when Abenomics got going in earnest.
“I think if there is a bias towards a stronger dollar, that’s a very clear play.”
The head of research also argued that Japanese equity fundamentals have improved “massively” over recent years, with corporate continuing to leverage downwards over a period of 20 years.
“This, in itself, depresses returns on equities,” he pointed out. “Yet despite that, you’ve had improvements in margins, you’ve had improvements through a lot of the underlying balance sheet fundamentals in Japan, and Japanese ROE [return on equity] – once you allow for that deleveraging effect – has actually declined back towards global levels. The underlying improvement is massive.
“I think a slight dollar firmness would be a major vote of confidence for Japanese equities, which is one of the reasons why we like them.”
Performance of fund vs currency in US dollars
Source: FE Analytics
Nicholas Price, who runs the Fidelity Japanese Values trust, said the current outlook for Japanese seems “well balanced” as global growth remains on track and the Japanese economy continues to expand beyond its potential growth rate.
“The Bank of Japan remains highly accommodative and domestic consumption is gradually improving alongside employment conditions,” he explained. “Public spending is also on the rise as stimulus measures enacted in 2016 take effect.
“Furthermore, indicators of manufacturing activity such as exports and production remain firm. At the micro level, consensus forecasts point towards double-digit profit growth in fiscal 2017 and equity valuations are supportive.”
That said, he warned that a slowdown in the global economic cycle could tilt risks to the downside, depending on which policies central banks decide to implement. Price added that global geopolitical factors, combined with heightened political uncertainty in Japan (recent polls suggest prime minister Shinzo Abe’s popularity is dwindling), could also impact sentiment.
“Although there have been no significant changes to the overall portfolio, I have increased holdings in fast growing services companies and globally competitive technology-related names,” the manager continued.
“For example, there are attractive opportunities in the online recruitment and outsourcing space, as well as in fashion e-commerce. In the technology sector, I have added positions in beneficiaries of secular growth in factory automation and medical equipment, as well as companies with leading global share in electronic components.
“Conversely, I have selectively sold positions in financials as near-term upside appeared limited given the strong run-up from late 2016 and the recent fallback in long-term interest rates.”
Simon Evan-Cook, senior investment manager of the Premier Multi-Asset funds, has been bullish on Japan for a number of years.
“We can see that other investors are becoming more interested, but this is coming from a position where Japan has been a highly unpopular investment destination for quite some time,” he reasoned.
“As such, it feels a long way from being a ‘hot’ market. I think the appeal for many investors lies with the fact that, after a long period of stagnation, Japanese earnings are growing fairly healthily.
“Corporate governance also seems to be meaningfully improving too. This had been a turn-off for international investors for a long time.”
Evan-Cook also likes the fact that Japanese equity valuations look “okay”, particularly in relation to the US.
“It’s also a market where active managers can make plenty of extra alpha, which is another advantage it has over the US,” he continued.
“We use a number of active managers in this market, the most high-profile of which are probably GLG Japan Core Alpha and Lindsell Train Japanese Equity, both of which have done fantastically well for us over the years we’ve held them.”
The former is headed up by Stephen Harker, Neil Edwards and Jeff Atherton and, as its name suggests, adopts a value approach to investing. It is unafraid to stray from the benchmark; its largest sector overweight relative to its TSE Topix benchmark is banks by 14.37 per cent and its largest underweight is to information & communication by 7.75 per cent. It also tends to focus on large-caps, with Toyota, Honda and Mitsubishi taking the top spot for largest individual portfolio holdings.
Over five years, the £1.4bn fund has outperformed its average peer and TSE Topix benchmark by 31.01 and 26.09 percentage points respectively with a total return of 127.91 per cent.
Performance of fund vs sector and benchmark over 5yrs
Source: FE Analytics
Lindsell Train Japanese Equity has five FE crowns and has been headed up by Michael Lindsell since 2004. The £150.5m fund has a low-turnover, highly-concentrated portfolio which will consist of between 20 and 35 holdings at any one time. Almost half of the portfolio is invested in consumer franchises including luxury beauty brand Shiseido, skincare manufacturer Mandom and beverages company Kirin.
Over five years, the fund has returned 134.26 per cent compared to its average peer and benchmark’s respective returns of 96.9 and 101.82 per cent.