A strategy which invests solely in inferior businesses that have generated an average return on equity of less than 5 per cent over the last 10 years is not recommended. However, dig deeper and scrutinise characteristic values of Japanese equity markets over a longer period and all is not lost. In contrast, an attractive concept presents itself: "systematic" value investing.
Systematic value investing in Japan could be achieved by selecting a portfolio of 100 of the most attractive stocks in the MSCI Japan index, which are chosen according to valuation criteria, such as EV/EBITDA or price to discounted cash flow. Proprietary evidence shows that if you recalculate and adjust your portfolio bi-annually, systematic value investing in Japan has outperformed the MSCI Japan by 5.8 per cent annually since 1990.
Performance of MSCI Japan over 1-yr
Source: Financial Express Analytics
While these returns alone might satisfy investors, extra alpha can be generated by adding market leading stocks to the portfolio. Such stocks should exhibit features such as products with high customer value, high entrance barriers, pricing power, cost-conscious management, above-average profitability, as well as a strong balance sheet. Investors should pick a concentrated basket of these stocks, for example 25, and apply a disciplined buy and hold strategy. Examples of attractive stocks include Fanuc, Nidec, Nitori and Daito Trust. An annual rebalancing of equally-weighted holdings should also be implemented to capture rewarding compound effects.
By carefully combining these two concepts – systematic value investing and holding shares of a few carefully selected companies – you have the potential to generate superior long term returns with minimised risk. Modelling such a strategy produces results which may surprise some investors, for example since 2003 the annual gross return of a 50/50 strategy would have been 10 per cent in Swiss francs, compared to the MSCI Japan which gained just under 2 per cent each year.
Ernst Glanzmann is portfolio manager for Japanese equities at Swiss & Global Asset Management. The views expressed here are his own.