Japan plugs in to emerging market growth story

Over the past decade the Japanese economy has been a consistent underperformer and 2011 proved to be no different. The threat of a global slowdown still concerns investors, as do economic fundamentals: demographics look weak with a rapidly ageing population, government debt is high and GDP growth low.

Yet GDP doesn’t necessarily reflect the health and growth opportunities of individual companies and nor does it reflect equity markets. Japanese corporate profits look promising and corporate actions are likely to pick up further.


A thriving backyard

Japanese companies offering more value for investors are export-oriented firms that operate a large proportion of their business overseas. Many of these companies have learned to innovate and flexibly adapt their business strategy to tap the higher growth potential abroad. They don’t have to go far.

Japan is surrounded by growth markets. It has longstanding trade relationships with emerging Asia and is therefore better positioned than Europe or the US, for instance. Already today, around 50 per cent of exports go to Asia.


Fast recovery in corporate profits

Extraordinary events in 2011 highlighted the highly flexible and dynamic nature of Japanese companies. The most expensive natural disaster on record hit Japan in 2011, leading to an overall economic loss of more than $200bn. Nevertheless, in a very short time, most companies were able to recover, which has been reflected in a pick-up in industrial production across the board. The economy has recovered quicker than many expected.

Across Japan, corporate profits have largely returned to pre-earthquake levels. Lower raw material costs and the strong yen should make a positive contribution to input costs and help companies sustain margins and profits. Internationally geared companies such as Fanuc, one of the world’s largest manufacturers of industrial robots, are reporting their best earnings ever.


Low valuations and high equity risk premiums

Japan has seen a sharper reduction in valuations than other major markets, with many equity prices at historic lows. This reflects investors’ concerns about the impact of the debt crisis in Europe and an economic slowdown in China.

Meanwhile, the equity risk premium has reached historic highs and indicates a possible sharp fall in corporate profits. However, none of the major fundamental indicators point at such an outcome. Valuations should go up both in relative and absolute terms.


The search for value

When looking at Japanese investments the only traps to avoid are top-down investments in indices that also include structurally weak companies.

Japan offers exceptional value for investors who are prepared to look for outstanding companies. For those investors seeking an active strategy, they can enhance their returns by combining two different strategies: one looks for few long-term leaders following a strict bottom-up selection of companies with excellent business models; the other focuses on value investments based on a more quantitative approach.

While the sovereign debt crisis continues to beleaguer Europe, Japanese companies are in relatively sound shape, which provides interesting investment opportunities.

Ernst Glanzmann manages the Julius Baer Japan Stock fund. The views expressed here are his own.