Japan is not known as a growth market, and it’s easy to see why. 
While other countries may be seeing slower population growth, Japan’s population peaked over a decade ago, and it is rapidly ageing.
While other economies are facing slower growth and lower inflation, Japan has experienced three “lost decades” of frequent recessions and doggedly persistent deflation.
And these tough demographic and economic conditions haven’t escaped the notice of investors in Japan’s stock market. While other stock markets continue to notch new record highs, Japan’s market peaked 30 years ago, and remains stuck beneath a so-called “iron coffin lid” some 40 per cent below its all-time high.
Even within the stock market, Japan has been a tough place for growth investors. Over the last 45 years, value shares have absolutely dominated growth shares in Japan, outperforming by about 6 per cent per annum, compared to just 2 per cent per annum outperformance for value shares globally.
In short, it is hard to get excited about Japan’s growth. But there is a big difference between growth of a market and growth in a market. Although we are value-oriented investors, we believe a company’s growth potential is a key component of its value, and there are wonderful growth companies on offer in Japan for investors who are willing to look bottom-up.
Japan’s drugstores are great examples. The most successful chains have grown by following a simple model. They roll out stores, operate them profitably, then reinvest the resulting cash into more new stores. With this strategy, the biggest and best chains have grown sales and earnings at a mid-teens rate—or better—for decades. We have held some of them, including Sundrug and Tsuruha, for more than 10 years.
The best chains have benefitted from a fragmented industry environment. In the US and UK, one to three chains dominate the market, but in Japan, the top five companies still account for less than half of industry sales. Because the leading operators are more efficient than the country’s motley legion of “mom and pop” chains, they can grow by acquiring or simply outcompeting smaller chains. That has led to some favourable trends for the winners: the industry’s overall store count and sales have grown, but the number of chains has declined. We believe further consolidation can support continued growth for the leading companies.
Japan’s drugstores are also one of a few beneficiaries of the country’s ageing population. Older people may be less willing to make a long trip to a big supermarket, or to make separate trips for food, prescriptions, and other healthcare products. Drugstores provide much better convenience, and at attractive prices—many are opening dispensing pharmacies within their stores, and some chains, like Cosmos Pharmaceutical, are able to sell food at even lower prices than supermarkets.
While we believe the drugstores continue to offer above-average growth prospects, we have to assess the price we are paying for that potential. Today, some drugstores trade at appealing valuations, while others appear fairly valued.
A similar pattern holds for Japan’s growth shares more broadly. The country is home to many outstanding companies, but too many of them trade at valuations that are too high for our liking. For investors, it is not enough to identify growth within a market. The key is to identify opportunities to buy growth at a reasonable price.
Rob Perrone is an investment counsellor at Orbis Investments. The views expressed above are his own and should not be taken as investment advice.