Markets have a way of defying even the most confident of predictions. Conditions can appear ideal for sparking a recovery and supporting growth, and yet the expected investment performance somehow fails to materialise.
Japanese markets have a bit of a reputation for causing disappointment. Investors wonder why this global success story, the world’s third-largest economy, has not consistently fed its way through to investment valuations. A thriving export-led economy like Japan’s should be able to sustain index performance over time. However, it has been tough over the last few decades to make a convincing investment case for that country, given the weakness of its domestic demand, its ongoing deflation, and its economy’s vulnerability to global downturns.
That is, until December 2012 and the election of Prime Minister Abe, when things began to change. By the standards of Japanese politics, Abe is a true radical, as demonstrated by the fact that his ideas have a name: “Abenomics”.
The recipe is a powerful combination of a more accommodative monetary policy, some old-fashioned fiscal stimulus, and then serious structural change in the Japanese corporate sector. Shaking things up in this way was recognition that continuing stagnation would fundamentally undermine the Japanese economy and threaten its long-term survival.
Of course, such wholesale change takes time to take full effect but it is now clear that progress is tangible and the opportunity to profit from it is real. Although 2018 was a challenging year, we strongly believe that attractive valuations and supportive domestic conditions are once again making a compelling case for Japanese stocks. Understanding the market takes time, but investment managers who do will have the chance to capitalise on some attractive valuations and specific company circumstances.
- The Bank of Japan remains committed to its accommodative policy
- Attractive valuations
- Government support remains active too
- Japan retains a proven edge in various industries
The Bank of Japan remains committed to its accommodative policy
The Japanese yen seems set to remain rather weak as the Bank of Japan stays committed to supporting the economy. Governor Kuroda, re-appointed in April 2018 for a five-year term, will ease monetary policy still further if he thinks it necessary, and the central bank’s reactive policies suggest interest rate differentials will keep the yen low in 2019. Japanese yen investors should see a trajectory similar to that of their continental European counterparts: the 8% to 10% VAT hike scheduled in October 2019 should mean that domestic policy will continue to favour a weak yen, boosting the exports needed for an economy that is still under repair.
The valuations of Japanese equities are near their 2008 lows despite domestic corporate earnings outpacing US earnings. Although Japan also has a large and vibrant technology sector, its equities have not kept pace with their US counterparts. In fact, despite earnings growing 63% since end-2013 versus 31% for US equities, Japan investors today pay 25% less in P/E terms, with multiples having fallen to 13.3 times. This is a level not seen since the lows of the 2008 global financial crisis.
Government support remains active too
Prime Minister Shinzo Abe is a political winner. His Liberal Democratic Party (LDP) enjoys a strong mandate empowering him to implement pro-growth structural reforms with little opposition.
With the LDP controlling a majority in both houses of parliament, political stability should enable the government to complete its transformation of the economy and society.
Japan is on track to record the longest period of economic growth in the post-war era. Nevertheless, Japan’s potential growth is being hampered by its ageing population and a loss of impetus from public investment. The rise in consumer spending is set to be only moderate, and despite strong private investment and automation efforts, growth may not pick up much beyond 1% in 2019.
Japan retains a proven edge in various industries
Japan is the third-largest economy in the world, and accounts for 10% of global market capitalisation. It lies at the heart of a dynamic Asian economy and trades heavily with fast-growing China. With the rise of automation and thanks to its unique long-standing involvement in automation, Japan has become a hub for robotic research. This is a sector which has the ability to drive structural change and threaten some more complacent global competitors.
- Reforming corporate governance to generate stronger returns
- New rules to bring Japanese companies closer to global standards
- An index fulfilling investor-focused criteria
- Strong domestic allocation from pension funds
Reforming corporate governance to generate stronger returns
By bolstering the attractiveness of Japanese companies, changes in corporate culture are contributing to making Japan an attractive long-term investment.
Corporate governance has been a key focus of Prime Minister Shinzo Abe’s overall economic revival program. His conviction was that reforming corporate governance and strengthening shareholder rights would help companies make better capital allocation decisions, and thereby generate higher returns and boost overall growth. This represents a clear break with previous approaches to corporate governance in Japan, whose companies have suffered from a reputation for being slow to embrace change. Overseas investors have long been calling on listed firms to be more transparent about their governance and the independence of their management.
New rules to bring Japanese companies closer to global standards
Since 2014, Shinzo Abe’s administration has pushed forward historic structural reforms, starting with the adoption of the Stewardship Code which was followed by the Corporate Governance Code in June 2015. The Stewardship Code is a voluntary code of conduct for institutional investors and fund managers “to promote the sustainable growth of companies through investment and dialogue”. The Corporate Governance Code defines fundamental principles for listed companies with the aim of attaining “sustainable corporate growth and increased corporate value over the mid- to long-term”. Companies have to disclose relevant information in accordance with those principles in a spirit of “comply or explain”.
The Stewardship Code was revised in 2017, urging the disclosure of more detailed proxy results. Institutional investors and asset owners are required to assume a higher level of fiduciary responsibility, with the aim of enhancing the return on equity (ROE) of the companies they are invested in. As for the Corporate Governance Code, a revised version was introduced in June 2018 to move Japan closer to global governance standards. The main changes focus on unwinding cross-shareholdings, broader adoption of compensation and nomination committees, and greater diversity on boards.
Change won’t happen overnight, but there is some evidence that reforms are slowly creating a more dynamic corporate environment, with clearer financial targets, rising shareholder returns and an increasing number of independent board members.
An index fulfilling investor-focused criteria
The launch of the JPX-Nikkei Index 400 was warmly welcomed in 2014. Operated by the media organisation Nikkei Inc. and the Tokyo Stock Exchange, the index is composed of 400 companies selected on the basis of investor-focused criteria, such as efficient use of capital and investor-centric management approaches.
According to the new selection rules announced in December 2018, inclusion in the index will now be based on constituents’ three-year average return on equity (ROE) and three-year cumulative operating profit, and on the disclosure of an English version of their corporate governance reports.
Strong domestic allocation from pension funds
Japanese pension funds, public and private, have been allocating a greater portion of their assets to equities, which provides another powerful support to the Japanese stock market.
This has notably been the case with Japan’s Government Pension Investment Fund (GPIF). With JPY 156.4 tn under management and a time horizon of 100 years, the GPIF is the world’s largest pension fund. As part of Prime Minister Shinzo Abe’s general push for structural reforms, his asset allocation policy was amended in 2014 to raise the fund’s maximum exposure to equities from 24% to 50% (Japanese and foreign equities’ stakes have since both risen from 12% to 25%). Given its predominance, the GPIF is also playing a critical role in enforcing the Stewardship Code through its external asset managers.
- Assessing the drivers of growth
- Inefficiencies effective active managers can exploit
- Seasoned teams and strong track records
Assessing the drivers of growth
In the environment described above, identifying price discrepancies between intrinsic value and market price is an important driver of alpha generation for investment managers. Investors therefore need managers with proven expertise in assessing growth, its drivers and how it could impact the fundamentals of companies.
Inefficiencies effective active managers can exploit
There is a large pool of stocks to pick from in Japan. Foreign investor volumes can dominate Japanese markets, with sentiment often being driven by risk-on/risk-off factors. This creates opportunities for active managers to generate sustainable alpha through a measured approach.
Seasoned teams and strong track records
At UBP we have a long history of partnerships with leading Japanese active equity managers.
They are focused, benchmark-aware portfolio creators with a high active share, favouring fundamental and bottom-up processes with an approach unrestricted by sectors and market caps. Those attributes are critical for alpha generation in the Japanese equity universe.
The research teams perform fundamental analyses on more than 1000 Japanese equities a year, which they choose according to their understanding of the edge the companies have in their respective industries. The shortlist for building the portfolio is then based on the Discounted Cash Flow (DCF) and five years’ future earnings growth of the companies analysed. The teams cultivate a collegial approach, encouraging original contributions and individual ideas. This style contrasts with that of traditional money managers and helps to underpin strong model investment portfolios.
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Cédric Le Berre