The market is benefitting from companies’ governance reforms, interest expressed by Warren Buffett, and Japan’s exit from its inflation cycle. Nonetheless, investors are seeing their stock market gains penalised by a falling yen. Here, Cédric Le Berre, Senior Investment Specialist with Union Bancaire Privée (UBP), speaks to Allnews about the market’s outlook.
Can the bullish trend in Japanese equities be sustained?
Some supports for the bullish trend can indeed be sustained, for example improvements in companies’ governance. We’re seeing a shift in the way companies are managed at boardroom level and the interests of minority shareholders are genuinely being taken into account. This shift is cultural and translates into the increasing inclusion of non-executive directors and specialists on executive boards. Companies, under pressure from institutional investors, also accept that they have to pay out more generous dividends or offer share buybacks when there’s excess cash.
There’s the start of a convergence in the management styles between Japan and the United States, and there’s still a lot of potential in terms, for example, of appointing non-executive directors to boards.
We’re used to saying that China is a communist country whose firms are managed in a capitalist way, whereas Japan is seen as a capitalist country, but a number of its companies are managed in the interests of the state and the government.
What proportion of firms have really changed their style of governance?
It’s often firms in the consumer spending, technology and healthcare sectors that have been early adopters of this style; they’re competing with foreign companies to offer the highest standards of governance.
Companies close to the government, such as consortia, banks, real-estate and infrastructure firms are now struggling to adapt, whereas small caps are, by their very nature, more flexible.
The automotive industry is a thing apart. It brings together the best of Japan and reflects a social tradition that makes it more flexible.
According to our estimates, 30% of listed companies are struggling to reform their governance, 50% are average and 20% are best-in-class.
UBP manages two Japanese funds. In 2023, why did the large-cap-focussed fund markedly outperform its small- and mid-cap counterpart?
The fund that focusses on the small- and mid-caps has indeed suffered because of stock selection. It invested in high-growth companies whose valuations were high. Since the conflict in Ukraine started, investors interested in Japan have favoured value over growth names. Warren Buffet has not been the only one to rediscover Japan because of its undervaluation; this anomaly, in our opinion, comes from a lack of coverage of the country by international investors.
The market is trading at between 14x and 16x future earnings, but there are significant differences between sectors and capitalisations. For instance, large caps have benefited from a major revaluation – the automotive sector in particular – and a drop in small caps’ valuations (which have less of a presence in ETFs), as well as the fact that they are less popular during a quick return of foreign investors to the market.
The weaker yen is problematic for franc-based investors. How do you compensate for losses in yen terms by the rise in equities?
Some clients favour asset classes hedged in francs. The cost of exchange-rate protection for francs is lower than for the dollar; investors pay more to protect themselves in dollars.
We wrongly thought that the yen would stop sliding, however, it seems prudent to remain neutral on the currency or to take an exposure with a view to the yen strengthening. The messaging from the new Governor of the Bank of Japan is quite dovish and he doesn’t seem to be in any hurry to raise interest rates.
Will any rise in the yen start with the shift of interest rates into positive territory?
That’s one of the aspects that should contribute to it. On top of that, there’s investors’ bets, such as hedge funds, which are still short on the yen.
We also saw a net return of investors at the end of 2023 and the beginning of 2024. If they buy more assets in yen, the currency should benefit, but this movement is only just getting under way.
What’s your two-year scenario?
We’re looking at the yen appreciating by about 10% against the franc and the dollar. This should have a significant impact on exporters (from machine tools to the auto sector), as well as on the major energy and commodity consumers.
Japan has benefited from currency repatriation for 3–4 years thanks to the fall in the yen and geopolitical concerns surrounding China.
What’s the geopolitical situation in Japan? Does the country pay its energy bills, like India does, in the local currency or in dollars?
The majority of the energy Japan consumes comes from Australian gas and coal. Their energy bills are in dollars, which is a burden for Japan. That said, the country has an ace up its sleeve: part of its nuclear reactor fleet is currently idle and could be reactivated.
In terms of geopolitics, Japan is benefiting from the slowdown in China, both from economic and capital inflows perspectives. This trend contrasts with the phenomenon at the start of the 2000s, when China surged ahead when it joined the WTO.
Nonetheless, Japan’s geopolitical situation should be complicated by its alliance with the United States and the US presidential election could play a major role here.
What’s your stance on auto manufacturers given China’s offensive on the electric vehicle front?
For a long time, we’ve been in discussions with our Japanese partners – who didn’t buy companies in this sector – first because of excessive valuations, and then because of too tardy a take-up of the EV theme. The electrification of the auto industry will clearly come from China – a market in which Tesla is suffering a great deal, by the way. Our large-cap manager doesn’t hold any automakers, with one exception, because of issues surrounding valuations.
Which equities are you favouring in Japan? What about those positions that Warren Buffett recently strengthened, such as Marubeni, Sumitomo, Mitsubishi, Itochu and Mitsui?
Our asset managers select equities with characteristics similar to those favoured by Warren Buffet, whilst at the same time looking to be more diversified. This is possible thanks to pockets of undervalued names.
They also like certain assets from domestic companies which benefit from the governance reforms, as well as the expected rises in wages and prices. Inflation, which has been encouraged for years by Japan, is finally appearing in the country and could have positive effects on household and business spending. We also know that investors are not overexposed to these sectors.
Is consumer spending a victim of the yen’s weakness and the ageing population?
We’re progressively seeing a transfer of wealth between generations which could bring about growth in consumer spending, but that will take time. That said, we’re also seeing upticks in purchases of autos and household appliances. When deflation persisted, households were banking on the fact that prices would continue to fall and were waiting before making purchases; a rise in prices could therefore be a strong reason for them to make the leap. The same applies to capital equipment purchases on the part of businesses, as well as to production capacity renewal.
What is the situation in Japan as regards the United States in the reshoring process?
Reshoring is a hotly debated topic. The United States has relatively few engineers for the rapid redevelopment of its industrial capacity, which has long since been relocated to south-east Asia, whereas Japan took another path. Even though it found itself suffering from a brain drain to South Korea and China, it nonetheless continued to train a number of engineers and protect its industrial base. Japan is better prepared than the United States for a multi-polar world. From steel to semiconductors, Japan remains the world’s number one in a wide range of fields, for example for certain types of specialised steel.
Japan isn’t a big player in AI or semiconductors. Is it suffering from its image of a country in decline?
Clearly, it’s suffering from it. For instance, it struggled to digitalise its working processes when Covid struck. Japan recognised the fact that it was lagging behind and brought itself up to speed. It won’t catch up with Taiwan and the US in the software field, but it will maintain an advantage in terms of hardware, in particular in robotisation.
You’ve followed the whole of Asia for many years now. If you were to invest in the region on a 5-year horizon, would you go for Japan, China or India?
I’d invest mainly in Japan and then then split the rest equally between China and India.
India is benefiting from its demography and from the increase in its productivity. However, this market has few opportunities for active managers in that companies are fairly valued. That said, investors have an interest in allocating at least something to India, given the country’s growth outlook. As for China, it’s attractive in terms of valuations following recent corrections. Japan, despite the return of Western investors, remains attractive and we’re strong believers in its potential. It’s a market that we know well and which still has undervalued investment pockets. Given the expectations for its currency and decisions from the BoJ, this market looks to us like a good investment opportunity.
Are investors coming back to Japan or are they still sceptical?
Investors are structurally cautious on Japan. It’s up to us as intermediaries to share our convictions and to present the current market dynamic. Japan’s structural deficits are well known, but measures are being taken incrementally to remedy these. Japan is one of our principal convictions for 2024.
Cédric Le Berre