Investing in Japanese equities

What does the future hold for Japan's equity market?

Just imagine it: the scene is the retirement party of a global equity fund manager. 

Amid the self-deprecating jokes about leaving to spend more time with his golf clubs and how he might be back if he gets under his wife’s feet too much, he says that, having only been in the market for 30 years, 'Of course I haven’t made money from Japanese equities yet.'

His words draw a knowing look from his peers, who all recognise the truth in his remarks. 

The truth is, those who seek to profit from the Japanese market are confronted with challenges around both the composition of the Nikkei index and the macroeconomic picture, despite certain Japanese companies being familiar names around the world. 

Investors looking at that market often find companies that have built up vast cash balances, but also a reluctance to distribute that cash via share buybacks or dividends, leaving investors frustrated.

Meanwhile, many of the largest Japanese conglomerates own shares in each other’s businesses, making it difficult for external shareholders to exert influence, meaning corporate strategy can be slow to evolve. 

At the macro level, ‘turning into Japan’ has become a shorthand used by many policy makers to describe the economic conditions they are seeking to avoid at all costs. 

Those conditions are expressed in terms of very low inflation and very low levels of economic growth, with bond prices high but equities also struggling. 

Household names

The malaise can also be seen in the fate of many Japanese exporters. 

Where once our shops were full of TVs and other household electrical appliances made by Japanese manufacturers, the labels now are much more likely to reveal the country of origin as Korea or Taiwan. 

While the broad contours of the Japanese economic unease can be seen in the performance of the Eurozone, and, to a lesser extent, the UK, there are also uniquely Japanese factors. 

These include the relatively low level of participation of women in the workforce compared with other western economies, a much older population than other developed markets, and a lack of immigration to the country. 

Politicians in Japan have, over the past decade, tried to address many of those issues, and have had sufficient success that many of the market-specific reasons for Japan being in the doghouse with some investors have become “great myths”, according to Sam Perry, senior investment manager for Japanese equities at Pictet. 

Government pressure

He says: “Since 2013, Japanese equities have outperformed relative to the big European markets, though they have underperformed against the US. 

“But you wouldn’t own the US right now if dividends were your priority anyway, and Japanese companies are yielding around what the European ones are.” 

He says successive Japanese governments have legislated to force companies to unwind stakes they own in other conglomerates, and to force those businesses to distribute more of their surplus cash to shareholders. 

Perry says the pressure on companies to act has become more intense in recent years.

The large cash piles built up by Japanese companies are, he says, a function of companies being very cautious following the crash of that country's economy and stock market in 1992, when they ran into huge debt, and have hoarded cash as a result. 

He says despite the changes occurring in Japan, sentiment remains very negative, with global holdings of Japanese equities by exchange-traded fund investors presently at the lowest level since 2012. 

New opportunities

John Paul Temperley, Japanese equity fund manager at Axa Investment Management, says companies strove to improve their balance sheets after the crash and “succeeded almost too well”. 

He says investors looking at the country should view the lack of some types of consumer electronics on their shop shelves as a positive.

According to Temperley, the largest Japanese companies consciously moved away from the manufacture of low-margin items such as TV sets, and into areas such as gaming or robotics where the profits are greater.

He says in terms of the domestic economy, Japan lagged behind the rest of the world when it came to digitalisation, but has begun to catch-up. 

Guillame Paillat, multi-asset investor at Aviva Investors, says that at the macro level, while Japan’s economic woes are well known by the market, it could be argued that the global economy is evolving in a way that is starting to resemble Japan.

If all economies begin to have the same characteristics, then the logical thing to do is buy the cheapest market, and that is Japan, he adds.

Paillat says: “Everyone else catches down to Japan, rather than Japan catches up. Japan has a very conservative culture and that can hinder dynamism in the economy.”

Joe Bauernfreund, manager of the AVI Japan Opportunity Trust, argues that the reputation of the Japanese market is not as bad as Europe but not as good as the US.

Bauernfreund says: "One of the reasons Japanese shares are so cheap is that perception issue – in other markets, if shares fall to very cheap levels, then someone comes in to buy it, but that doesn’t happen in Japan."

This is partly because of the perception, but also because, while in the UK, undervalued businesses get taken over by private equity companies, in Japan there are regulatory issues that block such takeovers. 

He says this means “there are far too many” smaller companies on the Japanese market, but says this also means the smaller companies are the cheapest part of the market.

Chris Taylor, who runs the Liontrust Japan fund, cautions that the rights of minority shareholders in Japan remain far from ideal, but says the stagnant nature of the domestic economy prompted the export businesses of Japan to invest heavily abroad, making them more efficient.

Global gazing   

Temperley says the fates of the Japanese economy and equity market are heavily linked with that of the global economy. 

He says: “The Japanese market does well when the world economy is expanding. It is very export oriented."

Pallait says the yen is a safe haven currency, so when people are optimistic about the world, it depreciates in value, which helps the exporters.

Taylor says: “Any post-Covid sustained recovery should favour the Japanese market, which remains firmly rooted at the lower end of global stock market valuation parameters.

He adds: "A major bearing on this outcome has been the relative sectoral split of the broad Japanese market as represented by the Topix index.

"Here, Topix's greater exposure to the clear beneficiaries of such a trend, namely the more cyclical/value industrials and consumer discretionary sectors, should underpin that market’s relative performance.

"By comparison the S&P 500’s high weighting in the clear pandemic beneficiaries, the information technology, healthcare and communication service sectors, accounted for that index’s much better returns since the end of 2019: 45.63 per cent vs 12.28 per cent.”

Nathan Sweeney is deputy chief investment officer of multi-asset at Marlborough, and presently has an overweight position towards Japanese equities.

He says that if we do get to a point where the market focuses less on growth because economic growth is already strong, and more on the valuations at which shares trade, then Japan, because it is a cheap market, would likely be one of the beneficiaries. 

Sweeney adds: “We see other reasons for a positive view on the outlook for Japanese equities. The new prime minister, Fumio Kishida, is pushing through £370bn in stimulus packages, which will boost the economy.

"In addition, the Japanese stock market is starting to attract renewed interest from overseas investors, and we believe domestic investment is also set to increase, particularly among younger Japanese investors. Of the close to 500,000 new direct investors last year, 50 per cent were aged under 40.” 

Inflation

Perry says there are also signs that inflation is, finally, coming to Japan after many decades, and inflation is generally positive for equities relative to bonds. 

Melissa Brown, managing director for applied research at risk analytics firm Qontigo, says she regards the Japanese market as likely to be more volatile in the year ahead, because while Japan itself has had little inflation in recent decades, the economy and market suffers if the UK and US, as buyers of Japanese goods, are contending with higher prices.

Masayuki Kichikawa, chief macro strategist at Sumitomo Mitsui DS Asset Management, says some of the trends that have emerged in the western world in recent years, such as ageing populations and the rise of automation, are areas that Japan as an economy is ahead of those in the western world.

Meanwhile, the areas where Japan has historically lagged, such as in attitudes to remote working, are changing as a result of the pandemic. 

Innovation

Shuntaro Takeuchi, portfolio manager at Matthews Asia, says: “For the past decade, the Japanese market has consistently outperformed European markets and even the Asia ex-Japan market, despite low GDP growth and low inflation. 

"Why? In our view the Japanese equity market is a beneficiary of incremental improvement in economic activity and profit growth driven by innovation.”  

He adds: “Labour populations are peaking in the US and China as the world [has started] facing issues that Japan has been facing over the last few decades. Baby boomers are nearing 70 years old and birth rates remain at record lows in almost all advanced economies.

"When you ask which companies have thrived amid a steady decline in labour force, ageing society, low birth rates, shrinking domestic demand and deflationary environment, the answer is growth companies in Japan.

"They have provided solutions to these structural challenges. Successful Japanese growth companies now have the opportunity to grow outside of Japan as these trends are starting to be felt globally.”

david.thorpe@ft.com