A Resurrection For Long-Stagnant Japanese Stocks?
By the end of 2017, the Japanese economy had expanded for two years straight, its longest growth streak since the 1980s. Reflecting this economic strength, in January of this year the Nikkei hit its highest level since 1991. Archibald Ciganer discusses what’s driving the Japanese economy and equities and what he thinks might happen next.
Q. What is driving this apparent resurrection in the Japanese stock market?
A. The first driver is Abenomics—the fiscal, monetary, and structural reform policies introduced by Prime Minister Shinzo Abe. The second is the prolonged U.S. recovery after the global financial crisis—the Japanese export economy relies heavily on the U.S. consumer.
Figure 1: Global Corporate Profit Growth by Region*
Indexed to 100, October 2007–March 2018
Past performance is not a reliable indicator of future performance.
*Corporate profit in U.S. dollars by region based on companies within the S&P 500 Index and the MSCI Emerging Markets, Europe ex UK,
Japan, and United Kingdom indices.
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The Bank of Japan’s expansive monetary policies have helped weaken the yen significantly. This has helped Japanese exports to the United States and made Chinese imports to Japan more expensive, importing inflation after years of Japan being mired in deflation. That changed Japanese consumer and corporate expectations and behaviour.
Q. What about Japanese companies and markets?
A. The quality of Japan’s companies has previously lagged that of the rest of the developed world, but they’re catching up now and starting to deliver better returns and treating shareholders better. The new Corporate Governance Code under Abenomics sets higher standards, more disclosure and better treatment of minority shareholders.
Another new regulation, the Stewardship Code, requires investors, such as pension funds and asset management companies, to show how they’re protecting investors and engaging with companies to align their interests. In the past, large Japanese insurance companies were major shareholders but would not push companies to run businesses better.
These reforms have improved Japanese stocks’ return on equity, which used to lag that of European stocks. Last year, Japan’s return on equity exceeded Europe’s. This has attracted foreign investors, who now own more than 30% of the Japanese equity market, more than Japanese domestic financial institutions.
Q. Haven’t we missed the boat in Japanese equities, following this strong run?
A. Certainly the Japanese market contains many expensive stocks, but it is also a broad, deep market, and valuations are not rich overall. We continue to find attractively valued opportunities among the c. 1,200 stocks in our investment universe. It’s not too late to invest. We believe the improvements will continue because the changes are still taking place slowly.
Q. How do you manage the strategy?
A. I look for companies benefiting from long-term social or technological change. Because they are seeing increasing demand, growth comes more easily even if these companies don’t invest aggressively. As an investor, you want to be on the right side of major trends, such as Japan’s ageing population, the rising purchasing power of emerging market consumers, and stricter environmental regulations. You want to be exposed to rising demand and have the competitive advantage necessary to enjoy that tailwind.
For example, we hold several Japanese staffing companies. With a strong economy and a structural labour shortage, workers are starting to change jobs more. Staffing companies find it easy to grow quickly if they execute well.
We also like companies that are restructuring, changing strategy, upgrading their product mix or improving governance—anything that might lead the market to change its mind about their prospects. These tend to be value stocks that are genuinely changing where there’s a catalyst.
Q. Which sectors do you like in this market?
A. First, services in a broad sense. One holding, a staffing company called Recruit, also offers many other different services to small and medium-sized businesses and produces consumer-oriented media. Beyond staffing companies, anything that plays to the evolving Japanese consumer.
Second, automation-related companies, such as Keyence and FANUC. Keyence is a consultant that designs plants for better use of automation, and supplies the components. FANUC makes industrial robots, benefitting from the strong global demand for improved productivity. Demand for automation is still strongest in advanced economies, but it’s growing very quickly in China. The number of robots there could expand multiple times.
Q. Which sectors are you avoiding?
A. Banking, for one. We think Japan has far too many lending institutions, from banks to government-affiliated lenders. In Japan you have a virtually unlimited supply of credit. As a result, net interest margins have been compressing forever, yield spreads are really thin, and, effectively, you still have negative interest rates. It’s just too difficult to make money. On top of that, you have very strict bank regulations. Bank fundamentals are not likely to improve until the sector consolidates.
Old-style manufacturers, such as steelmakers, also face headwinds, such as direct competition from China and other low-cost producers. It’s very difficult for these industries to retain pricing power, and many of them are being shipped to China.
Q. Isn’t this just another ‘false dawn’ for Japanese equities?
A. We believe that this time so many factors are pushing Japan along that there is no turning back. Previously, when things got bad, Japanese companies would temporarily raise their game—and then return to their old ways when things were better. This time, you have new governance and stewardship legislation, increased foreign investment, and growing competition from China preventing Japan from going backward.
There are risks, of course. Not every company is getting better, and some are resisting change. The Japanese market is slowly becoming more diverse, less cyclical, and less dependent on exporters. But it remains very exposed to the global macroeconomic cycle. If there’s a global downturn, particularly if it starts in the United States, Japanese profits will be hit—there’s no avoiding that.
Q. Last words?
A. Now may be the time to invest in Japan. We think it’s a quality market that is improving, and its risk/reward balance is really attractive. Japan has the attributes of a developed market, but it also has the advantage of having a lot of room for improvement. It could be a 20-year process, so I see considerable potential for gains.
Key Risks - The following risks are materially relevant to the strategy highlighted in this material:
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