Japan has been disappointing investors for 20 years and towards the end of 2009, it seemed they would abandon the region once and for all.
Major institutions were laying off Japanese analysts and closing funds last year. The Merrill Lynch Global Fund Manager survey showed Japan’s popularity at a low point, relative to both the rest of the world and to its own history.
Since then a number of multi-managers have moved overweight and it has been the top-performing fund sector this year. To what extent does Japan still merit its place in a portfolio?
The macroeconomic situation would suggest Japan should be avoided at all costs. At the end of January, deflation accelerated at its fastest pace since 1970. The strength of the Yen has also been a serious problem. It has damaged the competitiveness of exporters on which – in the absence of strong domestic demand – the economic recovery relies.
The Government’s interventions to combat deflation have been ineffective at best. The accession of the new Government, after 50 years of rule by the LDP, brought some hope of change, but so far there have been few significant new ideas. In the meantime, Japan’s public debt is approaching 200% of GDP. Paul Chesson, manager of the Invesco Perpetual Japan fund, says: “The Japanese Government has done little to alter the course of its economy. The new Government has disappointed investors with its lack of progress.”
S&P cut its rating on the country to negative from stable saying it had less scope on fiscal policy and the new Government had failed to reform. Rob Burdett, joint head of multi-manager at Thames River Capital, says: “Japan initially looked like it should be less affected by the credit crunch because its banks were more secure. But the country was caught out by political change and the banks were holding equities on their balance sheets, which meant they suffered along with everyone else.”
In 2009, the figures spoke for themselves. The average Japanese fund dipped 3.1%. It was the only sector, apart from UK gilts, that lost money for investors during the year. The Nikkei staged a last minute flourish to end the year up 17.3%, which put it in line with other major markets, but for most of the year, it was the laggard. Many thought it was the end of the line for long-only Japanese managers. Gartmore, for example, launched its Japan Absolute Return fund, the first UK retail fund of its kind, aiming to deliver returns from Japan in all conditions.
Better performance in 2010
Although the Nikkei and the FTSE 100 have fallen by similar amounts, there is a marked contrast in the performance of Japanese and UK funds. The IMA Japan sector average is up 4.51% year to date, second only to the Japanese Smaller Companies sector. The UK All Companies sector has dipped 4.73%.
There have been small improvements on the political side. John Millar, manager of the Martin Currie Japan fund, points to policies to tackle the country’s demographic problem with incentives for children. He adds: “This puts money into the pockets of the householder, which seems to be a good way of addressing deflation.” Burdett says there have also been tentative signs Japanese domestic investors are returning to their home market.
My old China
Its proximity to China is also a bonus. While there are echoes of the technology boom in companies and governments claiming they are geared to Chinese growth, the links with the Japanese economy are well-founded. In December, China represented 48% of all Japanese machinery orders for export. While overall exports rose 12.1% in December, exports to China rose 43%, helping offset a decline in US exports of 7%.
However, for most investors the attractions of Japan lie at a stock-specific valuation level rather than in any bet on an economic recovery. The issue for Paul Chesson, manager of Invesco Perpetual Japan, is not whether the Japanese economy looks weak or strong, it is whether companies can outperform. He says: “We made a lot of money last year, simply because certain areas of the market were too cheap and there were some great companies trading at low valuations. The attraction was the undervaluation of strong corporate assets.”
The relative under- or over-valuation of Japanese stocks is hotly debated, but most agree valuations look, at worst, fair value and, at best, cheap. David Varley, manager of Royal London Japan Growth, says P/Es generally paint a false picture of the relative valuation of Japanese stocks, but price to book valuations look reasonable compared to the country’s long-term average.
Burdett adds: “Valuations are still compellingly cheap, on an absolute basis, relative to book value, their own history and relative to other markets.” Millar agrees: “Analysts had large capitulated on Japan. As such, the market looks good value. The price to book ratio is approximately 1.1x, against a 10-year average of 1.5x. Asia ex Japan, in contrast, has a price to book of approximate 1.9x, compared to a long-term average of 1.6-1.7x.”
The key decision for long-only fund managers is the balance between exporters and more domestically-focused names. On the one hand, exporters are geared to the global economy and the growth of China, but they recovered substantially in 2009 and now look more expensive. Domestic stocks look cheaper, but will be more vulnerable to the internal economic problems within Japan.
Balancing your portfolio
Burdett has sought to balance the two across the Thames River portfolios, but the overall bias has moved to the domestic names. Varley says: “I found less value in the exporters in H2 of last year. I have been shifting my portfolio towards retail and convenience stores and some areas of construction.” He believes Japan’s exposure to China may be a short-term negative if it puts the brakes on its growth.
Chesson takes a similar view and has removed last year’s bias to exporters. His domestic exposure largely comprises financial companies, including banks and insurance companies. He says visibility of earnings for these stocks has improved since last year, with no commensurate rise in valuations.
Chesson believes there are no great expectations of Japanese companies built into valuations. He says: “The only thing we are interested in is whether expectations are under- or over-valued. It is not about fundamentals, it is about valuations of fundamentals.” It not all over for Japan and money can still be made in the region, but investors will have to look beyond the economic situation.
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