Atlantis investment fund manager Ed Merner expects expansion of small businesses to drive growth in the economy
With valuations on the Japanese market so low and corporate earnings set to turn positive, Ed Merner, of Atlantis Investment, believes downside risk is limited to just 10% to 15%. The next 18 months will see the market rise unless corporate earnings surprise on the down side, he said.
Merner, who speaks fluent Japanese, has been running money in Japan for almost 30 years. Based locally, he regularly conducts two to three company visits per day, which means he is able to pick out companies that managers 'looking at a Bloomberg screen in London will never find.'
He runs the Atlantis Japan Growth fund, an investment trust incorporated in Guernsey.
Merner feels the Japanese market is at or around the bottom of its cycle and that growth will be driven by small companies expanding. He acknowledged that structural economic problems are unlikely to disappear in the foreseeable future but argued this should not hinder recovery of the market.
Merner predicts tough times ahead for manufacturing, on which he feels the economy relies far too heavily. He sees small companies catering to focused sectors of the market as those most likely to flourish, pointing out that the success of post-war Japan was fuelled by small companies like Honda meeting the needs of consumers.
How important is it to be based in Tokyo?
I make two to three company visits a day. This is important on a fund like mine, which invests a lot in small companies. In a way, it's like prospecting. The more companies you visit, the more good ones you are likely to find. Good companies don't find you.
How much further has the bear market to go?
There is a high correlation between corporate earnings and stock market performance.
Generally, the stock market is about six to 12 months ahead of corporate earnings. For the year to the end of March, earnings were bad but the outlook for this year and next is much better.
Unless we're very wrong on our projections for corporate earnings, I'd say we are at the bottom of the market and I expect it to go up in the next year to 18 months. The downside risk is only 10% to 15%.
Is there a risk the poor performance of the US market could spill over into Japan?
The US economy is actually in good shape but the market is still suffering from the burst technology bubble. No one has predicted negative GDP growth for the US. Although the market is bad, the fundamentals are there and recovery should continue.
However, it follows that when investors are not investing in Europe and US markets, they don't invest in Japan. This is a serious risk because about 40% of floating shares in the Japanese market are owned by foreigners. If the US market continues to slide for a long time, there is a risk the Japanese market could go sideways or fall.
Won't the structural problems of the economy and the inability of the government to push through reform limit any upside?
The government does need to do more to help the transition from manufacturing to service industries. In Japan, manufacturing makes up more than 20% of GDP while in other industrialised countries, the figure is closer to 10%.
In a way, the country needs a crisis to speed up the reform process. The government here is bust. Officially, debt is 1.4 times GDP but when you look at off balance sheet loans, it is more like five or six times. Revenue continues to fall and costs are going up. The government has started to print money, which could lead to inflation, and people are seeing something is wrong.
However, government does not drive recovery in the economy. Post-war, Japan's strength came from small companies growing rapidly ' immediately after the war, Honda was a small company.
We are starting to see the emergence of well managed companies set to expand fast and drive growth in the economy as a whole. The Nikkei Index is at around 10,000 while, at the end of the 1980s, it was at 40,000. Valuations look reasonable and there are a lot of good value, recently established companies out there.
Are there some better established companies you are keen to avoid?
Yes, companies like Matsushita
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are not likely to fare well in the near future. The company, which makes Panasonic branded goods, lacks focus. It makes too many products and does not outsource.
It retains too much production in Japan and these factors mean it is late in the cycle of products and sells outmoded goods. It also has poor distribution. The company is fairly cash rich but this just means it has no incentive to go for more distribution in larger stores.
Funai provides a much better model. The company manufactures in China and limits itself to a few products like DVDs, TVs and VCRs. If a product is not popular, it stops making it.
How fast is the Japanese economy changing? Is there still a culture of a job for life?
A job for life was always something of a myth. It only ever applied to full-time employees of big companies. Those firms always employed what they called 'part timers', staff who work full hours but are on temporary contracts.
The construction industry labour force has always been made up of mostly part-time contracts. These contracts are becoming more prevalent and people are more likely to change companies of their own accord. Also, there are now more women in the labour market and they seem to be more willing to switch between companies.
What sectors are you overweight in?
Healthcare companies and pharmaceutical retailers are set to do well from the ageing population. Chains like Green Cross, Sundrug and Kirindo are benefiting from a tendency to buy drugs less from the hospital or surgery and more in the high street.
There are more stores focusing on prescription only or over the counter drugs. Specialisation allows stores to offer better service.
Other companies that will benefit from the sizeable elderly population are homecare services companies offering assistance to elderly people in their homes. Companies offering these services, like Nichi Gakan, have grown over recent years and will continue to do so.
Another area that has potential for growth is the discount retailer market. Japanese consumers are keener than before to get value for money.
A chain like Don Quijote is taking advantage of this trend and expanding fast. It has discounts from 5% to 80% and is open all night. It sells everything from milk to clothing and electrical items so shoppers going in for a specific purchase may come out with several goods.
Manufacturing is generally poorly placed. We hold practically nothing in smokestack industries. We have no utilities and no construction. We hold no shipping or airlines and have only a small exposure to steel.
Do you favour small and medium-sized companies?
Yes, at the moment they are in a good position to exploit opportunities in the economy. They are much more nimble and quick to adapt to current conditions. The big companies, which are very bureaucratic, are finding it hard to adapt. Smaller companies are also better value than larger ones at present.
How has being closed ended helped you as an investor?
We don't need to worry about inflows and outflows of money. In an open-ended fund, you inevitably get cash to invest when you don't need it.
Also, we can remain fully invested. Investors can also benefit as they can buy the fund at a discount.
Is the fund geared?
Yes, there is currently a 10% gearing. Now is a good time to find value stocks and any downside is limited. Unlike other funds, we have no currency hedging at the moment.
How well developed is the investment trust industry in Japan?
Traditionally, the investment trust market has been limited. The trusts used to be run by brokers and were aimed at maximising the broker's cut rather than the returns to investors.
The launch of several independent investment trusts in 1997 and 1998 was unfortunately timed. They initially went up but shortly afterwards were badly hit by poor market conditions and some went under.
This hit their popularity but there is now more variety and they should fare better under market conditions going forward. There are some new property investment trusts that are well placed and we are looking carefully at them for our portfolio.
FUND MANAGER: Ed Merner
Merner joined Atlantis Investment Corporation shortly after it was set up six years ago.
For 23 years prior to that, he was a Japan-based fund manager at Schroders, running equity and smaller companies portfolios.
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