With a new emphasis on profitability and a strong technology sector, Japan offers retail investors the chance to diversify their portfolios and should yield reasonable, if not astronomical, returns
The Japanese equity market has been one of the best-performing markets this year and during the first quarter, a number of the largest global institutions began to increase their weightings to Japan.
So should the upturn in performance be taken as a signal for retail investors also to begin focusing on the Japanese stock market? And if so, what sort of stocks should they look for?
I will start off with a couple of scenarios sometimes cited as a rationale to invest in Japan but which we do not think are likely to happen.
The first is that the economy is going to recover. Real GDP growth over the five years has an annualised 0.64% while nominal growth has been -0.28%. In 2000 and 2001, real growth was 2.4% and -0.5% respectively. The optimists hope that this will accelerate to somewhere near the trend growth rate of the glory days of the 1970s and 1980s of around 4%.
But this ignores the fact that Japan is now a mature economy slowly and painfully making the shift away from basic industries towards higher value-added production and services. The experience of other economies suggests that the trend growth rate is unlikely to reach more than 2.5%. While unemployment rises and consumption (55% of GDP) remains stalled, we can expect GDP growth to remain below that level. We are therefore forecasting real growth of 1.5% and 1.0% for 2002 and 2003 calendar years.
The second scenario is that a Japanese Mrs Thatcher will succeed in pushing through the unpopular but necessary reforms, which are necessary. The current Prime Minister, Koizumi, was elected on a popular platform to do this but appears unable to overcome the vested interests of the incumbent Liberal Democratic Party (LDP) politicians.
Debate is intense on subjects such as tax reform and deregulation but the ability to forge a new political direction seems to be lacking. The recent ejection of the popular ex-Foreign Minister Tanaka from the LDP may be a sign that Japan's political system is creaking at the seams and that political change may follow but we do not base our investment case on this scenario.
Now let me turn to some of the positive reasons why we believe that retail investors should consider investing in Japan. I will mention four in turn: new corporate focus on profitability, technological leaders, the benefits of diversification, and valuations.
Some Japanese companies competing in a global market, such as Toyota, have long recognised the need to focus on the return on capital, and the needs of the shareholder. The big change over the past five years has been the behaviour of companies operating domestically.
Of course, many do not see the light but those that do have proved profitable investments for investors. One of our favourite examples is the Bank of Yokohama.
Ten years ago, the company was in a similar position to most other Japanese banks, with high levels of bad loans, a rickety balance sheet and low profitability. Under an energetic and western-educated president, the bank cleaned up its balance sheet by reserving or writing off the bad loans through the years 1995-98, cut costs by closing down its head office and overseas network and focused its business on profitable lines such as retail mortgages. The result has been profits growth of 10% annualised over the past ten years and a growing band of adherents in the stock market.
Here, we have found that it is important to visit companies as most will talk the talk of restructuring but many are reluctant to take the pain associated with measures such as closing down head offices. Others are so unwieldy and large that management is unable to overcome internal opposition. Some of the largest and most famous names may fall into this latter camp.
A second reason to look at Japan is the existence of global winners in Japan, companies who have the opportunity to be a dominant player in their markets over the next five to ten years. Some of these companies are well known, such as car companies Toyota and Honda. Others are much less so, for example FANUC for industrial robots or Nitto Denko with a 70% share in polarised colour films (not those used by photographers but rather in flat screen production).
What is perhaps new to western investors here is that these companies are not simply innovators but have a technological lead in their product. The role of copying and producing goods at a cheaper price has now largely moved to SE Asia and increasingly China.
A third rationale for investing in Japan is that it gives some diversification to global investors. The point here is not that exposure to Japan somehow optimises a global equities portfolio, it is that there are investment themes in Japan that are difficult to find elsewhere in the world.
One of these is restructuring, as described above. The US and Europe have largely gone through this stage and investors have garnered good profits. Today, these opportunities to invest in restructuring in the US and Europe are fewer whereas in Japan they remain plentiful. Another theme that investors can only invest in by buying Japanese stocks is the normalisation of the Japanese financial system.
Here the market has moved towards our view that the Japanese banks are serious about cleaning up their balance sheets over the past few months. The implications are significant. If they are once again able to allocate capital in a normal fashion, without being constrained by bad debts, we believe that the return on capital throughout the economy is likely to rise. This in turn has positive implications for returns to shareholders. It is not possible to invest in these outside of Japan.
The final rationale for investing in Japanese equities is downside protection. Valuation measures today such as PER (price earnings ratio), PBT (price to book) and PSR (price to sales) are all close to the lower end of their long-term historic ranges. In contrast, even after two years of bear markets US and European markets are generally in the middle of their ranges.
The implication for investors is that, as happened in February 2002 we believe that, Japanese equities are likely to outperform in an environment of falling global markets.
What should investors bear in mind when considering investment in Japan? The first important point I have referred to above is that the ability to select the right stocks is essential. Not all companies will restructure, or adapt to changing times.
Over the past five years the TOPIX index has returned an annualised -7.2%, whereas a number of good stock selection funds including our own have achieved positive returns. For retail investors, we therefore believe that a passive indexed portfolio is likely to be inappropriate.
Should investors invest in growth or value type stocks? Traditionally foreign investors have sought exposure to blue-chip Japanese exporters in high-tech industries such as Sony, NEC to Tokyo Electron.
Our view is that competition from lower cost Asia, and excess capacity round the world will make it difficult for many of these companies to maintain their growth status. They are also vulnerable to fluctuations in the yen, and a double-dip in the US economy.
In contrast, we can have high confidence companies that are genuinely restructuring will meet their earnings targets. These opportunities tend to be domestic value-type companies going through the process of squeezing more profitability out of their assets. Examples are companies such as Dai Nippon Printing, the pulp and paper, and trading companies.
What about small cap versus large cap? Small-cap stocks have outperformed large caps year to date, as investors have fled blue-chip export names. It is important to distinguish smaller companies with genuine earnings growth potential. This may come from restructuring, a superior business model, or entrepreneurship. On the other hand many small caps are suppliers to traditional industries, and find themselves squeezed as their customers try to reduce costs.
These are unlikely to be good long- term investments, even though they may outperform relative to large caps over shorter periods.
As always when investing, risks remain. The most important in the longer term is the level of structural debt in Japan. This is approximately 130% of GDP, and continues to rise as tax revenues decline. Default is unlikely as the debt is primarily held by the domestic private sector. The experience of other countries teaches that the most likely way out is inflation, even though this may seem counter-intuitive today. Inflation would likely be negative for the yen but ultimately positive for real asset prices, including equities. This scenario is likely to take several years to play out.
So should investors invest in Japan? At the end of the 1980s, Japan and Japanese management methods were thought to be superior. By 2000 the pendulum had swung all the way towards US style capitalism.
Our best intuition is that it has already begun to swing back and that any investor with contrarian instincts should give Japan serious consideration.
Many Japanese companies competing on a global scale have long recognised the need to focus on return on capital.
One major reason to look at Japan is the existence of several global winners in the market.
Japanese equities are likely to outperform in an environment of falling global markets.
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