Restructuring announcements in Japan are less prolific these days and the new buzzword is recovery. ...
Restructuring announcements in Japan are less prolific these days and the new buzzword is recovery. But we should not lose sight of efforts to restructure.
For investors, economic growth without profits is like a rubber bone for a dog: interesting, but ultimately unrewarding.
The cyclical upturn in Japan, whether you are cautious or more optimistic, will inevitably end and companies that have not embraced the leaner-and-meaner philosophy will be found wanting.
The investor who makes restructuring a priority can probably rule out some sectors. Construction companies have done very little and chemical companies still have a long way to go.
But, by and large, a focus on successful restructuring does not lend itself to a sector-down approach.
Positive changes have been made by companies in most sectors. We are looking at every company on an individual basis, rather than taking a top-down approach and comparing one sector against another.
The first thing to note is that restructuring in itself is not enough. A company may have slashed costs and seen a skyward leap in profits this year, but if that is all there is to the story, it won't appear on our radar screen.
For example, despite mergers which have helped banks to break out of their traditional business models, bad habits linger. They still need to deal with their exposure to bad debts.
In addition, banks in Japan operate on thin margins compared to the west. The net interest margin is around 1%, compared with 4% in the US, and there are few signs of improvement. We need to see that profit growth is sustainable. Our portfolio holdings are selected because we believe they will be able to achieve strong growth at the top line in the future.
Cost cutting can be found in most sectors. But companies also need to achieve sustainable revenue growth.
We believe this rules out many exporters. To date, the recovery in Japan has to a large extent been export led.
Asia takes more than 40% of Japan's exports and while the first half of this year saw these economies growing at double-digit rates, growth is now on the way down. It also looks as if US growth is heading south.
So, when we halved our exposure to technology, media and telecoms earlier this year, we were most concerned about valuations among exporters. Many of these companies will be unable to live up to the optimistic expectations reflected in their still somewhat heady valuations.
However, for selected companies with a domestic focus the outlook has improved; albeit from a low base.
This side of the economy has been the slowest to pick up and we expect growth here will slow next year too but at least it will remain in positive territory.
This is the best environment some domestic companies will have seen for several years. For companies which have cut costs and survived the tough times to emerge leaner-and-meaner, things can only get better.
We have therefore maintained an exposure to selected TMT companies whose main market is Japan itself.
At the consumer level, Yahoo Japan demonstrates clear, visible growth in earnings. Net One sells the US company Cisco's data networking products within Japan.
It should benefit from the sharp increase in technology investment by Japanese companies.
There is plenty of room for growth in this area as, relative to the US, Japanese companies' spending on information technology (IT) is a long way behind.
Tokyo Broadcasting System, which broadcasts both national television and radio, is one of our largest holdings. This company should enjoy robust profits growth as Japanese companies increase their advertising budgets.
An area in which we have not stuck to an exclusively domestic bias is pharmaceuticals.
We don't believe the global economic slowdown is a threat to the healthcare industry.
In addition, Japanese pharmaceutical companies are becoming more global and enjoying increasing overseas sales.
Progress on meeting clinical harmonisation guidelines means drugs can be developed in Japan and the results from clinical trials can be used to licence the drug in another country, rather than starting the process all over again.
Yamanouchi Pharmaceutical is enjoying strong overseas sales. However, we also hold Banyu Pharmaceutical, which sells Merck's products in Japan, and again should benefit from the recent domestic pick up.
Pharmaceutical valuations in Japan (with the exception of the largest companies) are cheap compared to the west. Banyu trades on a price/earnings multiple of around two thirds that of its western counterparts.
Growth at the right price
We won't pay over the odds for growth. There are some really undervalued companies in most sectors given the polarisation of the market at the end of 1999.
Investors have become much more discriminating; valuations and recent international profits disappointments in the TMT sectors have led to sharp falls in Japan just like everywhere else.
Of course the stocks which have come off worst were those which reflected much too optimistic expectations in the first place.
With an eye on earnings sustainability, restructuring and realistic valuations, we are able to build a portfolio stock by stock. The paper manufacturer Rengo is benefiting from revenue growth as demand for its products has increased along with the moderate economic recovery. In addition, Rengo has also successfully rationalised its business.
The railway companies have had successful early retirement programmes. We have recently invested in Japan Railways West. The company is improving its profit margin through cost-cutting, but is also enjoying growth at the top line level as revenues increase with a revival in domestic travel.
For the most part, Japan has managed to avoid the rush of earnings downgrades that have been a feature of other markets. Textiles and
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