With Japan's economy on the road to recovery, this month's head-to-head discusses the merits of investing in large-cap stocks against the benefits of favouring mid and small caps
Jamie Jenkins, manager of the F&C Japanese Equity fund argues the case for investing in large-cap stocks
The recent strong performance of stocks in Japan may have come as a surprise to many, however, despite increased volatility the outlook is positive for large caps, according to Jenkins. He says a leap in banking stocks and strength in export-focused sectors at the end of March 2006 pushed the Nikkei 225 index above 17,000 for the first time in more than five years, which may have come as a surprise for investors, more familiar with disappointing news from the Japanese market over the last decade.
"The painful bursting of Japan's financial and real estate bubble in the early 1990s preceded a decade of stagnation, deflation and a downward grind in the equity market," he says. "The fall from grace of Japanese equities was staggering in its severity - in 1989 the Nikkei 225 stock average peaked at 39,000 but by 2003 it had plummeted to just 7,700."
However, Jenkins argues the Japanese economy started to show signs of economic recovery last year, encouraging investors to once again look at Japan. He explains data has continued to show a recovering domestic economy, solid export growth, better employment numbers, rising consumer activity and improving business confidence.
He adds: "We expect further improvement in Japanese economic data and ongoing outperformance by Japanese shares over the next few months. We are positive about Japanese large-cap stocks despite their increasing volatility over the past few months as the market was dragged down in February by concerns over US and local interest rates."
Despite this, recent economic releases have been generally positive, providing further evidence of the underlying recovery in the domestic economy. The Cabinet Office's consumer sentiment survey rose to its highest level in over a decade and data showed rising property prices in the major cities. Other data showed a higher current account surplus and an increase in industrial production.
"Stronger economic growth prompted the Bank of Japan to signal an end to its policy of quantitative monetary easing," says Jenkins. "Corporate data, positive direction from the US market and favourable currency movements for exporters are all providing good support."
He notes the top-performing large-cap sectors in March were security houses (+12.4%), real estate (+11.5%) and miscellaneous finance (+8.9%). In contrast, the worst performing sectors were mining (-7.5%), marine transport (-5.4%) and pulp paper (-4.8%).
Jenkins expects earnings to beat expectations in this coming season. "For the past 15 years, analysts have been operating in a deflationary environment and may well understate the impact of sustained gross domestic product growth on corporate earnings," he says.
"Large-cap sectors that are expanding their profits include banking, which is rising again after a number of extremely difficult years, real estate, which is experiencing an impressive asset price recovery, and industrial sectors geared into capital investment growth, such as machinery and plant equipment, which are currently in very strong demand."
One highly promising stock, says Jenkins, is Sumitomo Mitsui Financial Group, which is one of the three leading banks in Japan. This is due to concerns over non-performing loans and financial instability lifting and banks becoming more focused on loan growth and expansion of fee business, such as sales of investment trusts.
Investors in Japan are encouraged not only by the overall economic recovery but also by the recovery in domestic equity markets, which offer the prospect of enhanced returns compared to overseas bonds and postal deposits, Jenkins asserts. However, there are many Japanese companies that depend on success outside Japan.
He concludes: "The Japanese economy is susceptible to a number of outside factors, such as China's economic expansion, higher US interest rates and slowing US economic growth. The economy could also be affected by government policy errors, such as premature tightening of monetary and fiscal policy. The Bank of Japan is widely expected to raise interest rates by the end of the year.
"However, on balance, the skies are bright and clear for Japan over the medium term. Positive consumer sentiment, the prospect of an end to the zero interest rate policy, rising Chinese demand and improving corporate profitability are all positive for Japan. The market also continues to gain some momentum from expectations of continuing structural reform."
mid and small cap
Kevin Troup, who manages Japanese small and mid-caps at Martin Currie in Edinburgh, champions mid and small caps
The behaviour of mid and small caps can be idiosyncratic and almost likened to that of children, according to Troup. They are always subject to the parameters imposed by parents - in this case, the overall economic and market background, meaning that in each country there is a very different story to tell. In Troup's view, the fundamentals in Japan remain compelling. The economy is continuing to grow and private capital expenditure remains strong, as it has been for the past three years, while rising wages are underpinning consumption.
He explains: "The main economic event of late was an announcement by the Bank of Japan on monetary policy. Although its zero interest rate policy continues, the statement indicated the period of quantitative easing is finally coming to an end."
Troup believes the main catalyst for the bank's change in policy has been inflation, which, according to CPI data for November 2005, moved into positive territory for the first time in five years, partly because the index includes oil and food prices, both of which have been rising. The CPI figure has subsequently remained above zero. Furthermore, the survey confirmed the continuing recovery of the real estate market, with prices in all major cities rising.
"We see little reason to disagree with the consensus that Japan will generate steady economic growth of 2%-3% this year," he says. "Private capital expenditure should remain strong; capital stock in Japan is old and needs to be replaced. Corporate cashflows are very strong and capacity utilisation very high. The only caveat is this part of the economy has historically been highly cyclical and the current upswing is now in its fourth year."
Troup admits that even though share prices in Tokyo have risen only marginally during the first three months of this year, it was to be expected after the 40% rise recorded by Japanese stocks in the second half of last year.
"Japanese pension funds were the main sellers, as they attempted to bring their asset allocations back into line with their asset mix targets after the sharp rises in the Tokyo Stock Exchange (TSE) last year. Overseas investors remained net buyers of Japanese equities, albeit at a more modest rate than last year," he notes. "Trends in third-quarter earnings and forecasts for the full year have tended to be revised upwards again. Forecasts for the machinery, motor components, base metals, banks and stockbroking sectors, as well as those for some electronics companies, have been revised up."
Even new equity issuance has remained strong, says Troup. A number of companies have resorted to issuing new equity to fund expansion despite having strong balance sheets, however, this is one area in which the Japanese market has been disappointing.
He adds: "While management have clear targets for sales, for operating margins and for net profits, there are relatively few groups that target return on equity. We continue to expect good fundamentals will underpin the Japanese market. The fiscal year just ended will have seen earnings growth of around 15% and we expect to see growth of 10%-12% in the year to March 2007. The retirement of the first tranche of baby boomers will ensure most companies do not see any increase in their total salary bill - the continuation of this process should underpin earnings growth for the next few years.
"Valuations now look respectable rather than cheap. The price/earnings ratio on the market is 20 times March 2006 earnings. The market's price to book ratio is now 2.4 times. These levels are not too high for overseas investors and while this group remains a net buyer of the Japanese market, we can be quite confident that the market will continue to rise."
However, Troup stresses there are risks to this upbeat view. "The potential risk at present would be a sharp fall in overseas markets, which would increase their discount to the Japanese market and possibly result in profit-taking," he says. "But for equities as a whole, the context for mid and small caps is encouraging. They remain under-owned, under-researched and undervalued. They offer consistent outperformance with relatively low risk and exposure to the growing sectors of the domestic economy."
Troup says he will continue to focus on selecting mid and small-cap stocks, which offer the potential for positive earnings surprises and better use of their balance sheets, where they are allied to reasonable valuations. One example is Sumco, a producer of silicon wafers - an industry where Japanese firms maintain a healthy lead over their Asian competition.
He concludes: "Of course, there will always be 'problem children' among Japanese mid and small caps. But those that thrive often do so in a way their bigger brothers do not."
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