The Nikkei 225 Index had risen over 200% in a four-year period to December 1989, fuelled by financial deregulation and a loose monetary policy which had created a massive expansion in credit. The abundance of liquidity, offered by the domestic banks desperate to lend cheap money, then found its way into the stock market.
Property bubble
However, this was not the greatest source of speculation at the time. That dubious honour was reserved for the real estate market. Prime property in Tokyo was reportedly changing hands for $750,000 per square metre at the peak of the property bubble, and at that stage it was said that the value of Tokyo’s Imperial Palace exceeded that of all the real estate in the golden US state of California.
All parties end – and the inevitable bursting of the bubble was spectacular. Over the so called “lost decade” the Nikkei 225 Index fell from almost 40,000 to well below 10,000.
Real estate prices crashed in a similar fashion, as the banking system first imploded and then consolidated. The massive withdrawal of credit as Japanese banks deleveraged was a major factor in driving down both economic activity and the stockmarket.
The Government was slow to react, but eventually waded in, ballooning the national debt. Perversely, government bond yields plummeted, with ten-year yields falling from around 6% to below 1%. Today government bond yields remain around 1% and debt to GDP is 230%, which makes even Greece look a frugal nation.
Japan’s ability to refinance itself at such low interest rates has been its saving grace. Deflation, initiated by the asset price crash, has now become ingrained in the economy.
Nikkei performance
Unfavourable demographics, a strong currency and changing consumer habits have further exacerbated falling prices. While deflation has been supportive in real terms to the bond market, it has failed to serve the stockmarket.
Indeed, over the past three years since the market lows of March 2009, the combination of a strong yen and deflation have suppressed the performance of the Nikkei 225 Index relative to other global indices.
Whereas the US equity market has almost doubled over the same period, Japan has only climbed some 20%. Despite the tragedy of last year’s earthquake and tsunami, corporate Japan has achieved a strong earnings recovery through innovation and growing emerging market demand. Today the market trades near historic low valuations, the price to book ratio is 1x which is the cheapest level since the late ’60s.
The larger funds in the sector are managed by investors who know their history well and mostly have experience stretching back before the peak. It has been a long journey in the land of the rising sun for these fund managers, with many false dawns.
Whether it is the GLG team headed by Stephen Harker, the managers at Morant Wright or James Salter at Polar Capital, all demonstrate a long-term track record and consistent investment process.
GLG Japan CoreAlpha is a fund that we know well and has a focus on large cap stocks. The team are stockpickers, adopting a contrarian value approach. This requires the patience to wait for value to be realised and conviction to increase holdings if prices fall. As a result, the portfolio can differ from the index and be concentrated on a particular theme or sector.
A similar approach is taken by the team at Morant Wright, founded by Stephen Morant and Ian Wright in 1999. The team believes that company management is changing in Japan, moving towards a more shareholder-friendly environment with a focus on profitability – hence its focus on balance sheets and bottom-up fundamental analysis to identify undervalued companies to construct the portfolio.
Pragmatic style
Polar Capital Japan, managed by James Salter, is the largest fund in the sector. Unlike GLG or Morant Wright, the manager has more regard for the macro picture and top-down analysis will influence stock selection. As part of a due diligence process, understanding the manager’s experience is vital and Salter’s pragmatic style can be traced through his time with some first-class Japanese specialists.
The best performers in the past three years have been Japanese smaller companies funds, which is perhaps surprising in such difficult times. Logic suggests that investors would flock to defensive, large companies with safe, steady earnings streams. However, over the past few years, the more nimble smaller companies have been able to exploit the close proximity and growth of emerging markets better than larger corporates.
Technological innovation has been another factor powering the smaller company sector. Indeed, many of Apple’s products incorporate technology supplied by Japanese smaller businesses. Judging by fund size, not many fund buyers are exposed to the sector.
Small-cap value
Aberdeen Global Japanese Smaller Companies, circa £70m, is the largest in the top ten performers. M&G Japan Smaller Companies, managed by Max Godwin, is the most recognisable of the funds listed, although the track records of Axa Framlington, Baillie Gifford and Schroders should not be dismissed.
Despite the relatively strong performance of these funds, small caps continue to offer very good value and have been described as the cheapest asset class in the world.
We are told by Japanese managers the stock market is under-owned by foreign investors. Despite being a cheap market on the global stage, retail and institutional peer group analysis confirms this.
It is therefore surprising that with this lack of demand there are new launches in the sector. However, a closer inspection of the funds shows a growing trend of investors towards passive or index investments. In the UK retail market, RDR is focusing on better outcomes for the consumer and putting pressure on margins. In recent years Vanguard, the US investment house, has entered the UK market along with many other ETF providers. It seems that discretionary investment managers are demanding these to invest in alongside their active managers.
Since that peak in December 1989, selectors have mainly been rewarded on a relative performance basis by investing with stockpickers. The current economic situation in Western economies is consistently compared with Japan’s past and present. Time will tell if the West will suffer a similar fate.
What is certain is Japan has already served its lengthy sentence of deleveraging, while Europe and the US are only at the beginning or middle of theirs. Banking crises take time to resolve, as bad loans and write-downs are absorbed over many years.
Rude health
After two arduous decades, Japan’s banking system is in rude health. Balance sheets are strong and the ability and willingness to lend is there. This puts the country in a strong position relative to Western economies for the first time in decades.
A recent expansion in monetary policy and the introduction of a definitive 1% inflation target are further positive developments. While far from a certainty, should inflation return to the system, Japanese equities may well surprise significantly to the upside. Bond investors may prefer to be more vigilant.
