Olympics host Japan faces two big hurdles but fund buyers eye prizes

With the Tokyo Olympics beginning on Friday, the world’s eyes are on the Land of the Rising Sun. But is Japan an attractive investment opportunity against a backdrop of escalating Covid cases and hosting a major global sporting event without spectators?

The Games has faced a raft of public opposition because it occurs during the pandemic and at a time when coronavirus cases have jumped to their highest level in six months, just prior to the opening ceremony. Events are to be held without spectators which could deal a blow to the country’s tourism.

Two big hurdles to overcome

According to an outlook on the country from Lazard Asset Management published earlier this month, the ongoing pandemic and the success of the Olympics are the two big hurdles for the country to overcome this quarter.

It says while Japan has been slow to deliver vaccines, the number of vaccinations has risen exponentially in recent weeks and at the current pace, half of the population should be vaccinated by the end of August.

In terms of the Olympics, a survey by Japanese newspaper Asahi Shimbun showed 60% of voters in Tokyo want the Olympics and Paralympics called off this summer, but if they must be held, 64% think all spectators should be banned from attending.

But Lazard thinks the controversies surrounding the Games and vaccinations will subside by September, giving way to the prospect for a more upbeat outlook.

“By then, vaccination efforts may have progressed to the point that Japan’s economy can advance on a full reopening,” it says. “With manufacturing already performing well thanks to a pickup in global demand across a number of tech and auto fronts, a meaningful revival in services could benefit the broad economy quite a lot— and improve the current view of Suga’s leadership.”

Jupiter Japan Income co-manager Mitesh Patel thinks the slow speed of the country’s Covid vaccination rollout has left it lagging approximately six months behind countries such as the UK. He also notes because the Olympics will have no spectators, the country will miss out on a tourism boost.

Like Lazard, however, Patel sees these as temporary setbacks. “It is our view that these are distractions that will largely have dissipated by the end of the year.”

He adds the Japanese equity market continues to offer very attractive valuations compared to other developed equity markets.

“The strength of corporate balance sheets has never been better, supporting growing dividends and total shareholder pay-outs, and the market is under-owned by foreign investors and under-researched, resulting in market inefficiencies upon which active, high-conviction fund managers can capitalise.”

Some Japan funds have struggled more than others in recent years and according to BMO Gam’s Q2 2021 FundWatch Survey, the IA Japan sector has failed to deliver one fund that has achieved top quartile performance over three years. JO Hambro Capital Management recently closed its Japan fund after a period of underperformance while St James’s Place placed its Japan fund on a watchlist over value concerns.

Are fund buyers still bullish?

In Q1 this year, UK fund buyers surveyed by Last Word Research were bullish on Japanese equities as a value play to ride the Covid recovery wave. Half of those surveyed said they plan on topping up their Japanese equities exposure, a spike from Q3 and Q4 2020 when only 9.1% and 19.4% expressed plans to boost their weightings.

In February, the Nikkei 225 hit a 30-year high, but it has struggled since with the index underperforming the S&P 500 by more than 10% year-to-date. So are fund buyers still optimistic?

Iboss investment director Chris Metcalfe says he has been in this industry for almost 37 years, and in that time he has grown tired of trying to call what is going to happen in Japan.

“I have always found managers and experts who make a bullish case for investing, but then nothing happens,” he says.

As such, Iboss has typically used managers with the ability to flex their position between Japan and Asia. One fund the DFM has used is the Baillie Gifford Developed Asia fund, which has about 60% of its portfolio in Japan. “For us, it is about knowing our limitations, and we just had to accept we could not call Japan,” says Metcalfe.

He notes that historically, one reason to exclude Japan was its unconventional monetary policy but similar moves in recent years by other central banks, including the Federal Reserve and European Central Bank, has “levelled the playing field”. This led Iboss to increase exposure in May 2020 and incorporate a specific Japan-only equity holding.

Smith & Williamson Investment Management’s Managed Portfolio Service (MPS) is currently underweight Japan after reducing its allocation last year, but the team is considering increasing its weighting over the coming months.

James Burns, co-manager of Smith & Williamson Investment Management’s MPS, says: “We like the long-term outlook for Japan, and it is a market where managers can generate alpha due to the sheer number of companies there.

“While recycling profits into other geographical areas turned out to be a good decision as Japan has underperformed other international markets this year, we may well look at bringing that weighting back up in the coming months. It’s always good to top up an underweight position after a period of underperformance.”

Currency headwinds are crucial

But Metcalfe says another factor investors need to consider when it comes to investing in Japan revolves around the yen, and currency headwinds are a key reason why Japan as an overall index has underperformed other major indices since the rally.

This is particularly borne out in the difference between hedged and unhedged share classes. Metcalfe points to the JPM Japan fund, for which the hedged share class is up 27.2% over the past year while the unhedged has only risen 12.16%, according to FE Fundinfo data.

“This is a huge difference and something investors need to be aware of,” he adds. “It is very important to understand what you are buying, because while you can generate strong returns on the stock market, a lot of these can be wiped away on the currency trade.”

To manage this risk, Iboss has 50% hedged, 50% unhedged exposure “to try and provide us more of an outcome of the Japanese market, rather than the outcome of the Japanese yen”.

 Top IA Japan funds YTD

Source: FE Fundinfo, as at 20 Jul ’21

Where are the opportunities in Japan?

Patel says he and co-manager Dan Carter are finding opportunities in niche stock ideas within several secular growth themes. Thematic and stock examples include domestic digital transformation, where we see real changes to Japan’s old fashioned and labour-intensive business practices via companies like WingArc 1^st and JMDC.

“Ecommerce is the prime poster child for changing consumer preferences, but less well-known opportunities also exist elsewhere such as in the digital provision of financial services via companies like WealthNavi or job-seeking via Visional Holdings,” he adds.

“Finally, we look to exploit opportunities in businesses that are seeing global market share growth premised on their niche, high precision technology, be it in semiconductors, industrial ball bearings or healthcare/medical technology.”