Since Warren Buffett got involved, the world has gone crazy for Japan. The Nikkei is up 23.4% for the year to date (to 10 July 2023). That puts it 8.8%, 11.2% and 25.8% ahead of the S&P 500, Eurostoxx 50 and FTSE 100 respectively. Investors might well conclude that the easy gains have been made and look elsewhere.
The reasons for the success of the Japanese market for the year to date have been well-documented. Japan was later to emerge from Covid, and is now experiencing the economic upswing of reopening. It has finally laid deflation to rest, with rising prices and wages now a feature across the economy. However, more important have been the structural reforms that are finally galvanising Japan’s stolid corporate sector.
The Tokyo Stock Exchange has been promoting the soft requirement of a price-to-book ratio above one, alongside a raft of other measures to encourage better capital efficiency among Japanese corporates. With around half the Japanese index trading below book value, the move could be important in encouraging companies to unwind their cash piles and improve their return on equity.
For investors, this has been important in drawing asset allocators back to the region. For investors re-examining the sector, it may be tempting to ‘follow the money’, but as James Salter, fund manager on the Zennor Japan fund, points out, their choices so far have been idiosyncratic. Rather than putting capital to work in those companies most likely to benefit from structural reform, capital has been directed to many already-successful companies: “At a time when we’re saying buy Japan for higher inflation and corporate governance reform, they have bought AI.”
It is noteworthy that three of the top 10 funds in the IA Japan sector for the year to date are index trackers (two from Amundi and one from BlackRock). Equally, many of the top-performing funds are hedged. The pound has seen significant appreciation versus the yen since the start of the year, having started the year at 1:158, and ended up at 1:183.
Small cap weakness
Equally, some of the strongest long-term managers in Japan are near the bottom of the tables. Baillie Gifford, for example, has barely participated in the region’s bounce. Its focus on small- and mid-cap stocks has been a significant headwind, with that part of the market remaining largely ignored by incoming investors. Salter points out that this part of the market has little analyst coverage, so doesn’t tend to appeal to larger investors. Nevertheless, it is where the greatest mispricing occurs.
As such, the performance from the start of the year does not appear to provide a particularly good template for the likely outcome in the remainder of the year. Masaki Taketsume, manager of the Schroders Japan Trust, says: “There is no point buying already high quality companies to take advantage of this shift. Sony already has good corporate governance and a high return on equity. But in the low valuation segment of the market, they really have to do something. We are seeing more interesting opportunities there. Some 50% of companies in Japan are trading below 1x price to book. This is where the investment opportunity lies.” He says that this is not confined to particular sectors or types of companies, but investors need to look stock by stock.
They also need to understand individual management companies and who is willing and able to make the change. He says there are management teams that have never had to impose price rises on their customers and there are companies that will struggle. Salter says: “Will it go in a straight line? Absolutely not. For every two good stories, they’ll be a company that fights against change. Eventually, momentum will force better behaviour.”
Value in Japan?
Joe Bauernfreund, manager of the AVI Japan Opportunity Trust, expects the market to wake up to the value inherent in other parts of the market: “Typically, early capital tends to flow into large-cap names however, as the rally is sustained, we would expect there to be a trickle-down effect as capital seeks out smaller and better valued opportunities.
“A combination of increased shareholder activism and companies’ receptiveness to change are reflected in current higher share prices. Increased public engagement activity is helpful for active managers, reminding management that they are accountable to shareholders, and highlighting the risks of not listening to their investors’ suggestions.
“Our team typically focuses on small-cap companies, where we can buy larger stakes and work collaboratively with management to address underperformance. Support from regulators is also helpful. Given the current environment, investors can profit from the rise of shareholder activism particularly in Japan’s small companies.”
Shuntaro Takeuchi, portfolio manager on the Matthews Japan Strategy, says that over the long term, he also sees greater value in small caps over large caps. He is focusing on three areas in the current market.
He says: “The first is “cyclical growth” companies – namely those associated with semiconductors, automation and even auto components – which are seeing structural margin enhancements. Japanese corporate profits are still export-sector dominant and not immune to global manufacturing cycles, but some corporates have succeeded in consistently achieving better profitability during downturns.”
He also sees opportunities in “linear growth” and “idiosyncratic growth”: “To counter the decline in labour production and stay ahead of flat growth you need productivity growth and Japan is home to many companies that provide relevant solutions – like software, healthcare and IT services. They have played a considerable role in driving profit growth to the market overall. “Idiosyncratic growth” which is theme and industry agnostic, and the growth come from self-help.”
While the rally in Japan may have been led by the large caps, this is not where the greatest gains from the changing investment climate are likely to be found.
There are still opportunities among Japan’s small-cap companies and in specific sectors, which have so far been overlooked. It is these areas likely to be the strongest beneficiaries of reform and inflation, but they may be slow burn rather than quick win.