Should we give Japan another chance?

15 August 2012

How many times over the past two decades have headline wordplays on the Land of the Rising Sun been wheeled out, as fund managers and commentators spot tentative signs of recovery in the stagnant Japanese economy? And how many false dawns have followed?

So why should the current economic environment be any more promising for fund managers focused patiently on the area?

The past 15 years have seen a long and painful process of deleveraging taking place within the Japanese economy. Companies have dealt with massive debts and cut back on corporate investment because the banks weren't in a position to lend. As a result, they've started amassing piles of cash. Consumers, similarly, stopped spending and saved.

Despite the government's efforts to stimulate the economy, deflation has become part of the landscape. At the same time, Japan's longstanding position as a creditor to the rest of the world, despite its many troubles, has meant the yen has progressively strengthened against other leading currencies, making it harder for exporters to be competitive.

As if its economic legacy weren't trouble enough, early 2011 also saw Japan reeling from the Tohoku earthquake, tsunami and the Fukushima nuclear crisis, while the floods in Thailand caused big problems for many Japanese manufacturers based there. However, there are now encouraging signs of recovery, particularly in comparison with many other developed economies.

First-quarter GDP figures show the economy grew by an annualised 4.1%, driven mainly by consumer spending and post-quake work. It's expected to grow around 2% in the fiscal year to March 2013, underpinned by firm domestic demand and a pick-up in exports.

Cheap companies

But the main pro-Japan investment story focuses on the state of the country's companies, rather than its economy. Critically, it is exceptionally cheap.

According to Sam Perry, senior investment manager at Pictet Asset Management: "There have been only three days in the past 40 years when Japan's price-to-book ratio, currently around 0.8 (Topix index), was lower than it is now." In effect, over the longer term there's only one way for valuations to go, and that's up.

And its historical image as a source of growth stocks offering investors little opportunity for dividend yield is no longer accurate. The Topix index currently yields around 2.6%, slightly higher than the S&P 500 at 2.2%. Gavin Haynes, managing director of IFA Whitechurch Securities, adds that many Japanese stocks yield more than 3%, and 70% of the stockmarket yields more than 10-year Japanese government bonds.

Balancing the books

Another key point is the fact that companies have had to spend the past 10 years restructuring and rebuilding their balance sheets. "We fi nd many examples of healthy companies with high levels of cash on their balance sheets and strong ongoing cash flows," says Max Godwin, manager of the M&G Japan Smaller Companies fund.

That cash flow has been used in some industries not only to start paying investor dividends but also to expand production overseas, with new factories being built in more cost-effective locations such as China and Taiwan.

But Japan's efficiency drive has not occurred across the board. It has long depended on international trade, and it's the export-dominated industries that have become highly competitive; more protected areas of the economy such as distribution and services have seen much less improvement in productivity.

Perry points to global leaders in sectors such as smartphone and iPad components (Murata, Sumitomo Bakelite), autos and autoparts (Honda, Denso), digital SLR cameras (Canon, Nikon) and energy efficiency (Nippon Ceramic): Japan has to import all its energy, so it has become extremely good at maximising efficiency.

"The Japanese have an incredible stranglehold on material science. Although they do face competition from other Asian countries such as Taiwan and Korea, they just keep investing in research and development and moving up the value chain, so they remain at the top of their game," he explains.

Nathan Gibbs, manager of Schroder's Japan Alpha Plus fund, pinpoints the recent rebound, particularly in exports to Asian neighbours, as a key reason for bullishness. "We expect [these export levels] to move to all-time highs as the situation post-earthquake normalises," he says.

Best-performing unit trusts*


Best-performing investment trusts*


*Return on £100 invested over five years. Source: Morningstar, 5 July 2012

Too little, too late?

But despite the evident strengths of the export-oriented sectors of the economy, Godwin believes that Japan's decades in the wilderness, compounded by last year's events, mean investors have all but given up on it, and that valuations by no means take into account the extent of the overhaul and refocusing that has gone on among these firms.

He suggests that domestic firms are also mispriced. The general consensus is still dominated by perceptions of Japan's poor demographics and consumers' reluctance to spend. "In reality, cost control, integration and consolidation have not been taken account of. Nor has a positive change in consumer habits, which has seen rising consumption levels," Godwin comments.

If further proof were needed that the Japanese market remains thoroughly unfashionable, it is the fact that such large chunks are covered by only a mere handful of investment analysts.

A comparison of Japan's 1,600 largest companies against the US's 1,500 shows that 63% of Japanese companies are followed by two or fewer analysts, against only 4% of the US equivalent index. In addition, a third of the Japanese market receives no analyst coverage whatsoever; no US companies are in that position.

"This is a very, very unloved market, and there is a severe deficit of information on it, so you have to do much of the research yourself," adds Perry. But stockpicking managers do have considerable opportunity to uncover anomalies.

Signs of a rally

Further, as Haynes points out: "If we do start to see positive news flow emerging there is a lot of scope for a shift to this market, leading to a strong rally."

Perry believes there are several potential catalysts for such a rally. A real start to the post-earthquake reconstruction is one; so far, funds have been allocated but political shenanigans mean little has been paid out. He estimates the rebuilding of infrastructure and housing could boost GDP by as much as 2%.

An end to deflation is another. The Bank of Japan's (BoJ) Valentine's Day message, announcing an aim of 1% inflation through further quantitative easing, "seemed to indicate a new determination to end Japan's deflation", says Perry; but there are signs that the economy is already heading that way, as borrowing by both consumers and companies is finally beginning to rise anyway.

Exporters would also be given a helpful boost if there were clear evidence of a fall in the value of the yen - though given that Japan imports all its energy and much of its food, there are clear reasons why the BoJ would not want to see a major depreciation.

Nonetheless, there are various potential downsides. For example, Japan's export markets, which are heavily skewed towards Asia, could be hit if China's economy slows significantly. The eurozone crisis could also potentially cause problems, though Perry believes the risk is more of an indirect global slowdown than of direct impact: Europe accounts for less than 10% of Japan's exports.

Moreover, asset-rich Japanese banks are "jumping in with both feet" to snap up the classic banking business – ship, trade and aircraft financing, letters of credit and so on – that European banks have historically dominated but now lack capital to continue.

However, leading European manufacturers of cars and machinery number among some of Japan's most persistent competitors, and those European firms would benefit from further depreciation of the euro against the Japanese currency.

Clearly, global uncertainty is not making life easy for Japan. But all indications are that its export-led corporations are fit enough to take whatever is thrown at them - and cheap enough to enjoy a hefty rally when sentiment finally turns.


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