Is now the time to invest in Japan?

13 October 2009

The Japanese market has disappointed so many investors for so long that it's easy to understand why some have given up on it completely. A quick glance at the performance of Japan funds over the first half of this year would suggest they made the right call.

Japan was the worst-performing Investment Management Association (IMA) sector between January 2009 and July 2009, down more than 8%, while Global Emerging Markets rose 20% and the perky UK Smaller Companies increased more than 22% over the same period.
In its golden age in the post-war decades up to 1989, Japan was held up as a global model of economic growth and efficiency; even now it clings on to its position as the second largest economy in the world, behind the US. It's home to world-class brands from Honda and Toyota to Sony, Canon and Fujitsu.

But for the past 20 years, Japan has been struggling to recover from the collapse of its overheated economy and the bursting of its property bubble. The most well-known Japanese index, the Nikkei 225, which measures the average of the top 225 companies on the Tokyo Stock Exchange, peaked at 39,000 in December 1989, but by 4 September 2009 it had fallen by almost 75%, to 10,200.

Over the same period the FTSE All-Share doubled. The Tokyo stock price index (TOPIX), the other important stockmarket index for the Tokyo Stock Exchange, has fared equally badly.
So why has the Japanese economy been in such a quagmire for so long? There are many factors – economic, political, social and cultural. At Polar Capital, Japan fund manager James Salter points to "fragility in the banking system that took a long time to sort out, persistent price falls (deflation), an ageing population, and erratic policies from the government and the Bank of Japan".

For a long time too, growth was held back by Japanese firms' unwillingness to make the cutbacks needed to get their businesses back in profit. They chose to pile up stock rather than reduce production, and not only did they avoid laying employees off, but big companies would subsidise unprofitable businesses from more profitable areas.

The upshot of all this has been a chronic lack of demand from Japanese consumers, and an economy that is heavily reliant on classic high-quality Japanese exports – especially cars and technological goods – for any economic growth.

As Edwin Merner, manager of the Guernsey-based Atlantis Japan Growth Trust, says, although the five years of global growth from 2003 to early 2008 were "one of the longest expansion periods since the war, with steady growth of 1.5% to 2.5% and reasonable corporate earnings, there was no boom in consumer spending".
Hopes of a more long-term economic recovery were crushed by the current global recession. When it hit in 2008, Japan was both a winner and a loser. On the one hand, its banks did not suffer the fallout of the credit crunch, and Japanese companies didn't have a lot of debt.

But on the other, as Paul Chesson, manager of Invesco Perpetual Japan, points out, "there was no domestic growth, so the economy was vulnerable to global trends because of the importance of its exports".

When exports collapsed, plummeting by 26% in autumn 2008, firms took uncharacteristically drastic measures to cut costs. Unemployment rose and economic growth fell right off a cliff, down 12% in the last quarter of 2008 and a further 14% in the first quarter of this year.

There's general agreement that the worst of the economic cycle may be over for Japan, and at the end of August it was announced that Japan had officially exiled the recession. There are certainly some promising signs of recovery, says Salter.

For example, production levels had shrunk to as little as 30% of full manufacturing capacity early in the year but are now back up to between 50% and 60%. "The economy suffered a massive collapse, so we'd expect a reasonably robust recovery in exports and industrial production, and a sharp bounce back in corporate profits," he adds.
Another key issue is the importance of the Chinese market to Japan. China, rather than the doddery US, is now its largest trading partner.

With China's economy motoring strongly there's growing demand for goods such as cars, technology and specialist manufacturing machinery, where China does not have the expertise but Japan is a key player. As Salter puts it: "I see China as a very large whale, and Japan can do quite nicely as a barnacle on its side."

The general election on 30 August, which saw the 54-year rule of the Liberal Democrats end and the opposition Democratic Party take over, might also work in the economy's favour. While the rally that followed was short, the election could have longer-term effects on the economy.

"Japan's hidebound political system has long been blamed as a reason for its poor economic performance; that could all be about to change," says Keith Donaldson, manager of the Martin Currie Japan Alpha fund. "The new government is likely to encourage growth in domestic consumption, and combined with a pick-up in export demand, this would be a powerful driver for Japanese stocks."
Chesson is optimistic on more general grounds. One reason is that Japan is still very unfashionable with investors, because of its inability to boost its long-term economic growth through domestic demand. "But people are too focused on the longer-term issues; they're ignoring the economy's ability to enjoy a cyclical bounce and a recovery in corporate profits in the nearer term."

He also points out that there have been gradual changes in the way companies are run in recent years. "They've got an awful lot better at managing their businesses for profit," he says. "When demand collapsed in 2008, the big companies slashed their costs.

As a result, latest company results show that, in general, they moved from making a loss in the fourth quarter of 2008 to making a profit in the first quarter of 2009, even though sales had fallen so much. That's way better than anyone expected.

"Improvements in productivity won't solve the problem of long-term economic stagnation, but it's a good start, and with a recovery in demand we could see an impressive recovery in profits. That's what happened in 2004 after the tech bubble burst – but no one thinks it will happen this time; they think the recovery will be slow and halting."
The other key consideration is that the Japanese market is very cheap – "too cheap", says Donaldson. "More than half the companies in the Japanese market trade on a 'price-to-book' ratio of less than one (which basically means that their stockmarket price is less than the net value of all their tangible assets such as machinery, premises and stock). Yet companies have improved profitability and dividend payments."
So the market is pricing these shares for a prolonged and difficult economic recovery. But there are reasons – among them China's rapid and continuing growth and Japan's new leaner and meaner manufacturing sector – to think that recovery could happen much more dramatically than expected, at least for companies if not for the wider Japanese economy.
So is now the time to invest in Japan? Some investors think Japan really has had its day. Gary Reynolds, chief investment officer at wealth manager Courtiers, comments: "Given that Japan is the second largest market in the world, Courtiers would typically expect to hold some Japanese investments for its clients, but at present we hold nothing.

Japanese firms produce fantastic exports but they're operating in an expensive environment and they're so inflexible. I don't think Japan sees the competitive threat it faces from Korea and China."

Alan Smith, chief executive of IFA Capital Asset Management, takes a less extreme position, suggesting that Japan still has world-class businesses, so clients should have exposure to them. "To entirely exclude the second largest market in the world from client portfolios is a very big call. We would recommend that clients allocate around 10% to Japanese shares," he adds.
Stuart Fowler, director of No Monkey Business, is more bullish, suggesting a 17% allocation on the grounds that "Japan is currently somewhat cheaper than any other major market".

Will Japan ever return to its former glory within Asia? That's hard to imagine, given the untapped potential of India and China. But Martin Currie's Donaldson points out: "Ironically, the position of Japanese companies has never been stronger – and from an investment point of view, it's corporate Japan, rather than the Japanese economy, that really counts."

But different Japan funds have different focuses. Edwin Merner likes the manufacturers of glass for flat-screen TVs, which are likely to be increasingly sought-after by emerging market consumers. "Of the three companies making the glass, two are Japanese – and even the Koreans are buying from them."

At Polar Capital, Salter is focused on the Japanese companies tuned into China's growing demand for infrastructure: machinery; rolling stock; and green energy technology. Chesson is looking to a broader export market, including cars and electronics and the manufacturers selling to them.

One interesting question for investors is whether the current top-performing funds share common characteristics – is there something specific they're doing right? Yes, says Muna Abu-Habsa, fund analyst at Morningstar.

"Their managers have adopted a less defensive position, tending towards healthcare, utilities, technology and industrial materials stocks. They favour middle-sized stocks, and smaller, more concentrated portfolios."

Of course, Japan's promising position could be just another false dawn, as has happened many times before. One option for investors who are not fully convinced that the Japanese market will bounce back in a big way, but don't want to miss out altogether, is to look at funds in the broader Asia Including Japan sector.

"We typically prefer this sector, where the manager has the freedom to allocate assets across those countries in which he finds value," says Abu-Habsa.

Fund recommendations

Adrian Lowcock, senior investment adviser at Bestinvest, recommends GLG Japan Core Alpha:

"Stephen Harker, the manager of this portfolio, is strongly biased to ‘value' style stocks and large cap companies, which he believes offer the best potential to outperform the Japanese market."

Alan Smith, chief executive officer at Capital Asset Management, recommends Fidelity Japa:

"Fidelity Japan has been a consistent performer for many years. We also like Neptune Japan Opportunities, which as a smaller fund is more nimble and able to move in and out of positions to take advantage of opportunities."

Simon Gibson, independent adviser at Atkinson Bolton Consulting, recommends Invesco Perpetual Japan:

"We like this tightly managed fund, run by the highly respected Paul Chesson, and as an admittedly riskier bet, iShares MSCI Japan Small Cap ETF. We favour a passive fund due to Japanese Smaller Companies managers' historical struggle to outperform the index."

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