Renewal beckons for Japan

8 June 2010

Every few years the murmurs of a new dawn in Japan get louder. "This time it's different," chirps a chorus of investors.

The stockmarket has rallied, the government has got its act together and companies are more profitable, they argue.

Sure, there is a burst of stockmarket excitement and lucky investors with perfect timing are rewarded handsomely.

But a long period of stagnation normally follows and the chorus admits that nothing has really changed. China and India are much more exciting, they confess. Japan has had its day.

The murmurs started again at the end of last year. As 2010 began the Topix surged northwards and investors piled into Japan funds.

In January almost £75 million of net retail fund sales flowed into the Japan sector, the highest since April 2008, and a marked improvement from the massive outflows of early 2009, according to the Investment Management Association.

The most recent available figures are for March. These show that the chorus has become quieter - there were just £3.4 million of Japan fund sales in the month.

So is the rush over for another few years or are there signs that Japan has changed for good this time?

Lessons learnt

Donald Farquharson, manager of the Baillie Gifford Japanese fund, believes it's different this time and that companies have learned a lesson from Toyota's recent manufacturing errors and will change.

"Toyota became an organisation infatuated with cost-cutting. They pushed it too far," he notes. "This is true of corporate Japan in general. But I think that that's starting to come to an end. There's a lot of corporate change."

According to Farquharson we're seeing the "last of the demographic bulge", where managers in their 50s and 60s dominate company decisions. "The older senior people are leaving and there is more space for young people to come in.

"Defined benefit pension schemes are also being phased out, so the sense of staying in a job for life will change too."

Japan equity firm Morant Wright Management is also bullish, declaring that the "Japanese economy has turned the corner and the outlook for profit growth is very encouraging".

Japan fund managers are obviously going to extol the virtues of their patch. However, other investment managers are also becoming more positive about what is often considered the bag lady of Asia.

John Millar, manager of Martin Currie Pacific Trust, recently increased his weighting to Japan, saying "valuations are too cheap". And investment management firm Quilter has upped the Japan allocation in its model portfolios.

Duncan Gwyther, executive director at Quilter, says Japan is becoming more attractive due to political change and new blood coming into companies.

Japan's bounce back into favour is also partly the result of encouraging export figures, especially to Asia.

James Salter, manager of Polar Capital's Japan fund, explains: "The economy has begun a classic textbook recovery. In February exports climbed at their strongest rate in 30 years, growing by 45%.

"The importance of Japan's proximity to Asia cannot be underestimated. Shipments to China rose by 45% in February."

Another factor in Japan's revival is the Democratic Party of Japan (DPJ), which came to power last year. It has reduced unemployment and has started to address the country's demographic difficulties.

Japan has the fastest-ageing population in the world, with almost a quarter of its people currently over the age of 65. This makes it a nation of savers, not spenders, creating a myriad of problems for the economy.

So the DPJ has introduced a child benefit of ¥13,000 (£90) per month to get the birth rate up.

Reasons for optimism

Stephen Peters, investment analyst at stockbroker Charles Stanley, isn't convinced that the government is much different to the old one, and thinks Japan needs some inflation and currency devaluation before the economy truly revives.

However, he says the stockmarket is interesting. "It is predominantly made up of large exporting companies. They benefit directly from weakness in the yen.

"Secondly, these companies are exporting to Asia - a faster growth region. Thirdly, Japanese companies are typically cheaper than an Asian equivalent."

Farquharson says that consumers and small companies are more confident than they were at the end of 2008 and "profits are set to recover very sharply this year". He likes retailers and financials, and has added to his fund's Nomura and Suruga Bank holdings recently.

Farquharson adds: "Some younger businesses in retail are very attractive. A lot of people miss a trick on domestic Japan. There are structures in place that help the innovator grow their business quickly."

Another sector that could perform strongly is clean energy. Japan is proving to be a leader in green policies - its carbon emissions relative to GDP are the lowest in the world.

However, although the recently-resigned prime minister Yukio Hatoyama was committed to nuclear power innovation, his successor may have more pressing matters to deal with.

"As countries such as China and India sign nuclear agreements and look to develop their energy programmes, Japan will be the first country on speed-dial as the new players seek expertise," says Simon Finch, assistant investment manager of the Japan Equity Fund at Ashburton.

Same old story

For every optimist on Japan there is a pessimist. Farquharson's colleague Tom Slater at Scottish Mortgage Investment Trust doesn't like Japan as China is much cheaper. Chinese car manufacturers are cheaper than Japanese ones, for example.

Justine Fearns, investment research manager at financial adviser firm AWD Chase de Vere, says that although returns in Japan can be significant there is a lot of waiting, and she has "lost count of how many 'new dawns' there have been".

However, Fearns agrees with Peters that there are opportunities with exporting companies that can benefit from growth in other parts of the world.

Another issue for investors is the possibility that Japan will be downgraded. In January Standard & Poor's said that if economic data remained weak Japan's AA rating could fall by one notch.

Morant's Stephen Morant, though, is adamant that Japan is different to other highly indebted nations such as Greece.

He says that although gross debt is around 200% of GDP the situation looks less bad on a net basis, which brings the ratio below 100% and more in line with other countries.

"Encouragingly, nominal GDP for the year ending March 2011 is expected to grow for the first time in two years," he adds.

The economic problems that plague the country are hardly going to disappear overnight, but low equity valuations mean it could be time to join the chorus and review whether Japan should reappear in your portfolio.

This article was originally published in Money Observer - Moneywise's sister publication - in June 2010

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