Unloved and misunderstood?

Even after 25 years of relatively mediocre economic growth and with a stockmarket that has been in the wilderness for most of that time, Japan is still the third largest economy in the world.

The equity market has traditionally been seen as an uncorrelated play within developed world markets, very much dancing to its own tune.  In reality, that perceived wisdom was always questionable, as broadly speaking, the market only made significant progress when foreign buyers were at their most enthusiastic. This is because domestic Japanese institutions have largely remained wary of equities since the peak of the equity bubble in 1990, while Japanese individual investors have occasionally dipped in, but only when the market was showing significant momentum.

Japanese economic and monetary policies since 1990 have been hewn from the perspective of ever-increasing levels of desperation from the authorities, as they attempted to fight sclerotic economic growth. Their early response was to undertake huge fiscal spending programmes to manufacture economic activity. However, this did not achieve the desired effect, as there was no money multiplier impact in a debt-laden economy. Rather than undertake any serious supply-side reform, Japanese economic policy then waxed and waned between a mix of fiscal and monetary measures, with a weaker yen occasionally playing its part for the export market.

Prime Minister Koizumi made the first serious attempt at meaningful supply-side reforms in the early 2000s, but society’s deeply-embedded vested interests eventually defeated him. On a relative basis, the Japanese economy fared quite well through the global financial crisis (GFC), with domestic banks having limited exposure to the securitised and leveraged world that was prevalent in western developed financial institutions. However, the GFC lead to a substantially weaker global environment, leaving Japan with nowhere to hide. With government debt spiralling out of control, another solution had to be found, particularly after the devastation caused by the 2011 earthquake and subsequent tsunami.

Abe to the rescue?

At the end of 2012, Prime Minister Abe was swept into power on a reform package to end the decades of stagnation in the Japanese economy by undertaking bold monetary expansion, adopting flexible fiscal policies and driving through structural reforms. Collectively, his plans are known as the “three arrows” and they are designed to encourage Japanese companies, investors and the government to work together to solve the Japanese malaise.

Arrows one and two have already been fired. The Bank of Japan has undertaken massive fiscal easing through quantitative easing, while fiscal policy has remained very flexible to foster growth. The third arrow of structural growth through reforms inevitably yields less immediate results, but there has certainly been some progress in areas where reform is needed most, notably in corporate tax and governance, agriculture and healthcare.

Perhaps the most obvious manifestation of the third arrow is the focus by companies on improving and maintaining a higher return on equity (ROE). The creation of the JPX-Nikkei 400 Index, with its profit and ROE threshold targets, is the most tangible manifestation of improving corporate governance.  The creation of a stewardship code for investors and the introduction of the corporate governance code have also been supportive.

The implications of these changes are significant for investors. A market that was once dominated by mean-reverting stocks should now have healthy competition from secular growth stocks, where strong and growing profitability will be the measure of success. Japanese fund managers have a great opportunity to exploit this sea-change as it develops.

What to buy in the IA Japan?

Within The Adviser Centre, we currently feature five funds from the IA Japan sector, from four different market cap and style categories:

Larger-Cap, Blend
Schroder Tokyo  -The fund is managed by a very experienced Japanese equity market practitioner, who has a balanced approach which is grounded in company analysis. The Japanese franchise is well-resourced and has extensive local presence.

Larger-Cap, Growth
Baillie Gifford Japanese - A growth-orientated Japanese equity portfolio managed by a highly respected team, who apply a long-established and disciplined investment approach. Proprietary research and low turnover are hallmarks of the approach.

Larger-Cap Value
GLG Japan CoreAlpha - Offers investors exposure primarily to Japanese large-cap equities and is managed with value-biased and contrarian style, according to a long-established, disciplined approach.

Invesco Perpetual Japan - A valuation and conviction-driven Japanese equity fund that invests across the market-cap spectrum. An eclectic style leads to a unique performance profile, which is often at odds with the benchmark and many recognised peers.

Smaller-Cap, Growth
Legg Mason IF Japan Equity - A concentrated Japanese equity fund with a focus on smaller-cap companies with high growth prospects from domestic-focused businesses. It is a high-risk approach offered by a very experienced manager.
These featured managers are united by the length of their investment experience in this market, if not by their investment styles.  They are truly the survivors of the most testing kind of investment market, punctuated as it has been by relentless false dawns at the economic, political and market levels.  This most challenging of equity backdrops goes some way to explaining the presence of only 61 funds in the IA Japan sector, compared to over a 100 in the North America and Europe ex UK sectors (source: Investment Week, 3/7/15).

They are also united in being constructive about “Abenomics”, although they all counsel patience in respect of seeing the real benefits of the third arrow-inspired reforms.  However sceptical they might be about this, the fact that this structural change is occurring at a time when valuations are not excessive, corporate profits are strengthening and the economic outlook is improving, makes for a multi-layered and appealing investment case, a rare commodity in today’s global equity landscape.

Article written by Peter Toogood, Investment Director/Gill Hutchison, Head of Research

Article featured in Money Marketing (August 2015)