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Awakening the zombie

Investors are slow to switch on to vastly improved prospects in Japan

Stuart Fowler

Japan’s stockmarket is a valuable component of any geographically diversified equity exposure for a UK investor, fully competitive with US and European stocks.

The cycle of boom and bust in Japanese shares lies nearly 20 years in the past. In the past decade, by contrast, its sterling-adjusted returns are barely any different from other major, developed stockmarkets.

Yen strength against sterling turned out to be helpful for the competitiveness of returns and relative price movements would have been more volatile if the currency and local market had not been negatively correlated. Currency was particularly valuable in making Japanese equities top performers in the credit crunch bear market.

So why is Japan so under-represented in the portfolios of UK investors?

The answer is simple. The market is still so far below its long-term trend in real returns that any investor attracted to equities because of the tendency for reversion to a sustainable real return trend will see Japan as an awkward exception. The engine looks broken.

But the return to trend remains a source of potentially higher returns in the future than is achievable from the UK, US or Europe. If mean reversion does not happen, high Japanese exposure may still be as well rewarded relative to those other opportunities, as was the case in the past 10 years. But if it does happen, it will significantly boost managers’ returns against their sceptical peers.

My logic, based on long-term real returns, may read as rather superficial compared with the outputs of detailed analysis of the performance of Japan’s public companies and the value of its shares. But I believe both confirm my assessment.

The fundamental perform-ance of public companies has improved. An important measure of this has been lower rates of investment spending, boosting reported profits and dividends but also halting the past tendency of companies to erode their own returns on capital through poor capital allocation decisions. They have had better investment oppor-tunities in foreign countries, including their fast-growing neighbours. This is handy for global investors because local shares in other Asian markets are so overvalued.

Improving corporate performance has worked wonders for fundamental valuation measures. The two measures that depend on relatively stable economic inputs – book value and dividends – show big Japanese companies are now cheaper than their counterparts in the US. Earnings are less stable and specifically distorted by the recession in each country’s economy and are less reliable at a time like this. But we note the first section trailing price/ earnings ratio is only 16, almost identical to the S&P 500 ratio.

Stuart Fowler is managing director of No Monkey Business


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