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Could Japan return to favour despite slow growth?

The ongoing economic reforms, continued loose monetary policy and a weak yen keep boosting earnings momentum across corporate Japan.

The Japanese market gained further traction last week with the Nikkei 225 Stock Average closing above 20,000 for the first time in 15 years. Elsewhere the broader TOPIX index also surpassed its highest level since November 2007.

Despite the country’s slower than expected growth and historic economic challenges, is Japan worth another look?

JO Hambro Capital Management senior fund manager Ruth Nash believes Japan has the possibility of another year of high earnings growth.

“We’ve just started the new year in Japan and it could be another year of 20 per cent growth in profits,” she says.

Japan had the strongest earnings momentum of all three major developed regions in the last quarter of 2014 with some 67 per cent of TOPIX companies’ earnings growing at a record 8 per cent year-on-year, according to JP Morgan Asset Management.

JP Morgan Asset Management global market strategist Kerry Craig says the most obvious attraction of the Japanese market is indeed its price.

He says: “Even though the Nikkei 225 is up 13 per cent so far this year, and 180 per cent since its low in March 2009, the current forward price per earnings ratio is below the average of the last 15 years.”

Fidelity Worldwide Investment head of equities Alex Treves, however, says the market appears to have underestimated one of the progresses of prime minister Shinzo Abe’s growth strategy: corporate governance reforms.

He says: “Japanese companies are actively responding to calls for better governance. We are seeing signs of positive evolution in capital management as companies utilise excess cash for dividends and share buybacks and increase returns on equity.”

Premier AM senior investment manager Jake Robbins, who has been overweight in Japan since the QE programme in 2012, also believes Japan has to “unlock the cash”.

“In Japan the culture of company management is not so much shareholder friendly but stakeholder, so that drags down performance,” he says.

Cerno Capital co-founder and managing partner James Spence thinks that return on equity is indeed critical to explain corporate performance.

“The American corporate sector looks like a body builder in terms of tuning up [return on equity] while Japan has always served many different masters, not always prioritising shareholders.”

But Spence says a wind of change is blowing to Japan.

Spence’s group currently holds the largest thematic exposure of nearly 20 per cent to Japan equities in the £43.8m TM Cerno Select fund.

He adds: “Overweight for a lot of people means owning 11 or 12 per cent, but I challenge to find any other equity market in the world of comparable size that has the process cycle attributes that Japan has.”

Another big change is that domestic Japanese investors are returning to their own markets mostly because of pensions funds switching from bonds into equities, says Nash.

“If you want long-term growth you have to have more participation from domestic investors rather than from foreigners, which come and go. That could change the whole market,” she says.

Though the country is slowing coming out of an economic stagnation, Treves acknowledges that the current Japanese generation is still experiencing no rise in wage, a trend that has become “embedded in the culture”.

He says: “Unless you’ve been in Japan for a while it is quite hard to understand how anomalous Japan’s situation has been compared to the rest of the world.”

Many compare the Japan story to Europe but Europe is worse, he claims.

“Unemployment has decreased to 3.4 per cent in Japan in March while in southern Europe people will wait an awful long time before their wages increase.”

Though it is the third largest economy in the world, Japan has been considered an asset class modestly correlated to the global market and still a lot of people seem to be wary of the region.

Artemis portfolio manager Simon Edelsten, who manages the £47.3m Artemis Global Select fund, admits that an old generation of global equity managers have ignored Japan because of it performing very badly in the past.

Edelsten still has a heavy weighting to Japanese equities, currently making up 12.9 per cent of his portfolio, but will remain defensive waiting for the US interest rates moves.

Treves says: “Investors wouldn’t want to leave the US or European equities for example.

The accumulated lack of knowledge in the Japan market has got really severe.

“Japan has been out of fashion for a long time and it’ll take more than two or three years to rebuild the institutional knowledge which enables people to focus on this market.”

Though many are positive on the mid-term outlook for Japanese equities, fund managers think there are short-term risks such as a possible cyclical downturn in US activity, the deflationary threat in the Eurozone, and worrying recession scenarios in China.

Edelsten also says some Japanese companies have the tendency of making big acquisitions overseas and that would cause a further lack of liquidity.

He says: “It is a very complicated market and it takes a long time to learn about companies and see if the management is taking shareholders seriously.”

Treves, however, is convinced Japan’s rareity and success shouldn’t be underestimated: “It’s so unusual that you get a potential for so much change in such a big and misunderstood market.

“The extent to which people in Japan change policy as a group is very important. A tipping point can exist whereby some people start to change governance and many other people follow and that’d be so powerful in a market which is still not over-owned by foreigners.”

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