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Japanese value

Japan is in the midst of its interim reporting season and while first-half numbers have generally met expectations, firms have witnessed a sharp deterioration since October, with orders for machinery and machine tools slowing sharply.

Exports to Asia, which were reasonably buoyant, have slowed, adding to weakness already witnessed from Europe and America. As an export-led economy, Japan relies on external demand and the global downturn has led to market weakness. Over the last five years, exporters have been responsible for around half of Japan’s non-financial profit growth and last year almost all this growth could be attributed to the exporting sectors of the market.

Nevertheless, Japanese companies, in many respects, appear better positioned to withstand an economic slowdown than their global peers. During the “lost decade”, corporates paid down their debt, restructured and tidied their balance sheets. The debt to equity ratio is low at 39.8 per cent, compared with a world average of 42.5 per cent and a UK figure of 45.7 per cent.

With low interest rates, interest cover has improved markedly over the years and access to further funding is not being materially restricted as Japanese financials have largely avoided many of the large write-downs witnessed in the US and Europe.

Consumers are another area of strength. In comparison with the US, where most consumers’ wealth is tied up in property and stockmarkets, with only 14 per cent of financial assets in cash, Japanese consumers have over 50 per cent of their financial assets in cash, representing yen 750 trillion ($8trn).

Having experienced a prolonged period of deflation, the Japanese have adjusted to lower levels of consumption, with the latest generation of consumers actively avoiding excessive spending and debt. This has meant that Japan has not developed a self-sustaining domestically-led economy but it also should result in much less downside to consumption in the face of economic hardship.

Together with solid fundamentals, valuations in Japan are now attractive relative to history and other markets. Presently, almost 70 per cent of companies on the Topix first section are now trading at below book value, with the market itself at book.

For domestic investors, who are currently repatriating their investments in overseas assets, the equity yield of 3 per cent compares very favourably with the JGB 10-year yield of 1.5 per cent, with the current level of dividend likely to be maintained as payout ratios are low.

Japan also is one of the cheapest major markets on a price to sales and prices to cashflow basis. A severe economic slowdown is already priced in, with the Japanese market falling by over 40 per cent in YTD on a local currency basis in response, slightly worse than most other developed markets.

That said, given FX moves, the return from holding Japanese equities this year has substantially outperformed other major markets. Despite valuation appeal, however, global lead indicators are still falling and it is difficult to say with conviction that we are now definitely at the bottom.

The team at F&C is focusing on companies displaying defensive business models, sustainable growth and reasonable valuations. For example, we have strong positions in both the telecoms sector and railway transportation. Our search for relatively stable exporters has led us to purchase several small medical equipment companies, which have solid domestic customer bases and are expanding their share overseas.

We also believe now is a good opportunity to selectively buy cyclical companies which have been heavily sold, yet display superior business models and a strong position in their respective markets. Many such names have high levels of cash on their balance sheet, offering some downside protection.

At present, it is difficult to forecast the way ahead for the global economy, although, Japan looks reasonably resilient when compared with other markets.

We are only now entering a long period of adjustment by consumers globally and previous business models will be put to the test. It is too early to call any sort of market bottom but we feel that for long-term investors, real value exists in Japan, which, at book value, has priced in a lot of the economic turmoil ahead.

The Japanese market has traditionally outperformed strongly when the global economy picks up and right now offers investors prepared to wait a good buying opportunity.

Stefan Bain is fund manager of F&C’s Japan growth fund

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