A more difficult first quarter has cleared much of the froth out of the Japanese equity market and has allowed us to increase exposure at lower prices. Earnings growth is set to outpace other global markets, led not only by a weaker yen but also continued corporate restructuring and improvement on shareholder returns. Even after the blockbuster return in 2013, valuations are still attractive and offer one of the cheapest ways of benefiting from a synchronized acceleration in global growth.
Worries about a lack of progress on Shinzo Abe’s third arrow of structural reform are largely irrelevant, as are fears over the impact of an imminent rise in the sales tax. Japan needs inflation and higher equity prices if it has any chance of addressing its debt mountain. Having historically been hamstrung by a chaotic political system, this is now something the current government has the time, legal power and desire to do. The easiest route to this outcome remains a weaker yen – expect further monetary stimulus on top of the already aggressive easing the Bank of Japan is pursuing.
The mining sector remains as unloved as Japan was 18 months ago. Chronic overinvestment and fears over a China slowdown led to the sector lagging the FTSE All Share by over 30% in 2013 – a significant source of alpha for virtually every UK equity manager who were universally underweight. However, brighter times lie ahead. New management is making good progress increasing free cash flow through reduced capex and costs. Dividends from the sector, which already exceed that the broader market, will continue to grow. Further support will come from a depreciation in the Australian dollar and other producer nation’s currencies. All this will make it increasing hard for investor positioning to remain so depressed.
UK small caps
Finally, despite a good period of outperformance we continue to feel comfortable with our conviction play on the UK domestic recovery – Aberforth UK Smaller Companies. The portfolio remains cheap relative to the FTSE Small Cap Index (which is trading just at over 8x EV/EBITDA)
Attractively valued companies should be beneficiaries of an increasing amount of M&A activity. Many of the ingredients for this were in place last year, companies have record levels of cash on their balance sheet and the lure of growth through industry consolidation remains compelling. However activity remained low which can only be explained by continued low levels of confidence. We are more optimistic and feel confident that the UK domestic economy remains strong whilst we expect global growth to remain subdued but importantly improving. We would expect this environment to lead in time to increased M&A activity that should benefit smaller companies.
Most importantly we believe that after a period of strong performance from risk assets as a result of margin expansion, earnings growth will become the key driver of returns in 2014. As a result high conviction stock pickers like Aberforth should continue to outperform.
Tony Lanning is fund manager, Fusion Funds, at J.P. Morgan Asset Management