Investors waiting for the Japanese economic sunrise have needed to be patient but, for those who look closely, a change is happening where it counts.
Slowly, almost imperceptibly, the mindset of corporate executives is becoming more aligned with the desires of investors. Companies are returning cash to shareholders in bigger amounts than ever before in the form of dividends and share buybacks. Merger and acquisition activity is also growing rapidly. Hostile takeovers are starting to appear and private equity firms are beginning to take an interest in Japan.
For as long as the Japanese economy remains sluggish, this might not seem very important. However, we believe it marks a significant change in corporate Japan and one to be welcomed. Japanese companies have reduced costs substantially over the last few years, allowing a greater share of sales to pass through to the bottom line than ever before. This latest change suggests that companies are likely to be more shareholder-friendly than in previous economic cycles and more inclined to make better use of shareholder capital, even if just to avoid hostile takeovers.
If the US and Chinese economies continue to show solid growth, we believe the resulting increase in Japanese exports should be positive for capital and consumer spending. Right now, the main benefit to investors of exposure to Japan might be a degree of diversification of returns within Asia. However, with positive changes taking place in corporate Japan and valuations still attractive, when the economic sunrise comes, we believe the Japanese market will reveal its full potential to investors.
The investment approach we favour is designed to uncover companies which have neglected alpha. These are companies which our analysis suggests should perform better than the consensus expects but which are not widely covered by analysts. The market can be slow to appreciate the potential of these companies, presenting an attractive opportunity for investors.
In the shorter term, this contrarian approach can be out of favour at certain times but we firmly believe that a longer-term focus on attractively valued companies able to deliver higher than average earnings’ growth has the potential to be one of the most successful investment strategies.
Our strategy at the moment favours the property sector, where we believe companies are well positioned to deliver better than expected earnings’ growth for longer than generally expected by the market, and also the domestic retail sector.
Retail is an area of the market which is out of favour with investors,and where valuations are very low. However, we believe this neglect by investors presents an attractive medium to longer-term investment opportunity once consumer spending begins to rise again.
Japan has not been immune to the volatility in world equity markets over the last month. The immediate reason for this weakness has been concern about problems in the US housing loan market, where successive interest rate rises have hurt the ability of borrowers to repay their loans. This by itself would not ordinarily have a global impact but investors have expressed concern about the potential for slower growth in the US economy and whether financial institutions worldwide could have an exposure to these loans.
In the very short term, this has manifested itself as a surge in the strength of the yen, particularly against the dollar, and a degree of volatility in the Japanese equity market. We believe that equity markets are over-reacting, as they often do in these circumstances. Uncertainty in markets is increased by a lack of visibility and as the fuller picture becomes clear over the next few weeks, we expect much of this uncertainty to dissipate. There could be growth implications for the US but our view continues to be that the outlook for Japanese equity markets looks attractive over the medium to longer term, as the economic sunrise begins.
Joji Maki is head of the Japanese equity team at Baring Asset Management