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The sun also rises

There have been so many false dawns for Japan but yet again it has suffered another year in the doldrums but James Smith reports that some leading managers believe the market really is about to embark on an upturn

Japan has filled the role of perennial equity market underachiever over the last decade and it has had another difficult year.

Although many were predicting a revival before the March earthquake and tsunami, the Nikkei 225 index lost almost 19 per cent of its value after the disaster and although it recovered some ground midway through the year, it has since fallen back to the lowest level since March 2009.

But despite the difficult year and an enduringly tough macro background, several of the industry’s most respected managers have proved it is possible to generate strong returns if you pick the right Japanese stocks.

The best-performing fund by far over one and three years to mid-November is the Legg Mason Japan equity fund, quadrupling returns from the next best offering in the shorter period. The fund is up by 44 per cent over one year compared with 10 per cent from its closest rival.

The fact it is also comfortably the worst fund in the sector over five years – down by about 28 per cent – shows the big turn-round in performance from manager Hideo Shiozumi in the last few years.

Shiozumi has been running the fund since 1996 and his stockpicking focuses on growth companies, with a skew towards those that can benefit from changes in Japan’s economic and social structure.

This strategy worked well for most of the fund’s first decade up to 2005 but the wheels came off in 2006 and performance remained poor for the best part of three years.

Shiozumi says there were two reasons for this and both have passed, at least for now. “First was a general deterioration in company quality, with several IPOs coming to market from poorly run companies. This came to a head with the Livedoor scandal in 2006 and, as so many domestic investors held these stocks, their falls obviously dented sentiment on the small-cap sector as a whole,” he says.

The second factor behind the small-cap malaise in this period was sharp rises in several emerging markets, including China and India. He says: “Because smaller company investment remains largely domestic – accounting for 70 per cent of total turnover – a general redirection of assets towards these emerging markets left the majority of local companies depressed.”

Japanese companies are as reliant on emerging-market demand as the rest of the world but Shiozumi says several of these countries are battling higher inflation and predicting slowing economic growth. This should mean another widespread desertion of domestic Japanese stocks is unlikely.

Since the earthquake, Shiozumi says ongoing yen strength and a weakening global outlook has encouraged investors to focus on stocks in service sectors, such as the internet, which are fairly immune from economic trends.

With the fund overweight in areas such as web services and healthcare, the fund has continued to make money as the majority of its peers fell.
About 44 per cent of the portfolio is in service companies and 24 per cent in retail – with more than 50 per cent overall exposed to the internet theme.

Fidelity’s Japan smaller companies is another fund that has correctly called the prevailing market trends, although it can also boast sector-leading five-year performance, returning 3.8 per cent over five years against a sector average of -11.3 per cent.

Manager Jun Tano says holdings in mid/small-cap cyclical shares in the auto, machinery and metals sectors have all benefited from firm growth in the Asia region.
Key activity heading into this year saw the manager reduce positions in cyclical exporters, including Nikon, TDK and Asahi Glass, where business momentum was peaking. He added holdings in laggard domestic stocks in the toiletries, household goods and retailing sectors.

“I focused on undervalued companies, such as Kobayashi Pharmaceutical, FamilyMart and Marui Group, which appeared poised for a recovery in earnings amid a return to top-line growth and ongoing cost-cutting efforts.

“A combination of growth in China and a rebound in the US should underpin a cyclical recovery in Japan, whereby a pick-up in exports drives broader economic activity.

“In the mid/small-cap sector, many stocks trade on single-digit earnings multiples and are returning to peak earnings. The presence of a substantial valuation gap with bigger companies suggests potential for future outperformance.”

Schroders’ Nathan Gibbs, who runs the Japan alpha plus fund, is another who says the country’s economy was showing clear signs of recovery in the months leading up to the earthquake and the country is in a different position from when the last big earthquake struck in 1996.

“This is a very different situation than the Kobe earthquake in 1996, which exacerbated an already weakening trend. It is also worth remembering that such events are tragic but they rarely change the direction of underlying fundamentals. In general, Japanese companies are in a healthy position – operational gearing is strong and cash levels are high.”

Gibbs says in the days immediately after the earth-quake, indiscriminate selling took hold of the stockmarket but relative performance improved quickly as information emerged that allowed investors to take a more considered view of individual stocks.

Another of the strongest funds in the Japanese equity sector over five years is Neptune Japan opportunities managed by Chris Taylor.

Mirroring Shiozumi’s return profile in reverse, his Japan opportunities fund is top in its peer group over five years but close to the bottom over 12 months, suffering from hedging yen exposure back to sterling.

His longer-term performance figures show the benefits of shorting Japan in 2008 but Taylor’s aversion to domestic exposure and subsequent yen hedging has weighed on performance as the currency continues to thrive.

Taylor says the post-quake rally in the yen, when the G7 intervened to stabilise it, corresponds with Neptune’s analysis that Japan is bust, the currency is overvalued and the only functioning parts of the economy are the big global multinationals.

But even with this gloomy analysis, he says there are opportunities. “We believe the key Japanese companies are global multinationals that have heavily invested in the non-OECD economies over the last 15 years.

“These investments, in terms of their revenue and profits contribution, have hit critical mass and are now in an excellent position to exploit the two-thirds of global growth the non-OECD will generate between 2007 and 2014.”

Taylor says ongoing political stalemate continues to hamper any effort to rein in Japan’s burgeoning national debt, the expanding annual budget deficit and the yen’s short-term rise.

“All these are compounding Japan’s potential to recover, as well as undermining its ability to tackle the highly negative fiscal fundamentals. In fact, it is accelerating the deterioration, which in itself will eventually undermine the yen.

“We remain convinced the factors behind recent economic disruptions will prove relatively short-lived and Japan will rebound strongly, when we expect the yen will also weaken.

“The fund will continue to focus its investments on Japan-based global multinationals and will remain hedged against the yen due to the country’s deteriorating fiscal position.”



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