Japan becomes new investor favourite

Japan was the second-best performer last month, according to figures from the In

Figures from the Investment Association (IA) show that investors turned positive towards Japan in October. The sector was among the largest in terms of net retail sales and the second-best performer last month.

It continues an impressive performance from Japanese equities this year, with the Nikkei recently hitting 21-year highs as Shinzo Abe won another term in office following a surprise election. However, Japan's market is still around 50 per cent lower than the market's all-time in 1989.

Investor optimism has been boosted by a number of factors. Japan's unemployment rate is at record low levels, and GDP has expanded for six straight quarters - the longest sustained bout of growth since before the global financial crisis.

On top, earlier this year, nominal GDP surpassed its 1997 level, marking the beginning of the end of a multi-decade long period of deflation. The IMF recently upgraded its outlook for the Japanese economy, due to a general increase in global demand and also the supportive polices of the government and central bank.

The Bank of Japan's (BOJ) governor Haruhiko Kuroda has committed to keeping ultra-loose monetary policy until inflation rises from the current 0.5 per cent level to the target of 2 per cent, even as central banks in the US and Europe are tightening their policies. This should ultimately lead to a weaker yen and strengthen the attractiveness of Japanese exports further.

Policy boost to company profits

In such a favourable environment corporate earnings have begun to recover over recent months and valuations remain attractive relative to other markets. Interestingly, despite higher expected earnings growth and markets outperforming this year, Japan currently trades at a discount to developed markets on a 12-month forward price-to-earnings (PE) basis, and trades at a discount to its own history.

Against this backdrop, investors expect more upside in Japanese equities from the continuation of current policies, rising earnings, and increasing profitability of Japanese companies.

Meanwhile, corporate governance continues to be a major focus in Japan. Economic reform is also encouraging companies to prioritise shareholders with share buybacks, dividend increases and M&A activity. For example, 2016 saw 25 per cent of companies buy back their shares. This increasingly looks like a structural change.

Challenges and opportunity

Investors should be aware of Japan's historic economic challenges. Over the years the country has relied heavily on massive monetary easing, central bank balance sheet and asset buying to fight deflation and restart growth with inflation.

The BOJ now owns two-fifths of the country's sovereign debt and two-thirds of its domestic ETF market. While these purchases have mainly supported Japanese equities and prevented the yen from appreciating too far, it does raise the risk of reduced liquidity and increased volatility when the BOJ starts tightening policies.

Despite challenges faced by the economy, the Japanese stockmarket still offers plenty of opportunities for investors. Here are three Money Observer Rated funds well-positioned to benefit from a favourable macro backdrop and offer investors active exposure to Japanese equities.

Baillie Gifford Japan Trust (BGFD) is for investors looking for long-term core exposure to Japanese equities. The trust has been managed by highly experienced fund manager Sarah Whitley since 1991, but she will be retiring in April 2018. Following her retirement, Matthew Brett will take over as lead portfolio manager of the trust, supported by Praveen Ku.

The team looks for companies across the market-cap spectrum that can generate sustainable sales growth in excess of market expectations over the long term. The process has been diligently followed for many years and provides investors with exceptionally strong returns during different market conditions.

Lindsell Train Japanese Equity Fund is for investors looking for long-term growth in Japanese equities, but who can tolerate short term volatility. The fund is managed by seasoned investor Michael Lindsell who has been covering Japanese equities since 1985.

The manager invests in high-quality companies with durable, cash-generative business franchises through a portfolio of 20-30 best stock ideas. He has successfully and consistently applied his approach for many years and delivered strong performance over the longer term. Investors should be aware that, due to the manager bias to high quality companies, the fund will typically underperform in strongly rising markets.

Legg Mason IF Japan Equity Fund is for investors looking for smaller and mid-cap exposure to Japanese equities. The fund is run by veteran investor Hideo Shiozumi who has been managing Japanese equity since 1970.

He creates a highly concentrated, benchmark agnostic portfolio primarily of small-cap companies that generate most of their revenues domestically. These stocks tend to exhibit significant volatility, so is more appropriate for higher risk investors or as part of a diversified portfolio.  

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