Investors use the Asian country as a source of alpha, playing monetary policy and yen weakness. However, this approach means that they miss out on long-term diversification attributes.
Economic momentum in Japan deteriorated this year. Exports towards the US in particular dropped off, mainly due to high comps rather than the global trade war. The latter could have an impact, but negative effects will likely play out from 2019 onwards.
Meanwhile, the Bank of Japan failed to act decisively to raise inflation when economic momentum was supportive. Now, faced with a diminishing growth profile for next year and a consumption tax hike in autumn 2019, its hands will be tied from spring 2019 to spring 2020.
However, underlying domestic economic conditions, such as core wage growth and business fundamentals, are encouraging. Cash flow has improved, and businesses are now increasing capital expenditure with a focus on the sustainability of operations. This bodes well for productivity in the long run.
Currently at 12.5x P/E, share prices are not reflective of these trends. Thus, to improve valuations in a sustainable way, with business margins already at their highest level on record, companies need to improve dividend policies and enhance share repurchase programmes. The reality is that most companies have strong balance sheets and still need to improve their payouts to shareholders.
Returns to shareholders now sit at approximately 45%, with a 30% payout ratio and up to 15% buybacks. While this constitutes an improvement from a decade ago, when figures were in the teens, shareholder friendliness in Japan has a long way to go. This creates opportunity for price discovery and optionality in a range of stocks.
Capitalising on a shifting market structure
The Japanese market is becoming much less cyclical. The weighting of service companies has increased dramatically, while that of cyclical companies and exporters has diminished. Domestic-oriented companies are also gaining prominence. Our sector-agnostic portfolio is exposed to both domestic and export-oriented industries, to capture these macro variations.
With less cyclicality, market volatility has relatively diminished. These shifting dynamics create an attractive proposition for the long run – with companies more resilient to macro market vagaries. This is a proposition that tourist investors, who bought the Japanese earnings momentum, and then sold out when it fell, will miss.
The importance of being agnostic
The Japanese rally rested largely on the surge of growth mid caps. Previously undiscovered, these are now expensive, which is testimony to their popularity. On the other hand, mega caps, which unperformed the Topix for four consecutive years, and large caps, are now relatively cheap.
We have identified some of these undervalued mega and large caps that will deliver exposure to the economic cycle, whereas more resilient non-cyclical mid-cap stocks serve to anchor the fund against economic and market movements.
A couple of years ago, the valuations of numerous growth mid caps went up, prompting us to gradually reduce our exposure to them.
But not all mid-cap stocks are expensive – we still hold more than the benchmark. Over the past decade, growth stocks largely outperformed value investments, bloating valuations. Growth currently looks expensive; hence, we have found opportunities in value mid caps, where cheapness still abounds.
Unearthing idiosyncratic opportunities
Our approach is style agnostic; we don’t have a bias. Instead, we are opportunistic: finding good companies at the right price – regardless of whether they fit into the growth or value category. In doing so, we are able to avoid potentially seismic shifts in market momentum.
Style rotation can be particularly dangerous for investors. People are always buying the past, but past success is not always an accurate gauge of future returns. Trying to time the market and getting it wrong can be catastrophic.
As growth investing experiences fatigue in Japan – growth mid caps have no more room to expand – a regime change could be just around the corner.
By unearthing idiosyncratic opportunities, for example, in rail companies, which are seeing the number of users steadily climb, we are able to avoid the disruptive impact of market-style rotation.
Such as strategy, with low stock-level beta correlation, also allows us to mitigate upcoming macro uncertainty.
Joël Le Saux, manager of the OYSTER Japan Opportunities fund at SYZ Asset Management.
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