Why Japan offers the best hunting ground for value investors

The pressure building in developed equity markets last year was felt most keenly in Japan, which now looks poised to make the strongest rebound.

Well, that wasn’t much fun for investors: 2018 promised so much but ended up delivering very little, if anything at all. Of all major asset classes referenced by UK investors, only property ended up meaningfully in the black – up around 7%. Cash and gilts returned a little over 0.5%. With a 3.1% loss, global developed markets fared better than commodities, emerging market equities and UK shares, which propped up the asset class performance table with near 10% losses.

Fearful investors

So much for adopting a diversified portfolio. Even a balanced multi-asset strategy would have netted a small loss of 1.2%, the weakest reading since 2008, according to Royal London Asset Management. The reasons fear has been stalking the global investment landscape are known: trade wars, rising interest rates and quantitative tightening, slowing global growth and, particularly for us, Brexit.

I had hoped to get through the first few paragraphs without using the B word, sorry, but the less said about the awful options presented by the government to our bickering elected representatives the better. As I write, in early January, there is little point in second-guessing the outcome of the Brexit process, but my money is on impasse and an extension of Article 50. Either way, the sensible course is to adopt a balanced approach to investment, particularly in relation to equities.

A decent Brexit outcome, in which one would expect sterling to gain strongly against other major currencies, will be a headwind for the FTSE 100 index. That is because roughly 80% of FTSE 100 profits come from overseas, so those earnings would be worth less in a stronger sterling scenario.

Conversely, pretty much any deal, bar no deal, would cure the sickly, beaten-up stocks in the lower reaches of the UK market. But here there is also the danger of catching the proverbial falling knife. Nevertheless, some well-respected fund managers have been stocking up on good-Brexit (or no-Brexit) plays – some of them for a while now – when stockpiling the tinned goods and tin hats might be the more prudent approach.

A surge in sterling would also make overseas investments less profitable than has been the case. A weaker dollar is already taking the shine off the post-Christmas bounce from foreign equities. In the US, investors have taken heart from suggestions that the US Federal Reserve will not raise interest rates as far or as fast in 2019 as had been thought.

Indeed, there could be more juice to be squeezed from the US, given that markets tend to react to recessionary indicators more than to fears that the market is overvalued. With the US economy still in rude health, there could still be opportunities to buy the dips and profit, but these opportunities look likely to be more fleeting than in the past.

A table of 2019 Rated Funds for investors in Japan

 

Further danger ahead

One of my favourite measures of relative value is the 10-year cyclically adjusted price earnings (Cape) ratio . Despite the worst December in living memory for US stocks, this measure is still indicating danger ahead: its current reading, at a multiple of around 29 times, has been synonymous with severe market crashes in 2000 and 1929.

Where the US leads, the rest of the world follows. But there is one market where UK investors can potentially satisfy three near-term themes – safe haven, value and bounce – in one go: Japan.

As a holder of a few Japan-focused investment trusts, I’ve often been surprised by their resilience in the face of market falls. The reason is the currency translation effect: global investors tend to flock to the yen in times of market or global economic stress, so for us investors in sterling, a stronger yen will somewhat mask any further fall in Japanese equity prices.

Before the post-Christmas recovery, Japan’s Topix index was down 24% on the year – pretty nasty. But in sterling terms, the fall was a slightly more palatable 17%. On a one-year view to 9 January, the difference is more marked, particularly as the yen has gained strength. Whereas the local market is down 17%, the sterling-adjusted fall is less than half that at just 8%.

It is reasonable to expect yen strength to persist well into next year. Furthermore, equity strategists writing in JPMorgan Asset Management’s capital market assumptions paper for 2019 point to Japan as one of the most attractive markets today. “Central to our view on Japanese equities is the expectation that governance-led reforms are likely to drive a sustainable increase in return on equity (ROE), along with greater capital returns to shareholders,” they say.

Corporate governance reforms have been one of prime minister Shinzo Abe’s ‘three arrows’ designed to stimulate the economy, coupled with fiscal largesse and an extraordinary amount of quantitative easing (which is now being tapered).

Japanese ROE and net margins have reached an all-time high, say JPMorgan’s strategists, and have “materially exceeded our longer-term view”. This has led the strategy team to question whether their reform-driven expectations are “too conservative”. Although their forecast of a strong yen in 2019 will be a headwind for Japanese exporters, they do not think it will be enough to erode the benefits to overseas investors that a stronger yen will bring. Although the country was among the worst-performing developed markets in 2018, starting valuations for 2019 now provide “a critical boost to forward-looking returns for Japanese equities,” they say.

All of this “conspires to make Japan a very attractive investment destination” in 2019, according to Michel Perera, chief investment officer at Canaccord Genuity Wealth Management.

A table of global funds and trusts with high Japan weightings

 

Japan under-represented

Japan is the world’s third largest economy and its second largest stockmarket by market capitalisation. It has an 8.9% weighting in the FTSE World index and 8.6% in the MSCI World index. Yet actively managed global funds, as a whole, tend to give Japan the cold shoulder. The average exposure of 318 funds in the Investment Association’s global sector is under 5%; the 20 investment trusts in the equivalent sector have a 7% average weighting.

The table shows global funds and trusts with higher-than-average exposure to Japan equities. Among funds, Neptune Global Smaller Companies tops the list at 24%, followed by Money Observer Rated Fund Lindsell Train Global Equity at 21%. Note that value-oriented multi-manager funds such as Schroder MM International and Scottish Widows Multi-Manager International Equity have higher weightings to Japan than has historically been the case.

The Japanese value theme can also be seen among investment trusts, led by the 18% and 17% respective exposures to Japan from British Empire Trust and EP Global Opportunities, and Scottish Investment Trust’s 10% weighting. Unlocking value in Japan is also the aim of a new trust from Asset Value Investors, the management group behind British Empire. Its £80 million AVI Japan Opportunity Trust (see New kids on the block: we examine five new investment trusts for more) focuses on over-capitalised Japanese smaller companies with the aim of engaging with management “to unlock value in this under-researched area of the market”.

Plenty of opportunities will be available to exploit, because Japan is awash with publicly listed smaller companies – as demonstrated by the index-tracking Vanguard Global Small-Cap Index fund, which has a near-13% weighting to Japan.

The clearest danger to a rosy future for Japan equities is the knock-on effects of a full-blown trade war between the US and China. But global growth is still reasonably robust (albeit less so than a year ago), and Japan’s stockmarket continues to trade at a relative discount to most other developed markets. Its outlook looks a lot brighter than others.

The author was editor of Money Observer from 1998 to 2015.

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