Is it a good time for investors to follow the Sage of Omaha’s lead and take another look at Japan, asks David Craik.
If you mention Japan to most British investors, they will probably shake their head and whisper something about the three dreaded “Ds”. Fear of deflation, ageing demographics and national debt, which is around two and a half times the size of its GDP, have darkened investors views of the Land of the Rising Sun since the market crash of the early 1990s.
According to Fidelity the Tokyo market is worth less than 7% of the total value of global shares. Meanwhile, figures from the Investment Association reveal that UK investors have pulled around £700 million from Japanese funds this year.
However, at the end of August, investment guru Warren Buffett revealed that his group Berkshire Hathaway had been building 5% stakes in five Japanese trading houses – Itochu, Marubeni, Mitsubishi, Mitsui, and Sumitomo – over the last 12 months.
The move was notable not just because Buffett has traditionally invested in big US stocks such as Coca-Cola (NYSE:KO), but that it came days after the resignation of Japanese prime minister Shinzo Abe because of ill health.
Is there a link? Could returns recover under the new prime minister Yoshihide Suga? In general, is this a good time for investors to follow Buffett’s lead and take another look at Japan?
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Why Buffett has made the move into Japan
There seems to be a perfectly good reason why Buffett has made the move.
Equities in Japan have performed strongly in recent years with the Nikkei 225 Index surging from 12,397 on 1 January 2013 to a three-decade high of 25,349 on 11 November, closely matching the gains seen in the US S&P 500.
Return on equity has doubled for all listed Japanese equities from under 5% to 10.8% between 2012 and 2018. Dividend yields, according to Schroders, are 2.8%, better than the 2.2% seen in the US.
Despite this, says Richard Aston, portfolio manager of Coupland Cardiff’s CC Japan Income & Growth Fund and CC Japan Income & Growth Trust (LSE:CCJI), foreign investment flows have been “net zero” since 2012, the year Abe became prime minister.
Aston says inflows were strong up to 2016 as investors reacted warmly to “Abenomics” – the attempt to re-boot the Japanese economy and tackle deflation through monetary easing, fiscal stimulus and structural reform of corporate governance to help increase shareholder dividends.
Progress has been made with higher employment, and the curbing of deflation – although the average core inflation rate of 0.68% is short of the 2% target.
There has also been a substantial uptick in corporate governance. “Pension funds and businesses now get it,” says Adrian Hickey, head of Japanese equities at Pictet Asset Management. “They see that it matters to focus on profitability and shareholder returns.”
Dividends are on the rise
Richard Batty, fund manager on the multi-asset team at Invesco, agrees: “The Corporate Governance Code has led to a whole new level of engagement between corporates and both domestic and foreign investors that is improving transparency,” he says. “This backdrop has also encouraged the corporate sector to increase the dividend payout ratio from a low 30%, to Western stock-market levels of 40% last year.”
However, post-2016 foreign flows have drifted lower until this September when Aston noted that “all that buying since 2012 had been unwound”. He adds: “It appears as if foreign investors have lost their enthusiasm for change despite the steady underlying advances that have been encouraged during the Abenomics period. The legacy of disappointment and stop-start equity markets in the past have created fear that prevents some investors giving the improvements in corporate governance and shareholder return due attention.”
Hickey believes the gains of Abenomics have been too “subtle” to tempt foreign investors. “There have been incremental improvements but very little dramatic catalysts to invest in Japan,” he says.
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US/China trade war has weighed on sentiment
Aside from the three dreaded Ds, fears over global economic growth and the US/China trade wars have weighed on sentiment.
But a positive that could tempt investors looking at Japan today, and perhaps a key reason why Buffett spotted an opportunity, is low company valuations
According to Bloomberg, the S&P 500 has a 12-month forward price/earnings ratio of around 21 compared with 14 for the Tokyo Stock Price Index (TOPIX).
“There are a lot of very cheap, undervalued companies in Japan because of a lack of sell-side research and too much cash on the balance sheet, including some with 100% of their market cap in cash. It is a remarkable anomaly but since the crash of 1990 companies have wanted to have strong balance sheets. The market does not value that cash,” says Joe Bauernfreund, portfolio manager at AVI Japan Opportunity Trust (LSE:AJOT) and the AVI Global Trust (LSE:AGT) in which 30% is invested in mainly Japanese small caps.
Bauernfreund sees low valuations as an opportunity. He adds: “We invest in good-quality businesses that are trading at discounts to their net asset value,” he says. “It leads us to look at areas of the market that are overlooked and neglected by other investors. We are active investors, so we encourage firms to use that cash such as through share buybacks or M&A.”
‘Suganomics’ replaces Abenomics
What difference will the new prime minister make to this investment landscape?
Batty is certainly encouraged by Suga’s talk of a “continuity agenda”. “Continuity of the corporate reform and economic agenda, progressive dividend payout policies and a competitive yen mean that Japanese equities remain a good investment opportunity for our multi-asset funds,” he says.
However, there are areas where “Suganomics” may differ, such as increasing competition in the telecoms sector leading to reduced mobile phone fees. There will also likely be a push for more investment in digitalisation and information technology.
“Suga is legislating for a new digital agency because Japan’s information technology needs to be pulled into the 21st century. Its systems are outdated and inefficient,” says Bauernfreund. “For a country which is so technologically advanced in areas such as robotics, their domestic companies lag way behind in terms of capability. Virtually every company in Japan has a fax machine and during lockdown many people couldn’t work from home as they did not have the systems to cope. There is a digital cliff approaching by 2025 unless it invests in technology.”
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Where fund managers are finding opportunities
As a result, AVI has been investing in growth companies including software integration specialists such as NS Solutions.
Nicholas Price, manager of Fidelity Japan Trust (LSE:FJV), says it is focusing on companies that will benefit from the shift to 5G technology and the new data-driven work from home cycle. Key holdings for him include Murata Manufacturing and electronics group TDK.
Hickey says Picet has, like Buffett, increased its exposure to commodities and other cyclical stocks that have suffered in the pandemic. “Japan is really a global market, it is a play on global demand for information technology or industrials in particular,” he says. “Domestic demand tends to be stable. There is no real long-term growth given the demographics. Buffett has highlighted where there is value in Japan.”
Indeed, Aston reveals that he has noted an uptick in foreign inflows into Japan since Buffett’s announcement.
“It could be coincidence or perhaps people following in his footsteps,” he says. “Maybe the change of leader has given investors a chance to re-assess their opinions on Japan. As a country, it is recovering quicker than the West from the pandemic with up to 90% of people back in offices and the bars crowded.”
Bauernfreund believes Japanese small caps will be a “great play” in the global economic recovery from the virus. “They have cheap valuations, but strong balance sheets and no debt. They have been under-managed but are seeing a pick-up in earnings that will boost profit and share prices. We also expect to see more M&A activity, which has not been a big feature in Japan recently. Private equity firms have plenty of cash and are scouring the world for value. They will find it in Japan.”
There is also a strong sense that everyone is more like Japan now following Covid-19.
“The image of Japan is low growth, big public debt and an ageing population. Well, it’s not so different from Europe anymore,” Bauernfreund states. “It is so cheap and has so much opportunity. We absolutely expect returns to improve. It is the perfect storm.”
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