Japan – Land of the Rising Sun or False Dawn?

In the last six months or so I have generally not been recommending my clients buy equities, instead sell them. My advice has been to take profits and reduce risk in an expectation of a stock market sell off, euphemistically called a “correction.” This is investment speak suggesting a collapse in equity prices is actually a good thing. In some senses it is, in paring back overpriced stock valuations to more justifiable levels and reminding over confident investors that shares can down as well as up. But major sell-offs are rarely pleasant as investors discovered in 2008 when portfolio values tumbled.

Anyway back to my main point, the case for Japanese equities, an exception to my advice to reduce equity exposure. Last week I listened to an interesting webinar from the manager of the JP Morgan Japan fund, Nicholas Weindling, someone I had not heard before. He argued the case for Japan was good citing stable government, positive company earnings growth and a growing culture of shareholder value, historically a weakness in corporate Japan. With inflation below target of 2% p.a. ongoing quantitative easing is likely to continue to be supportive of asset prices. In contrast in Europe the European Central Bank (ECB) will begin to taper its bond buying programme in the autumn as economic growth has surprised on the up side. European equities have been the bright spot in 2017.

Weindling argued that corporate governance improvements in Japan were structural with almost all companies on the TSE1 (Tokyo Stock Exchange, large companies) have an independent director, a huge rise since 2010. There has also been a significant increase since 2014 in companies having targets for ROE (return on equity) and ROA (return on asset) in their medium term plans.

Another compelling observation was on the fact that the Japanese equity market is under-researched, in absolute terms and relative to the US and Europe. For example take Japan’s TOPIX index with 2012 companies, a broader index than the better known Nikkei 225. Around 2/3rd of the companies have either one analyst or no analyst cover. The equivalent figures for the US Russell 3000 index and the S&P Europe BMI index with 1,862 names were 10% or less, whilst 50% or more had 2-10 analysts in both regions. What this means is that strong Japanese companies are likely to go under the radar and many of these will be under-valued. This inefficiency strongly favours active stock picking fund management based in Japan, something Weindling claims is rare.

Finally Weindling cited a significant rise in-bound tourism since 2012 and a growing participation of women in the labour market as being good for the economy. Both of these facts I was unaware of.

Of course not all is rosy in Japan, economic growth is sluggish, debt to GDP remains high, consumers are notoriously reluctant spenders and Japan’s demographic is ageing. Moreover Japan has a history of disappointing investors since the great crash in 1990. The land of the rising sun has more often proved to be a false dawn. That said many fund managers and asset allocators see good potential in Japan and are talking this market up.

To conclude a small or additional allocation to Japanese equities may be appropriate for many investors and given the choice I favour unhedged share classes i.e. those that do not hedge the currency risk of investing in a non-Sterling currency. What this means is that if the Yen strengthens against Sterling UK investors will benefit from the currency move as well as the underlying gains in share prices. With the Yen being a traditional safe haven currency, in a global equity sell-off it is likely to strengthen whilst problems and uncertainty with Brexit could weaken the pound. Currency risk is one all UK investors face whenever they buy overseas funds and it is another issue that needs to be considered.

The content of this blog is my own understanding of the JP Morgan Japan fund manager’s views on the Japanese economy and market prospects and my comments are intended as general commentary only. Nothing in this article should be construed as personal investment advice for example to invest in Japanese equities. You should seek individual advice based on your own financial circumstances before making investment decisions.