With equity markets across the globe looking stretched – and ripe for correction as volatility picks up – Japan has been singled out as good value by many commentators this year.
And it seems investors are paying attention. Funds in the Investment Association (IA) Japan sector saw their best net inflows in two and a half years, while the IA Japanese Smaller Companies sector saw its best flows in more than a decade in February, according to Morningstar Direct data.
Investors pumped £464 million into Japanese equity funds last month, with the IA Japan sector now seeing six months of consecutive inflows. £1.6 billion has now been invested into these funds in that time.
Despite being one of the smallest sectors, IA Japanese Smaller Companies is the best performing over three, five and 10 years. The £53 million of inflows in February was the most on record.
“The distinguishing feature in Japanese markets since the end of the global financial crisis has been the rise of mid caps,” says Joel Le Saux, manager of the OYSTER Japan Opportunities Fund. Japanese mid caps have returned 235% in the past nine years, well outpacing both large and mega-cap stocks.
There are certainly some compelling reasons to buy into the Japanese equity story, with attractive valuations, a reformist Prime Minister and the ongoing change in corporate governance.
Attractive Valuations
On relative valuation grounds, compared to other global stock markets, Japan remains attractive. “It’s still cheap on every metric relative to the rest of the world,” says David Vickers, multi-asset portfolio manager at Russell Investments.
While Vickers says that compared to its recent past the Japanese stock market can look quite expensive, if you look further back in time “Japan actually looks very cheap”. The main Nikkei 225 index currently stands 44% below its 1989 peak.
But Tristan Hanson, manager of the M&G Global Target Return Fund, cautions against taking that too literally. “Japan did get to very expensive levels, so I would look more at the absolute level of valuation, rather than drawing too much of a comparison to its long-term history,” he says.
At around 14 times forward earnings, the market certainly looks attractive, Hanson continues. “But I wouldn’t say it was any more outstanding than emerging markets or Europe.”
Corporate Change
One key positive for equity investors in Japan is the change in companies’ attitudes towards shareholders. It’s a shift Richard Kaye, manager of the Comgest Growth Japan Fund, who has been investing in the country for over 20 years, has seen in recent times.
He notes the fact that the number of listed Japanese companies that have external directors is currently at a record high, as is the amount of cash firms return to shareholders, in the form of both dividends and share buybacks.
“And on the ground, we are seeing that as well. Half of the companies in our portfolio we have held for more than five years. We’ve got a long relationship with those companies and many of them when we started were very reluctant to even meet us or share any information when they did meet us,” he adds.
Now, he says, many companies are understanding the importance of keeping a stable minority shareholder base. “The companies have a natural need to engage and we’re seeing many examples of this.”
With Japanese companies now accounting for just over 9% of the MSCI World Index, the second largest single-country weighting behind the US, this is an important development for investors.
Fund Flows
Japanese equities have been popular amongst UK investors since mid-2017. The fund with most inflows in February was the passive Royal London Japan Tracker, with £79 million invested. The fund tracks the FTSE World Japan Index.
Following that were two popular actively managed offerings, Baillie Gifford Japanese, which has been the most popular over the past year, and Legg Mason IF Japan Equity, which we found out recently was one of the most popular funds with baby boomer SIPP investors, according to data from The Share Centre.
The Morningstar Gold Rated Man GLG Japan Core Alpha Fund saw its popularity wane a little, with just £19 million taken in February. Despite that, it’s still the second most-popular Japanese fund in the past 12 months, having added almost £600 million in assets.
The only other actively managed mandate that is rated Gold by Morningstar analysts is Schroder Tokyo, run by Andrew Rose.
If investors are now looking for passive exposure to the market, Morningstar highly rates iShares Japan Equity and HSBC Japan Index, which both track the FTSE Japan Index.
