Why Japan is the Fund Picker's Favourite Market

Japan is set for a positive 2018 thanks to a combination of a positive economy and improving corporate governance, according to analysts

David Brenchley 4 January, 2018 | 2:46PM
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With global equity markets flying and growth very much on an upward curve around the world, asset allocation ought to be simple. However, many regions still divide opinion.

The US is expensive relative to pretty much everywhere. The UK has plenty of known unknowns. China remains an enigma to many. Europe is at the risk of becoming a “crowded trade”.

But one area most seem to agree on is Japan. Sure, there are potential headwinds here, too. Demographics remain challenging and accounting scandals persists at some of the country’s best-known companies. Not to mention its debt-to-GDP, at well over 200%, is higher even than Greece’s.

Still, both main Japanese indices, the TOPIX and Nikkei 225, posted gains of over 16% in 2017. And, despite scandals at the likes of Toshiba (6502) and Kobe Steel (5406), corporate governance standards keep improving.

While a glance at the cyclically adjusted price/earnings (CAPE) measure suggests there may be better value around the world, Japan is by no means expensive.

According to data from financial planning group Tilney, the Japanese equity market was trading on a Shiller P/E of 25.84 times as at 30 November, only slightly above its long-term average of 23.36. Further, despite currently trading at a 25-year high, the Nikkei is still 40% shy of its 1989 peak.

“In terms of corporate fundamentals and valuations, Japanese stocks are relatively cheap globally and the earnings environment is positive,” says Nicholas Price, manager of the Fidelity Japanese Values Investment Trust (FJV). This suggests a reasonable level of upside for the market in 2018.

Johan Du Preez, manager of the M&G Japan and M&G Japan Smaller Companies Funds, agrees that valuations remain compelling. But there are other reasons to believe Japan will continue to progress.

Abenomics Strategy Creates Stability

Many point to Shinzo Abe’s successful snap lower house election as a key event. That helped the Prime Minister strengthen his position and continue with to implement his Abenomics strategy. It should also help stability at the Bank of Japan, with Haruhiko Kuroda now expected to gain another term as Governor after his current one ends in April.

But Du Preez says the corporate governance reforms are the basis of his bullish investment case. “The introduction of the stakeholder and governance codes has been the Abe government’s biggest contribution to shareholder outcomes,” he explains.

The introduction of these codes has led to increased investor engagement with companies, which has, in turn, significantly improved their cost structures, helping to drive improved profitability. “Furthermore, companies have become more focused on shareholder value - dividends and share buybacks in total are now well ahead of the levels seen before the global financial crisis.”

The prospect of higher wage costs could impact some companies negatively, but should this materialise it would be positive for the economy and overall sentiment. Therefore, the big risks facing Japan come externally, according to Ken Maeda, head of Japanese equities at Schroders.

First, the risk of increased US protectionism and trade retaliation under President Donald Trump still exists. Second, the threat of nuclear action from noisy neighbour North Korea lingers.

“Although hugely significant, the binary nature of the possible outcomes makes it impossible to effectively price in this risk to equity portfolios,” continues Maeda.

What Does This Mean for Investors?

At a stock level, Du Preez says that, while investors have been keen to participate in the stock market rally, they have shied away from taking on equity risk. As a result, preference has been for apparent safe earnings stream like consumer staples and utilities.

Going into 2018, Du Preez sees opportunities in the more economically sensitive names, such as financials. These look “cheap relative to their trend earnings and have substantially improved both profits and shareholder returns”.

“Moreover, these companies have managed to achieve this during a time of relatively muted economic growth.”

Looking at funds, Adrian Lowcock, investment director at Architas, tips two to look out for focused on the region.

Man GLG Japan Core Alpha, managed by contrarian Stephen Harker, is currently positioned to benefit from a stronger economy in Japan, with exposure to cyclicals and financials. Morningstar analysts rate the fund Gold. “The fund combines experienced management with a well-established process that we believe will reward long-term investors,” says Peter Brunt.

Baillie Gifford Japanese is another suggestion from Lowcock. The managers look for companies with steady growth, special situations, cyclical stocks and secular themes, he says. Currently, it has exposure to cyclical industries, car manufacturers and technology. However, investors should brace themselves for the possibility of short-term underperformance and volatility due to its long-term growth nature.

Daniel Adams, senior investment analyst at Psigma, likes RWC Japan. He says the fund directly exploits the theme of improved corporate governance and shareholder friendliness. It works with companies it invests in “to ensure improving shareholder value with company management”.

One investment trust rated Gold by Morningstar analysts is Schroder Japan Growth (SJG), managed by Andrew Rose. It is higher risk than some of its peers due to the use of gearing, which detracted from returns in 2008. However, Rose is an experienced manager with a robust and proven process.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Baillie Gifford Japanese B Acc1,984.06 GBP0.36Rating
Fidelity Japan Trust Ord178.63 GBX-0.49Rating
Kobe Steel Ltd1,991.50 JPY0.10
M&G Japan GBP I Acc3,832.08 GBP-0.21Rating
M&G Japan Smaller Companies GBP I Acc4,570.41 GBP0.68Rating
Man GLG Japan CoreAlpha Profl Acc C269.21 GBP-0.48Rating
Redwheel Nissay Japan Foc R GBP Acc UnH135.96 GBP0.83Rating
Schroder Japan Trust Ord263.52 GBX-0.18Rating
Toshiba Corp  

About Author

David Brenchley

David Brenchley  is a Reporter for Morningstar.co.uk

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