Magazine Issues » April 2009


A comparatively cautious nation, Japan’s balance books are strong and its banks remain virtually untouched by toxic debt – so why have investors withdrawn funds? By Angele Spiteri Paris...

sushi.jpgThe Japanese, whom Western asset managers have criticised in the past for slack business practices, could now return the gesture. It is often said that corporate governance in Japan lags the supposedly higher standards set by Western companies. A jobs-for-life policy, in particular, has always frustrated foreign investors.

But now that everyone living east of Munich is questioning the wisdom of Western capitalism, it is notable that the balance sheets of Japan’s companies are not perforated by leverage. Arguably Japan had more foresight than American and European companies when it came to the dangers of gearing, and this even extended to its banks, which remain virtually untouched by the toxic-assets disaster.

“All corporate Japan is in good shape,” says Scott McGlashan, of JO Hambro Capital Management. “Balance-sheet gearing is at the lowest it’s been for almost 40 years. While the rest of the world has been increasing their leverage, Japan has been decreasing its leverage.”

Cash that these companies have stashed away, says McGlashan, could leave corporate Japan as the sole survivor if the global recession takes longer than expected to play out.

“One of the companies we invest in called Keyence has two years’ worth of operating expenses sitting in cash on its balance sheet. So if it doesn’t make a sale, it doesn’t have to go out of business for two years.

“In a funny way, the more difficult it is for the US and Europe now, the better it is strategically for Japan. In a worst-case scenario, Japanese companies will inherit the earth at this point because their balance sheets are so strong.”

Jonathan Allum, Japan strategist at KBC Financial Products, says: “However horrendous the situation, the main names in several manufacturing sectors are survivors… People would rather buy cyclical stocks with strong balance sheets on the hope or expectation of a recovery.”

Japanese companies have not found themselves in this happy position by chance. They have truly understood the meaning of the word cautious.

Christopher Renwick, of Chuo Mitsui Trust International, says: “Over the last decade, the Japanese have got a lot more responsive in dealing with macro economic issues more nimbly than companies in Europe and the US.  Manufacturers have got very adept at cutting back production, cutting back inventories, downsizing operations and generally anticipating the impact of global recession and a drop in global demand.”

But none of this means it is any easier to sell Japanese funds. Even domestic investors, who perhaps feel Japan’s corporate failings more acutely, put much of their considerable savings abroad.

McGlashan, of JO Hambro, says: “The typical Japanese pension fund has more invested in overseas equities than domestic equities. That is a strange position to be in going forward considering what has happened in overseas markets in the last
18 months.”

Meanwhile, foreign investors, so important to the market, have left in droves. Hirofumi Kasai, CIO of Japanese equities at Tokio Marine Asset Management, says: “Foreign investors have repatriated their money to their own countries since Japan is somewhat of a marginal market. This investor behaviour led to poor [stock market] performance, in spite of the fact that balance sheets are sound.”

Collateral damage
In 2008 the S&P Japan 500 saw the biggest decline since World War II. The market sold off aggressively as hedge funds and other investors from the US and Europe pulled out of Japan.

But what drove these investors away if corporate Japan is so healthy?

A high exposure of the Japanese economy to foreign demand means that a strong currency led to largely undeserved corporate losses, say managers.

But it could also be Japan’s poor stock market performance is merely collateral damage from the direct damage inflicted
on investors through their activities elsewhere in the world. “The confusion came from the US, but the Japanese equity market had the same depreciation,” says Yuichi Chiguchi, Japanese equity strategist at Diam International.

Allum, at KBC, says: “It’s kind of unfair that Japan, which has avoided any great boom and bust, ends up suffering worse economically than places like the US and the UK.”

If domestic investors remain focused on foreign markets like China, it will be the same foreigners that drove Japan downwards that could well capitalise on an eventual recovery in the region. But that won’t be just yet. The abysmal corporate earnings in 2008 are forecasted to be followed by weak earnings until March 2010. Although the market rallied by 9.1% on 19 March 2009 the country has experienced several false dawns in the past. McGlashan believes the rally was a result of investors covering short positions.

But he adds: “In September or October we should see something more sustained.”

Renwick, at Chuo Mitsui Trust International, says: “If you think that demand is coming back, then a rally on the Japanese market is likely to be a lot more sustainable than one on this side of the planet.”

This is something institutional investors should be aware of to avoid losing out, claim certain managers. Charles Beazley, president, Nikko Asset Management Europe, says: “If Japan rallies aggressively and early then people will have to chase Japan and they hate doing that.”

The sustainability of an eventual rally looks likely, based on the fact that Japan does not have the deep systemic problems pervading the financial system in the West. The integrity of the Japanese system is very strong and in fact Renwick says its institutions are in the healthiest state they’ve ever been.

Hard lessons
One of the main reasons for this is that Japan learnt its lessons the hard way early on and has been cautious ever since the 1990s crisis. Dealing with a crisis environment in Japan is ‘business as usual’.

Beazley, at Nikko, says: “Even when they’re doing well, Japanese businessmen will always tell you life is very difficult. It is almost reminiscent of the war generation. The lost decade of the 1990s was such a crucible experience for them that certain behaviour has been ingrained.”

Frugality has become part and parcel for Japanese consumers and this prudence has also been infused with the way companies are run. Many were severely burned in the late 1980s and early 1990s and would now rather focus their efforts on one thing rather than overstretch themselves.

“It has interesting echoes for us in the West,” notes Beazley, suggesting Westerners in difficulty could learn from Japan.
Following on from the cautiousness that is now deep-seated in the Japanese psyche, several Japanese companies exhausted their inventories in 2008 in an effort to lower their production costs in these troubled times.

“Production was cut by half,” says Kasai, of Tokio Marine Asset Management. “Half of this was because of the global slowdown and the other half was emergency inventory adjustment in response to the crisis.”

But Chiguchi, of DIAM, says the cut in production was too extreme and although there might not be an uptick in demand, companies still need to increase their production.

Political game
Time will tell whether foreign investors will be enticed back. If they are, however, they may just find that domestic investors are joining them. McGlashan, of JO Hambro, says that politics could have a significant hand in triggering a recovery in the Japanese equity market.

“Usually talking about politics in Japan is a complete waste of time. But now there’s a huge amount of public dissatisfaction with the way Japan is being governed and we may see substantial political change this year.”

He says that a change in government could really excite domestic investors and help them shake off the crust of cynicism they have grown in the years of Liberal Democratic rule.

Jonathan Ashworth, equity analyst at Barclays Wealth, says: “The government is very unpopular. People are tired of politics and one wonders whether an election would have any true positive effect.”

But Kasai, of Tokio Marine Asset Management, says: “The only important thing is the perception of international investors.” 

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