Japan is famously reforming its economy and corporate practices. Our panel of experts – including allfunds, M&G INvestments, Fidelity and sparx group – argue this could end the cycle of disappointment with Japanese equities.
Nicholas Price (portfolio manager, Fidelity International)
Alastair Dean (senior analyst, Stonehage Fleming)
AnaÏs Gfeller (senior analyst, Allfunds)
Jamie Frere-Scott (head of research, RMCP)
Masa Takeda (portfolio manager, Sparx Group)
Oliver Wayne (lead equity researcher, Redington)
Carl Vine (co-head of Asian equities and lead portfolio manager, M&G Investments)
Nick Wood (head of investment fund research, Quilter Cheviot)
Matt Johnston (founder, MRJ Investment Advisory (moderator and writer))
The eyes of the world will be on Japan in 2020 with the Olympics coming to Tokyo in July. The economy and stock market attract investor attention too – but a large degree of scepticism comes with this attention. Waves of enthusiasm are frequently dashed by disappointing returns.
There are many common beliefs and, perhaps, misconceptions about Japan’s economy and its equity market. To name a few:
- Japan is an ageing economy in secular decline.
- Japanese companies are stuffed with inefficiencies, lag global peers in governance and are not run in the interests of minority investors.
- Japan is a ‘value’ market.
- Japan has had its turn; China is now the dominant force in Asia.
Funds Europe and Camradata, in partnership with MRJ Investment Advisory, put together a panel of leading fund managers and fund selection specialists with in-depth knowledge of the Japanese market to discuss these points and more.
It should be noted this discussion took place before the full emergence of coronavirus and we publish it in the assumption that the underlying fundamentals highlighted here will remain valid during the longer term.
In the Asian region, these days China takes the lion’s share of the press. Its growth outlook, its opening up to foreign investors, and the concerns about debt and the US/ China trade wars that surround it – and not forgetting coronavirus – provide no shortage of journalistic copy. In this context, it’s easy to forget that Japan remains the third-largest global economy – and the third-largest stock market.
Investment Association figures for November last year show UK investors deployed £24.5 billion in Japanese all-cap and small-cap. This is a number not to be sniffed at. But who is allocating?
Secular de-risking of UK corporate pension schemes continues apace and so equity investments have generally shrunk.
Oliver Wayne, lead equity researcher at institutional investment consultant Redington, says that it is typically only the largest corporate pension schemes and endowments that consider Japanese equities, with most taking exposure through broader global equity mandates.
The intermediated wealth channel differs somewhat. Demand there for risk assets remains strong. Jamie Frere-Scott, head of research at RMCP, says dedicated Japanese equities exposure may account for up to 3%-5% of a balanced portfolio. This number resonated with other panel members.
The corporate governance J-curve
Since 2012, no Japanese fund research meeting passes without mention of Abenomics and its ‘three arrows’: monetary stimulus, fiscal expansion and structural reforms. Shinzo Abe put forward these ideas on his re-election in 2012 with the ambition of jolting Japan from its flatlining growth and targeting reflation of the economy.
With the first two arrows showing some positive signs of impact, our panel focused on the third and vital area of structural reforms, including corporate governance initiatives.
Carl Vine, co-head of Asian equities and lead portfolio manager of M&G Investment’s Japan Equity Fund and Japan Smaller Companies Fund, has been covering Japanese equities for over 20 years.
“In the eighties and nineties there was a debate raging about the nature of Japanese capitalism and the shift away from a model where capital was not really allocated but seemingly distributed by the main banks at the direction of the government, to a private market allocation of capital,” he says.
Vine notes that Japanese companies have done a decent job of getting their margins up – but capital allocation had been poor. This is a vital point.
“We thought this change in capital allocation might take five to seven years. It’s taken about 20!”
However, a theme that shone through in the panel discussion was that change is finally occurring. Referencing Abenomics, Vine adds: “If we take a step back and consider what’s been happening, in the last five to six years, it is an amazing government-led, multifaceted and coordinated attempt to cajole and push boardrooms to behave differently, and what we are seeing now is a J-curve lagged effect with these changes cascading.”
State-sponsored initiatives have included the Japan Stewardship Code, Corporate Governance Code and initiatives in M&A guidelines and Companies Acts. This is a full arsenal of directives pushing for change and the results could be exceptionally positive. Many companies sweating their assets harder to generate sales could see a closing of the gap between public and private market valuations. Indeed, improved ROE and ROA metrics may bring Japanese company valuations closer to global multiples with a further benefit being the return of cash to investors through uplifts in dividend payments and share buybacks.
Nicholas Price, portfolio manager for the Fidelity Japan Aggressive Fund and the Fidelity Japan Trust, added: “It is stark how far Japan has come already. We’ve already got to US payout ratios of 60%. So, progress is being made, but there’s a long way to go.”
Masa Takeda, portfolio manager of the Sparx Group Japan Focus All Cap Strategy – while similarly enthused on the outlook – nevertheless says: “Japanese companies are really changing in a big way, but the economy lacks growth. The problems of a declining population and ageing demographics is a significant structural overhang.”
Takeda noted how tough these headwinds are to remove. Despite signs of inflation emerging, Japanese citizens remain cautious about spending.
Fear of the activist
Nick Wood, head of investment fund research at Quilter Cheviot, has recently returned from a week’s research trip in Japan to see for himself if change is truly afoot. He witnessed governance improvements but questioned if the payout ratio charts that are frequently shown in asset manager presentations show a complete picture of improved capital allocation.
“Despite dividends and buybacks rising, so are cash levels,” says Wood. And Price agreed, commenting on how over-capitalised many Japanese companies remain.
Payout ratios would need to rise to 80%-plus, the panel heard. Either that or companies would need to become more aggressive in terms of M&A activity and domestic consolidation to really start impacting return on equity.
Wood says he had the opportunity to meet the Government Pension Investment Fund, the Japan Pension Fund Association and specialists who train boardroom members on governance matters. There are signs of movement, but he questioned if the real reason for change in boardrooms is a fear of activists.
M&G’s Vine echoed these sentiments but noted there is something of a sea-change. “In the mid-2000s when activists first arrived, the regulatory and cultural environment was unprepared, and some prominent investors got shut down as a result.
The heavily revised governance and stewardship codes have changed that, with Japanese domestic investors being seen to vote in favour of foreign activist proposals.”
What about ‘cross shareholdings’, which remain prevalent in Japan? It is commonplace to see Japanese companies owning each other’s stock and board directorships being passed around, resulting in groupthink and glacial change. Interestingly, Wood also notes examples of companies holding significant portions of their market-cap in the shares of their customers. This is unlikely to be a decision made on the grounds of efficient capital allocation.
Encouraging laggards to improve capital allocation can be approached in several ways, including the ‘carrot and stick’ approach.
The stick is the fear of the activist. Price noted that company engagement and rankings of engagement on governance relative to their peers can have the desired effect as boards that fall behind are shamed into action.
Redington’s Wayne raised management incentivisation. We can call it the ‘carrot’. Redington likes to see appropriate financial alignment with investors from both fund managers and company management and says that “if the incentives to raise shareholder returns are not there through stock compensation, [then] marginal improvements rather than a step change may follow”.
Vine mentioned a fourfold increase in companies using stock-based compensation, from around 400 companies to around 1,600 since 2013. They may not have the strength of their Western counterparts but, again, progress is being made.
Is it sunset for the ‘salarymen’?
Corporate Japan is known for its hierarchical nature with progression coming from time served, rather than achievements delivered. Alastair Dean, senior analyst at Stonehage Fleming, a family office, questioned whether Japanese companies’ relationships with their workforce could be an impediment to capital allocation.
“In a poorly performing business, if your labour force is large, and doesn’t want to go, in practice, how can management implement change?”
Takeda, of Sparx Group, says this is why structural reforms are so important. “Two years ago, several labour reform bills were implemented, the whole idea being to raise labour productivity, which remains at the bottom of OECD nations. We need to move on from age-old labour practices like lifetime employment systems, but they are so ingrained in people’s mindsets, it’s hard to change.”
While improvements are being made, in many instances there remains a culture where boardroom seats are passed around and where there is an inexorable rise from boardroom, to CEO, to chairman and then lifetime adviser. This is not an ideal environment for fresh ideas and impetus.
But do these cultural norms apply across all companies and sectors? It would appear not. Our asset-manager panellists confirmed that many top graduates, unlike their fathers before them, were not looking for jobs for life with lumbering Japanese conglomerates, and instead preferred more dynamic pre-IPO businesses and start-ups, resulting in more dynamic management practices.
Headwinds remain, though. All the managers lamented the paucity of top-notch senior executive management. Diversity also remains an issue. While there has been an uptick in immigration and women are being encouraged back to work, Japan lags global peers.
Overall it would seem, corporate governance improvements remain a journey, not a destination.
Growth, ageing and the yen
Japan’s demographic outlook is stark. According to the Ministry of Internal Affairs and Communication’s Japan Yearbook, it is estimated that a third of Japan’s population is aged 60-plus, with one person in eight over 75 years old. With birth rates declining and scepticism from the Japanese populace towards immigration, the problem is not going away. Data estimates the population falling from circa 128 million in 2010 to 87 million in 2060. This is a huge structural headwind, so where does economic growth come from?
Two distinct approaches were put forward. Takeda seeks it from selecting Japanese global leaders in large-cap multinational companies. Price, while having a broad approach, has more emphasis on hunting domestically for under-covered smaller and mid-sized companies with a clear runway of growth.
Takeda led a discussion on seeking growth overseas and the impact on his portfolio arising from currency sensitivity. He had alluded to the structural demographic concerns early in the discussion. “I exclusively focus on global companies, because that’s where I see sustainable growth coming. For the largest companies, I must say, I think the only way to wisely spend your capital is to invest overseas.”
Japan has global leaders in precision manufacturing and robotics on the industrial side and on consumer goods brands that appeal strongly to the rising middle classes of emerging economies such as China, India and Indonesia. Chinese consumers especially remain sceptical on provenance, safety and quality of domestic brands. This makes Japanese products very attractive – cosmetics and baby-products companies see significant demand.
There are numerous exemplars of global successes. Pigeon, a Japanese business focusing on baby products, has seen explosive sales growth from expanding into China. Toyota, the poster child for manufacturing excellence and the Kaizen philosophy of continuous improvements in manufacturing practices, has risen to the top of global car manufacturers by sales volume.
However, Frere-Scott questioned the track record of Japanese expansion overseas due to a “litany of capital destruction” having been seen. Takeda conceded the track record had been poor, but a forensic analysis can identify the wheat from the chaff on capital allocation and organic expansion.
The panel turned to yen volatility and the impact on earnings. Takeda conceded that Japan for a long time has been viewed as a yen trade. When risk is off, the currency rises. This is bad news for exporters and the market falls, and vice versa.
However, this is too broad-brush. “On a case-by-case basis, carefully selecting the right companies with wide moats, high margins and global diversification can manage these concerns.”
Furthermore, many companies nowadays – such as Sony – have their costs and revenues denominated in the same overseas currency. Despite being an exporter, a strong yen is a net positive for their profitability.
In concluding, Takeda made a valuable argument that for a global investor, investing in a Japanese equity portfolio of global businesses on an unhedged basis delivers a natural hedge, thereby calming currency volatility.
There was consensus from the fund selectors on the panel that, although it had not always been the case, leaving a Japan equity portfolio unhedged often makes sense in the portfolio context.
Dynamic small companies
Price, of Fidelity, is a portfolio manager who fishes in different pools for growth. In Japan, he scours the market for growth in mid/small caps. Price has been resident in Japan for many years developing an understanding of Japanese culture and is a fluent Japanese speaker. This helps him get under the skin of the culture of the smaller companies he analyses and, in his view, this is a fertile hunting ground.
One reason is that the Japanese equity market has unique characteristics for potential alpha generation. “I see enormous dynamism in start-ups with differentiated business models. We see circa 100 IPOs a year and with only about 20% of them covered by the analyst community, that provides great opportunities.”
Referencing the debate on corporate governance, Price adds: “Mid-caps are also more open to investor engagement, so this is great territory for us to influence and unlock value.”
The depth of Japanese small and mid-cap stocks to choose from is substantial. A lack of M&A activity, historic listing of subsidiaries and companies listing considerably earlier than their global peers has resulted in a huge bank of companies to choose from. The rise of the internet has levelled the playing field on informational access, but the managers continue to see great value in visiting companies at their HQs and manufacturing habitats, and interviewing their supply chain and customers in Japan and abroad. Travelling beyond the financial bubble of Tokyo to the regions can unearth less commonly examined opportunities, such as intelligence on production capabilities and company culture.
Price manages the Fidelity Japan Trust, a closed-end investment trust. The vehicle may take stakes in pre-IPO companies, which allows Price to turn over many stones and uncover nascent sector growth and disruptors pre-listing. The recent themes he noted in these earlier stage companies were of dynamism and higher-quality management coming from top-tier Japanese universities with a more entrepreneurial mindset.
There are myriad investment opportunities in Japanese funds, from all-cap, large or small-cap, value, growth and even income stocks. What would a fund selector look for?
Anaïs Gfeller, senior analyst specialising in Asia, emerging markets and Japan equities at fund platform Allfunds, says: “Across all sectors, our clients are demanding ESG-labelled products. Governance is such an important dynamic in Japan that this is vital in our research; it does not matter if that comes from a value, growth or small-cap mentality.”
She also notes that the Japanese market is prone to rapid style rotation and, accordingly, it is sensible to have all bases covered in the portfolio context.
When asked what causes investors sleepless nights, the rise of passive investment globally was a concern the panel cited. There was some good news for Japanese active managers, though. Although fund selectors on the panel had considered passive investment, given the characteristics of the Japanese market, evidence suggests there is a good case for consistent alpha net of fees. Therefore, actively managed portfolios remained important for our panellists.
A couple of further themes came through. Firstly, our selectors were orientated to identify all-cap managers and sought an edge regardless of style bias. Secondly, our selectors liked to see managers demonstrate an intensive understanding of the culture of Japanese corporate management, ideally coupled with Japanese language skills.
So, are we seeing a new dawn in the Land of the Rising Sun? Yes, but with a note of caution. You need the patience to realise this will take time. The discussion featured a wide array of thought and input. The fulcrum, though, and an area consistently returned to, was the change in governance and the opportunities this brings. While analytical scepticism remains essential, the green shoots of change make the Japanese market well worth monitoring for opportunities and returns in a balanced portfolio.
This panel was hosted by Funds Europe and Camradata in association with MRJ Investment Advisory: www.mrjinvestment.com.
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