Search for value in resilient Japan
Many Japanese firms adopt a flexible stance to thrive – especially export-orientated ones, and despite the chronic lethargy gripping the domestic economy, investors can find opportunities.
The Japanese economy has been a consistent underperformer over the past decade. Government debt is high, and GDP growth low. Yet GDP does not necessarily reflect the health and growth opportunities of individual companies. Indeed, Japanese corporate profits look promising and corporate actions are likely to pick up.
There are two types of Japanese companies, one offering more, the other less value for investors. There are, for instance, export-oriented firms that do a big portion of their business overseas. Many of these companies have learned to innovate and adapt their business strategy to tap the higher growth potential abroad. And they do not have to go far: The archipelago is surrounded by growth markets. Japan has longstanding trade relationships with emerging Asia and is therefore better positioned than Europe or America, for instance. About 50% of exports already go to Asia.
These international firms dominate equity markets, but only play a minor role in GDP. When, for instance, international companies such as Suzuki and Nissan decide to relocate parts of their business to other countries, this has a negative impact on GDP but potentially increases the companies’ growth and profitability prospects.
On the other hand, there are many Japanese companies that depend on domestic demand. They are trapped in the lethargic home market. To release their inherent value, many domestic-oriented companies would have to vigorously restructure and re-invent their business models. So far such restructuring efforts have been muted. (Strategy continues below)
From a macroeconomic point of view, Japan’s economy is dominated by these domestically-oriented industries. Indeed, almost 50% of the country’s GDP consists of the services industry, including government services. GDP growth is therefore likely to remain subdued.
There is only one sub-category of home market driven firms that investors should not ignore – companies that profit from fundamental lifestyle changes in Japan. One of these major changes is the rapidly increasing number of single households. Selected convenience stores and furniture providers are well positioned to profit from this development.
It is remarkable how fast Japanese companies have recovered from the extraordinary events in 2011, underlining their high flexibility and dynamics. The Fukushima disaster led to an overall economic loss of more than $200 billion (£129 billion), making it the costliest natural catastrophe on record. Nevertheless, within a short time, most companies were able to recover production and boost the morale of employees.
Corporate profits have largely returned to pre-earthquake levels. Lower raw material costs and the strong yen should make a positive contribution to input costs and help companies sustain margins and profits. Internationally-geared companies such as Fanuc, one of the world’s largest makers of industrial robots, are reporting their best earnings ever.
”It is remarkable how fast Japanese companies have recovered from the extraordinary events in 2011”
Another noteworthy development is the increasing number of corporate actions. For example, share buybacks jumped by 80% in the six months to September relative to the previous six months. Dividends are also expected to increase year-on-year. In addition, the strong yen can help convince Japanese companies to engage in mergers and acquisitions at home and overseas. The value of deals surged 78% in 2011, topping the earlier record in 2008.
Japan has seen a sharper reduction than other major markets, with valuations at historic lows. This reflects investors’ concerns about the impact of the debt crisis in Europe and an economic slowdown in China. Meanwhile, the equity risk premium has reached historic highs and indicates a possible sharp fall of corporate profits. However, none of the major fundamental indicators points at such an outcome. In fact, valuations should go up both in relative and absolute terms.
All these developments demonstrate that investors unjustly treat the Japanese market like an unloved child. The only traps to avoid are top-down investments in indices that also include the structurally weak companies. Japan offers exceptional value for investors willing to actively look for outstanding companies. Investors seeking an active strategy can enhance their returns by combining two different strategies: one looks for few long-term leaders following a strict bottom-up selection of companies with excellent business models. The other focuses on value investments based on a more quantitative approach. The results of these two approaches are depicted in the chart, showing the performance of a “leader portfolio” and a “systematic portfolio” versus MSCI World.
With attractive stock valuations and a return to better corporate profitability, investors can obtain exposure to Japanese equities at relatively low cost. While the sovereign debt crisis continues to grip Europe, Japanese companies are in relatively sound shape. This provides interesting investment opportunities.
Ernst Glanzmann manages Julius Baer Japan Stock fund at Swiss & Global Asset Management.
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