Big in Japan
Can the stock market rally be sustained?
It’s an exciting time to be investing in Japan. Despite recent volatility, it has been a landmark year for Japanese markets. This week the Japanese market hit an all-time high closing above 42,000 for the first time in history. This has been driven by a range of corporate governance reforms, as well as a move away from a deflationary environment.
With the Japan and Japanese Smaller Companies sectors trading at discounts of 10% and 8% respectively, could now be the time for investors to take a look at the world’s fourth-largest economy?
On 11 June, a media roundtable was held by the AIC featuring Richard Aston, Portfolio Manager of CC Japan Income & Growth Trust, Masaki Taketsume, Fund Manager of Schroder Japan Trust, and Paul ffolkes Davis, Chairman of Rising Sun Management, which advises Nippon Active Value Fund, to discuss the outlook for Japan in 2024 and the opportunities and challenges that Japanese investment trusts face.
Their comments were collated alongside views from Joe Bauernfreund, Portfolio Manager of AVI Japan Opportunity Trust, Nicholas Price, Portfolio Manager of Fidelity Japan Trust, Nicholas Weindling, Co-Manager of JPMorgan Japanese Investment Trust, Miyako Urabe, Co-Manager of JPMorgan Japan Small Cap Growth & Income and Praveen Kumar, Investment Manager of the Japanese Equities Team at Baillie Gifford, which manages Baillie Gifford Japan Trust and Baillie Gifford Shin Nippon.
What are the drivers behind the Japanese market rally?
Masaki Taketsume, Fund Manager of Schroder Japan Trust, said: “After several decades of deflation, Japan is shifting towards an inflationary era, which should benefit corporate earnings growth. Under an inflationary environment, Japanese companies can increase their revenues and earnings not only through volume growth but also through price increases, which were absent during the deflationary period.”
“Under an inflationary environment, Japanese companies can increase their revenues and earnings not only through volume growth but also through price increases...”
Joe Bauernfreund, Portfolio Manager of AVI Japan Opportunity Trust, said: “The two key factors have been valuation and corporate governance reform. Japan has looked good value for many years and over the past two decades has periodically drawn in foreign capital. But until last year, the positive flows tended to be short term in nature, as investors became frustrated by a market that was cheap, but nothing ever happened to address that undervaluation. Over the past 12 months, investors have recognised that the governance reforms are working – they are changing corporate behaviour. And that for the first time in decades Japan is no longer a value trap, but it is a cheap market with a catalyst.”
“For the first time in decades Japan is no longer a value trap, but it is a cheap market with a catalyst.”
Nicholas Weindling, Co-Manager of JPMorgan Japanese Investment Trust, said: “Corporate governance reforms across Japan have contributed significantly towards the recent strong performance of the Japanese stock market. With the encouragement of the government, regulators and shareholders, Japanese companies are now adopting ever higher standards of independence and transparency which have been welcomed by investors. Measures include the appointment of more independent external directors to company boards, tighter internal controls and more transparent disclosure rules, as well as improved shareholder returns. With many Japanese companies still awash with cash, we expect further significant efforts to return cash to shareholders.”
Can this rally be sustained or is it running out of steam?
Praveen Kumar, Investment Manager of the Japanese Equities Team at Baillie Gifford, which manages Baillie Gifford Japan Trust and Baillie Gifford Shin Nippon, said: “It may be that the stocks that drive the next leg of the rally could be different from those that have driven the current leg. The current rally is being driven mostly by large-cap, currency sensitive exporters and other cyclical stocks, plus interest-rate sensitive businesses like banks and insurers. Also, large companies with significant cross-shareholdings have been doing extremely well in share price terms as they are rapidly selling down their cross-shareholdings and returning the cash raised to shareholders. The next leg of this rally could be driven by small and mid-cap growth stocks, and other large-cap growth stocks that have been sold off very aggressively and indiscriminately in favour of the type of stocks mentioned above.”
“The current rally is being driven mostly by large-cap, currency sensitive exporters and other cyclical stocks, plus interest-rate sensitive businesses like banks and insurers.”
Nicholas Price, Portfolio Manager of Fidelity Japan Trust, said: “In terms of valuations, Japanese equities traded on a forward price-to-earnings multiple north of 50x during the bubble period, so the current multiple of around 15x does not look expensive historically nor relative to other markets, especially considering current interest rates. Moreover, a sustained improvement in returns on equity would support a higher price-to-book multiple, and the economic trend towards moderate inflation supports higher earnings-based valuations.”
Miyako Urabe, Co-Manager of JPMorgan Japan Small Cap Growth & Income, said: “The Japanese economy is undergoing a period of profound transformation, generating exciting investment opportunities capable of flourishing regardless of the near-term economic environment.
“Japan is at a very early stage of digitalisation compared to the rest of the world, and this, combined with the trend towards industrial automation, has the potential to help drive significant growth and/or productivity gains over the medium term. Demographic changes, developments in medical technology and the transition to renewable energy are also contributing to rapid structural change. The country’s innovative and dynamic small cap companies are ideally placed to thrive in this environment, already leading the way in a variety of niche markets.”
“The Japanese economy is undergoing a period of profound transformation, generating exciting investment opportunities capable of flourishing regardless of the near-term economic environment.”
Joe Bauernfreund, Portfolio Manager of AVI Japan Opportunity Trust, said: “The rally can be sustained because there are still so many undervalued companies in Japan. And if we have an environment in which management is focused on shareholder returns and the regulator and the Tokyo Stock Exchange are piling pressure on companies to address their undervaluation, then there is no reason for the capital that has been drawn to Japan to reverse direction whilst there is still value on the table, and whilst there are increasing levels of corporate activity occurring. Private equity is a key factor in the increased amount of corporate activity, and the growing presence of both foreign and domestic private equity players reflects the attractive opportunities they are seeing in the market.”
Nicholas Weindling, Co-Manager of JPMorgan Japanese Investment Trust, said: “There are good reasons to believe that we will continue to see improvements in the Japanese market. For example, signs of a positive shift in Japan’s labour market are emerging, with companies starting to raise wages significantly for the first time in 30 years. This year’s spring wage negotiations resulted in a 5.3% wage increase, the highest in 33 years and well above the inflation rate. This rise in real wages should boost consumer sentiment and support domestic demand, especially as rising prices encourage spending now rather than saving.
“…signs of a positive shift in Japan’s labour market are emerging, with companies starting to raise wages significantly for the first time in 30 years.”
“Furthermore, through its recent changes to monetary policy the Bank of Japan is making concerted efforts to bolster liquidity and stimulate growth, which should be positive for the market in the near term.”
Richard Aston, Portfolio Manager of CC Japan Income & Growth Trust, said: “Despite the strong run in 2023, the market valuations are still well within ranges established in the post-financial crisis period which suggests that there is significant further upside potential on the basis that capital efficiency, corporate governance and shareholder returns are all breaking into new territory and set to go further. Combined with an increased confidence in growth potential, I believe this should ensure that the market will continue its strong upward trajectory since it bottomed in 2011.”
Where are you currently finding opportunities?
Masaki Taketsume, Fund Manager of Schroder Japan Trust, said: “From the perspective of inflation, we favour companies in the domestic service sector that have strong pricing power. This is because we believe that the driver of inflation is shifting from raw material costs to wage growth. Therefore, companies with strong pricing power can increase prices more than the underlying wage cost increases, which accelerates revenue and earnings growth.
“One example of such a stock is Kyoritsu Maintenance, an operator of business hotels under the brand name 'Dormy Inn'. They have a strong presence in the market and have already achieved a 21% increase in their average room rate, resulting in robust earnings growth last year.
“From a corporate governance perspective, we favour Toyota Industries. As the original company of the Toyota Motor group, they hold significant amounts of stocks in group companies such as Toyota Motor, Denso, Aisin and others. The value of their holdings in Toyota group stocks is worth more than their market capitalisation.”
“Financial sectors are key beneficiaries of the normalisation of monetary policy in Japan.”
Richard Aston, Portfolio Manager of CC Japan Income & Growth Trust, said: “Financial sectors are key beneficiaries of the normalisation of monetary policy in Japan. Sectors such as banks and insurance have benefitted from higher return opportunities as rates rise and this has been reflected to shareholders as these sectors have been amongst the main proponents of improved capital efficiency and returns.
“Small and mid-cap stocks in Japan have underperformed the rising market which has created some attractive investment opportunities in well established companies with strong financial characteristics, management capability and competitive positioning.”
Nicholas Price, Portfolio Manager of Fidelity Japan Trust, said: “Given the Bank of Japan’s dovish tone and limited scope for yen strengthening, export-oriented companies look attractive amid signs of a recovery in the global manufacturing PMI. We favour exposure to industrial cyclicality through technology and factory automation-related names. There are also opportunities in automobile-related companies that are committed to addressing price-to-book ratios below 1x through better balance sheet management and increasing shareholder returns.”
“Like Germany, Japan has what one might call a 'Mittelstand' of small to mid-cap industrial processes or manufacturing companies, normally part of a larger customer's supply chain, that exhibit various characteristics that we look for.”
Paul ffolkes Davis, Chairman of Rising Sun Management, which advises Nippon Active Value Fund, said: “Like Germany, Japan has what one might call a 'Mittelstand' of small to mid-cap industrial processes or manufacturing companies, normally part of a larger customer's supply chain, that exhibit various characteristics that we look for. Recent successful engagements, reaching different conclusions, include T&K Toka and Mitsuboshi Belting.”
Praveen Kumar, Investment Manager of the Japanese Equities Team at Baillie Gifford, which manages Baillie Gifford Japan Trust and Baillie Gifford Shin Nippon, said: “We are seeing significant investment opportunities in small to medium sized growth companies in Japan that have been sold off aggressively over the past three years despite showing rapid sales and profit growth. A recent example is SWCC Group, which makes electrical wires, cables and connectors, and is a big beneficiary of investment in renewables and upgrading of Japan’s ageing energy infrastructure (shares have more than doubled since we first bought them in May last year).”
Miyako Urabe, Co-Manager of JPMorgan Japan Small Cap Growth & Income, said: “With an ageing and declining population, we expect Japan’s labour market to remain tight over the long term. Potential beneficiaries of such trends may include internet companies which can accelerate digitalisation and help improve labour productivity, or staffing companies which can enjoy strong demand. Medley provides staffing services focusing on healthcare workers such as nurses and elderly care workers, an industry where labour shortage is particularly severe and jobs-to-applicants ratio high. The company also provides digital services for the healthcare industry, such as software solutions for electronic medical records, telemedicine and online dispensing.”
