A new dawn for Japan?

Posted by Liz Rees in Weekly musings category on 14 Feb 19


Japan has a history of false dawns for investors. Following a ‘tech style bubble’ in the 1980s, the Nikkei index reached nearly 40,000 before a crash took place.

Since then, returns have disappointed; to put this into context, since 1990, the US S&P 500 is up 1,166%, the MSCI World Index is up 459%, while the Nikkei is down by 48% ! So has anything changed and should Japan be part of a diversified portfolio?

The big picture

Optimism is growing about the prospects for Japan. The catalyst was the election of Prime Minister Shinzo Abe in 2012, who initiated a 3 stage programme of economic reform, named the three arrows after a famous Japanese fable. The first, monetary policy, and the second, fiscal stimulus through tax initiatives and infrastructure spending, have already had an impact on the economy, with sales and profit margins at record levels. The third, structural reform, is ongoing, and includes deregulation to promote growth and make markets more efficient. 

Since Abe’s appointment the Nikkei has outperformed the MSCI World Index, gaining 99% against 86%, though it still lags the US. Significantly, returns have been driven by earnings growth rather than the valuation re-ratings we have seen elsewhere, and persistent deflation has been eradicated. There is a target to boost productivity growth to 2.2% p.a. in the next decade.

A corporate governance code has been introduced to improve shareholder relations and dividend pay-outs. Listed companies must now have at least two independent directors on their board and institutional investors are required to be more actively involved.

Japan’s revitalisation has faced the dual challenges of an ageing population and high public debt accumulated during years of deflation. While GDP growth still looks pedestrian - the IMF expects 1.1% this year, after 0.9% in 2018 - this is against a shrinking population and low inflation. In fact, since the late 1990s, growth in real GDP per head has surpassed other major economies.

Meanwhile, domestic demand is well placed to increase, with wages growing at close to 2%. In this respect an ageing population has been favourable; a smaller workforce means wages are pushed up which supports consumer spending and the 2% inflation target. Labour shortages are being addressed by encouraging women and older workers to return to the jobs market, along with plans for a more open immigration policy and further automation. Higher tax revenues should help address the debt issue.

A growth story

Japan has plenty of interesting and unique investments, from automation and robotics to healthcare and artificial intelligence. Japan is at the heart of the global robotics revolution that looks set to transform society; innovative robots are now being used in education, healthcare and transport.

Tourism is booming, helped by increasing numbers of visitors from China, where less than 10% of the population currently have passports. The hosting of the Rugby World Cup this year and the 2020 Olympics is set to deliver a further boost.

Japan is not short of opportunities for value investors either with many industrial companies the cheapest they have been for a decade. More manufacturing has been moved overseas which has improved competitiveness and produced gains in market share.

Land of the rising dividend

Given the tendency for companies to accumulate cash rather than pay dividends, yields in Japan have historically been very low. In contrast to the high corporate debt levels in many countries, over half of Japanese companies have more cash than debt.

Better corporate governance, and demand for income, has led to strong growth in dividends and more companies are including targets in their medium-term plans. While dividend yields still look modest compared to the UK market, the low dividend pay-out ratio of under 35% of earnings leaves plenty of room to grow dividends as well as reinvesting in business expansion.

Where do the risks lie?

Japan is an exporting nation so will not be immune from any slowdown in global growth, particularly in China; 19% of exports go to China and 31% to the rest of Asia. Indeed, there are some signs that trade war concerns have hit orders, notably for cars and smartphones. However, fund managers express confidence that earnings projections are extremely conservative and there is still potential for surprises on the upside.

Investors should keep an eye on the direction of the yen; the dependency on exports means the Japanese stock market tends to rise when the yen is weak. However, in times of turbulence, the yen is considered a safe haven and strengthens. This means the Japanese market can be volatile, as international investors trade in and out.

The country’s vulnerability to natural disasters can also bring short term disruption; earthquakes and flooding hurt the economy in Q3 2018, yet it bounced back strongly in the final quarter, reflecting the country’s efficiency in dealing with such misfortune.

Plenty of choice for investors

Japan is attractively valued compared with other markets and is proving a popular choice for asset allocators this year. The funds and investment trusts available offer a range of styles.

Man GLG Japan Core Alpha Fund, run by Stephen Harker, features in our ISA guide this year. Stephen has extensive experience and focuses on large cap value stocks. A different, but equally successful strategy, is that employed by Michael Lindsell of Lindsell Train Japanese Equity Fund; he takes big positions in consumer defensive and healthcare sectors.

If you prefer to include Japan as part of a global portfolio which favours the region, Lindsell Train Global Equity Fund has a 23% weighting while British Empire Trust has 32%. The latter targets special situations on large discounts to asset value and is an activist shareholder.

Despite being a major developed economy, Japanese companies are under-researched which creates opportunities for active managers to exploit. Whichever approach you prefer, Japan offers investors growth at a reasonable price.

Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser. 

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