Even after 25 years of mediocre economic growth and with a stockmarket in the wilderness for most of that time, Japan is still the third largest economy in the world.
The equity market has traditionally been seen as an uncorrelated play within the developed world, very much dancing to its own tune. In reality, that was always questionable as, broadly speaking, the market only made significant progress when foreign buyers were at their most enthusiastic. Japanese institutions have been wary of equities since the peak of the bubble in 1990 and while individual domestic investors have occasionally dipped in it tended only to be when the market was showing significant momentum.
Economic and monetary policies since 1990 have been hewn from the perspective of ever-increasing levels of desperation from the authorities, as they attempted to fight sclerotic economic growth.
On a relative basis, the Japanese economy fared quite well through the global financial crisis, with domestic banks having limited exposure to the securitised and leveraged world prevalent in western institutions. However, the crisis led to a substantially weaker global environment, leaving Japan with nowhere to hide. With government debt spiralling out of control, another solution had to be found, particularly after the devastation caused by the 2011 earthquake and subsequent tsunami.
Abe to the rescue?
At the end of 2012, Prime Minister Abe was swept into power on a reform package to end the decades of stagnation. Collectively, his plans are known as the “three arrows” and are designed to encourage Japanese companies, investors and the government to work together to solve the country’s malaise.
Arrows one and two have already been fired. The Bank of Japan has undertaken quantitative easing, while fiscal policy has remained very flexible to foster growth. The third arrow of structural growth through reforms inevitably yields less immediate results but there has certainly been some progress in areas where reform is needed most, notably in corporate tax and governance, agriculture and healthcare.
Perhaps the most obvious manifestation of the third arrow is the focus by companies on improving and maintaining a higher return on equity. The creation of the JPX-Nikkei 400 index, with its profit and ROE threshold targets, is the most tangible manifestation of improving corporate governance. The creation of a stewardship code for investors and the introduction of the corporate governance code have also been supportive.
The implications of these changes are significant. A market that was once dominated by mean-reverting stocks should now have healthy competition from secular growth ones, where strong and growing profitability will be the measure of success. Japanese fund managers have a great opportunity to exploit this sea-change as it develops.
What to buy?
We currently feature five funds from the IA Japan sector, from four different market cap and style categories.
Schroder Tokyo (larger-cap; blend style)
Managed by a very experienced Japanese equity market practitioner, with a balanced approach that is grounded in company analysis. The Japanese franchise is well-resourced and has extensive local presence.
Baillie Gifford Japanese (larger-cap; growth style)
A growth-orientated Japanese equity portfolio managed by a highly respected team, who apply a long-established and disciplined investment approach. Proprietary research and low turnover are hallmarks of the approach.
GLG Japan Core Alpha (larger-cap; value style)
Offers investors exposure primarily to Japanese large-cap equities and is managed with value-biased and contrarian style, according to a long established, disciplined approach.
Invesco Perpetual Japan (larger-cap; value style)
A valuation and conviction-driven Japanese equity fund that invests across the market-cap spectrum. An eclectic style leads to a unique performance profile, which is often at odds with the benchmark and many recognised peers.
Legg Mason IF Japan Equity (smaller-cap; growth style)
A concentrated Japanese equity fund with a focus on smaller-cap companies with high growth prospects from domestic-focused businesses. It is a high-risk approach offered by a very experienced manager.
These managers are united by the length of experience in this market, if not by investment styles. They are the survivors of the most testing kind of market, punctuated as it has been by relentless false dawns at the economic, political and market levels.
Structural change is occurring at a time when valuations are not excessive, corporate profits are strengthening and the economic outlook is improving. This makes for a multi-layered and appealing investment case: a rare commodity in today’s global equity landscape.
Gill Hutchison is head of investment research at City Financial.