Ride on Japan’s discounted cycle

Martin Currie’s Claire Marwick reckons Japanese stocks are ripe for the picking as the sector hits the bottom of the performance tables and multinationals are on cheap valuations.

Japan was relegated to third place in the world economic rankings according to data released in August, the latest in a long line of humiliations for the one-time wonder child of the world economy.

Over the past year, the average Japan unit trust was down 2.3%, and was saved from being the worst investment category for British investors only by one other sector – Japanese Smaller Companies. So it’s curious to see the investment groups that are out there pushing Japan funds on to investors, such as Neptune and Martin Currie.

”High tech companies you’ve never heard of are at the heart of the goods we use every day”

In March I was in Tokyo with Neptune Japan Opportunities’ Chris Taylor. He’s a huge bear on the domestic Japanese economy, which is basically flat-lining as the population ages. Neptune argues that in a no-growth deflationary economy, corporates cut investment, capital expenditure and wages. And in aggregate, it means that no-one increases their bottom line. Companies can’t raise profitability, and face a vicious downward spiral.

But Japan’s export sector is a far more compelling story with truly multinational companies on cheap valuations that investors cannot ignore, says Taylor.

However, like many investors in Japan, Taylor has been caught out by the surprise strength of the yen (he’d expected it to fall and hedged accordingly) and his fund sits at the bottom of the one-year performance tables.

Martin Currie is perhaps not as bearish as Neptune, although Claire Marwick, a co-manager of the Japan Alpha fund, shares Taylor’s frustration at the country’s perpetual political gridlock. Its latest prime minister, Naoto Kan, only in office since June, is facing a challenge from Ichiro Ozawa, a controversial power broker. (Ozawa has called Americans “simple minded” and said “I don’t like British people”).

Just focus on Japan’s extraordinary (and cheap) multinationals rather than domestic politics, says Marwick. (article continues below)

And focus on the fact that Japan is a cyclical play on the world economy. In the aftermath of the credit crunch, exports collapsed, but Japanese companies cut utilisation rates further. To managers such as Marwick, a sign to start buying.

“Demand was horrendous, but supply was cut even further. Some tech companies were down to utilisation rates of just 20% from 100% two years earlier. Our analysis indicated that at some point production had to rise, and our estimates for profits were higher than the average among the analysts.”

Because of Japanese manufacturing’s cyclical nature, as an equity market “timing is especially important,” she says.

If anything, she got in too early, starting to buy cyclicals in early 2009 before the March/April recovery. “The turnaround took more time than we thought,” she says, but the fund was well-positioned when it did come.

But what sort of stocks do you buy at the bottom of a manufacturing cycle? For Marwick, it is all about balance sheet analysis, although in general Japanese companies are not indebted in the style of Anglo-American companies. They have been deleveraging since the end of the bubble in 1989 and carry little or no debt.

One of the fund’s early buys was Jtekt, which makes bearings and steering systems, with Toyota one of its biggest customers. At one point it was selling at below book value, but Marwick saw it as a geared play on the recovery of auto sales. It shares more than doubled in the first half of 2009.

She also liked Nippon Denko, which makes additives for steel producers. It went from ¥210 (£1.60) to above ¥500 in a few months in the first quarter of 2009. Neither stocks have done well since, in Jtekt’s case falling back hard.

Marwick says the fund took profits in mid to late 2009 from its manufacturing recovery stories and started to move into financial stocks. Mitsubishi UFJ Financial is its single biggest holding. But, it remains 59% invested in Japanese manufacturers and 13% in financials.

This year has been all about stockpicking, says Marwick. For example, one of her bigger punts has been on JX Holdings, a refinery group formed from a merger.

I use the word “punt” deliberately. This is not a buy-and-hold fund. Japan Alpha is an unconstrained fund with 30-40 stocks and an yearly turnover of about 300%. It’s the long side of Martin Currie’s Japan hedge fund. It’s an all-cap fund but liquidity considerations means it tends not to stray too far down the capitalisation scale.

Deflation and demographics will hold back Japan domestically, fears Marwick, which is why the Japanese market is unloved and under-owned. Discussions on Japan have become mired clichés such as “two lost decades”.

But Marwick says these attitudes are out of date, blinding investors to the potential of the Japanese market, which has shifted focus to the fast growing economies of Asia. China has overtaken America as the destination for much of Japan’s exports, although she acknowledges that often they are re-exported on to Europe and America.

What one can’t deny is the strength of Japanese technological innovation. It’s extraordinary how many patents the Japanese register – more than all Europe put together – and how much it spends on research and development. High tech companies you’ve never heard of are at the heart of the goods we use every day. For example, Nidec makes 75% of the motors that power hard disk drives in laptops and PCs.

But all that’s meaningless unless investors can tap in. And Marwick says there has almost never been a better time to buy. She prefers to use price/book rather than price/earnings, and by that measure, Japanese stocks are trading at a 40% discount to their average over the past 10 years.

What’s most appealing about Japanese, from a British perspective at least, is the fact that they’re at the bottom of the Investment Management Association tables. Global emerging markets are at the top, Japan is at the bottom. It looks like its ripe time for rotation.