Experience pays in hunt for Japanese nuggets

Philip Whittome, manager of the Investec Japan and Japan Equity funds, speaks to Frances Hughes.

Q: Why is now a good time to launch the onshore Investec Japan fund?

A: We are optimistic about Japan in more of a structural way than we have been and there is more of a consensus view that Japan is restructuring now.

In the 1990s, when there was negative economic growth in Japan, two things held the economy up: the export sector and government spending. But now, although exports are still doing well, the domestic economy is the main driver for growth, not government spending, which is a big change from the 1990s.

Strength in corporate cashflow and profitability has also become much better over the past few years. Companies’ balance sheets are strong and structurally Japan is much more profitable.

Q: You say this fund will be managed in exactly the same way as the offshore Japan Equity fund. Will there be any differences?

A: No. They are clones of each other.

Q: You say you are very conscious of risk and this fund is unusual in the way it looks at risk. What do you mean by that?

A: Risk is one of the big things we have always stressed with this fund. I believe fairly strongly that Japan is a difficult market in which to invest. It is hard to predict, so we promote this fund as a core fund. That is the philosophy behind it: more stability.

The Japanese market as a whole has been a lot more volatile than other markets over the past five years. America and Britain have annualised volatility of about 18%, Continental European markets are at about 19%, but the Japanese market is at 22%. It is important to negotiate this volatility, so we are cautious of taking very large stock and sector bets.

The maximum bet we allow ourselves is 3% outside the benchmark for individual stocks, and 5% outside the benchmark for sectors. Our Japan Equity fund has been in the bottom quartile for risk for more or less all time periods.

Q: You say that not many managers have been looking at the Japanese market as long as you have. In what ways has your experience in Japan enabled you to make better decisions?

A: The fact that I can actually remember the last “bear” market in Japan means that I can imagine a market in Japan that other managers cannot envisage. Other fund managers and analysts tend to focus on the better-known, obvious blue-chip names – for example, Sony, Panasonic, Honda and Toyota. But there are a lot of small and mid-cap companies in Japan. In the Japanese real estate market, for example, we own shares in Sumitomo Realty, one of the big three. We are 1.3% overweight in the company but are more overweight in two smaller real estate companies: Tokyo Tatemono and Nihon Eslead. I have followed them for years.

The longer you spend in a market, the more you are aware of the interesting little companies. I have been looking at the Japanese market for nearly 20 years and have lived in Japan on and off for five years, which makes it easier to move outside the more boring range of stocks and find the more interesting nuggets.

Q: How many stocks will there be in the fund?

A: We tend to say 50 to 65 stocks. At the moment we have 55.

Q: Why this bracket?

A: Having too many stocks can make a portfolio vague and woolly; having too few loses the benefits of diversification. This way, the average stock is roughly 2%, which is a reasonable weighting.

Q: Do you have a preference regarding the size of a company?

A: No, we can invest right across the spectrum. Low-cap, I say, is below 200bn (980m). We have 11 stocks like that, which amounts to 15% of the portfolio.

Q: How do you choose your stocks?

A: There are four factors. First is revisions in earnings – whether on average the analyst community is revising up the expectations of profitability. Second there are cashflow-based valuations and return on investment, which means we are looking for cheap companies. Then we look at whether returns are higher than the cost of capital. Last we have what we call “technicals”, which is share price momentum. We try to find shares that are in a stable up trend relative to the index.

We give each stock a score from one to four in each of the four factors, so the highest score is 16 points. Then we double-check the sustainability and durability of those scores and make sure they are appropriate. It is a good system and forces you to look at both the highest and lowest-scoring stocks. It is a constant reminder that you have to look at all of them. Milbon, for example, is a company I bought a couple of weeks ago. It is a small company that makes hair dye. It scored 14.5 and I bought 1% of it. I would have liked more but it is a small company and is not liquid enough.

Q: What areas are you investing in at the moment?

A: We are overweight in the auto sector by 4.5%. We are also overweight in some other cyclical areas in terms of the domestic economy. For example, we are overweight in the construction and real estate industry by 2.2%. We are also overweight in chemicals companies by 5%, and in machinery by 3%. But everything we do is bottom-up, driven by the system, and what the scores are in terms of our four factors, so our sector weighting is a result of a lot of bottom-up stock ideas.

Q: Is your strategy completely bottom-up?

A: You have to be aware of what is going on, but it is quite hard to forecast these things. The key is that we are aware rather than trying to outperform using top-down. The two difficulties with top-down are first that macroeconomic variables are already widely forecasted by a lot of people, and second that markets may not move the way you want them to, even if you get it right. So you have to be “righter” than everyone else, and even then it still might not be reflected in the stockmarket.

Q: What is your investment horizon?

A: We have no specific investment horizon, but on average we hold stocks for 18 months to two years. It really does depend on how well they are doing and for how long. For example, I do not think I have ever not held Canon.

Q: You have said that there has been a change in the mindset of Japanese managers. What do you mean by that?

A:I agree with the consensus that they have become more profit conscious. Until the mid 1990s, Japanese companies were protected from takeovers because of their high proportion of stable shareholders. The ratio of such shareholders has dropped dramatically since then, from 50% in the 1990s to well under 20% now. So Japanese companies are much more sensitive to takeovers and this has created a sea change in corporate culture.

Q: Have you any predictions for Japan’s future economy?

A: The consensus is that real GDP growth has just started and this is just the beginning of a long-term trend.

Philip Whittome is the manager of the onshore Investec Japan fund, which launched on April 10, 2006. He has also been running the group’s offshore Japan Equity fund for nine and a half years.