Executive Summary
- Ongoing structural reforms will continue to drive the market’s rerating
- The small and mid-caps universe is prime territory for valuation-based investors
- Compared to other developed markets, investors are still under allocated to Japan
1. Is the Japan market still a compelling opportunity for value investors?
The three structural tailwinds that we have talked about before, namely i) a move from deflation to inflation, ii) better corporate profitability through corporate governance reforms, and iii) a stronger capex environment, remain in place and we believe have multi-year longevity.
We expect to see ongoing announcements from corporates this year regarding measures to improve underlying profitability and rationalise balance sheets. Although share buybacks are important, it is the genuine restructuring of businesses that will move the valuation dial over the coming years. Anecdotal evidence suggests there is genuine momentum building here. Real wages could also turn positive in late 2024 with cost push inflation easing and a strong outcome from the annual shunto wage negotiations in the first quarter; there is a possibility that next year’s spring wage negotiations will result in significant wage increases for the third consecutive year. In fact, the latest data released indicated inflation-adjusted real wages rose in June for the first time in more than two years, with nominal pay gaining at the fastest pace in nearly three decades.
Equity valuations across a range of metrics currently sit in the middle of a long-term range which suggests they are certainly not stretched and look attractive versus other developed markets. The reforms over the last ten years have also resulted in improving margins, and this trend is likely to continue. Equally the earnings per share growth in Japan has been more robust than the US and EU since 2012. We would also argue that with the above structural tailwinds in place, why shouldn’t Japanese equities start to trade at a premium to previously suppressed levels?
According to Nomura, foreign investors are still underweight in their Japan allocations, and both higher inflation and the new NISA program could spur domestic investors back into equities this year. There is significant support for Japanese equities both at the macro and micro level, and the ongoing structural changes make Japan the stand-out market globally. Japanese equities should continue to re-rate as the deflationary era comes to ends.
2. Given that many large value stocks have run up, is the opportunity set shrinking?
True, the rally to date has mostly been driven by large caps. Japan’s small caps have not moved in tandem. There is still a wide investable universe of small and mid-cap stocks that have undemanding valuations making it a prime territory for longer term valuation-driven stock pickers. Many of them are currently trading below their book value.
An inflationary cycle typically favours small caps more so than large caps as more of small and mid-caps tend to be tied to the domestic economy. In such an environment, we, as valuation-disciplined investors, have behaved in a contrarian manner and have supported our positions in global basics and domestic names with a tilt to mid-capitalisation names which have been lagging in performance.
In domestics, we have added to names in the transportation businesses and construction businesses where managements have shown commitment to price hikes and cost discipline. Under global basics, we do not own trading companies where valuations are not attractive but continue to support chemicals which still operate under a depressed environment and low market expectations.
One point to note is that in the recent market sell offs, the negative share price impact was notable in the large export-related sectors where valuations have become stretched. The broadening of performance across different types of stocks should continue to sustain future market performance.
3. Are the Tokyo Stock Exchange’s (TSE) reforms driving credible changes in Japan corporates?
TSE’s corporate governance reforms have already nudged multiple large cap companies to act to improve return on equity. Japanese corporates continue to execute buybacks at record historical levels with the aim of optimising their under-levered balance sheets. Cross-shareholdings are being unwound, with significant moves in traditionally tightly knit allegiant shareholder relationships in autos, financials and construction value chains. This should further improve boards’ accountability to minority shareholders as well as spur further activist involvement.
We also observe an urgency among management teams in relation to business portfolio reforms across conglomerate-type corporates, with exits from non-core businesses and reallocation of capital to areas of strength. We expect these efforts to support the market in the mid-to-long term. As investors who have been involved in this market for a long time, we feel that the current change in corporate behaviour is both significant and sustainable.
4. What is the impact of the USD/JPY relationship on the companies you invest in?
The government had intervened several times to support the weak yen during 1H of 2024 but the effectiveness was limited as the rate differential between US and Japan was large. That is narrowing now with the Bank of Japan’s (BOJ) decision to hike rates and expectations for the US Federal Reserve to cut rates as soon as September. It could lead to stabilisation or some strengthening of the yen. This environment could also lead to a change in market leadership from large-cap yen-sensitive names to a broader cohort of stocks including domestics and small and mid-cap stocks.
Despite the BOJ’s policy move, there is no change in our bottom-up investment views given that our approach (which focuses on the sustainable trend earnings of companies) has also taken into consideration the possibility of the BOJ’s normalisation of monetary policy in our valuation of investee companies.
5. What makes your investment style durable and repeatable?
Our purely bottom-up investment process is focused on exploiting behavioural biases in the market that have led to significant mispricing episodes. Behavioural biases, like extrapolation or risk-aversion, are persistently available. However, one needs a disciplined application of a well-defined investment process to effectively exploit them.
We start by screening a wide investment universe of over 2,000 companies and applying consistent anchors around valuation. We target only high impact valuation outliers i.e. stocks that have a significant difference between price and valuation. Our in-depth research efforts focus on the most mispriced opportunities that offer the greatest potential return.
Our value differentiator lies in our detailed analysis and peer review that tests the longer drivers of a company’s sustainable earnings using a consistent valuation framework. This approach delivers unique insights and a clear understanding of a company’s valuation drivers. The focus on sustainable earnings differentiates us from a market that obsesses over near-term reported earnings.
Our team’s culture of challenge and debate, long experience of investing in the Japan market and the disciplined application of the investment process through different market cycles and episodes are important ingredients for strong long-term performance delivery.
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