Identifying the episodically mispriced opportunities in Japan

The unprecedented impacts from Covid-19 have been pervasive. Extreme measures, relating to social distancing and “flattening the curve” to dampen the impact to national health systems, have led to a global economic shutdown. This, in turn, has been accompanied by an extreme and rapid economic policy transition. This global health crisis challenges all kinds of norms, whether that be political, economic, cultural or societal. It is clear to see in the increasingly violent price moves across global asset classes, the extremely emotional market price response that reflects uncertainty and a deep fear of the unknown.

The market has already priced a deep recession

One of the unknowns that the market is currently grappling with is the degree of impact to companies from a combined severe supply chain and demand shock (see Fig. 1). Expectations have rapidly moved to reflect this unknown.

Fig. 1a. Japan PMI service business activity

Fig. 1b. Japan consumer confidence index

Accordingly, the challenge facing investors is to assess and differentiate between impacts that are likely to be temporary and those which are likely to be permanent. We observe that the market’s pricing beliefs have yet to differentiate between the two. The market’s narrow focus does not reflect the wide range of potential future outcomes in this environment. However, we believe the market has already priced in a deep global recession. See Fig. 2.

Fig. 2 Cross-asset implied probability of recession

With heightened uncertainty around future outcomes, the market response has been to pay any price for the perceived comfort of shorter-term earnings visibility. The observed herding behaviour around already expensively valued defensive companies and the speed at which the market has moved is truly episodic. See Fig. 3.

Fig. 3. MSCI Japan Value vs. Growth book-to-price Differential

Such periods of extreme and indiscriminate pricing behaviour - where the market fails to differentiate between what is likely to be shorter-term and cyclical and what is permanent and structural – tend to offer significant investment opportunities.

Strong balance sheet health may now be a competitive advantage for Corporate Japan

One factor that may now be in the favour for some Japanese companies is their strong balance sheet health compared with global peers. Entering this extremely uncertain period with a strong balance sheet improves the probability that a company can withstand the impacts from a weak global economy. Whilst it has been a trend for US firms over the past ten years to increase leverage amid a low interest rate environment and increase shareholder returns through share buybacks, corporate Japan has typically taken a more conservative path. Long term restructuring efforts, including deleveraging of balance sheets, has led to high levels of cash. Currently, it is estimated around 52.6% of the TOPIX Index (ex-financials) is in a net cash position versus 14.0% and 16.5% or the US S&P500 and MSCI Europe respectively. See Fig. 4

Fig. 4: TOPIX index companies’ net cash positions vs other major markets

Valuations for Japan are attractive compared to global equities

The market has priced a lot of bad news in the valuations for Japan equities in general. Amid this uncertain global economic environment, starting valuations are critically important.

Fig. 5: Japan Price to Cash Earnings Relative to MSCI World

We see two key risks in the current environment. The first risk for investors is the risk of materially overpaying for comfort or perceived certainty in a flight to “safe” assets, without regard to the price. We address this risk by focusing our attention on the most attractively valued companies – these are often mispriced because the market is ignoring them. Historically, the most extreme market environments, like the one we are now experiencing, offer the most significant investment opportunities for our approach.

The second key risk is that the near-term economic shock turns into a permanent reduction in earnings or that a cash flow or liquidity problem becomes a solvency problem. We address this risk by stress testing our valuation assumptions to address potential impacts from an economic shock.

What is a stress test and how can it help in extreme market environments?

Although ongoing monitoring of our trend earnings assumptions has always been part of our process, our focus of attention has now turned increasingly to an assessment of the risk that shorter-term liquidity issues potentially become solvency issues that negate the reliability of trend return outcomes.

We are stress testing companies’ abilities to fund their longer-term operations. We are stress testing scenarios relating to cashflow levels; access to funding, implications for balance sheet leverage and potential for shareholder dilution. We are monitoring for changes in a company’s ability to focus on their core drivers of profitability; and the ability and willingness of management to respond in an extremely challenging and competitive market environment.

In our analysis, we are looking to understand what the market has already priced in for a company. We test whether we are more than compensated for the wider range of outcomes including the tail risks associated with an extreme outcome.

Most importantly, we are looking to identity potential risks to our trend assumptions that may be contingent on binary outcomes, which may be out of the control of the company and fall outside of our investment edge. For example, scenarios where creditors or government bodies dictate the viability for a company as an ongoing concern, potentially at the expense of the minority shareholder.

Whilst our analysis is very detailed, it does not attempt to forecast the path of earnings, and our decisions are not reliant on forecast accuracy. This becomes a vitally important differentiating factor where short-term outcomes are exceedingly uncertain.

Unprecedented global fiscal and monetary stimulus offers support in recessionary environment

The combined fiscal and monetary stimulus response to date has been unprecedented. See Fig. 6. The last time the world experienced this level of fiscal stimulus was post World War 2. Prior to the US’ USD2 trillion economic relief package, which was signed into law in late March, a cumulative USD1.5 trillion of fiscal stimulus was announced globally. Japan announced its own economic measures in April, which included fiscal spending, as well as loans and guarantees, amounting to JPY108.2 trillion, or 19.6% of GDP.

Fig. 6. Unprecedented Fiscal Support Packages Announced to Date

In addition to the fiscal measures, in March, the Bank of Japan had stepped up purchases of exchange traded funds (ETFs) and J-real estate investment trusts (J-REITs). Later, in April, the central bank further increased its monetary stimulus by saying that it will buy an unlimited amount of government bonds and ramp up its purchases of corporate bonds. Quantitative easing (QE) in Japan is now facilitating the fiscal response through less conventional measures. Perhaps this reflects the realisation that QE, without fiscal stimulus, has not been sufficient to impact nominal growth.

Challenging the entrenched market risk preferences around growth

Besides the economic risk arising from the current pandemic, investors also face the risk of materially overpaying for comfort or perceived certainty. For more than a decade we have experienced global policy trends reflecting fiscal austerity combined with QE – which has generally been deflationary in nature. This has reinforced the current global growth regime around a permanent state of low growth, low inflation and low interest rates.

In an environment with scarcity of growth, equities with high visibility of earnings stability and secular growth stories have benefitted. The move towards outright monetisation is one potential outcome that may challenge the entrenched market pricing beliefs. One potential regime shift that is not being priced by the market is where higher nominal growth and rising inflation are a possibility. Coordinated fiscal and monetary stimulus on an unprecedented scale, has the potential to impact the market’s nominal growth expectations and entrenched pricing beliefs.

In a scenario where nominal growth is higher and more widespread, the significant premium currently enjoyed by extremely expensive defensive companies with high short-term earnings visibility or by technology companies with higher earnings growth momentum, may rapidly disappear.

The range of global growth outcomes are potentially far wider than what the market’s entrenched pricing beliefs currently reflect. These examples of expensively valued themes and equities are not immune from shocks to their own supply chain and changes in demand, or to market surprises.

The risks are skewed heavily to the downside for such companies where current earnings streams do not justify their trend valuation, let alone ones that are extremely expensive and are vulnerable to the same market surprises. Valuations for growth themes are now comparable to the 2000 technology bubble extremes. See Fig. 7.

Fig. 7: MSCI Japan Growth Index price-to-book relative to MSCI Japan Value Index price-to-book*

We have been stating for an extended period that the weight of probabilities suggests these extremes are not sustainable. Investors become more vulnerable to ‘surprises’, no matter how small they may appear, where valuations are at extremes.

Staying true to our process

We acknowledge the wide range of potential outcomes that could emanate from the COVID 19 fallout on our society and our global economy. Rather than trying to forecast the potential outcomes, we focus instead on differentiating between the probability that the impacts to a company are temporary or permanent. We will continue to monitor our trend assumptions to keep the weight of probabilities in our favour. We do not attempt to forecast the path of earnings. This is a vitally important differentiating factor, especially when short term outcomes are exceeding uncertain such as in these current times. We believe that our focus on sustainable earnings gives us a differentiated sustainable edge to identify the significant opportunities that are episodically mispriced today, which can add value to our clients over the long term.