The return of private Japanese investors to the stock market could trigger a real rally, believes Richard Kaye, manager of the Comgest Growth Japan Fund. However, not all Japanese stocks will profit from this, he warns.
Kaye, who has been managing money in Japan for 24 years, says he has ‘never been this optimistic’ about Japanese equities, an unloved asset class that has been overlooked by foreign and domestic investors alike. During the past decade, the Japanese stock market has been mainly driven by asset purchases by the central bank and the country’s national pension fund. But that’s now quickly changing, notes Kate.
‘Private pension funds are returning to their domestic market after a 20-year absence. Throughout the preceding period, they had been afraid of Japanese stocks due to the bursting of the stock market bubble at the end of the 1980s. Since only 1% of their portfolio today consists of local shares, the growth potential is considerable,’ he says. ‘In addition, the number of retail investors wanting to enter the stock market for the first time is at a record high. The five Japanese online brokers cannot cope with the demand and prospective investors have to wait 20 days for an account to be opened.’
Entry point
Kaye points out that since the beginning of this year, $3.4 billion has already flowed into Japanese equities through ETFs, half of which has come from Japanese investors. ‘They have seen the crisis as an opportunity.’
What makes Japan attractive too, says Kaye, is that Japan has been affected much less by the coronavirus outbreak than other developed markets. ‘Outside Japan, there has been little attention for this. Taking this into account, now is an interesting entry point.’
Nevertheless, Japanese stock market indices have lagged other markets since the mid-March. ‘Japan is still a misunderstood country, economy and stock market,’ stresses Kaye. Moreover, ‘don’t forget that Japanese stock market indices have underperformed other developed markets for 20 to 30 years, and that has stuck with investors. Underperformance has endured over the last five years, even though Japanese corporate profits have grown much faster than American profits.’ Consequently, the Japanese stock market has become relatively cheaper. ‘This is now finally being noticed, especially by the Japanese themselves.’
New versus old
For Richard Kaye, Japanese stocks provide an excellent springboard to capitalise on Asia’s long-term growth, as 60-70% of Japanese companies’ profits are generated outside Japan, with the lion’s share of this coming from the rest of Asia. ‘In general, Japanese companies are cheaper than their Asian peers, have higher liquidity, better governance and a longer track record. It is also important that many of these companies have been able to tell a positive story in recent weeks thanks to the recovery in China, Vietnam, Taiwan and other countries in the region.’
According to Kaye, investors ignore this and are asking the wrong questions. ‘They want to know whether Toyota or Japanese banks are attractively priced. But these industries stand for the old Japan and are experiencing a structural decline. They are not benefiting from growth in Asia and are not responding sufficiently to changing trends. It is unfortunate that the various Japanese stock market indices still consist mainly of old Japan such as the automobile industry, banks, large chemical companies, producers of machinery, trading groups such as Mitshubishi Corporation and shipping companies. And it is therefore regrettable that many investors buy Japanese ETFs. Chances are that profit growth will disappoint and the ETF in question will lag behind.’
The Comgest Japan Equities fund, which has an 11-year track record, fully plays the Asia card and ignores the old Japan. And that is paying off: year-to-date the fund has outperformed the broad Topix index by 11%. ‘There are some 300 to 400 stocks of the total of 2,000 Japanese listed companies in which we could invest on the basis of solid historical growth and return on capital, but our portfolio consists of only 30 to 35 names. We try to select only the best companies on this list by basing ourselves on capital discipline, the attractiveness of the business model and competitiveness. In fact, we are looking for companies that we can hold on to forever. We have been owning one-fifth of our portfolio for more than 10 years.’
Shares in which Kaye invests tend to have an above-average price/earnings ratio of between 25 and 30, while the Japanese stock market average is 12 times earnings. ‘We’ve always had a 100% premium against the average. This is justified given the higher growth rate of our companies. But that doesn’t really mean anything because the old Japan creates the distortion in valuations. These companies have to be cheap because they destroy value.’
Trade war
Kaye is unreservedly positive about Japan, but are there any threats that could undermine his investment case? ‘The biggest threat is a trade war between the US and Japan, not the Sino-American dispute. Japan even took advantage of the latter because some Japanese companies gained market share because their American competitors were side-lined. A threat would therefore be if the Americans suddenly introduced tariffs on Japanese products. And with President Trump, that possibility always exists.’
However, Kaye mentions that Japan has already had its fair share of trade wars and thanks to this experience it knows how to deal with them. ‘In the ’70s and ’80s it already had to deal with American protectionism. And as a countermove Japan then built massive production facilities in the US. The machine builder Komatsu, for example, produces almost as much in the US as Caterpillar. It is worth mentioning that the day Trump was elected, and stock markets fell strongly, the Japanese prime minister Shinzo Abe already met him in the Trump tower. The US has been Japan’s most important trading partner for 40 years!’