Investors wise to be wary of false dawn in Japan

From Due Diligence 26 September 2012

By Graham Duce

Investors should take predictions of a Japanese recovery with a pinch of salt, but skilled stockpickers can undoubtly find value among the country’s companies

What have nappies got to do with economics? Well, as it turns out in Japan, quite a lot. Japan’s aging population and deteriorating demographics are no secret but incredibly adult nappy sales now outstrip those for babies. When you factor in their unsustainably high debt burden and increasing reliance on external funding (international investors) as global rebalancing continues, you start to get a feel for the sheer scale of the challenge to policy makers.

Against this background, a negative view on the Japanese yen and their government bonds (JGBs) seems justified – although in times of risk aversion, JGBs are perceived as safe havens. It is possible that this may be the year in which investors begin to start asking serious questions about Japan’s fiscal sustainability. Recent industrial and manufacturing data has been weak as export demand from China and Europe has been particularly soft and companies have been cutting back on production and in order to adjust inventories.

The relative strength of the yen also poses a threat to Japanese exporters. By all accounts companies have largely factored in an exchange rate of 80 yen to the US dollar, but should that rate strengthen to around 70, things could get far more difficult for them. That said, there are encouraging signs for the labour market and, potentially, the end of corrosive disinflation now that the Bank of Japan has adopted a 1 per cent inflation target.

In overall terms, growth of up to 2 per cent may be achievable this year which, relative to other developed markets, compares quite favourably. Furthermore, Japan had to contend with a great deal last year. In addition to concerns over a global slowdown, it also had to weather the tragic earthquake and Thai floods; both of which severely constrained supply chains. The latter had a particularly adverse effect on the auto manufacturers.

RELENTLESSLY OPTIMISTIC

But in the face of such clear economic challenges, the optimists chime that the Japanese stockmarket is cheap, and therefore represents great value! If I had a pound for every time I had heard this over the last decade I would have accumulated a pot potentially large enough to bailout Greece. My recent trip to Japan was no different. Fund managers and company management alike continue to weave a positive spin on Japan’s precarious malaise.

It is a well-worn tale by now. Investors have been repeatedly told that, despite its problems, the dynamism which propelled Japan to the top global economic table cannot have simply evaporated overnight. Equity valuations are cheap as they have been out of favour, and right now presents the perfect buying opportunity. It sounds remarkably familiar doesn’t it? Such an argument could have been credibly levelled at any point over recent years and, as a regular interviewer of Japanese fund managers, I have heard my fair share of versions of the story.

As the false dawns have come and gone, investors, including me, have become ever wary of proclamations along these lines. Underlying fund managers in Japan have also learned to tone down and adapt their enthusiasm somewhat.

Yet, despite the relatively negative overall macroeconomic picture, the underlying value argument has never really gone away. Japanese companies are trading on price-to-book valuations of 0.9 and earnings multiples of 10 times. This is a long way from the heady multiples of 70 times experienced in the late 1980s, and it is not fair to continually tar them all with the same brush.

We ultimately see Japan as a stockpicking market – evidenced by the 80 per cent disparity of returns over the 3 years to end of May – as there are some hidden gems among the heap of lacklustre companies. My recent trip only served to reinforce this view and, while I remain quite sceptical about the chances of a sustained Japanese rally, I do have conviction that there are many excellent, well run companies to be found. A good example of this is Don Quijote, who are a discount retailer covering a wide range of products from groceries to electronics to clothing. Their logistics and distribution systems are world class and allow them to compete successfully on price.

So, in summary, I would urge investors to be wary of another false dawn, but for those willing to look hard enough, the potential returns are available. We remain relatively neutral to Japan but where we do have exposure, we look for managers who generate returns via stock selection. Two of our long-held funds include GLG Japan Core Alpha and CF Morant Wright Japan, and we are more than comfortable placing our faith in talented bottom-up fund managers with a proven track record.