Japan: going for gold

In the same way that the delayed Olympics are now set to go ahead after last year’s false start, it looks as if the Japanese stock market is finally set to do likewise.

Turning the clock back to the start of last year would have seen investors assuming a widespread and accelerating pick up in global economic activity after fears of a China-US trade war proved largely illusory. The US economy was motoring along with the lowest rates of unemployment seen since 1969, accompanied by burgeoning world trade, and all this was taking place against a relatively benign background of steady and historically low interest rates and a stable oil price of around $60 per barrel. Under such circumstances, Japanese corporate earnings were expected to do well given most rely on overseas sales, particularly across the Far East and the US, to generate profits growth.

Jumping back to the present, the backdrop looks remarkably similar, but boosted by the roughly $16 trillion of Covid-19 related funds distributed by OECD (Organisation for Economic Co-operation and Development) governments, placing the Japanese market back on the starting blocks for a good run again. The IMF (International Monetary Fund), in its 6 April update, expects global growth to hit 6% in 2021, the highest annual total since records began in 1980, with the US the overall biggest contributor.

The improved financial fitness of corporations should prove telling in competition with their foreign rivals in the race to see whether the Tokyo market does better than most of its peers. Since the 1989/90 peak, Japanese firms have managed to triple their average return on equity (RoE) and double their return on capital employed (RoCE) while totally reversing their debt position to the extent that more than 1,200 out of all the 3,500 listed firms hold more cash than debt.

This should leave Japanese firms relatively better placed to deal with any rise in interest rates and lay behind almost none of them cutting or omitting their dividend payments over the last 18 months – unlike many of their US, EU or UK rivals. Likewise, they also managed to maintain margins across the pandemic, such that for Q4 2020, average non-financial company operating profit margins and aggregate operating profits both hit all-time record highs.

In terms of position, the market started the year with much lower valuation ratings than its OECD comparators and almost half of its own peak levels set back in 1989/90. All this seems to have caught out foreign investors, who collectively have sold around $160 billion of Japanese stocks since mid-2015. International investors have been largely absent from the market, just like they will be from the Olympic audience, with some only recently becoming net buyers, diminishing their ability to disrupt any market advance.

Therefore, the Japanese market exhibits features that suggest it is well placed for a strong run against its peers over the year. To date in 2021, the TOPIX index has regained the 2,000 level last seen in mid-April 1991, almost 30 years ago. Across the intervening period, even allowing for sterling’s depreciation, a UK investor would only have made 133% by investing in Japan, compared to 1,516% in the MSCI World ex-Japan index, 2,277% in the S&P 500 index and 4,052% in the NASDAQ composite index. This shows the ground that has to be made up over the longer term.

At the portfolio level, we have held the majority of our positions for more than five years and are invested on the basis that the key determinant of a Japanese firm’s profits growth is a combination of a global industry-leading position and the success of its overseas operations. This is largely due to a steadily shrinking population domestically, down three million to 125 million over the last 11 years and continuing to decline.

Delving further into the portfolios, we have a number of stocks set to benefit from the US consumer recovery, such as Toyota, Subaru and Seven & I - the last two more recent additions in 2020 - as well as Nintendo and Bandai. These continue to do well from new product releases, having been longer-term gainers from Covid keeping many people at home. In the industrial arena, we have kept our exposures to Komatsu and various factory automation plays such as Fanuc, Keyence and Amada, all of which are likely to do well out of President Biden’s bills encouraging infrastructure and capital investment.

On a global basis, we should benefit from similar investments being made elsewhere, such as India’s $500 billion program of spending. Meanwhile, across the World, the current, and likely continuing, boost to semiconductor production over the next few years to overcome the current widespread shortage should see our silicon providers Sumco and Shin-etsu Chemical do well, given that there are only three main suppliers worldwide and a shortage in their capacity.

Closer to home, with the Japanese government passing five bills related to better digitisation of the country, particularly across local and central government which have over 1,700 disparate systems, should provide opportunities for large system integrators like Fujitsu and Hitachi on the industrial client front. There is little political threat, despite a general election having to be held by 22 October, as the leading party - the Liberal Democrat Party (LDP) - has 40% of the voting intent with the nearest opposition party, the Constitutional Democratic Party, only mustering a lowly 13%.

It appears that sterling’s position as the long-term whipping boy of the foreign exchange markets is finally over thanks to a relatively benign Brexit settlement, the success of the vaccination program and the subsequent more likely return of economic growth, accompanied by higher interest rates. At the same time, the yen’s recent safe haven status-based appreciation should reverse, as we expect this feature will help underwrite a multi-year recovery in Japanese corporate profits. As such, the portfolios will remain overweight in large, well-financed industry dominant Japanese multinationals that are set to benefit most from the currency’s likely weakening.

Discrete years' performance (%)*, to previous quarter-end:

*Source: FE Analytics as at 31.03.21 versus comparator benchmarks. Quartile rankings as at 31.03.21, generated on 13.04.21.

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