The investment house discusses where it sees investment potential, and how the Japanese small-cap sector may not be receiving the attention it deserves.

There is a big gap between expensive “defensive” sectors and less costly cyclical stocks in Japan, and considerable valuation opportunities to be unearthed by investors patient enough to see results come through, according to asset management house Eastspring.

With Japanese and other markets often beholden to near-term swings in sentiment – shown by behavioural finance to be traps for the unaware – this very action opens up opportunities, according to Max Godwin, portfolio manager at Eastspring’s Japan equity team.

“Stock markets and investors tend to attach too much importance to short-term news flow, short-term market or economic trends, and so on. For instance, in Japan over the last 12 months the market has been consumed with macro worries surrounding a hard landing in China, or worries about a stronger yen, by way of example,” he told this publication in a recent interview.

“In individual company terms, those with a near term trend of deteriorating earnings surprises, or negative news flow, tend to get heavily sold off well below fundamental fair value. In fact, the opposite is also true, you can get expense stocks where news flow helps push stocks above fair value, such as FANG at the moment or the IT bubble in 2000. Naturally, this all eventually ends in tears. However, it is always hard to predict when a trend of expensive or cheap stocks will end,” he said. (“FANG” stands for the following companies: Facebook, Amazon, Netflix and Google).

“In the longer term, stock markets are more rational. As Buffett and Graham said aptly, in the long run they are 'a weighing machine not a voting machine’...What this means is that, over time, individual stocks will tend to mean revert to their fundamental fair value, based on a reasonable estimate of long-term sustainable average earnings,” Godwin said.

Over the last five years, Godwin's Eastspring Investment Japan Smaller Companies strategy, which has more than $186 million under management, has delivered a cumulative performance of 74.5 per cent, against a Japan equity sector result of 21.2 per cent (source: Trustnet). This particular fund strategy, a unit trust registered in Luxembourg, was launched in March 2008.

Because it takes time for markets to revert to the mean after a period of significant swings, Godwin said his average holding period for a security is typically three to five years.

“There is not enough attention paid to this short term-long term dynamic. However, this insight can equally be used to beat the market, via a kind of arbitrage. If you can design a process that consistently identifies cheap stocks in which earnings and valuation terms have historically underperformed the market that have improving earnings and valuations multiples, you will beat the index. It’s ultimately just maths,” he continued.

Focus area
An area of focus because of the opportunities from under-analysis is Japanese small-caps, he said.

Godwin said this part of the investable universe in Japan is wide, with about 2,000 stocks. It is also relatively thinly covered by brokers, so there are plenty of unappreciated opportunities. More than 50 per cent of the Topix benchmark is not covered at all by brokers, or only one broker, he said. By contrast, large-cap stocks will typically be covered by 10 or 15 different brokers. 

Asked about its stock screening process, Godwin said his firm looks at themes such as structural decline, poor management and mistakes.

“The key is to separate the sheep from the goats. Most stocks are cheap for a reason, because they are a value trap and deserve to be. With a select few we will be able to come to a high degree of conviction that, over our holding period, the shares will re-rate,” he said. "The reason for re-rating is usually a likely mid-term improvement in earnings or valuation; though this in itself can again be driven by a variety of factors."

Godwin gave the example of auto component stocks after the 2008 crash. Japanese car sales globally collapsed and so did component sector profits and the shares and valuation multiples. Godwin said his firm chose some select stocks, for example those with high global market share, good balance sheets, relatively low capital spending, and management who cut fixed stocks in case key US end-market car sales did not mean revert to previous levels. “Within a year or two all these stocks were back to their previous profit and valuation levels. But at the time, all brokers had them all on a 'sell' rating because of their focus on the short-term issues,” he said.

More broadly, there has been a change, coming from policymakers, in encouraging more focus in boardrooms on return on equity.

“20 years ago when you visited a company management would say 'ROE? what's that? ROA? What’s that?' Now they are increasingly starting to target it. Simple but effective. For example, a recent example has been the listed stock Cocokara Fine 3098, which has been a big outperformer for us. It’s a nationwide drugstore chain made up of three regionals. We visited a few years ago as sales and profits per store had collapsed when it came up on our screens. It had started out as an inexplicably low return business versus its peers and now returns had gone down even lower. There was no broker coverage so most market participants simply ignored it,” Godwin said.

“Upon talking to management the reason for the poor business performance became clear. A major internal change and reorganisation aimed at maximising the scale of the business was underway. The management had tried in one go to unify all systems- logistics, purchasing, POS, HR and head office. Short term there was chaos. However our view was that in the long run these changes would lead to much better than historic ROE, similar to peers in fact. The only thing we didn’t know was how long this would take. In the end it took about one and a half years before earnings started to recover and the stock started to outperform nicely,” he said.