Eastspring Investments, the $247 billion asset management business of Prudential, discusses investment opportunities in Japan's equity market, emphasising how ongoing structural reforms will continue to drive the market.

Singapore-headquartered Eastspring Investments highlighted this week how structural reforms will continue to drive the Japanese market’s re-rating, with the small and mid-caps universe being prime territory for valuation-based investors.

Eastspring believes that the three structural tailwinds will have multi-year longevity – namely a move from deflation to inflation, better corporate profitability through governance reforms, and a stronger capex environment remaining in place.

The firm expects to see announcements this year from corporates regarding measures to improve underlying profitability and rationalise balance sheets. Although share buybacks are important, Eastspring thinks it is the genuine restructuring of businesses that will improve valuations over the coming years. There is also a possibility that next year’s spring wage negotiations will result in significant wage increases for the third consecutive year.

“Equity valuations across a range of metrics currently sit in the middle of a long-term range which suggests they are certainly not stretched and look attractive versus other developed markets. The reforms over the last 10 years have also resulted in improving margins, and this trend is likely to continue. Equally the earnings per share growth in Japan has been more robust than the US and EU since 2012,” the firm added.

According to asset manager Nomura, foreign investors are still underweight in their Japan allocations, compared with other developed markets. “There is significant support for Japanese equities both at the macro and micro level, and the ongoing structural changes make Japan the stand-out market globally. Japanese equities should continue to re-rate as the deflationary era comes to end,” Eastspring said.

Small and mid-cap stocks
The firm highlighted how the rally to date has mostly been driven by large caps – Japan’s small caps have not moved in tandem. “There is still a wide investable universe of small and mid-cap stocks that have undemanding valuations making it a prime territory for longer term valuation-driven stock pickers. Many of them are currently trading below their book value,” Eastspring said.

An inflationary cycle typically favours small caps more than large caps as more SMIDs tend to be tied to the domestic economy. In such an environment, Eastspring has behaved in a contrarian manner and supported its positions in global basics and domestic names with a tilt to mid-capitalisation names which have been lagging in performance.

In domestics, the firm has added to names in transport and construction businesses where managements have shown commitment to price hikes and cost discipline. Under global basics, Eastspring does not own trading companies where valuations are not attractive but it continues to support chemicals which still operate under a depressed environment with low market expectations.

The firm emphasised that in the recent market sell offs, the negative share price impact was notable in the large export-related sectors where valuations have become stretched. The broadening of performance across different types of stocks should lead to sustainability of overall future market performance.

Stefan Sommerville, the investment specialist for Bermuda-based Orbis Investments, also favours Japanese mid-caps, saying that they should benefit from the improvement in corporate governance. He thinks that some of the large-cap names are overvalued. Sommerville's top holdings include Japanese drugstores Sugi Pharmacy, for example, as well as Japan's bank Sumitomo Mitsui Financial Group. UBS Global Wealth Management also sees potential in Japan's banks, IT services, electronic components and semiconductor equipment stocks. See more commentary here.

Eastspring also believes that Tokyo Stock Exchange’s (TSE) reforms are driving credible changes in Japan corporates. “TSE’s corporate governance reforms have already nudged multiple large cap companies to act to improve return on equity. Cross-shareholdings are being unwound, with significant moves in traditionally tightly knit allegiant shareholder relationships in autos, financials and construction value chains,” Eastspring said. “This should further improve boards’ accountability to minority shareholders as well as spur further activist involvement.” 

In summary, Eastspring believes that management teams need to realign the portfolios of conglomerate corporations – i.e. exit non-core businesses and reallocate capital to stronger areas.