A drumbeat is building around the case for holding Japanese stocks as reform measures unlock value and build momentum. This article sets out some of the case.

There have been so many false dawns about Japan’s stock market in recent years that some investors have understandably lost heart. But recent evidence may suggest that at long last a set of reforms is making Japanese equities attractive once again. With emerging market stocks feeling the heat from rising US interest rates and some concerns about some other markets, Japan has been gaining a bit more attention. 

One firm with “boots on the ground” in Japan, giving it the ability, it says, to find the market “diamonds” amidst the dross is Comgest, a France-based firm with $32.0 billion of assets under management (as of the end of June, 2018) and a network of offices worldwide. With a number of investment funds tapping into Asia, it is understandably positive, but one of its senior figures argues that the facts back up a more upbeat case for Japan. The author of this piece, Richard Kaye, is a portfolio manager and analyst at Comgest Growth Japan, one of that firm’s funds. (More details about Kaye are below.)

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Japan as a market is full of growth opportunities if you know where to look. The country has been substantially transformed since Prime Minister Shinzo Abe took up the reins of government five years ago. Abe has encouraged profound changes in both political and economic governance as well as improving earnings quality and growth, even in a global low growth environment. But his Abenomics were just the tip of the iceberg. For equity investors like Comgest, Japan’s opportunities lie in companies that are seeking to solve long-term issues such as an ageing population, bringing more women into the workforce, addressing the needs of their tourism boom, or supplying Asia’s new emerging consumer class.

Even so, Japan remains a frontier market in the sense that much of its quality and growth has not been explored enough.

A quick glance at analysts’ reporting shows that Japan is vastly under-covered compared with other developed markets, and where there is coverage, it typically lacks differentiation. 

Analyst coverage of the Japan vs the US: 10x per stock 

Source: Nomura

This declining analyst coverage reflects the common opinion that Japan is not worth investing in, except as a “greater fool” value market. The data defy that perception, for the overall market but more importantly for individual stocks. 

To identify the best opportunities, I stand behind the belief that by carefully screening companies and investing in a concentrated universe, we could achieve double-digit aggregated profit growth over ten years. This is demonstrated by our selected portfolio of stocks which has steadily outgrown the profit of the overall market - even though that overall market is also growing. 

For example, finding new, less-traditional companies which represent the country’s openness to changes, whether these are tech, demographic or health disruptors, can make all the difference when looking at investing long term in the country. It is also worth noting that there are many Japanese companies that have grown far beyond the domestic market; for example, think of fashion brand Uniqlo which has become strongly recognised in the West; or Pigeon, a baby product manufacturer whose baby bottles are the most sought-after in China.

From a broader perspective, the overall Japanese market shows the highest average profit growth of any region for the last six years, and this is reflected in improving investment efficiency or Return On Invested Capital (ROIC). Japan lagged the rest of the world for 20 years, but has caught up sharply.

ROIC Comparison Japan making up for twenty years

Source: Facstset

Although profit growth has now returned and specific opportunities abound, there are many aspects of Japan which remain undiscovered and provide untapped potential for generating alpha, especially over a long-term period. The most obvious indication of this is that Japan’s average valuation discount to world markets has widened - not narrowed unlike other countries - as its earnings growth has accelerated but flows into the market have not kept up.

Japan PER discount to MSCI AC World increasing as earnings accelerate 

Source: Factset

Looking ahead, I believe that a major trigger is at hand to correct this undervaluation: the domestic institutional investor has woken from a 20-year hibernation and is returning to the Japanese market, and doing so with quality and engaged focus, hence the popularity of the JPX 400 quality benchmark in incremental fund flows. Indeed, the JPX 400 sets governance, returns and shareholder engagement criteria which filter down to the best Japanese companies, and it has been a central catalyst in governance reform. More importantly, perhaps, the unwinding of cross-shareholding and the need of defined-benefit pension funds to address underfunding has catapulted the minority investor into an unprecedented position of prominence. 

Twenty-eight years from its market peak, Japan alone among world markets has declining valuations but improving profit growth and shareholder return. The correct investment parameters in this environment can offer unparalleled opportunities.

Footnote:

1,  Factset as of 12 July 2018

About the author

Richard Kaye joined Comgest in 2009 as an analyst and portfolio manager, bringing with him a wealth of experience in Japanese equities. On joining Comgest, he became co-lead of Comgest’s Japan equity strategy. Starting his career in 1994 as an analyst with the Industrial Bank of Japan, Richard joined Merrill Lynch in the same role in 1996. In 2005 he moved to the Wellington Management Company in Boston as a portfolio manager of Japanese TMT stocks. Richard graduated from Oxford University where he majored in Oriental Studies.

All details current as at 30 September 2017 unless otherwise stated. General data sources: Comgest analysis, Factset (market & portfolio data, financial ratios).

Disclaimer

All opinions and estimates are current opinions only and are subject to change. Forward-looking statements may not be realised. The information and any opinions have been obtained from or are based on information from sources believed to be reliable, but accuracy cannot be guaranteed.