Beyond the rally: finding lasting growth in Japan

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With its elegant clubhouse and manicured greens, Koganei Country Club is one of Tokyo’s most prestigious golf courses. In the late 1980s, a businessman offered $3.5m to any member who would sell him their spot.

There were no takers. It was the peak of Japan’s heady trade in golf club memberships, status symbols of the country’s phenomenal boom. Property prices were skyrocketing and, in 1989, the Nikkei stock index hit an all-time high and 40 per cent of global assets were allocated to the country, Japan looked set to overtake the US as the number one economy.

Then the bubble burst. By 2004, you could pick up a membership at Koganei for less than a seventh of that peak price. ‘Lost decades’ dragged on, marked by slow growth, falling prices and rising unemployment.

All that now seems to be changing. Now that inflation has returned and exporters are rediscovering their mojo, Donald Farquharson, a veteran of many Japanese false dawns, believes that the best-led companies promise to sustain growth into the future – beyond the current rally.

“There is a marked difference in confidence and the enthusiasm that a lot of entrepreneurs are now exuding,” Farquharson reflects in a recent episode of Short Briefings on Long Term Thinking. He believes that “the growth these companies are demonstrating will come through in terms of earnings and cash flow and ultimately will drive share prices”.

This view that it’s an exciting time to be invested in the Japanese market, is based on more than a temporary fillip from higher interest rates and a weaker yen. So far, these macroeconomic factors have mainly boosted traditional sectors, such as carmakers and banks. Meanwhile, the entrepreneurial growth companies that Baillie Gifford prefers, in sectors such as IT services, factory automation, and the “fabulous Japanese skincare and cosmetics brands,” have been overlooked. That, he says, presents an opportunity for investors prepared to look beneath the headlines.

It’s not just the urban landscape that has changed since Farquharson’s first foray into the country in the post-bubble days. Back in 1990, a mere 4 per cent of the Japan Fund was invested in founder-run companies. Today, it’s almost half the portfolio. “The opportunity set has changed spectacularly. You’re sitting in the room with the person who set up the company and who holds the vision for where that company is going to go.”

For seekers of growth companies, quality of management is a key differentiator. Farquharson cites Olympus, once best known for its cameras, now solely focused on medical endoscopes used to probe and explore inside the body in various procedures.

“I met the chief executive Stefan Kaufmann, who’s German. Olympus is the market leader in endoscopy with about 70 per cent of the global market.”

A foreign chief executive is still unusual, and a lack of international experience is still a problem for Japanese firms. In the case of Olympus, Kaufmann has got the company back on track after a lack of transparency caused a run-in with regulators. “I’m very optimistic about a company that is lowly valued and still dominates its industry.”

Another company firing Farquharson’s enthusiasm is Nihon M&A a rare beneficiary of the demographic pressures the country famously faces. It advises companies on mergers and acquisitions.

“In Japan, there are about 3.5 million small, medium-sized companies. Roughly half have a CEO founder over the age of 70 and face a succession issue. This is where Nihon M&A can step in. It’s by far the biggest advisor in this area. Companies aren’t concerned solely about getting the best price [for a buy-out]. They’re concerned about their workforce. They’re concerned about the continuity of their business. Nihon M&A has skills here that others can’t replicate.”

For Farquharson, widespread preconceptions help long-term investors who can see value and growth potential in Japan that others overlook. He also cites misconceptions such as the one that exporters dominate Japan. In fact, “exports as part of GDP are lower than they are in the UK”.

You wouldn’t know from the headlines, he suggests, that over the last 10 years, Japanese companies’ earnings growth has been higher than in the US. “People don’t believe that, but they can check. There’s actually been true earnings growth over my career, but we’re still coloured by all these [past] comments around deflation and the sorry state of the Nikkei.”

No one expects the days of multi-million-dollar golf club memberships to return any time soon. Nevertheless, Farquharson believes that Japan’s current return to fashion with investors still doesn’t reflect its full potential for growth investors.

“Japan is a much more vibrant, much more exciting market than many give it credit for”. He says. “There are lots of opportunities. It’s a great hunting ground.”

The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

This communication contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research, but is classified as advertising under Art 68 of the Financial Services Act (‘FinSA’) and Baillie Gifford and its staff may have dealt in the investments concerned.

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