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Seasoned investors will have seen many false dawns from the Japanese stock market. After an extraordinary run of performance in the 1970s and 80s, the Japanese stock market reached a peak in 1989 that, more than 30 years later, it is yet to surpass. Now, however, the stars appear to be aligning for a prolonged period of better performance. Here we explore the reasons why and explain how the Schroder Japan Growth Fund plc is poised to benefit.
Most global equity portfolios today are under-exposed to the Japan stock market. Years of underperformance and dashed hopes of recovery have led to many investors progressively giving up on the region. Gradual capitulation on this scale can eventually be the friend of the disciplined, contrarian, long-term investor. It may feel comfortable following the herd, but there is always elevated risk in a crowded trade. There is less risk, however, investing in parts of the global equity market that are less congested, because valuations tend to be much more modest.
As the chart below demonstrates, that is certainly the case for the Japanese stock market today. Global lethargy towards this once highly respected regional stock market has increasingly weighed on valuations. With the exception of the dislocation associated with the start of the Covid pandemic in 2020, Japanese equities have been becoming steadily cheaper in price/earnings terms for more than a decade. Many other regional stock markets have become much more expensive during this time, as typified by the US S&P 500 index shown on the chart. This leaves the Japanese stock market in attractive valuation territory in both absolute terms, and relative to other regions.
Japanese equities are cheap in absolute and relative terms
Source: Bloomberg, as at 03/09/2022
Meanwhile, the value-oriented investment approach employed by Masaki Taketsume and Schroders’ investment team in managing the Schroder Japan Growth Fund plc, means the portfolio is keenly focused towards the most attractively valued parts of the Japanese market. The portfolio typically consists of 60-70 of the highest quality undervalued companies that can be found in Japan, with a current bias towards mid and small cap companies with excellent growth prospects.
Japan is still perceived by many to be a low growth economy, with poor returns and an anachronistic corporate culture. We would agree that the Japanese economy continues to have its problems, including poor demographics and a high government debt to GDP ratio, but many other mature economies will soon face similar dynamics.
Indeed, in many other respects, Japan has changed dramatically in recent years, as we explore below. Much of the rest of the world has not yet given Japan the credit it deserves for this transformation, and the gap between the old perception and the new reality, means Japan has a golden opportunity to surprise positively from here. Recent corporate results support this thesis, as Masaki explains:
“Overall, the most recent earnings season saw results again coming in ahead of expectations and profit margins appear to have remained resilient. With many companies having made conservative forecasts for this fiscal year, there is scope for upward revisions.”
Masaki Taketsume, Portfolio Manager, Schroder Japan Growth Fund plc
Japan’s new dynamics
Experienced investors will have heard much of this before – several times. So, it is important that we explore the changes that Japan has been undergoing which make the current environment a genuinely interesting time to be considering investment in the region.
The first of these changes relates to corporate governance. Historically, the structure of corporate Japan has been dominated by the keiretsu system, which is a structure of cross-shareholdings and close relationships between customers, suppliers, their banks and competitors. As the Japanese economy has struggled over the last thirty years, this system has been increasingly criticised from a governance perspective, because it can lead to inefficient capital allocation and poor decision-making. The system has also made it hard for shareholders to agitate for management change and has fostered a culture that was generally unresponsive to shareholder demands.
Corporate Japan is changing, however. The transformation began in 2014, when the late Shinzo Abe’s government commenced a push to overhaul corporate governance as part of a broader effort to make Japanese companies more competitive on the global stage. A new corporate governance code was introduced in 2015, and ongoing revision since then have focused on specific issues, including the unbundling of cross-shareholdings. As Taketsume explains, this is already having a meaningful impact for investors.
“We remain very positive on the ongoing improvements in corporate governance and the scope for this to generate real value for investors. Although this is partly a qualitative assessment through our discussions with company managements, there are also measurable impacts such as improving Return on Equity and a record level of share buybacks.”
Masaki Taketsume, Portfolio Manager, Schroder Japan Growth Fund plc
This transformation is illustrated in the chart below, which shows dividends and share buybacks at all-time highs. The fact that Japanese companies are generally in good financial health, with high cash levels compared to their counterparts in the US and Europe, should help this trend to continue.
Dividends and share buybacks from Japanese companies
Source: Nomura, based on data disclosed by each company. 605360
Meanwhile, the second major change to consider is the economic environment which, for the first time in decades, paints Japan in a favourable light compared to its global peers. The Japanese economy has been blighted by deflationary pressures for years, but may now be heading into a period of sustainably positive inflation. Indeed, the Bank of Japan may be the only central bank to welcome some of the global inflationary pressure seen in 2022. By contrast, inflation is seen as a threat in the west. The Japanese economy, however, is not seeing the same level of inflation as that being experienced in the US and Europe, which is a relative positive. Masaki describes the Bank of Japan as “a clear outlier in global monetary policy”, with interest rates being maintained at very low levels, which provides support for the domestic economy and indeed its stock market. Consensus forecasts continue to point to modest growth for the Japanese economy in 2023, at a time when much of the rest of the developed world is increasingly at risk of recession.
This more benign economic environment, coupled with the prospect of improving returns, could help underpin an attractive long-term opportunity in Japanese equities.
Japanese inflationary pressures are more modest than elsewhere
Source: Schroder, Eikon as at 27 September 2022
Capturing the opportunity with the Schroder Japan Growth Fund plc
Masaki Taketsume was appointed as portfolio manager of the Schroder Japan Growth Fund plc in July 2019, and performance since then has been encouraging. Market conditions have favoured his value-oriented investment style during a period in which the growth style has faltered. Alongside good stock-picking, this has led to top of peer group performance over the last three years, in terms of both share price and net asset value. Despite this, the discount between the trust’s share price and net asset value is yet to narrow.
The portfolio contains a good balance between domestic and export exposure. Despite the travails of the last thirty years, Japan remains the third largest economy in the world and, in addition to a huge domestic opportunity, it is home to many world-leading companies with capabilities that are often under-appreciated by investors. The portfolio also has a small cap bias, particularly within the domestic service sectors, where Masaki anticipates a strong recovery. As a long-term fundamental investor, with the backing of Schroders’ small cap specialists in Tokyo, he sees consistent opportunities to add value in small cap, given how under-researched this part of the market is compared to larger Japanese companies.
Overall, it does finally feel as though the time may have arrived for the Japanese stock market to shine brightly once more, and we believe the Schroder Japan Growth Fund plc is well positioned to capture this long-term opportunity.
This information is a marketing communication.
This document does not constitute an offer to anyone, or a solicitation by anyone, to subscribe for shares of Schroder Japan Growth Fund plc (the “Company”). Nothing in this document should be construed as advice and is therefore not a recommendation to buy or sell shares.
Any reference to sectors/countries/stocks/securities are for illustrative purposes only and not a recommendation to buy or sell any financial instrument/securities or adopt any investment strategy. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on any views or information in the material when taking individual investment and/or strategic decisions.
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Issued in November 2022 by Schroder Unit Trusts Limited, 1 London Wall Place, London EC2Y 5AU.
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