Winds of change

Where the ‘Oracle of Omaha’ goes, others tend to follow and Warren Buffett has made his billions from spotting attractive investment opportunities ahead of the crowd. In this case, Buffett’s interest was piqued by the attractive valuations of Japanese equities after decades of neglect from investors, leading to his acquisition of a 5% stake in Japan’s largest five trading companies in 2020.

After meeting Japanese executives last April, Buffett doubled-down and increased his stake in the five conglomerates to more than 8.5%. As has often been the case, it proved an astute move as four of the companies (Itochu, Marubeni, Mitsubishi and Mitsui) delivered an average share price return of almost 50% in 2023. As veteran investor Charlie Munger succinctly put it, “it was awfully easy money” and $43 billion of net foreign inflows subsequently followed as Japanese equities bounced firmly back onto investors’ radars.

With the leading Japanese indices recently hitting 34-year highs, investors may be wondering whether it’s too late to join the party. However, a positive macroeconomic environment, comprehensive corporate reforms and robust company fundamentals should continue to be a source of alpha generation for Japanese equities.

A bold new era

Let’s start with the basics: Japan is an economic powerhouse, behind only the US, China and Germany (as measured by GDP). Western economies may be grappling with spiralling inflation but, after decades of deflation, the return of inflation has finally allowed the Bank of Japan to draw a line on its negative interest rate policy.

The importance of inflation to the wider economic health of Japan shouldn’t be underestimated, as Masaki Taketsume, manager of Schroder Japan (SJG), explains: “This is an environment in which Japanese companies appear to be regaining pricing power for the first time in decades. When coupled with improved consumer purchasing power through wage increases, this should drive healthy levels of corporate earnings growth.”

“An element of these higher profits can then be recycled back into the economy through further wage increases, driving a positive cycle of broader economic progress that has been largely absent from Japan for a generation.”

Another tailwind is the continuation of the far-reaching corporate governance reforms introduced to stimulate interest from foreign investors. The Tokyo Stock Exchange has applied pressure on companies to improve their capital efficiency, including the return of cash to shareholders rather than hoarding cash reserves. The sharp rise in share buybacks and dividends is testament to the success of this policy and, as the chart below shows, total returns from dividends have increased four-fold over the last decade:

Shareholder activism is also proving effective in encouraging management teams to focus on maximising value for shareholders, and one of the benefits of active fund management is the opportunity to engage meaningfully with management teams to shape corporate strategy.

By way of example, the SJG team has encouraged logistics services provider Sankyu to adopt a higher pay-out ratio, resulting in a commitment to increase its dividend pay-out from 20% to 40% and the introduction of share buybacks over the last three years. This enhanced income strategy has also contributed to a rise in Sankyu’s share price of more than 25% over the last two years (as at 07/05/2024).

In rude health

Although the Nikkei 225 recently hit an all-time high, valuations of Japanese equities remain attractive relative to both global peers and long-term averages. The MSCI Japan Index is currently trading on a forward price-earnings ratio of 15 times, compared to 20 times for the MSCI US Index, according to Yardeni (as at 06/05/2024).

Putting this into context, the MSCI Japan is forecast to deliver similar revenue growth to the MSCI US in 2025, together with strong forecast growth of 9% in annual earnings. The latest quarterly earnings season saw a number of upside revisions to earnings forecasts for Japanese companies, driving earnings per share for the TOPIX to record highs, as shown in the chart below:

Japan has long been recognised as a global leader in cars and electronics but its broad expertise in other sectors is perhaps less widely appreciated. The Japanese stock market is a hotbed of smaller, innovative companies that are well-positioned to capitalize on strong secular growth drivers for mega-trends such as robotics, artificial intelligence and decarbonisation.

The Japanese stock market also provides greater sector diversification than many of its peers, boasting strength in industrial, consumer discretionary, information technology, and financial services sectors, to name but a few. In contrast, the U.S. market has a heavy concentration of technology mega-caps, while the semiconductor sector dominates in Korea and Taiwan.

One of SJG’s largest holdings is currently Toyota, which often suffers from a perception of being a relative ‘dinosaur’ in the paradigm shift to electric vehicles. However, Masaki believes that the market is undervaluing Toyota’s expertise in electric vehicles: its first and highly successful hybrid vehicle, the Prius, was launched in 1997 and the company has achieved profitability across its hybrid, plug-in and battery-powered range of vehicles. In addition, Toyota recently announced the development of a solid-state battery capable of a 1,000km range on a single charge by 2028.

Why it pays to be selective

Japan is a prime example of an under-researched market: only 7% of the S&P 1500 index has no more than two sell-side analysts compared to almost 70% for the TOPIX in Japan, according to Bloomberg. This illustrates the value of active fund managers who can deploy their ‘on the ground’ research expertise to uncover pricing inefficiencies and valuation opportunities.

SJG manager, Masaki Taketsume, has 28 years’ experience of investing in Japanese equities and is supported by the Schroders’ team of 28 equity analysts based in Tokyo. The team builds strong relationships with management teams, including an active engagement programme of 2,500 contacts with Japanese companies each year.

SJG holds a ‘best ideas’ portfolio of around 60-70 stocks and is unconstrained by market cap and sector. Masaki looks for strong company-specific growth drivers, focusing on well-managed, high-quality companies whose current valuation does not reflect their potential. This value-oriented tilt differentiates the trust from its peer group, however, this is not an ‘old guard’ Japan value strategy and valuation is looked at in conjunction with quality and growth characteristics.

Around 40% of the portfolio is categorised as ‘market misperceptions’ where Masaki believes that positive growth prospects have not been reflected in current valuations (as with Toyota). The trust also holds around 30% of the portfolio in ‘market oversight’ companies, which are seen as undervalued companies with defendable franchises in niche product areas and are often smaller-caps due to the lack of research. Masaki holds around 15% of the portfolio in ‘short-term overreactions’ which are more opportunistic positions to capitalise on the depressed valuations of quality companies.

Overall, the portfolio is currently overweight small and mid-cap stocks that should benefit from the recovery in the domestic economy and underweight more growth-orientated stocks which Masaki feels are trading at high valuations.

This approach has yielded impressive results, with SJG achieving a net asset value total return of more than 50% over the last five years (as at 06/05/2024), the second-highest in the AIC Japan sector. It has also outperformed the benchmark index (the TOPIX TR JPY GBP) over one, three and five years by NAV returns (as at 06/05/2024). As mentioned earlier, growth in dividend distributions has also been a feature of portfolio companies and SJG is currently trading on a dividend yield of 2.1% (as at 06/05/2024) although the trust’s main objective is to maximise capital growth.

Looking ahead, Japanese equities should continue to benefit from the increased appetite from global investors, together with a supportive macroeconomic and regulatory environment. While the valuations of large-cap Japanese stocks have risen over the last few years, the smaller-cap end of the market continues to provide opportunities for active stock-pickers. And staying on the topic of successful stock-pickers, Japanese equities continue to boast the much-vaunted Buffett seal of approval.

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