Posted inEquitiesJapan

Fund Selector: Japanese equities

The Japanese market tends to behave differently to other developed markets. First, companies are reviewed on a price/book value comparison and not price/earnings as is more popular in the UK and other western markets.

The country also has a tendency for stocks to revert to the mean. Over time, expensive companies get cheaper and those cheaper value businesses are re-rated upwards. Likewise, return on equity also reverts to mean.

Over the years, this mean reversion has led to value investing becoming a successful strategy, presenting an excellent backdrop for investors who are willing to buy cheap and wait for the mean reversion to kick in.

However, since the 2009 financial crisis the value trend has been on its longest run of underperformance in 40 years, only showing signs of recovery at the end of 2016. Value investing has more recently been the exception rather than the rule.

An influencing interest

The main reason for this anomaly has been quantitative easing and negative interest rates. Since Shinzo Abe came into power, there has been a link between falling interest rates and the poor performance of value stocks. Abenomics also drove renewed focus on return on capital employed, improving the performance of growth companies. 

The negative interest rate policy, introduced in January 2016, had two effects, one intended and the other not. As planned, bond yields were driven down but, unintentionally, it was suggested that monetary policy had reached its limits.

The negative interest rates policy also put pressure on the domestic banking system. The sector lost a quarter of its value relative to the rest of the stock market in six months.

The financials sector had its own crisis between 1998 and 2003. Japanese banks were in bad shape, comparable to Italy today. The sector then rallied as the banks repaired their balance sheets but were badly hit by the financial crisis. They suffered again because of the negative interest rate policy.

Japanese banks are rated much lower than many global banks, even though they are well capitalised and very profitable. The sector rallied from early 2016 lows after the Bank of Japan adjusted its negative interest rate policy to target 0% for 10-year bonds. However, there is still scope for further rerating as interest rates seem to have bottomed in Japan.

Negative interest rates created some opportunities for value investors but they had to wait for the style to pay back. It finally did in the middle of 2016 when the Bank of Japan adjusted its interest rates, leading to a rebound in cyclicals and financials.

Yen games

You cannot talk about Japan without mentioning the currency. The yen plays an important role in investment returns. Because the country is a major exporter, a strong yen is bad for company profits and therefore tends to lead to a weaker stock market and vice versa. In the last six months of 2016, UK investors could have had a double whammy of investment returns from Japan. The yen had been strong just as the pound weakened following the Brexit decision. The returns you got from Japan in the latter half of 2016 varied significantly depending on whether you had hedged your currency or not.

Most managers in the sector do not try to predict which way the currency will go in Japan. However, the Bank of Japan seems intent on weakening the currency from its recent highs through its target of 0% interest rate on 10-year bonds.

It is likely that the zero-yield policy will be kept in place until CPI inflation overshoots its 2% target, taking it to the summer of 2018 at least.

A clear divide

Funds in Japan are often clearly separated into value or growth, as well as by capitalisation. In the past three years it has been mid- and smaller-companies funds that have delivered some strong returns for investors. 

 

Part of the Bonhill Group.