However, the reform-minded policies of prime minister Shinzō Abe – who was re-elected in September – have helped restore confidence in the country, encouraging investors to return in droves. In the six years since Abe took office, the Nikkei 225 has risen by more than 140%.
This year, 10 Japanese equity funds have been launched for pan-European investors, according to FE Analytics.
“There has been a growing interest in Japanese equities,” says Richard Kaye, who runs the Comgest Growth Japan equities fund. “Profit growth at Japanese corporates has been among the highest in the world in recent years, driven by both domestic and international investment. The market has taken a new direction.”
Nomura Asset Management’s senior investment officer Yuichi Murao says there were times during “the lost decades” that followed the 1991 crash when he thought the market would never recover.
“Over the past five years, share prices have doubled and earnings have doubled, on the back of bottom-up approaches by Japanese corporations.”
The country’s GDP growth rate remains modest – economic expansion in Q2 was 0.7% – but Murao says the country’s “potential growth rate” was on the rise on the back of a surge in the number of people in the workforce, boosted by a rise in immigration.
It is reported that as many as 340,000 foreign workers could enter Japan during the next five years if a planned amendment to the immigration control law is passed by the Japanese parliament.
Moreover, female participation in the workforce had risen massively, in addition to retired people returning to the labour market, on the back of various government initiatives, according to Murao. Wage growth in Japan hit a 21-year high this year and the unemployment rate fell to 2.3% in September.
A new dawn?
The shift from ‘old’ to ‘new’ Japan has been driven by investment in companies that focus on core business strengths and profit growth, says Comgest’s Kaye.
The government of prime minister Abe, which came to power in 2012, has boosted shareholder rights through its stewardship and governance code, encouraging shareholder involvement. “Companies that increased shareholder engagement now have more skin in the game,” says Kaye.
Another significant societal shift has been the increase in women and foreigners in the workforce. This year, the country eased immigration restrictions in a bid to tackle labour shortages.
The Japanese macroeconomic picture – the economy is only 2.2% bigger in real terms than when Abe came to power – is only half the picture, says Nomura’s Murao.
“Over the past five years, share prices have doubled and earnings have doubled, on the back of bottom-up approaches by Japanese corporations,” he says. “What’s happening on the macro level and in the corporate sector are totally different.”
W&W Asset Management head of fund of funds portfolio management Carsten Riester says renewed optimism under Abe encouraged him to almost double (from 7-13%) his benchmark’s investment in Japanese equities.
“There is a huge underweight overall to Japanese equities as most institutional investors are committed to US, European equities and some emerging markets. But when it comes to Japan, they still remember the long track record where Japanese equities underperformed,” he says.
“Since institutional investors don’t really focus on Japan we like to go deeper into the asset class as we don’t want to be a consensus investor – we try to be contrarian, especially when it comes to liquidity flows.”
Riester adds that there has been a noticeable shift in Japanese companies’ appreciation of shareholder rights, which has translated into higher profitability and greater return on equity.
Supporting Riester’s claim that there has been an underweight in the asset class, pan-European fund selector sentiment towards Japanese equities dropped into marginally negative territory in Q3, following a downward trajectory since the start of 2018, according to Last Word Research.
Source: Last Word Research
During Q3, 12% of European fund selectors said they were looking to increase their Japanese equities allocations over the 12 months to September 2019. A further 52% said they planned to hold their allocations, 15% to decrease and 21% did not use the asset class.
Source: Last Word Research
The asset class is 22nd out of 26 in terms of popularity. However, Dutch selectors were the most positive towards Japanese equities, placing them 11th, while the Swiss were the most negative and had them in 24th place.
“With investment sentiment peaking in December 2017, Japanese equities enjoyed a great start to the year attracting flows of €5bn in the first two months,” the research said. “Average sentiment has been on a downward slope ever since and is now marginally negative. We have witnessed some money go out of the asset class and believe there is potential for more outflows.”
According to Morningstar, for the year to September 2018, the asset class experienced flows of €6.5bn.
However, fund manager sentiment has been consistently high over the past three years, according to Quilter data.
In terms of fund selection, appealing investments can be found in technology plays, related to the internet of things, automation and robotics, says Riester. Moreover, Japan’s biotech space is developing fast on the back of government support, according to Kaye.
Investments that exploit rising Asian consumer demand for Japanese products are also worth a look, adds Kaye. “A lot of Asian consumers from mainland China, Hong Kong, Thailand and Korea find many aspects of Japan culture desirable. We call it the ‘cool Japan play’.
“If you look at consumption of Japanese manga, apparel, pop music and cosmetics, it’s clear that Japan is an icon for youth culture in Asia, and that translates into equity investments,” he says. “There are seven times more Asian consumers that grew up in the same income band as your average middle-class Japanese consumer… and those Asian consumers want to buy Japanese goods.”
Co-operative credit bank Caja de Ingenieros fund selector, Sergi Biosca, says he has tactically changed from euro-hedged investments to non-hedged investments, in a bid to increase his yen exposure.
“The Japanese currency is historically cheap and has revalorisation potential, and in case of a market slowdown the yen would appreciate and act as a hedge,” Biosca says. “We did this to increase portfolio diversification and reduce risk.”
Currency volatility can create short-term noise for the market and individual stocks, notes Kaye.
Ultra-loose monetary policy has been a hallmark of ‘Abenomics’, the prime minister’s programme aimed at rebooting the country’s economy.
The Bank of Japan kept monetary policy steady in its October meeting – short-term interest rates at -0.1% and long-term rates at about 0% – and indicated it was in no rush to reduce its fiscal stimulus programme.
However, Kaye adds he is not too concerned about the policy of ultra-low interest rates. “Not all companies are affected in the same way [by the policy] and fundamental changes are going on in society that have nothing to do with interest rates.”
He says a much more pressing consideration is that Japanese society is changing, led by technological shifts and a larger workforce. “It’s far more important to focus on companies that are geared towards those societal changes,” according to Kaye.
Risks on the horizon
The strength of the Japanese stock market is, of course, highly correlated to the global economy and risks emanating from the US-China trade spat, and concerns that global growth may have peaked could affect investor sentiment and corporate profitability in the near term, Biosca warns.
He says: “A worst-case scenario would be the imposition of tariffs on imports of Japanese vehicles and automotive parts by the Trump administration. This would have a considerable impact on the economy.”
Japanese equity funds to watch
Two Japanese equity funds Riester likes are Swisscanto’s Equity Fund Small and Mid Cap Japan, and Parvest’s Equity Japan Small Cap.
The funds returned 42.7% and 46.2%, respectively, over the three years to 31 October 2018, according to FE Analytics. Both funds have beaten the sector average (16.5%) and their respective benchmarks, Topix Mid-400 (14.95%) and Russell Nomura Small Cap (29.1%) over the same time period.
Carsten Riester’s Japanese equity fund picks v sector and benchmarks
Riester adds he likes the Swisscanto fund as it’s run by Japanese Sparx Asset Management – local people who speak Japanese and “understand the Japanese mentality”.
The fund’s largest sector weight is industrials at 43.2%, information technology at 20.6%, consumer discretionary at 15.9%, commodities at 6.3% and healthcare at 4%.
Consumer discretionary is the largest sector weighting for the Parvest fund at 20.5%, followed by producer durables (19.7%), technology (17.5%), materials and processioning (13.4%), and financial services (7.4%).