Japanese equities, in particular, appear to be priced attractively compared to other developed market stocks, and should hold up well against any blips or turbulence similar to what we experienced earlier in the year.
Source: GS Quantum, Factset, GS Global ECS Research calculations. As at 18 January 2018
Notes: Japanese universe is TSE1. US universe is S&P500. European universe is GS covered firms which are part of Euro Stoxx 600 (excluding financials). EV/Sales and EV/EBITDA excludes financials. P/E for US is based on GS Global ECS Research operating EPS forecasts, and P/E for Europe is on a pre-amortization basis. Asia excluding Japan universe is MSCI US$ basis market index (local currency) and is based on FactSet and I/B/E/S estimates. Please note the above is based on forecasts, not real data.
Taking a 12-month view, we expect Japanese equities to do well. In our view, January’s corrections should then have provided a good entry point for those who weren’t exposed to the stock market, and were looking for a good time to start.
Picking and choosing
As an active investor, we tend to look at individual stocks and judge them on their own merits. However, we do occasionally identify interesting thematic ideas.
For example, we took an overweight position in Japanese banks. As far as we know, we were one of a few managers to take a meaningful overweight position in the area.
As an active investor, we tend to look at individual stocks and judge them on their own merits."
The prevailing notion then was that lending margins for Japanese banks would continue to languish, but we believed that an inflationary environment could end this trend and cause margins to increase as financial market discounts inflation expectation.
Additionally, we believed that Japanese banks would be able to easily meet upcoming minimum capital requirements set by the Bank of International Settlements. Our expectation was that this would likely result in these banks returning capital to their investors via dividends or a share buyback.
Japanese stocks are already priced quite attractively, with many trading on 9 to 10 times price earnings ratio. We believe higher prices, attractive valuations, together with expectations for a reasonable dividend payout, makes Japanese banks a sector worthy of consideration.
Beyond the thematic, we are, at heart, an active investor. As such, we mainly focus on individual stocks and judge them on their own merits. For our strategy, we also try to seek value in transformational changes because they are idiosyncratic in nature and are only gradually discounted in share price.
For instance, we previously took a position in a HR and marketing service company . The company had realised early on that its traditional business model was under threat by transactions being moved online. In response, it invested in a US internet start-up in 2012.
We realised then that the competitiveness of this business model was not well-understood by the market. The company subsequently experienced outsized topline growth which saw the market reassess the stock and eventually its value more than doubled.
The key point to note is that almost all the growth was derived from the market understanding of the acquired business’ value. The acquisition was indeed the transformational deal for this company.
The big payback
Indeed, recent times have seen a marked improvement in the way Japanese companies treat their shareholders. Part of the reason for this is how reform ushered in by Abenomics saw vast amounts of public funds being plowed into corporates via ETF buying by the Bank of Japan and the national pension fund. Compared to pre-Abenomic periods, much of the capital currently flowing within the Nikkei and TOPIX now comprise public funds, hence government involvement in pushing for better corporate governance among Japanese companies.
Among the benefits of this have been vastly improved levels of corporate governance among Japanese companies.
According to edition 17 of the Janus Henderson Global Dividend Index, which tracks dividend payout trends among global corporates, Japanese dividends paid in the entire 2017 rose 8.1% to $70.0bn, an increase of 11.8% on an underlying basis once the weaker yen was factored in.
We expect these trends to continue broadly into 2018 and beyond. Generally speaking, we expect the improving relationship between Japanese corporates and investors, set in motion by Abenomics, will continue to take place in spite of any leadership change since the policies have been working well thus far.
Currency risk cuts both ways
In terms of risk, a shock in the currency movement, where there is a steep appreciation of the yen, could hurt exporters and disrupt the Japanese market’s momentum. However, the scenario would be positive for domestic business franchises such as Japanese banks as market seems to have undervalued cashflow sourced domestically. In the end, this comes back to the BOJ and its policies. They clearly monitor the exchange rate when considering monetary policy. We think the possibility of that particular risk scenario is lower now than when compared to previous times, although government instability may cause some uncertainty with regards to monetary policy and exchange rate controls.
We don’t expect a rapidly rising market like the fourth quarter of 2017 or more of what we experienced in January 2018. In that scenario, the market was willing to pay anything for thematic growth, thus, factors like strong fundamentals, management quality or valuation were not being considered.
Since then, we believe discipline has returned to the market and paying attention to very important factors like management quality, valuations, would be important.
We are expecting 10-15% in index performance from Japan, which is slightly better than our expectations from other global markets. As we alluded to earlier, this is because there is a valuation gap between Japan and other developed markets, and there is room to catch up.
In summary, Japan has the potential to outperform other markets, but one shouldn’t expect drastic levels of returns similar to what was experienced in early January, rather, more modest numbers are reasonable to expect.
Stock selection will be key as is attention to valuation and the management quality of companies. Based on these criteria, we will endeavour to deliver a decent return on assets for our clients.
1. Bloomberg, March 2018
2. Janus Henderson Investors, as at December 2017