Japan, the economy and stock market that investors love to hate, is once again seeing renewed interest from Western investors. After 25 years of fits and starts, growth in earnings and GDP have exceeded expectations this year. Second quarter annualized GDP growth came in at a surprising 4% compared to forecasts of 2.5%. Many investors who had written off Abenomics as a failure (the Japanese version of easy money as directed by Prime Minister Shinzo Abe) are starting to reconsider their position. While we are encouraged by the positive economic news, we believe the improvement in the Japanese economy is only a small part of the case for Japanese equities. Our view is based upon a number of more subtle changes that are likely to benefit Japanese shareholders in the future.
In June, our equity research team embarked on a project focused on the Japanese stock market. We found a number of interesting trends supporting a positive view toward Japanese equities, including inefficient and under-researched markets, a general disdain for Japanese stocks based upon past disappointments, improving corporate governance practices, and the rising wealth of the Asian consumer.
In our view, the combination of these trends presents significant opportunities for active managers to construct concentrated portfolios of global-facing companies with shareholder-friendly management teams. These companies, which increasingly export to China and emerging Asia, just happen to be based in the highly inefficient equity markets of Japan.
At the outset of our Japan research, we found ourselves evaluating the prospects of the Japanese economy and Abenomics. The prospects for the Japanese economy are important when considering an allocation to Japan, but the opportunity we were evaluating was the replacement of market-tracking index funds with a concentrated, actively managed portfolio. After some time, we realized opportunities in Japan are centred on market inefficiency, positive trends in corporate governance, and increasing commerce with emerging Asia.
As a result of dwindling investor interest, analyst coverage in Japanese stock markets is exceedingly thin. As of June 2017, 64% of Japanese companies are covered by one analyst or no analyst at all. In other parts of the developed markets (The US and Europe), less than 10% of publicly-traded stocks get such limited attention. Almost 40% of companies in those markets have eleven or more analysts covering their shares. By contrast, only 10% of public companies in Japan receive that much coverage. Less analyst coverage means more opportunity for those managers willing to do their own intensive research.
The difficulty of the language and insularity of Japanese culture, especially business culture, also contribute to the high return potential from stock picking. These characteristics make it more difficult for foreign hedge funds and traders to identify and arbitrage market inefficiencies. As a result, we focused our search on country-specific Japan funds as opposed to those with broader international mandates.
Japan is experiencing a slow and steady revolution in corporate governance and shareholder returns-based management. Companies listed on the Tokyo Stock Exchange returned a record of 17.7 trillion yen to shareholders during the fiscal year ending March 2017, according to Goldman Sachs. That number represents an increase of 3.4% from the year before, after rising over 20% during each of the previous two fiscal years. Nonetheless, the speed and scale of this revolution are inconsistent across the market. Active management is crucial in order to identify those companies truly committed to enhancing shareholder value. A focus on quality management teams when picking stocks should, therefore, provide a significant boon to a concentrated portfolio relative to the index.
Japan is in a strong position to benefit from rising wealth across the region. Until recently, the quintessential high quality Japanese products (think Shimano bike parts and Japanese diapers) have been unaffordable for much of the population of emerging markets across Asia. The explosion of the middle-class consumer segment in Asia can only be a net positive for Japanese exporters. Again, active management is necessary to take full advantage of this trend by selecting well-managed, export-oriented Japanese companies focused on these emerging trends.
While active management is not the best choice in many asset classes and geographic regions, we believe that active management is poised to significantly outperform in Japan over the coming years. With appropriate research, we believe that investors will benefit by finding those managers poised to capitalize on these trends.
As featured in Family Office Magazine, Autumn 17
Andrew joined in 2016 from Brown Brothers Harriman where he worked in Fund Accounting Services, generating net asset values for large mutual funds and resolving issues related to derivatives pricing, capital stock transactions, and manager performance fees. Previously, Andrew was an associate at PwC in their Risk Assurance practice where he audited investment industry clients’ internal control and regulatory frameworks. Andrew graduated with a B.A. in Economics from Colorado College, where his senior thesis analyzed incentive structures surrounding public company boards of directors in relation to takeovers and acquisitions. He spent his junior year at the London School of Economics & Political Science studying Finance and Accounting. Andrew passed the CFA level III exam in 2016. Learn more about Andrew Hacker.