A perplexing market

In 1853 a small fleet of five black US navy ships led by USS Powhatan and commanded by Commodore Matthew Perry, anchored at Tokyo Bay and opened up Japan to international trade after 250 years of isolation. A combination of diplomatic finesse backed up by gunboats had transformed the attitudes of the entrenched ruling class.
Today, after almost 15 years of Japanese stockmarkets languishing in the doldrums, many investors are seeing real change, driven again by intervention from outside. “Foreigners and real investors have replaced the ‘stable’ shareholders and this has focused Japanese management on shareholder value because there is a possibility that if they don’t focus on their business, they could be taken out,” according to Keith Donaldson, director of Japanese equities at Martin Currie in Edinburgh.
Japan is a perplexing market for investment. During the Japanese bubble years of the 1980s, the astronomical P/E ratios of the market were justified on the basis that Japan was ‘different’ to other markets. The bank-dominated capitalism built around the intertwined cross-shareholdings of the large Keiretsus that dominated the post-war Japanese economy had produced the world’s largest economy after the US. Built on the success of the four large pre-war Zaibatsus – Mitsubishi, Mitsui, Sumitomo and Yasuda – they were the engines of Japanese economy. The closest parallel to this was the bank-dominated post-war economy of Germany, and both seemed to indicate an alternative model to the shareholder-dominated approach of the Anglo-Saxon economies.
However, the recent years of deflation, a stagnant economy and faltering stock market have tried the patience of most investors who have been faced with a number of false dawns.
There might now be scope for more optimism, according to Donaldson: “We have been in the market a long time so we have been sceptical about the developments. But since 2003 we have become more positive on the changes and much more positive on relative valuations.”
Two fundamental developments have been the unwinding of cross-shareholdings by banks and the increased emphasis on shareholders. The catalyst has been the collapse of the banking sector, driven by the huge extent of bad loans. The last five years have finally seen the Japanese banks making provisions for their
bad loans and the environment for the banking sector has changed dramatically during the last couple of years.
The 20 major banks of 10 years ago have now consolidated to three or four. Foreign investors now account for almost 25% of the stock market, driving profound changes in the attitude of management to shareholders. However, the Keiretsu cross-shareholdings still account for 25% of the market and stable or acquiescent shareholders account for a large proportion of the rest, enabling value-destroying transactions to still take place within the Keiretsu groups, such as Mitsubishi Heavy’s purchase of shares in Mitsubishi Motors earlier this year. Dividend yields of 1%, which, even combined with share buy-backs giving a total yield of around 2%, are still seen as giving a low payout ratio of 20% compared with other markets.

The Japanese corporate structure is changing with Sony, for example, replacing its chairman and chief executive as well as other board members after poor performance and even going so far as to emulate Nissan Motors in choosing a gaijin as CEO, with Howard Stringer the former head of Sony’s US operations who cut around $700m (e1bn) a year in overheads from Sony’s US business.
Whether he will match the success of Carlos Ghosn, who is credited with the dramatic turn around of Nissan Motor Company, remains to be seen but in facing up to the numerous challenges facing Sony, the requirement to keep his shareholders happy must be near the top of his agenda.
Eric Huizing of the Ahold pension scheme in the Netherlands is one of the advocates of increased investment in Japan. “The reasons why we would want to increase exposure to Japan are quite clear. The macro-economic scenario, with Japan coming out of a deflation scenario, growth is quite limited compared to the US, but not with Europe. On the corporate side we have seen important changes like a focus on cash flows and a restructuring of balance sheets. Production is being moved overseas and companies are able to profit from the economic growth seen in China and other parts of Asia. Companies that are export-oriented are benefiting.”
According to Mark Roxburgh at Nomura Asset Management, “2003 was an important psychological turning point because returns from the Japanese market were so high, about 45%. 2004 was a positive year as well, returning about 8%. This focused a lot of institutional minds on their Japanese weighting levels; they were reminded that the Japanese market is a higher alpha than the US or Europe.”

For European schemes such as Ahold’s, increased weighting in Japan is also part of a broader move towards more international investment. Huizing explains: “When I joined in the beginning of 2000, almost everything was invested in the Netherlands. We decided to move towards a more international approach. The introduction of the euro made it easier. The board had to make the decision on what percentage to invest abroad. They decided 75% in Europe and 25% outside, with 12.5% in US and 7.5% in Pacific including Japan and 5% in emerging markets. There is still a home bias but the original Dutch orientation has become more international.”
Moving forward, he wants “to increase the exposure to the region including Japan” and “discuss with my board a higher weighting for the Pacific, which is more in line with the weighting in the MSCI World Index”.
Russell Investment Group, which runs multi-manager Japanese equity funds using a stable comprising Societe Generale Asset Management (SGAM), Taiko Daido Asset Management (TDK), BGI, Martin Currie and JP Morgan Fleming (JPMF), does not take a view on the market as a whole. According to Christophe Caspar, portfolio manager for all Russell’s Japan equity funds, their “managers are poised for a cyclical and structural upturn”. The summary view is that “absolute valuations are at a historical low. The P/E ratio at 17, is the lowest for 20 years and price/book is below the 30-year average. Japan is at the lower end of the average price/book compared to the US during the last 30 years.”
While there has been some negative press recently, and figures for the last two quarters have been weak, looking forward, “the Bank of Japan’s TANKAN survey is close to a 13-year high, although the optimism of the corporate sector has not been transferred to the consumer”.
Donaldson points out: “If you look at the actual valuations of the market, Japan trades on our figures at about the same P/E as the US and European markets. Yet it is on a return
on equity of just under 10% against 17-18% in the US and 15% in Europe. So you can see the possibilities. As restructuring goes forward and profitability improves Japan should move to a higher valuation. In addition, the market is back down to valuation levels seen in Japan in the 1970s. So it has gone all the way up and all the way down and it looks attractive relative to the other markets.”
Roxburgh also has the view that “prospects for the Japanese market look very good in the long term”, although he qualifies that by adding that they are “not so great in the next six months”. The key positives as he sees it are: the non-performing loan overhang will have passed in six months ($1trn of bank debt will have been written off); an uptick in new bank loans; improving economic conditions with falling unemployment, and a positive CPI figure is expected in 2006; return on equity at an all time high, and much improved corporate profitability; a great deal of corporate restructuring has taken place over the last five years; an Asian domestic market which has been developing in recent years which could take up the slack if the US market slows; international investors are now buyers of significant amounts of Japanese equities; and, finally, the fact that shareholder value has risen up the priority list of Japanese companies.
Given the large amount of restructuring taking place in Japan, it is not surprising that, as Donaldson says, “the private equity sector is increasing in size, quite dramatically really. There are private equity funds, which use a slightly different methodology when extracting value. In Japan there are a number of deep value companies where market value is less than assets. You might have net cash on the balance sheets as well. A number of the private equity companies have bought stakes in these companies, trying to force them to make changes. US firms like Ripplewood have been very successful and encouraged domestic private equity companies to try and make management changes.
“Other firms have been trying to push managements to make changes by taking stakes and applying pressure. They might not have been completely successful but they have encouraged managements of companies trading on significant discounts to focus on shareholder value.”
Despite having one of the largest equity markets in the world, accounting for around 10% of global market capitalisation, the lack of a shareholder focused culture does give rise to inefficiencies that can be exploited by institutional fund managers. According to Roxburgh: “Nomura’s research shows that the Japanese market produces an excess return of 2-3% against around 1.5% in the US. We believe that these results show that a good active manager can add value.”
Russell’s Caspar agrees that “active management did do well in the 1990s when the median manager within the Japan specialists beat the Topix till 1998”. However, he goes on to point out that “from 1998/99 the median manager is only just at the benchmark for the five-year track record. The market is becoming more efficient. It was a one-way bet in the 1990s. Banks were underperforming and exporters outperformed”.
Despite this he does see Japan as “a market where stock picking can do well – it has more inefficiencies than other markets. For example, cross-shareholdings need to be unwound and managers do well by avoiding these.”

The move towards a shareholder focus is also still new to the Japanese markets. “In the US, earnings revisions are factored in within seconds, in Japan, it takes a few weeks, or never. It is not a focus. The market has been moving from an irrational market to a more rational market over the last 10-15 years.” As “a very large proportion of Topix is not covered by any broker” according to Caspar, “if you can get information, it will be important for shareholders”.
Russell monitors 200 managers in the Japan universe, three-quarters of these are based in Japan, with a large proportion of the rest based in the UK, with some also in the US and
the rest of Europe. Of the current line-up in their multi-manager fund, three of the five firms are Japan-based, and Russell has 19 firms in total on its buy-list. For Russell, a key element is manager-specific risk. “Some managers don’t always deliver what they say they will. You need to go back to fundamentals – is the process still good, has the wind blown in their face, or has the process been degraded?”
The emphasis on choosing companies that have a shareholder focus is something that a number of fund managers see as essential. Donaldson for example, states that as part of Martin Curries own process: “We look at which companies have the desire or ability to reward shareholders. This is relatively new in Japan. In the past companies didn’t care much about shareholders because their shares were held by banks and insurance companies, who were ‘stable investors’. But now that foreigners and pension funds are large shareholders there is more pressure on Japanese companies to become more shareholder friendly.”
BGI manages Japanese equities actively using its global equity methodology. For the Russell multi-manager fund, it uses the MSCI Japan index with almost 350 stocks and a large cap bias, which may make the selection of undervalued and shareholder focused companies more straightforward in a completely quantitative process.
Other managers such as Nomura, while using quantitative techniques to screen the universe use “a variety of predominantly value-oriented criteria to make an initial assessment of the relative attractiveness of stocks”. According to Roxburgh, this is combined “with detailed fundamental analysis and research with 80% conducted in-house, including 3,900 company visits in 2002”.
Gaining any insights from meetings with management is always a somewhat haphazard and controversial process and can depend very much on the level of access that a fund manager can have. For Martin Currie, the critical issues that can be discussed at a meeting with Japanese management are: the positioning of the company within its marketplace; the use of cash flow, particularly whether excess cash flow is used to pay dividends or for share buy-backs, and the competitive landscape and areas for future growth.

The Scottish managers such as Martin Currie pride themselves on the fact that their very distance from Japan can mean that they can get the best of both worlds, by sending staff regularly to Japan for visits but also benefiting from who they are able to see in Edinburgh. Donaldson points out that “about 350 companies come and see us here each year. Crucially, when these companies come on a roadshow they bring the CEO or CFO, so you see someone who is very senior, whereas in Japan it is much harder to see senior people.”
Interestingly, the Scottish link with Japan goes much deeper, with the ‘Scottish Samurai’, Thomas Glover, credited with helping to set up Mitsubishi and contributing heavily to the industrialisation of Japan in the 19th century.
Many investors are convinced that prospects for the Japanese market are the best for a decade or more. If structural change and lower valuations are the primary reasons for this confidence, perhaps potential investors should consider not just their relative weighting to listed Japanese equities but also exposure to the private equity market in Japan, which is proving to be at the forefront of many of the developments.