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Special Report

ESG: The metrics jigsaw



The DPJ’s election victory puts Japan back in the spotlight. Martin Steward asks, is it a sleeping Asian dragon - or just a dinosaur?

Foreign investors look at Japan’s equity market in the same way children look at broccoli - they know it’s full of good things, but they can’t help turning their noses up at it.
Let’s list all those vitamins and minerals. After 15 years struggling against a feckless political elite and horrible macroeconomics, Japan’s blue chips are among the leanest and meanest in the world. Fixed costs have been hacked - the country’s workforce is 25% part-time or contract-based - and bitter experience meant Japan’s firms started the fiscal year planning for continued economic decline, setting them up nicely for eeconomic recovery. Return on equity is about 8% - doubling since the mid-1990s while companies have been de-leveraging: they embrace the coming upturn with pristine balance sheets.

Furthermore, Japan may be pro-cyclical, but it no longer relies on the sick men of the OECD to pull it along. Toyota has an impressive 20% of the US ‘cash for clunkers’ programme (knocking GM into second place), but it is more important to note that more than half of Japan’s exports now head into Asia.

“Everyone wants to buy Asia, but show them Japan and it’s: ‘Well, maybe next week’,” notes Michael Amsellem, portfolio manager at Lombard Odier. “But Japan is at the heart of Asia!”

Chris Taylor at Neptune Investment Management agrees: “They are all over the non-OECD markets,” he says. “Everyone thinks Suzuki makes motorbikes - well, it does, but it also owns more than half of Maruti, the car manufacturer with 70-80% of the Indian market.”

In many ways the West’s gateway to the Asia-growth story, Japan leads in precision manufacturing - infrastructure machinery, clean energy, and so on - that can feed off the region’s growing capital investment. A company like Komatsu maintains pricing power into emerging Asia by competing on quality: Chinese machines conk out after six months; Korean versions might make it to 36; but Komatsu’s can be worked 24/7 for years on end.

Finally, there are the valuations. Despite rising 12.8% for the year to the end of August, the TOPIX still lags other pro-cyclical markets. Average price-to-book ratio is just 1.3, close to a 40-year low; while a dividend yield of around 2% looks good next to the 1.32% on the 10-year JGB. Despite all this, foreign investors always seem to need a big rally, or a big story, before allocating to Japan.

Political change
The Democratic Party of Japan (DPJ) dumping the Liberal Democratic Party (LDP) out of power for the first time in five decades is certainly a big story for the Japanese. Outsiders maintain some scepticism, pointing to policy similarities and the fact that half the DPJ are LDP defectors. But if the DPJ eventually wrests control of both houses of the Diet there is hope that it can take on the all-powerful bureaucracy, which has thrived by playing both houses against one another and is widely blamed for stifling economic progress. Critics point to practices like amakudari, literally ‘descent from heaven’, whereby retiring bureaucrats are rewarded with executive positions in companies they had previously overseen.

“It is little exaggeration to say that this has a parallel with the fall of the Berlin Wall,” claims Stephen Church, an analyst at Japaninvest with a reputation for the quality of his official contacts. “The bureaucracy includes good people stuck in a frightful system, some parts of which date back to 1716, and the LDP is incapable of dealing with that historical baggage. But a story doing the rounds in the tabloids at the moment is that young bureaucrats are having difficulty finding wives because the outlook for tax benefits, amakudari and all the rest of it look so bleak.”

So much for the marriage market, but is this going to affect the equity market? What could any government offer global titans like Sony, Nintendo, Toyota, Fujitsu or Trend Micro? Add all their suppliers and it’s evident that a big chunk of the market is already doing perfectly well, thank you very much.

“I’m afraid to say that the election will be of no significance at all for investors,” says Paul Chesson, portfolio manager with Invesco Perpetual. Yuichi Chiguchi, senior portfolio manager with DIAM, agrees: “Exporters like Honda and Toyota have the experience to develop their businesses outside Japan, so their attractiveness remains the same even if we have political change.” Still, he does point to the DPJ’s key policy package for green technology as a source of potential progress, a theme picked up by Hirofumi Kasai, CIO for Japanese equities at Tokio Marine Asset Management: “Toyota invested a huge amount into technology - and that’s why Japan has led the world in that sector. But other countries have been investing, too, and are catching up with our standards. So now a national policy to promote the development of these technological standards can make a difference in most sections of the strategically important technology industries.”

At the very least, the DPJ is not actively hostile to the idea that Japan should be competing with the US and Germany to sell high-spec products into emerging markets. By contrast, the Ministry of Economy, Trade and Industry (METI) under the LDP was more concerned about competing with China and Taiwan to export to the West; a commitment to low-end manufacturing is partly to blame for Japan’s long-depressed wages and the consequent crippling of domestic demand.

The domestic economy is the real focus of the DPJ’s manifesto: stimulating consumption and righting out-of-kilter demographics. Highway tolls will be scrapped; subsidies are pledged for agriculture and for installing solar power in homes; pension reform and a rise in the minimum wage are mooted; and ¥26,000 (€200) will go to each child under 12 months old and ¥20,000 (€150) to each new birth, with free education and healthcare.
“This will represent a pretty big change,” insists Erina Jindai, client portfolio manager with JPMorgan Asset Management. “Ask parents why they don’t have more than one child and they all tell you it’s about cost.”

Those buying the domestic stimulus story pick out three main areas that would benefit: baby and childcare (companies like Benesse, Tokyo Individualized Educational Institute, Takara Tomy); healthcare and age-related (Nichii Gakkan, Message Co); and green technology (Japan Wind Development, Toshiba, Japan Steel Works). But this will not be easy to play, as many domestic-growth stocks are small or unlisted, and much of the anticipated benefit from a DPJ regime is already priced in on the exchanges.

Moreover, Peter might get robbed to pay Paul. A minimum wage and a move away from flexible employment could undermine much of the corporates’ recent progress, and exporters could suffer from the new regime’s implicit willingness to let the yen ‘correct’ upwards.

Japan’s finances could put the brakes on the whole DPJ project anyway. The new government wants to find ¥20trn (€150bn), but the budget deficit is 10% of GDP and the government debt-to-GDP ratio is 180%. Its funding plan is a typical pre-election catalogue of cuts to “waste” and realisation of “hidden treasures” like Bank of Japan reserves and state assets.

“To win this election, the DPJ had to appeal to voters,” says Daisuke Ishihara, a portfolio specialist with Chuo Mitsui Asset Management. “In the future, however, they’ll have to think seriously about raising taxes.”

Neither party fancies that as long as consumer demand remains so muted but it would be foolish to rule it out forever, particularly if the DPJ manages to take the upper house next year.

“Most Japanese, including us, have expectations for a breakthrough in spending methodology with the bureaucrats,” says Chiguchi at DIAM.

Alpha or beta?
These issues are fundamental to asset allocation. The current, pro-cyclical market looks terrific for a tactical allocation, but few would hold it strategically. The widely-perceived lack of alpha opportunity compounds this problem.

“The pool of managers who can outperform consistently is relatively small,” says Nizam Hamid, head of sales strategy for ETF giant iShares. “Over the past 12 months active Japan managers as a group have underperformed [MSCI Japan] by just under 300bps. The peak year for outperformance was 2005, but even then only 40% of managers outperformed the benchmark. With other benchmarks you really get a spike in peak years, with more than 50% outperforming.”

One active manager, Ignis Asset Management, shifted its (small) Japan fund to a sub-contracted indexed solution in July, partly out of belief that consistent outperformance is tough for European managers. Nonetheless, performance dispersion between the best and worst Japan funds looks similar to that between the best and worst US large-caps or emerging markets funds. Consistent outperformance can be had, but much of it appears to come from ‘smart beta’ plays.

“Over the last 10 years the most difficult thing to manage in Japan has been sector rotation,” says Lombard Odier’s Amsellem. “It turns very, very quickly. If locals are buying, small and mid-caps do better. When the foreigners finally get interested, the large-caps improve. And if the yen weakens, foreigners often buy any exporter; when it strengthens, they sell them all again.”

“This opportunity is not just about loading up on beta,” says Chesson at Invesco Perpetual. But like many of his peers his relative-value judgments work out at sector level. He notes that he can still buy car-assembly firms at the same price as blast-furnace steel companies. “You might expect a deep cyclical business like steel to have very high earnings in a recovery and therefore high beta, but you have to weigh that against paying zero premium for manufacturers who are adding value, and knowing that high fixed-cost sectors, like steel, need a certain ‘break-even’ degree of recovery, while those with lower fixed costs will be able to cut their cloth to the level of business as it evolves. At the moment I want to invest in high-quality businesses with strong balance sheets and global brands.”

Those sound like stock-specific criteria, but they can equally translate into overweights in ‘global leaders’ in electronics and autos and underweights in commodity cyclicals. Going any deeper than that to release value is not impossible. For example, Peng Tang at Lombard Odier, picks out Elpida Memory against its DRAM competitors thanks to its strategic partnership with a Taiwanese producer, potentially locking in two sets of government subsidy; while Neil Edwards, co-manager of GLG’s strictly value-based, contrarian Japan CoreAlpha Fund, compares NTT DoCoMo (P/B 1.4, yielding 3.6%) and KDDI (1.3 and 2.0%) with their peer, Softbank, whose P/B of 6.0 and yields at 0.2% “we wouldn’t touch with the proverbial”. But in general, 15 years of Darwinian selection have resulted in brutally efficient large-caps competing in highly-specialised industries.

“Frankly, most people who think they get the nitty-gritty of Japanese companies are kidding themselves,” Edwards insists. “Unless you know physics or chemistry to a fairly high level you can’t truly understand these businesses.”

However (and this is where the DPJ’s anti-cyclical, Asia-friendly economic policies could provide some leverage for strategic allocators to Japan) the picture is different among traditionally domestically-focused industries.

“In consumer goods, healthcare and agriculture there is still a lot of room for restructuring, potential for de-regulation, and a lot of potential consolidation,” says Jindai.
Of particular interest are those firms that want to take their place alongside Japan’s big boys, selling into growing Asian markets.

“There’s a company called AceCook that has 40% market share in noodles in Vietnam,” says Amsellem. “It’s not just the big multinationals selling into emerging Asia, and that’s something new.” At the moment, everyone is talking about the proposed merger between arch-rival brewers Kirin and Suntory. “That’s not to tackle the Japanese market, it’s to tackle the Asian market,” says Amsellem. “We see more and more of that.”

Kasai at Tokio Marine picks out beauty products manufacturer Shiseido as a firm with a strategic eye on new Asian spending. Similarly, Daisuke at Chuo Mitsui contrasts Uni-Charm, which sells 23% (and rising) of its sanitary towels and diapers into the rest of Asia, with Kao Corp, dominant at home with a similar product range with “relatively weak motivation” to expand its overseas sales beyond the current 10%.

So there is potential for a fundamental rebalancing of the Japanese economy and market: as the global leaders’ continue to turn more to emerging markets, we could see domestic industries grow in the TOPIX, and consolidation between smaller, domestic manufacturers looking for a piece of the Asia-growth action. All of this improves the strategic-allocation case: Asian growth is long-term; and the turn to smaller, previously domestically-focused names should increase alpha opportunities just as competition for that alpha is bottoming-out. “There has been a big loss of know-how,” as Amsellem puts it. “No one wanted to be a Japan fund manager over the last 10 years.”

Putting that in the context of the election result, it is true that the DPJ administration could do a lot to hinder the progress of those small- and mid-sized enterprises; but then again, the change in culture it represents provides much of the premise for discussing that potential progress in the first place.


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