Waiting for the sun to rise
The laggard of the 1990s, Japan is making a re-appearance on investors’ radar screens. Now trading close to 19 year lows, the Japanese stock market contains world-class companies on cheap valuations whose management have little incentive to artificially boost profit numbers. As US and European markets have toppled, Japan has outperformed by almost 20% and is seen is having relatively little downside after the long bear market.
Hopes of a rebound in the stock market are predicated on the assumption that Japan is coming out of recession. Consensus forecasts of increases in operating profits are encouraging, with manufacturing profits forecast to rise 40.2%, and non-manufacturing by 7.5%, making an overall figure ex-financials of +20.1%. The recent Tankan survey reported business confidence up for the first time in two years. However, the rebound of GDP in the first quarter may be suspect when considered against a background of falling store and auto sales, lower incomes and the prospect of increasing unemployment. Corporate capital expenditure is also unlikely to rise as most industries have overcapacity.
The government’s ability to stimulate the economy is constrained by the already high budget deficit, which caused debt ratings agencies to downgrade Japanese government bonds. But so long as Japanese interest rates remain low the government can easily finance the debt. Japan’s debt is almost exclusively domestically held and the savings surplus means that there is a ready appetite for government issues. In addition, Japan has one of the lowest tax burdens in the world, at 10% of GDP, so there is the possibility of a fiscal package to raise revenues.
Possibly one of the best arguments for investing in Japan is that it has 10 years experience of dealing with deflation, whereas for the US and elsewhere it is a frightening prospect. The Japanese economy is protected by high household cash balances, which outstrip household debt by a factor of two. Assets in equities are only 10% of household assets, so Japanese private investors are less affected by stock market declines than their US counterparts.
Most European pension funds are currently under-invested in Japan. Although the lowest risk proposition is to add as diversified a basket as possible, most funds initially add equities in the home market, pursuing the now largely discredited ‘home bias’, and then allocate money towards overseas markets. Hence European pension fund allocations towards Japan will always be lower than its share of global equity market capitalisation.
In the UK, up until recently actuaries applied a discounted dividend approach to valuing equities and this caused a write down in the value of any assets whose dividend yields were well below the level of UK inflation. Any allocation towards a low yielding market, such as Japan, would have a negative effect on solvency. Actuaries now value holdings based on their market value, but the legacy is some vestigial confusion as to the right Japan allocation.
Market capitalisation weightings have received bad press of late, as investors have realised that it results in higher allocations to overvalued markets. There is a move towards fixed weights, which may in themselves appear arbitrary, but resolve the difficulty of finding other theoretically sound bases for allocation. Ian Barnes, a consultant with Frank Russell, warns against taking short-term tactical bets commenting, “all markets have equal returns in the long run”.
In the first quarter of 2002, foreigners increased equity holdings in Japan, and their demand was readily met by disposals from banks and life companies. Even trust companies, collectors of pensions contributions, were net sellers in May and June. This is thought to be a function of the yen’s appreciation against the dollar, which caused the proportion of Japanese pension fund assets in Japanese equities to rise above 40% as the Topix neared 1,100. Some pension funds have returned to government control, which created selling as government funds typically have just 20% in equities.
In the second quarter, the government imposed restrictions on short selling, easing a technical situation that had supported share prices. Selling pressure has also come from unwinding of cross-holdings. Some succour may come from share buybacks, since over 60% of listed companies have announced schemes amounting to 2% of the Tokyo Stock Exchange market capitalisation.
There are fundamental differences in the relationship between companies and their shareholders in Japan that may come as a shock to Western eyes. Some commentators have described it as a culture of shareholder abuse, citing a lack of independent directors, a chronic shortage of independent auditors, and poor disclosure. Eight percent of Japanese companies collude to have their AGM’s on the same day, these meetings lasting typically no more than 30 minutes. This suppresses shareholder discussion and public accountability of directors. However, under Prime Minister Koizumi, a programme of reform is being pursued, including changes to the commercial code, creation of holding companies, stock options, shareholder monitoring and accounting changes. Any concerns over accounting irregularities in Japan are on a different scale to the difficulties in the US. Few Japanese companies operate stock option schemes and, in general, the accounting system is cleaner. But if recent events in the US damage confidence in the US system of corporate governance, this could undermine the progress of reform in Japan.
Japanese equities offer better value than US equities, trading on average at 1.5 - 1.6 times book value, as opposed to nearer 2.9 times in the US, according to Deutsche Bank. In a report issued in August 2002, Deutsche Bank Japanese equity strategist Ryogi Musah foresees a government policy shift in the event of a fall in the Nikkei index to below 9,000, to pay-off non-performing bank loans, and rescue bank balance sheets, and this would provide some support to the stock market, although a reversal of the reform program. But Musah warns that, in the face of a global recession, Japan’s outperformance will be relative, not absolute.
Musah views Japan as defensive, in the context of a collapse in the US, a flight from dollar assets and lower growth worldwide, and recommends funds be overweight Japan in global portfolios. Within Japanese equities, Musah favours value plays and stocks with bond-like characteristics, also stocks related to domestic demand with a stable cashflow. Exporters, tech stocks and those sensitive to the economy should be avoided. Musah also highlights stocks that have fallen out of favour, such as banks and telecoms companies, whom he terms ‘lifeline’ industries that it is difficult to do without.
In the year to date, value stocks have outperformed growth stocks by around 5% and small caps have outperformed large caps. Over the five years the winning style has varied, more or less in keeping with global trends. Pre-1997 value stocks outperformed, whereas between 1997 and 1999 growth stocks did better. Since 1999 value management has been in the ascendant again. There are few specialist small cap managers in Japan, but given the relatively small Japanese allocations, there is generally no need for a separate small cap allocation.
Barnes cautions against placing all one’s Japanese allocation with one manager for reasons of manager risk as well as style, but he concedes that it is difficult to achieve a combination of managers that is style neutral, because the style universe is not as well populated in Japanese equities as in other developed markets like the US or UK. In combining managers, Barnes suggests identifying complementary processes, for example a quantitative core manager who is risk-controlled, plus one who follows a style. Because few managers will accept less than $50m into a managed account, and given that most funds will allocate 5% or less to Japan, realistically only funds of $2bn or more can make direct segregated allocations to managers. In fact, he advises further diversification using three to five managers if possible, which increases this fund size further.
According to Satoshi Tawada, manager researcher at Frank Russell in Tokyo, tracking error targets are typically a function of the manager’s process, although in some cases the manager is able to set tracking error targets according to client preference. A core manager will typically target a 2-3% tracking error, whereas an aggressive satellite manager will have wider bands of 5% to as high as 10%, and higher performance targets. Some managers are so high risk that their tracking error is unconstrained. Alpha targets are set by managers to indicate realisable excess returns, for a given level of risk. Tawada splits the prevailing styles of management in Japan into four, these being small cap, market-oriented, growth and value. Within each category there are small differences between managers, a function of the different investment processes. As market-oriented managers occupy the middle of the style spectrum, this group could include managers with a value bias and the so-called growth-at-reasonable-price or GARP managers, whose style exposures are not as extreme as true value or growth managers.
Frank Russell’s Japanese multi-manager product contains four managers, two specialist and two core or market oriented managers. The specialists are Trust Company of the West, a deep value manager, and Jardine Fleming, a growth manager, these two being negatively correlated to each other. The low risk core manager is JP Morgan and the remaining manager is Martin Currie whose style varies from growth to value in reaction to market themes. Concurring that no style prevails over the long term, manager of the Frank Russell Japan multi-manager product, Christoff Gaspard comments, “each of the managers are specialist in a particular segment and the aim is to achieve low volatility relative to the index at the fund level”. Each manager has contractual constraints, which relate to their investment philosophy. Investments are pooled, but clients place their money into one of three vehicles, set up to comply with a specific regulatory framework. The largest fund, at $770m, is for UK clients. The remaining $430m under management is split between a Netherlands and a Japanese vehicle. “Multi-manager is a strong concept for pension funds who are not capable of making their own manager selection, and for those whose Japanese allocation is too small,” says Gaspard.
In selecting a manager, one characteristic that has to be considered is the location and culture of the fund management team. Managers at Japanese houses tend to take fewer risks than the international managers, a function of the risk aversion of the domestic client base and low fees. Also staff rotate into and out of asset management, so do not have the opportunity to build up expertise. A manager with no Tokyo representation will suffer from late news flow and a lack of corporate contact. However, these managers tend to take a more global view and have the benefit of perspective. International managers both within and outside Japan tend to focus on the blue-chip names, and so are more likely to miss out on interesting growth stocks than their domestic counterparts.
Gartmore Japan, with ¥200bn (E1.7bn) of specialist mandates, has a seven person fund management team based in Japan, running retail, institutional and hedge fund money. Two fund managers in London run the Japanese portion of global accounts, and the four sector analysts in Tokyo have the support of global sector analysts in London for technology, telecoms and pharmaceutical stocks. Fund manager Sanae Sakai comments on the importance of following global trends, saying, “technology and auto companies earn more outside Japan than inside, and in some domestic sectors, restructuring and rationalisation has taken place once weaker players have gone bankrupt”. On banks, Sakai comments on operational changes and introduction of risk pricing that should improve profitability. For instance until recently, Japanese banks rarely applied different interest rates based on the customer’s credit standing. Sakai explains Gartmore’s positive view on Japan: “For some companies, as deflationary pressures ease, we shall see management’s cost cutting efforts feeding through into increasing profitability. We are positive on sectors that are consolidating, such as iron and steel and retailers. Among financials we prefer leasing companies who will benefit from a move towards asset deficiency.” Gartmore runs mandates to three degrees of risk and composites have underperformed the Topix index in the year to date, and last three years, but outperformed over a five and 10 year time frame.
JP Morgan Fleming offers the choice of two quite different approaches to running Japanese money, as it has kept both of the legacy J P Morgan and Jardine Fleming teams. Both operate a bottom-up style, but whereas J P Morgan value stocks using a strict dividend discount model, Jardine Fleming consider qualitative factors as well, in particular management dependability. Specialist portfolios are typically $100m or more, with European pension funds a growing segment. Richard Cardiff, fund manager with Jardine Fleming comments: “Jardine Fleming’s style is pragmatic growth whereas the dividend discount model gives J P Morgan a slight value bias”. Jardine Fleming mainly accept mandates with high tracking error targets, with J P Morgan operating closer to the index. Both teams have achieved information ratios of around one.
Edinburgh-based Martin Currie has $1.5bn invested in Japan through global and specialist mandates and as director of Japanese equities Mike McNaught-Davis comments: “Japan is defensive in the current environment and on relatively cheap price /earnings ratios”. Martin Currie’s style varies according to the market environment, but it avoids over-priced growth stocks. Its process looks for companies with strong balance sheets, cash rich and which generate strong cash flow from their operations. Managers select companies with niche products, some technology advantage or a high and unassailable market share, an example being Secom, which has a 50% share of the home security market. Generally, Martin Currie accepts mandates with tracking error between three and seven percent and uses that tracking error in the main for stock specific bets, and some sector bets. Martin Currie funds report an information ratio of 1.2 over the last nine years and McNaught-Davis considers the distance from the market to be an advantage opining, “being located away from Japan keeps us from getting swept up in market sentiment”.