One of the most difficult challenges facing international investment strategists is getting Japan right. Japan has always presented a very difficult question in regard to putting it in a context of international alternatives.
The difficulty arises from so many unique characteristics of the Japanese financial system and the stock market. The problem is the greater for the confusion that exists between New York and London on the appropriate methodology for setting a proper neutral weight for Japan in international portfolios. The US perspective, largely conditioned by academics, says that the market capitalisation of Japan, applied through the spot rate of exchange, gives the proper neutral country weight for the Tokyo market.
There might be logic to this approach if international markets were reasonably perfect” and the currency a stable value. However, it is apparent that international markets are extraordinarily inefficient one with another and are still driven by local perceptions and prejudices. Currencies are notoriously volatile. One would think it would not matter very much in an international industry such as airlines whether a stock was quoted in Singapore, London or Tokyo but the different P/E ratings are remarkable - Singapore Airlines 8.9, British Airways 11.6 and Japan Airlines 1,673!
Both the methodologies most widely adopted to deal with the Japanese problem have proved vulnerable. The American methodology has the effect of exaggerating the importance of Japan by a large margin. This is due to the past strength of the currency combined with the high price earnings ratio on which the Tokyo market is rated. A third factor is the duplication of equity holdings, since much of the market is cross-held by way of strategic investments between trading partners. None of these factors is reflected in the MSCI index, which at one time showed Japan as being a significantly larger “neutral” weight in international strategy than the US market.
When the world was being told that the Japanese market accounted for over 40% of the world total, international investors were being encouraged to raise their neutral weight for Japan to over 40%. The bias of using that index as a benchmark was to encourage managers to raise their weighting for Japan at the top of the market. Tracker funds following the index compounded the problem. By the same token, when the Japanese market fell to 14,000 the Japanese market was then valued at 17% of the world and the benchmark encouraged managers to reduce their holdings.
The self-evident bias to encourage managers to raise their weighting in Japan when the market is high and to lower it when the market is low is self-evidently counterproductive over a complete cycle. It is tantamount to encouraging managers to buy high and sell low - the very reverse of an intelligent international investment policy.
The American methodology was rejected by London, which chose to set its own standard by taking the average of all pension funds as the benchmark. This is clearly more pragmatic than the American theoretical approach. It saved London’s clients a great deal of money as the Japanese market declined from 39,000 to 14,000. The UK market has, in effect, established the neutral weighting for Japan by looking at what everyone else has done - after the event. The current weighting of Japan in the WM universe of pension funds is 18.3% of the total committed to international markets.
The problem in setting an appropriate strategic “neutral” weight for Japan thus remains unresolved. Our consultancy has spent time and effort in establishing a rational alternative based on the financial statements of the companies composing the various country indices - adjusting the quotient for over-valued or under-valued currencies. This has produced a promising formula which has been back-tested. It shows strong evidence of reducing volatility and increasing the rate of return by comparison to any international index that is based on market capitalisation and the spot rates of exchange.
Our approach to setting a neutral value for Japan is based on the financial realities. The companies that compose an index can be accessed through their financial statements. It is possible to draw from those financial statements a picture of the investment reality in terms of the wealth creation process, drawing on the balance sheet values and the creation of cash flow. Based on spot rates of exchange the current neutral weight for Japan (on an ex-UK basis) is 17.0%. When the currency is adjusted for purchasing power parity the neutral weight for Japan falls to 9.2%. This is a much lower “neutral” than the cap-weighted model which gives 20.5%; and lower than the WM median of 18.3%. Investors have been given a false idea of the true significance of the Tokyo market.
In terms of currency the yen has fallen from ¥360 to the dollar in 1974 to a recent high of ¥80 to the dollar in 1996. (Since then the currency has depreciated to a current level of ¥124.) The performance of the yen is a vivid example of how investment returns can be dominated by currency movements. At the time of the Plaza Accord in the mid 1980s the yen/dollar rate was ¥260.
Conventional correlations for the Japanese market show that investors in Japan pay little attention to dividends and, for that matter, rather little attention to earnings. The most compelling correlation is with book value or net balance sheets. In the post-war period, when Japan’s industries were financed by the banks, the banks had little interest in passing on dividends to shareholders but considerable interest in building the balance sheets against which they were lending money. This bias led the Japanese financial system to adopt a series of measures to encourage capital formation. These measures are still with us today. It is therefore more appropriate to study Japanese cash flow than earnings.
On the basis both of cash flow analysis and book value the Japanese market is in a zone of attractive relative value and long-term investors should have a full exposure. However, as the previous paragraphs have indicated, the neutral standard value for Japan is greatly overstated by both the market capitalisation methodology and by the London consensus approach.
The persistence of Japan’s problems is due to the serious damage done by the financial bubble of the 1980s. Unfortunately, the remedying of excess valuations of all sorts has been deferred by the traditional Japanese practice of camouflaging the true position. Whilst the authorities might have thought that this was an intelligent way to avoid financial panic it has had the unfortunate effect of stretching out the adjustment period much longer than might otherwise have been the case.
As a result there is no doubt that Japan has lost a great deal of the self-confidence which propelled it during the 1980s. When confidence is low equities reflect it in lower ratings. In Japan there is now a 10-year record of disastrous results from those investing in the stock market. This takes time to redress. In the meantime the Japanese market has seen a significant downward re-rating. This has not been sufficiently appreciated by strategists, who are too prone to study markets in relation to cyclical trading patterns. A new set of parameters seems appropriate.”
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