Pay-back time in Tokyo

For many, Japan was the surprise performer of the last 12 months, with a return of 49.6% over the fiscal year to March 2004. Most fund managers in the region anticipate strong earnings in the current year, driven by corporate structural reforms and a global and domestic cyclical recovery. Japan GDP data for the fourth quarter of 2003 showed nominal growth of 2.6%, and deflation is abating, as evidenced by the producer price index figures. Global growth benefits the Japanese stock market disproportionately because of its heavy weighting towards cyclicals. More than 50% of the Japanese stock market is cyclical stocks, versus 21% in the US, 15% UK and 20% in Europe. Because of the level of “extraordinary” items in Japanese profit figures, cashflow is a better measure of earnings. On a price to cashflow basis Japanese stocks are cheap, trading at eight times cashflow.
Foreigners have led the charge into Japan, with foreign shareholders now owning some 20% of the Japanese stock market. Martin Currie’s Japanese team has closed for new business, having seen inflows across the board from European and UK pension funds. Michael McNaught-Davis, Japan portfolio manager at Martin Currie, notes less domestic selling pressure with half as much equities coming from banks as last year. Life companies finished selling, and little or no more stock is arising from daiko-henjo pension funds, which liquidated equities to give cash back to the government. McNaught-Davis sees an imbalance developing between the supply of stock and demand.
A number of UK and European funds, including AP1, AP3, Aviva and Pilkington have awarded mandates in the last year to Japanese manager, Nomura Asset Management (NAM), whose marketing manager Mark Roxburgh suggests that the improvement in the market has prompted increased allocations and a review of the manager stable. “It seems that European investors are now more comfortable awarding mandates to Japanese-based managers,” comments Roxburgh. AP3 increased its Japanese allocation by 2.5 percentage points in March 2004 after changing its manager mix from an equal split between Schoders and Capital International to one that was 50% Capital International, 25% NAM and 25% JP Morgan Fleming. AP3 fund manager Cecilia Sved comments that the change was intended to achieve increased diversification and an optimal manager mix.
For Nigel Richardson, global strategist and Japan specialist at Axa Investment Management, the question is whether Japan can sustain secular growth, or whether it is destined to remain a cyclical story. Richardson suggests that, had it not been for shocks in 1995, 1997 and 2000, it would have grown strongly over this period. “Japan is 45% cyclical stocks, with high betas and heavily exposed to world trade. It is no wonder that Japan always outperforms in an upswing,” declares Richardson. “Japan is a text book economy in its response to stimuli, both spending and investment. Positive trends in production, income and employment should feed through to consumer spending as it did in 1996 and 2000. 2004 is the acid test for Japan. If Japan cannot achieve sustained growth in this environment, however, then it is in the grip of a structural problem.”
Growth is a necessary condition for investors to want to invest in equities, but it is not sufficient, according to Richardson. “Quoted companies are generating cashflow but investors need to be sure that they are not simply going to pour it down the drain. As a result of massive debt repayment that debt to cashflow ratios as low as it has ever been. Companies are now starting to devote free cashflow towards share buybacks and around 400 Topix companies have announced their intention to raise dividends.”
Share buyback doubled the effective dividend yield to around 2.5% in 2003. Whereas UK companies payout 31% of cash flow as dividends, and Europe and the US pays 23%, Japan only pay 8% of cash flow as dividends. Clearly there is ample room for dividend payouts to increase. Increasing foreign ownership of Japanese equities could push companies in this direction, according to Richardson. “In the last few years the only buyers of Japanese equities have been foreigners. Some of these are investors that take strategic positions and force changes of policy by management.”
Japanese pension funds, which have promised 2.5% returns to investors, can also encourage companies to pay higher dividends, via proxy voting companies. Japanese companies have effectively increased the proportion of activist shareholders by holding as non-voting Treasury shares stock bought in share buybacks. This Treasury stock will ultimately be used to fund share option schemes, giving management a greater incentive to operate to shareholders’ benefit.
FTSE International is engaged in developing an SRI product for the Japanese market, rolling out FTSE4Good, which is already well established in Europe and the US. Paul Hoff, head of FTSE Asia Pacific, states: “Corporate governance is of growing interest in Japan. There are already funds which have some emphasis on environmental sustainability, but none that take a broader view on human and stakeholder rights.”
Joji Maki, head of the Tokyo-based Baring Asset Management (BAM) Japan team affirms that the prospects for Japan as a whole are much more positive. Comments Maki, “the main reasons for this are progress on three fronts: easing deflation, progress with restructuring, which is improving profitability, and cheaper valuations. Deflation was a major concern, but now the CPI has turned positive, for the first time since April 1998. Tokyo real estate has started to appreciate, and there is high correlation between property prices and department store sales. Japanese companies have also deleted excess production capacity, which was depressing capital goods prices, and capacity is now back to the levels of1992. This should result in new capital spending by Japanese companies. Restructuring is mostly evident at the company, rather than the economic level, with most companies now abandoning the seniority system for wage determination. These two effects have reduced the breakeven point for Japanese companies by 10 percentage points from a peak in 1994, making it easier for them to make profits.”
Traditionally the Japanese economy has been export-led, but, according to John Takayuki Kusanagi, lead manager of the DIAM Japan New Growth fund, spots of data are emerging that confirm growth in personal consumption. Kusanagi points to department store sales data released recently which showed sales up 10% year-on-year. Real estate, both commercial and residential, is also improving, with vacancy rates for Tokyo office buildings down and condominium sales strong. As Kusanagi relates, “if personal consumption, real estate and bank lending to small and medium-sized firms increases, the domestic sector will have a good year. If not, it is the export-led sectors that will win out.”
The last set of GDP figures from Japan at 6.4% on an annualised basis emphasised the growth trend, with positive GDP growth in the preceding four quarters. Much of this growth is driven by capex spend, the average age of Japanese machinery being 11.5 years. The major electronics firms have negotiated a wage settlement that increases wages, a turnaround from last years wage cuts. Within the steel and computer sectors companies are setting reasonable salaries and bonuses.
The key themes for Japan, in McNaught-Davis’s view, are the capex cycle, which is benefiting machinery and machine tool manufacturers, as well as commercial software companies and supplier of manufacturers of flat screen technology, and domestic spending. Martin Currie is reorientating its portfolios towards banks, real estate, consumer loan companies and retail, bringing weightings back to neutral, or in some cases overweight. McNaught-Davis explains, “the tilt of the fund is moving from defensive and export towards cyclical and domestic.” Earnings growth in 2003 was 30% and Martin Currie estimates earnings growth for the market of 15% this year.
The weakness of the banking sector has undermined restructuring and threatened the entire stability of the financial system at times. However, following aggressive write-downs, non-performing loans, which had accounted for 8.8% in March 2002, declined to 5.8% in September 2003. Banks are experiencing negative loan growth, largely because the corporate sector has a cash surplus to the extent of 7% of GDP. Some of the banks that received government bailouts a few years ago have started to pay back their debt to the government, an example being Misuho Bank, which received ¥300bn (E2.3bn). Some banks are writing back part of their overprovisioning for bad debts, for example Mitsubishi Tokyo Finance Group, which wrote back ¥10bn that turned out not to be bad debts. But not all banks are safe, and there are rumours of one large commercial bank, which has lent extensively to small to medium–sized firms, that is understood to be at risk of failure.
JP Morgan portfolio manager Stephen Mitchell stresses the importance of the Chinese investment boom as a positive impact on Japanese growth. “As China develops” Mitchell explains, “it is turning to Japanese companies to help it complete large infrastructure improvement projects, as well as to supply everything from new factory equipment through to consumer products like cars and cosmetics.” Chinese demand is reflected in Japan’s export figures, with 43% now going to China and the rest of Asia, against 30% ten years ago. Some might lay the blame for Japanese deflation at the door of the Chinese, but BAM’s Maki comments that so long as Japan retains manufacturing of high added value products, this separation of production capacity is working well.

According to Jerry Wang, manager of the Vision Asia Maximus multi-manager fund, the Japanese stock market breaks down into three broad categories. Says Wang, “there are the big global companies whose earnings are related to global economies. The domestic giants include sectors like insurance, retail and banks, and the third group are smaller cap, entrepreneurial players with more investor focus, who are taking market share from the large caps. The domestic giants are natural targets for funds that can go short. Within manufacturing a typical pairs trade is to go long the company that manufacturers in China and short its counterpart that manufactures in Japan. In terms of performance versus the rest of the world, Japan might look toppy, but equally the p/e ratio has fallen below that of Europe and the US for the first time in decades.”
What could discolour this rosey picture are longer-term problems like the fiscal deficit, 8% of GDP, and tax hikes, if they were to come too early in the recovery, might stop it in its tracks. McNaught-Davis considers that the government has learnt much since1996 when it raised VAT from 3 to 5%. Remarks McNaught-Davis, “Koizumias said that VAT will not be raised before 2007, and with the recovery so fragile, it is unlikely to make the same mistake again.”
In Kusanagi’s view the main threats are international, whether it be more terrorist attacks, a loss for Bush, or the bursting of the Chinese bubble. Exporters are at risk to greater US protectionism or a dramatic strengthening of the Yen, which would hit export earnings. The Bank of Japan recently announced its intention to lower the rate at which it intervenes to halt Yen appreciation, from 105/$ to 109/$.
Another technical factor could disturb the delicate balance between domestic selling and foreign buying. Domestic funds are primarily benchmarked against the Topix index, run by the Tokyo Stock Exchange. The Topix index is weighted by the number of listed shares, and is calculated as the ratio of the current market value to the base market value, times 100. It is based on all the common stocks listed on the first section of the Tokyo Stock Exchange, broadly 1,500 names. In almost all cases the number of listed shares will be the total outstanding shares in the company accounts. An exception is made for companies with a large government ownership, with these shares excluded from the calculation. There is a range of sub-indices by size and market capitalisation.
FTSE’s Hoff, warns that adjustments to the Topix index to account for free float might destabilise stock flows in the near term. Explains Hoff: “The Tokyo Stock Exchange has just announced a consultation exercise on whether the Topix index should be free float adjusted. The current format of the index makes it too easy for managers to put poor performance down to factors outside their control.” FTSE Japan is already based on the free float rather than issued share capital. Funds that use this index as a benchmark will already have the appropriate stock weightings. FTSE found that, of the 434 stocks in its All World Japan index, six stocks, when adjusted for investability, had their index weightings reduced by 80%. Another 114 had weightings reduced by 50-70% when investability measures were applied. According to FTSE free float adjustments if applied to Topix index weightings could require heavy selling of certain stocks.
DIAM runs funds that operate between a 2 to 10% tracking error against the Topix. Kusanagi comments, “We do not operate to a specific style. The Japanese market is so volatile that adherence to a single style gives rise to excessive performance swings from one year to the next. Whereas last year the market was growth-driven, now we are seeing a move towards value stocks. Sector rotation can occur over the course of two to three weeks, because of the rise of short term traders, like hedge funds and security broker dealers.” Ironically, after such an emphasis on restructuring, it is the companies that did not remove unwanted equity holdings from their balance sheets that have done best in the recent rally. Kusanagi gives the example of Daiei, a supermarket chain on the verge of bankruptcy, which was one of last year’s best performers.
Kusanagi has split portfolio exposure between electronics and autos, and banks, retail and real estate. In the next quarter he anticipates deciding whether to overweight domestic-oriented stocks, or to cut back. Critical to Kusanagi’s decision is the performance of real estate in Japan’s two largest cities, Tokyo and Osaka. A recent March release of real estate price data showed some positive signs in some parts of the country but overall real estate prices fell, although the rate of decrease is dwindling. The Bank of Japan business confidence survey, which comes out in April, will show whether the high confidence levels of the large cap companies has filtered down to small and mid cap firms. Increased bank lending would complete the more positive picture.

Kusanagi anticipates diverting some 10-15% of the fund towards steel and non-ferrous metals, and some service sectors. Real estate is already 10% of the fund, but some 3% is in Real Estate Investment Trusts. Kusanagi anticipates moving some of this diversified exposure towards companies with direct exposure to the commercial market in Tokyo and Osaka, which are more sensitive to reflation. Clearly timing is everything, but over the longer term Kusanagi is confident on seeing 10-15% appreciation in the Japan indices by the end of this year, given valuations of 20 times earnings, despite forecast earnings growth in the major industries of 20%.
BAM operates a GARP philosophy, and tries to identify companies with high eps growth and return on equity with a p/e ratio no more than 120% of the market from its investable universe of 500 companies. Maki reports, “the average eps growth of the portfolio is 47%, versus index growth forecasted at 25%. The return on equity of the portfolio is 10.6% versus benchmark of 9.1%. The p/e ratio of the portfolio is 98% that of the market, itself an all-time low.” BAM runs a highly concentrated portfolio of 42 names, using Barra to enforce constraints on stock and sector bets and keep the tracking error between 6-10%. The BAM’s team consists of three investment managers, all of which are Japanese and have on average 14 years of experience investing in Japan. Maki sees most opportunity in the small to mid cap space, where there is less analyst coverage.
Nomura has 31 corporate analysts in Tokyo, a research spend of $9m (E7.6m) per annum. All are Japanese, providing a significant cultural and language advantage. NAM’s buy-side analysts were ranked first overall in a 2003 Reuters survey of Japanese corporations. Independent buy-side research has become more important as a differentiator of asset managers, as concern has grown over the quality of broker research. NAM scored strongly on use of time, quality of relationship, understanding of company and industry, preparation, meeting conduct and feedback. However, Japanese companies reportedly intend to devote more time to meetings with non-Japanese investment firms, given the higher foreign ownership and tendency towards activism.
NAM’s philosophy is to compare a company’s current valuations against historic averages and buy or sell according to whether the share is on a discount or a premium. Further fundamental research is done before investment. Portfolios consist of 80-100 stocks, and NAM actively takes off-benchmark bets, to take advantage of its analyst coverage. NAM operates core mandates, with no style bias, with a tracking error range of 4-7%. The vast majority of domestic mandates are run against the Topix.

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