Few markets have experienced such a switchback ride as Japanese equities. In the 1980s, borne up on the back of a bull market, they outperformed the rest of the world’s equity markets. In the 1990s, dragged down by a bear market, they under performed just as spectacularly.
It is hardly surprising, therefore, that some investors have decided to get out and stay out. Denis Clough, head of Japanese equities at Schroders, says “the hardest job I have on the institutional side is the crisis of confidence in Japan. There’s an acceptance that active managers have done relatively well, but the absolute returns have been so awful that a lot of institutional investors are washing their hands of the market and saying it’s much less important than it used to be, it’s been awful for ages, so why bother?”
However, there are now some compelling reasons why investors should at least re-consider Japan. One reason is that it is different from other markets, says Clough. “In the past 18 months, Japan hasn’t followed anything like as closely the gyrations of the US, whereas Europe at times has just seemed a high beta version of the US.”
Another reason is that last year Japan significantly outperformed the rest of the world markets. There are two possible explanations for this. The first is that the Japanese economy is improving. The second is that the economies of the other developed markets are deteriorating. In other words, other developed markets are beginning to feel the same sort of pain as Japan.
Clough suggests the latter explanation is more persuasive: “It’s not that Japan did particularly well in absolute terms or that Japan seemed to solve its problems. It’s more a perception that the problems of deflation, which are severe, are ones that Japanese companies have been living with .and though they’re not exactly enjoying it they’ve got used to it.
“In a rather cruel way, in Japan we’ve had plenty of practice. So I don’t have to guess how companies will cope in these conditions. I’ve now got quite a lot of hard evidence who can and who can’t.”
At the macro-economic level the picture remains bleak. Richard Heelis, head of Japanese equities at Pictet Asset Management, sees no sign of a turnaround: “There’s no escaping the fact that Japan’s economic situation is dire. Prime minister Junichiro Koizumi has been slow to deliver the reforms he promised when he came to power two years ago and as a result macroeconomic conditions just seem to keep on deteriorating. Japan’s deflationary spiral continues, business activity stays sluggish, unemployment keeps on rising and consumers remain reluctant to spend.”
Fund managers have preferred to focus on what is happening at the micro-economic level. Here the effects of corporate restructuring companies is beginning to filter through to companies’ balance sheets. “The profits picture in Japan has actually been a pretty good over the past 18 months,” says Clough
Plan sponsors are often unimpressed with the performance of a single company, he says. But even at a broader level, the picture is encouraging. “If you look at the flow of corporate funds as a percentage of GDP, for the last five years the corporate sector in Japan has been generating lots of free cash flow, and free cash flow in the long run is a pretty good approximation of profits.
“This is evidence in aggregate that the Japanese corporate sector has been getting its act together. There are now quite a number of companies in Japan that do look very cheap in relation to the cash flow they are generating and the cash that may already be on the balance sheet today.

Shusaku Saito, head of Japanese equities at Credit Suisse Asset Management in Tokyo, says all the signs of corporate recovery are evident: “As a result of consecutive restructuring by a lot of companies, overall corporate earnings is expected to recover over 35% this fiscal year. Even if no sales growth is estimated, profit is likely to be increased roughly between 5% and 10% mainly due to deepening restructuring efforts.”
Saito also suggests that the strong aversion to Japanese equities provides opportunities. “Japan is the only country where the dividend yield of 1.25 is higher than 10 years JGB yield of 0.7%. This symbolises the prevailing risk-averse investment behaviour, and we are always looking for investment opportunities in such an extreme situation”.
The chief attraction of a Japanese equities, therefore, is as a recovery play. What makes Japan doubly attractive is that even if its recovery does not arrive, its position is no worse than that of countries that are beginning to struggle with the problems of a deflationary spiral.
Cameron Sinclair, marketing director of Daiwa SBI, says: “Although it is difficult to argue that the Japanese economy will recover soon, it now looks no worse than the rest of the world. And at least problems such as deflation are a known quantity in Japan, while in Europe and US they have been perceived as problems only fairly recently.”
With the global economy facing growing uncertainty, many managers of Japanese equities have few or no significant bets in sector allocation. Sector allocation is now more a question of which sectors to avoid rather than which sectors to invest in.
Banking is universally out of favour as a sector, chiefly because of their legacies of bad loans and cross-shareholdings. “We remain underweight in banking because the major banks cannot dispose of enough non-performing loans in a deflationary Japanese economy and because they are suffering from a huge amount of evaluation loss of cross share holdings,” says Saito.
However, he adds that the partial nationalisation of city banks such as UFJ and Mizuho this month could provide the catalyst for the revival of the banking sector.
Others point out that the banks are still not charging enough in terms of fee revenue and spreads on lending. “For us to become more positive in the banks either they’ve got to address the charging or we’ve got to feel much more optimistic about the economy and therefore feel that the bad debt problems are going to get better naturally. And at the moment I’m not confident of either of those,” says Clough.
Managers are drilling down to individual company level to find the winners. Some are concentrating on the larger, well-capitalised companies on the assumption that the tougher environment will weed out the weaker companies. Deregulation, for example, has allowed the stronger companies to win the share of the market they deserved, but were denied for regulatory reasons. It has also stripped weaker companies of a market share they did not merit.
“The economic environment is going to remain very tough. And if the environment remains tough, on the whole it’s better to be in the stronger companies,” says Clough.
Generally, there is a bias to quality. CSAM prefers ‘quality large caps’ with global competitiveness. Daiwa’s shopping list includes internationally competitive manufacturers such as Canon and Shin-etsu Chemical, companies that are characterised by good valuations, positive earnings and sound balance sheets. It argues that though these quality names have not necessarily performed well recently, usually for reasons of supply and demand, fundamentals should reassert themselves.
The need to keep a close eye on what is going on at the corporate level means that fund managers and analysts need to be within a taxi ride of Japanese company headquarters. Choosing a manager for Japanese equities means choosing a manager with a substantial Tokyo-based operation.
Daiwa SBI’s Japanese equity management team in Tokyo, for example, is made up of 27 portfolio managers and 19 in-house analysts. An international client management team of four portfolio managers looks after European clients.
The Tokyo based team at Schroders are central to identifying a universe of stocks to pick from. Fund managers and analysts will sift through Japanese companies to decide which stocks to follow. They then grade their selection on a scale of one to four. Above them is a ‘construction team’ of five fund managers – two in London and three in Tokyo – who use this information to set an institutional model portfolio for the whole group.
Stock-picking skills are important in an area where institutional investors are demanding a more active style of fund management. In this respect, Japan is no different from other markets. After a long bear market, investors do not want to tie themselves to and index which has delivered dismal results. They want some active management.
CSAM in Tokyo takes a thematic approach to stock-picking. “We identify themes and paradigm changes in corporate Japan and determining which companies will benefit from these,” says Saito. “Early recognition of these structural changes allows us to exploit the market tendency to consistently overvalue or under value sectors and individual stocks.”
Active management demands a broad benchmark. TOPIX, the benchmark that captures the companies listed on the Tokyo Stock Exchange (TSE) First Section is popular with institutional investors because of its breadth of coverage, market weighting and investability (although the strongest reason for its popularity may be that the Pension Fund Association has used it as a Japanese equity benchmark since 1986). The best-known Japanese market index, the Nikkei 225 is price-weighted, rather than market-cap weighted, which makes it almost useless as a representative benchmark. Although the Nikkei 300 is market-cap weighted, it is not recognised as a benchmark for the Japanese market.
The other popular indices are the MSCI Japan and the FTSP–Japan. The MSCI Japan is designed to provide a benchmark that represents accurately the opportunities available to international intuitional investors. The FTSP –Japan aims to capture between 82 and 90% of the investable market capitalisation available for the Japanese market, and is accepted as the definitive performance measure for investors needing a global benchmark.

Fund managers are likely to use a mix of these three for their clients. Broadly a third of Schroders Japanese equities business is benchmarked against each, for example, with the US clients tending to choose the MSCI, European clients choosing the FTSP and Japanese clients choosing TOPIX. However, the universes of the three indices are quite different. While the MSCI and FTSP cover around 300 stocks each, TOPIX covers around 1,400 stock. The choice is therefore between an index that includes a significant number of medium and small caps and indices dominated by large caps.
TOPIX has the advantage that it is much less concentrated than most European indices. Currently there are only two stocks in the TSE First Section that account for more than 2% of the index – Toyota and NTT Docomo, which are each both slightly under 5% of the index.
This lack of concentration makes TOPIX particularly attractive to active managers of the equities listed, says Clough. “It means that if we are trying to be active in the sense of being quite different from the index, then if we don’t like the stock then our typical position will be zero. Now, if the benchmark index was incredibly concentrated, it wouldn’t be sensible from a risk point of view to run a portfolio in that way.”
The Russell/Nomura Japan Index, which represents 98% of the investable Japanese equity market is notable since it categorises stocks into various style indices. These indices show that the value index has outperformed the growth index in 15 of the past 18 years, outperforming by 5.65% over the period.
Japan is regarded as a classic style market, where value has been in the ascendant since the 1980s. Some asset managers have geared their investment process to this. Daiwa SBI’s approach to Japanese equity management, for instance, is based on value-oriented active management, (although it also has a fund management team specialising in growth-oriented stocks). Its investment philosophy is to invest in undervalued stocks based on quantitative screening (valuation) and intensive judgemental bottom up analysis (evaluation). By combining these analyses, it tries to identify undervalued stocks where intrinsic value will be reflected in the share price.
Sinclair says the application of these techniques has produced a consistent ability to identify ‘triggers’ or catalysts for change in individual stock valuations. “What you’ll see often is that low value stocks remain so for long periods of time. So it is important to identify the trigger to be able to spot low value stocks with realistic growth potential,” he says.
Will value continue to outperform growth in Japan? Daiwa believes it will, given the mature nature of the Japanese market. However, others are not so sure. Robert Schwob, director of Style Research in London, has argued that the value theme in Japan during the 1980s and early 1990s was simply the reflection of a market anomaly created by systematic non-competitive practices. Schwob says the return to market realism in Japan in 2000 may have laid the conditions for genuine style investing. And the new economic environment in Japan should favour growth stocks over value stocks.
However, whether the current global environment will favour Japanese equity mandates is more questionable. Last year saw a flurry of mandates awarded by European pension funds. The US/German industrial group Daimler Chrysler pension fund awarded Edinburgh based asset manager Martin Currie a E70m Japanese long-only equity mandate. Ireland’s National Pensions Reserve Fund awarded Japanese Active Equity mandates to Daiwa SBI and JP Morgan Fleming, each worth E125m. The Third Swedish National Pension Fund (AP3) divided its E260m Japanese equities mandate equally between Capital International and Schroders.
Lena Djurberg, portfolio manager at AP3’s external management team, says that AP’s strategy is to hire external asset managers where these can be expected to outperform its own internal managers. “This applies especially to Asian equities markets, where local presence is a crucial prerequisite to successful asset management. In addition, this is a region where there is good potential to outperform the market. It has therefore been essential to find active managers for these equities portfolios.”
The current climate has damped down interest, says Sinclair of Daiwa. “We have seen a definite slowdown in the amount of RFPs in this asset class. With equity markets in their current state, this lull period is predictable, but given that we are forecasting improving equity markets on a six to twelve month horizon, we feel that now is the time to be actively marketing these types of products.”
Daiwa is focusing its marketing efforts on markets where there has been either a favourable change in corporate pension regulation or a trend toward specialist overseas equity briefs. These are more likely to be found in countries such as the Netherlands, which historically have had strong allocations to overseas equities. Another potential market is the UK local government market, where there has been a move from balanced to specialist investment strategies.
What may encourage investors to consider or re-consider Japan is the current appetite for more risk. “If there’s a direction it is clearly towards upping the risk relative to the index, ” says Clough. “Typically our client base is looking to outperform the index by more than 2% a year. And if anything, the shift at the moment is for people to be prepared to take even more risk than that.
“You may think Japan isn’t going to give much by way of index returns but it has been an area where it has been possible to make a little bit of money for clients, adding 5% to 7% on top of the benchmark return.
“That’s not to say Japan has been a good place to have your money relative to other areas – it clearly hasn’t. On the other hand, most clients think that market returns are going to be pretty modest over the next five years, so any value added is going to be a very important part of their total return.”
So investors in Japanese equities are promised something more sedate than a switchback ride. But in the present climate they may be happy to settle for that.