Discerning equity investors who focus on quality companies not temporary tailwinds can find pockets of growth in Japan the coming year.
In the month since Donald Trump’s election upset, Japan’s Topix climbed 17% in US dollar terms. Almost half of this performance came from a resurgent dollar. Given the close historical correlation between Japan’s stock market and the exchange rate, many asset allocators have already made their call for next year: go long the market on a hedged basis.
Exporters were first to gain from a weakening yen, given the boost that depreciation gives their competitiveness globally. Insurers and banks have also benefitted from Bank of Japan (BoJ) efforts to control the yield curve. By creating a floor for rates, the central bank helped to alleviate concerns about further declines in interest income due to its negative interest-rate policy.
Japan delivered GDP growth of 0.9% over the past year.
But we would caution against making too much of cheap yen effects or yield-curve control. Both are subject to change. In the meantime, global demand remains weak. Japan delivered GDP growth of just 0.9% over the past year despite the yen having spent the majority of the second half of 2015 below ¥120 to the dollar.
It was only a few months before, besides, that the yen was surging amid concerns the BoJ was running out of options. Trump’s stimulatory fiscal plans, including a possible tax amnesty for corporate cash held overseas, are likely now to support the dollar; more US rate hikes are being priced in. But for how long will that depress the yen? With Europe facing key plebiscites, risk perceptions could change quickly. It is yen volatility, not weakness, that the market can count on.
Investors might consider neutralising currency effects rather than trying to play the trend. This is best done at the stock level. We believe investing should be based on analysis of a firm’s business model, balance sheet and cash flows, not short-term tailwinds. Only by researching a management team can we be sure they will reward us as a shareholder.
We see opportunities in mid- and large-cap companies with a regional or global manufacturing footprint.
We see opportunities in mid- and large-cap companies with a regional or global manufacturing footprint, which provides a natural currency hedge. While their yen sales may appear weak, they can react to local demand where they are based to drive revenues.
Broader geographic exposure also diversifies their earnings away from Japan, a shrinking market where aging demographics remain a drag on consumption. Medical equipment manufacturer Sysmex, power tools-maker Makita and PVC-maker Shin-Etsu Chemical all generate more than three-quarters of their revenue overseas.
Shin-Etsu is, in fact, our top holding. It is a worldwide producer of polyvinyl chloride, a synthetic polymer with wide commercial and industrial uses, and semiconductor silicones, which are used in electronic products such as smartphones. Demand for both remains resilient. This firm has built scale in its businesses while managing its productive capacity carefully, which is key due to high investment costs. It is also well positioned in markets that recognise the quality of its end-products. We have confidence in its experienced management team.
We also like domestic champions such as Seven & i Holdings, a retail conglomerate with interests that span convenience and discount stores, supermarkets, department stores and food services. It is the operator of Seven-Eleven, which as an industry leader is able to sell a high proportion of own-brand products. Its average daily revenue per store is about $6,000, compared with less than $5,000 for its closest rivals. Even after consumer spending plunged once authorities raised the GST to 8% in 2014, Seven-Eleven grew same-store sales and market share. It is a progressive company able to prosper amid weak consumption. We expect its current restructuring to be positive for long-term growth.
Another factor in Japanese companies’ favour is the rising level of dividend pay-outs, which underlines how more companies are prioritising shareholder returns. It’s possible to have conversations on governance and capital allocation now that were unthinkable a few years ago. Thank new codes on governance and transparency for nudging companies in the right direction. Share buybacks are also at an all-time high. However, investors need to exercise caution. Buying back shares when their valuations are high is actually poor capital allocation.
Clearly selective buying for the long term may not be the top-of-mind message about Japan right now. The new orthodoxy is that money can be made more easily through asset allocation bets than going to the trouble of finding decent companies. But that view is a response to prolonged abnormal policies around the world. If a new kind of politics and rising bond yields rip those policies up, we could face more volatility, not less. Investors may want to reconsider their approach.
The article above by Kwok Chern-Yeh Head of Investment Management, Japan, Aberdeen Solutions, originally appeared on the Aberdeen Assest Management ‘Thinking Aloud’ blog on 12th January 2017