The conundrum of Japan today | Linchpin
Japan is a conundrum for investors at the moment. A lot is going right, but it seems to have fallen off the map for asset allocators, despite being the world’s third largest economy and second largest market by market capitalisation. In this article, I look at the background to this.
Are investors underweight Japan?
I start by asking whether investors really are underweight Japanese equities. Anecdotally, there is little interest, perhaps because there are bigger decisions to take on bonds, fixed income, tech, ESG, etc. However, on the metholology which our friends at CrossBorder Capital use, Japan is one of the most over-owned equity markets. They find that the market capitalisation of the Japanese stock market as a percentage of the whole is at a high level compared to history, presumably because the value of other assets (e.g., bonds, tech stocks) has fallen. One reason for the lack of interest may therefore be that Japan is by default already overweight in asset allocators’ portfolios.
Fundamental reasons to invest in Japan
That notwithstanding, there are good fundamental reasons for allocating to Japan. It remains one of the very few manufacturers of high-end technology (robotics etc), that should benefit from the increased role of digitalisation and artificial intelligence in our lives. It has historically been an energy importer but has the capacity through nuclear, tide, and hydro to be self-sufficient relatively quickly. And it is geographically well placed with links to both China and the U.S.
At a corporate level, governance is improving, albeit there remains a considerable spread between the best and the worst companies in this respect. Profit margins have risen from 3% in 2010 to around 7% today, reflecting this improvement in decision-making and a greater emphasis on shareholders. This notwithstanding, Japanese corporates have always looked to a much wider range of stakeholders than just their shareholders, which helps them on the social side of ESG. They have also tended to have much longer investment horizons, and therefore more sustainable – both environmentally and otherwise – business models.
Stock market and currency are cheap in absolute and relative terms
The Japanese stock market is cheap relative to other markets. For example, at an aggregate level, TOPIX trades at about 11x prospective earnings, about half that of the United States S&P 500 index. The price to book is just over 1x, compared to 4x. If we delve into more esoteric measures, such as the price per tangible asset, Japan’s valuation is only 10% of the U.S index.
Of course, this is not a pure apples and apples comparison. Japan has no leverage at aggregate level, whereas the U.S. equity market is substantially geared, and U.S. company balance sheets generally are skewed to intangible rather than tangible assets. Against a more testing financial environment for investors, these may be seen as advantages or disadvantages, but they should at least mitigate downside risk.
The Japanese yen is also historically cheap. Between 1986 to 2012 it traded about 30% above the OECD purchasing power parity rate, but since then it has fallen by an annualised 5% or so. It now trades at about 30% below the PPP rate. For existing investors, this has been a headwind, but for prospective ones, it is an opportunity.
History, society, and culture remain negatives for investors
Against all this, there are some powerful negative features for investors. Even today, one is the legacy of 30 years of very low economic growth and inflation and investors’ disappointed hopes. But over the past ten years, the TOPIX index has returned 12.7% annualised (to 31/7/22) in yen terms, so that does not look like the only explanation.
More recently, there is some debate about whether Japan Inc is well placed in the world. The Chinese economic growth rate is coming down fast, frictions to trade and commerce are growing, and Japan is not immune to the soaring prices of energy and food. In the worst case, Japan might have to choose between the two superpowers.
Japan’s ability (or perhaps desire) to integrate with the rest of the world is also under question. Even after 40 years of the JET programme to improve English language skills, fluent English speakers remain rare. Many outward looking young Japanese move overseas, while immigration is still significantly restricted. While women are now a much larger part of the workforce, the glass ceiling remains in place to a greater extent than elsewhere. Japan’s response to COVID has been closer to China’s than to the West’s.
On the policy side, the Bank of Japan remains stubbornly out of step with other central banks in targeting lower interest rates and bond yields. After thirty years of very low inflation consumers and salarymen have not yet made the psychological jump towards higher inflation expectations, which is why Japanese inflation today is still at 2%. However, it is worth recalling that Japan has a history of inflation just as much as most other countries do, and the BoJ policy may backfire.
There are wider questions too about the quality of government in Japan and its ability to act decisively in a rapidly changing world. Defence is one obvious point where the Chinese threat to Japan’s southernmost islands needs to be countered. Nuclear power is another where Japan has a technological lead and the capacity to start generating an additional 230 Tera Watt Hours (approximately equivalent to 1/3 of European gas imports from Russia), but where the arguments after the Fukushima disaster still rage. And question marks remain over Prime Minister Kishida’s commitment to follow up on Abe’s legacy.
The Japanese market has become even less efficient
Finally, I wonder whether the obstacles which overseas investors face when investing in Japan end up with their putting it into the ‘too difficult box'. While it is a large and fertile market, few companies are covered by analysts, and language, culture, and travel all put barriers in the way. Obtaining a visa to visit Japan post-COVID is not a simple process. A common response to this is to invest through ETFs or global mandates which get their Japanese exposure from a small pool of large cap stocks. But I would argue that this makes the market even more inefficient and therefore attractive for those with the right skill set.
Do cheap valuations trump the negatives?
My own views today are swung by the astonishing cheapness of Japan relative to other markets, both in terms of stock valuations and the currency. As I am expecting another leg down in markets generally, I believe that Japanese equities should fall by less. The Japanese Embassy permitting, I hope to visit Japan later in the autumn and will report back after that.
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