Japan: The Land of the Rising Stock Market

As seen in this month’s issue of Master Investor Magazine.

By Rowan Chaplin

Investment case for Japan

Following the December 2012 re-election of Prime Minister Shinzo Abe, the prospects for investors in Japan look far more attractive than at any time since the bursting of the Japan bubble. With the clear support of industry and shareholders alike, a combination of “Abenomics” – namely, fiscal stimulus, monetary easing and structural reforms – and the looser monetary policy advocated by BoJ Governor Kuroda, the investment case is viewed by many as compelling. The historic reasons for avoiding investment in Japan are being removed at pace and the August 2013 introduction of the JPX 400 Index (admitting only those companies that adhere to global investment standards and the Corporate Governance code introduced in June 2015) is having the desired effect of raising management awareness of the need for Japanese corporations to compete in the global marketplace.

The market rallied after the election of Mr Abe in 2012 due to the hope that there would be change, but few could have envisaged the amount and scale of positive change that has occurred. Rather than carrying on with the same monetary policy and the Yen becoming ever stronger and hurting the manufacturing base, Mr Abe and Mr Kuroda decided it was time for change.

It could be argued that at some point, even though Japanese bond issuance was a largely Japanese affair, there were questions as to how long economic stagnation and government deficits could go on for. Abenomics seeks to boost the economy and benefit from increasing tax revenues and closing the fiscal deficit. The benefits from increasing wages should feed down to consumption and put an end to fears of stagnation and delayed spending.

Quantitative Easing (QE) had been adopted by most central banks as a way of stimulating their economies and weakening the associated currencies to improve export competitiveness. It had bought time everywhere else, why could this not work in Japan? QE was finally adopted by the BoJ, copied and renamed QQE, Qualitative and Quantitative Easing. Combined with reform, the Japanese economy was going to be revitalised.

After the initial easing in April 2013, Mr Kuroda surprised the market again in October 2014, by increasing government bond purchases to ¥ 80 trillion and extending the duration by three years, to enable the BoJ to buy in the 7 to 10 year maturity range. Rather than forcing the various public pensions to support the JGB market at yields that were going to ensure a capital loss if deflation was defeated, the economy picked up, and the stock market took off, the GPIF (see below) was given the freedom to optimise its investment strategy.

Much has been written about how disappointing and ineffectual the third arrow of Abenomics (promised structural reforms) has been, but maybe investors are confusing arrows and ‘silver bullets’. The problems of Japan were many years in the making; their undoing was never going to happen overnight.

As Martin Malone of Mint Partners Ltd. said in his piece, “Turbocharging Japan’s Gameplan”, “Overall the 2013-2016 period will see an impact equivalent to 200% of Japanese GDP or in dollar terms equivalent to US$ 10 trillion.” Let’s not be too downbeat about the pace of change while many of the policy levers are still being pulled and their effects are not yet completely felt.

Corporate Governance

Corporate governance in Japan has been a problem area for investors for many years. T Boone Pickens famously tried to take on Koito Manufacturing, giving up in 1991. In the early 2000s more aggressive shareholder activism hardened Japanese resolve not to yield to outside forces. Investors felt that while Japan seemed cheap it was unlikely that management would act in shareholder interests. Many investors had been frustrated over the years by many false dawns of recovery in Japan and a sense of ‘won’t be fooled again’ presided over many participants. Japan had disappointed again and again, which helps to explain why some investors retain a degree of caution towards Abenomics today.

Real Change

The introduction of the JPX-400, an index constructed as a result of meeting quality and profitability criteria, ROE (return on equity) and other profitability measures, plays on a societal trait of wanting to conform and be included. The ‘shame’ of being excluded from this index has resulted in a dramatic change of company strategy and planned shareholder returns. Amada, a machine tool maker was one of the first to change and Fanuc, the traditionally shareholder ‘unfriendly’ company surprisingly responded to outside pressure from a US Investor. Dividends and buybacks rose dramatically and an investor relations department was created. It seems that

corporate governance has been embraced officially, and now investors are pushing on an open door in Japan. Additionally a code for corporate governance was announced by the Ito commission and implemented in June 2015.

The Code outlines:

– The need to treat all shareholders equally, particularly minority and foreign shareholders.

– Co-operation with stakeholders other than shareholders.

– Appropriate information disclosure and transparency to build a useful dialogue with shareholders.

– Fiduciary responsibilities of the board.

In the past there was less confidence that profits would fall to the bottom line and that management would act in the best interests of shareholders. Companies argued that they invested for the long term and this often hid a lack of strategy. Michael Porter in his book ‘Can Japan Compete?’, written with Hirotaka Takeuchi and Mariko Sakakibara, outlines how many companies in Japan focus on operational efficiency in their businesses, rather than questioning whether they should be in those businesses at all.

Investment Themes

Over the years, there have been many sustainable investment themes and sources of competitive advantage in Japan, and many of them still exist now. After the bubble, foreign investors focused on industries where Japan was taking market share and as earnings grew valuations tended to move towards those of global peers. The global sectors were Auto, Pharmaceuticals and Electronics. These sectors also had the advantage of being immune to the strong Yen and were seen as much more competitive when compared to some of the sleepier more domestic related sectors in Japan. Japanese automobile manufacturers have done incredibly well in North America during a time of high fuel prices. Japanese cars are seen as very well made and fuel efficient. Toyota now has a 14.6% market share in the US (year to March 2015). Fuji Heavy (Subaru) has done well with its active safety, four-wheel drive systems and safety braking systems. Japanese companies have a 37.3% global market share in aggregate.

Spinoffs

Successful industries breed an efficient, leading edge supply chain and this is particularly true of the auto industry. Supplying to leading car companies also creates a leading auto parts industry. US auto manufacturers and some struggling European auto companies are starting to benchmark themselves on their Asian rivals and they order parts from the likes of Denso and gearbox maker Aisin Seiki. Of course these dynamics change, but with the current theme being safety related car features, Japanese companies excel in this sub-sector in addition to just executing efficiently.

Hybrid technology is an area of expertise in Japan and there are many rival technologies to choose from. Hydrogen fuel cells as well as hybrid fuel / battery combinations provide manufacturers with options.

Battery technology is another strength in Japan, with Panasonic in a JV withwith Tesla, the US automaker, Sony for mobile phones, and of course GS Yuasa, the slightly accident prone Boeing supplier. Many of these hybrid related companies, like GS Yuasa, have not been helped by the collapse in the oil price, as demand for environmental cars is largely correlated to the price of oil. The current situation provides another opportunity to assess and invest in these companies again.

Electronic components are another source of competitive advantage in Japan. Miniaturisation is a key strength of the components industry and even if some of the older established Japanese electronics companies have lost their completive edge, the current leaders of Apple and Samsung have taken up the slack and have been major users of electronic components from the likes of Murata, Nidec and Alps Electric, who are just a few of the companies to benefit from the tablet and smartphone wave.

Making the next generation of consumer products also helps Japanese robotics companies such as Fanuc and Yaskawa Electric who equip the production lines of Hon Hai (Foxconn) in Taiwan and China, and who recently announced plans to expand production in India. An example of this would be mobile phone manufacturers sourcing high quality machine centre and robo-drills from Japan in response to consumer demand for better specification handsets and tablets.

Problem Sectors

Software companies in Japan generally do well from home-grown projects – for example, the ‘My Number’ social security system upgrade to simplify pension records. The upgrading of Japan’s banking system infrastructure also requires custom design and suits the more domestic IT contractors. NTT Data and Nippon Unisys are examples of firms benefiting from these contracts. These projects are often won by domestic firms, but question marks exist about their ability to win overseas contracts. After the implementation of these domestic projects, some analysts are revising down orders for some software firms, and with contract rates for engineers at all-time highs much of the good news could be in the price.

In smartphones and tablets nearly all the software is sourced in the US, with IoS and Android now dominating mobile handset software. Without control over the operating system, where much of the functionality and value added exists, it is possible that Sony and Samsung become ‘just’ hardware manufacturers and good though this is, is it enough? Sony withdrew from PCs, and smartphones are very similar products, so without scale what is the future for this division? Microsoft recently wrote off a portion of its Nokia acquisition, demonstrating continuing market share problems with Windows phone software and the importance it plays in business performance.

LCD

Having established an early lead in panels, there was a sense that investment in ever better screens would lead to a pot of gold. Sadly this particular pot remains firmly at the end of the rainbow and seemingly unattainable. Sharp and the LCD supply chain remain troubled and phone makers are happy to support them as sources of cheap screens. They invest in machinery to help them manufacture screens in hope of keeping them alive; otherwise the price of panels could increase dramatically.

Where to invest now?

Year to date the GPIF (Government Pension Investment Fund) has been moving out of JGBs (Government Bonds) and into equities using ‘Smart Beta’ which effectively means following JPX 400 selection criteria. Smart Beta involves assembling an index, not based solely on a market cap basis, and adding different, normally qualitative measures to picking investments.

Analysing the market quantitatively, unsurprisingly, value and quality factors exhibit outperformance year to date as investors follow or imitate the investment strategy adopted by the GPIF. Momentum as a factor also backs this up. Stocks with strong sensitivity to macro factors have not been happy places to invest as a combination of the Greek / Euro turmoil and wobbles in China have taken their toll.

Topre 5975 Jp

Topre has divisions in high tensile steel pressing technologies and refrigeration for temperature controlled logistics. Topre acquired the pressing business from Yachiyo, a Honda group company, in some well-timed consolidation of the Auto Parts sector. Traditionally Topre was a Nissan supplier so a cross Keiretsu acquisition (cross group) is seen as a progressive step in the right direction.

In food distribution, Topre’s temperature controlled deliveries are part of ‘safety’ within distribution and should be a growth area for the future. The company currently trades at a PBR (Price Book Ratio) of just over 1 times and a PER (price earnings ratio) just less than 10 times. ROE of 11.2% and cash dividend cover associated with the acquisition could come in lower than expected, making this company potentially even more interesting.

Daifuku 6383

Daifuku operates in the material handling arena and automates smart warehouses to improve efficiency in customer inventory control. Daifuku previously used the strong Yen to purchase businesses in the US to improve its visibility there. Profitability will improve from here. Automotive factory automation is seen as a growth area, and some of the early plants set up by Toyota and Honda are nearly 30 years old and are being upgraded and replaced. Airline automated baggage handling is another area of expertise. Daifuku’s exhibits ROE of 9.6% and dividend cover of 4 times. Analysts are forecasting record earnings for March 2016.

Pacific Industrial 7250

This company is a leading tyre valve manufacturer and has advanced safety related products to record tyre pressure in real time to alert the driver of any problems at an early stage. Safety, as mentioned above, is an area where automakers are trying to differentiate their products and Pacific industrial is well placed to benefit from this. The company has an ROE of 10.2%, a Price Book ratio of 0.85 times and dividend cover of 5.2 times.

About Rowan Chaplin

Rowan Chaplin is a Fund Manager at Stratton Street with more than 25 years’ experience in investment management, with a focus on Japan. He is also a former Director and Head of Japanese Equity Desk, with both buy-side (F&C Asset Management and CQS) and sell-side experience (Mizuho). Rowan was AA rated by S&P in April 2000 when the FP Tokyo Trust fund was ranked 20/181 and 25/154 over three and five years, respectively. He joined Stratton Street in May 2014.