Japanese corporates: Selectivity is key
Dean Cashman (pictured), fund manager of the Eastspring Investments – Japan Dynamic Fund and head the Japan Equity team at Eastspring comments on the outlook for Japanese corporates.
For investors who choose to focus on the ever changing daily macroeconomic news flow, it becomes a challenge to identify what is really important in forming investment decisions. What is the appropriate response to swings in market sentiment around concerns for the global cycle and the issues facing China? What about the effects of reflationary policies of Abenomics? Are Quantitative Easing and economic reforms on the right path and how should we position for the future?
Too often we observe significant weight being applied to almost irrelevant information in decision making.
This approach overlooks that it is almost impossible to consistently forecast the effects of short term news flow on markets, relying on an ability to “time the market” in a world that holds an uncertain future. Patient investors, by contrast, have the advantage of allowing share prices to reveal the most attractive investment opportunities, taking advantage whilst other focus on short term noise.
For instance, one of the latest trends is the market’s narrow focus around defensive stocks. This appears to be a response being driven by aversion to rising volatility. These kinds of stocks appear to offer comfort to investors due to a perception of certainty around the delivery of shorter term earnings. Examples of these names can be commonly found in Consumer Staples; Pharmaceuticals; Railways; and Utilities.
The main problem with this investment thesis is that many market participants are willing to handsomely over pay for this comfort from perceived earnings certainty. This is something to avoid at all costs as overpaying for shorter term certainty can give way to longer term underperformance. A herd-like focus on shorter term macroeconomic news flow often serves to harm investors’ longer term returns.
This raises a big question: where is the value in this?
On the other hand, the market’s narrow focus on themes can leave behind a long tail of unloved, out of favour and very cheap names for contrarian investors seeking out value to exploit. These opportunities are best identified on a stock by stock basis.
Identifying companies with very attractive starting valuations is essential to this approach. However it is also encouraging to observe supportive trend earnings being delivered for a number of the mispriced opportunities that can be identified. More broadly in Japan, since 2013 there have been eleven straight quarters of upwardly revised earnings, each time beating the market’s expectations.
In aggregate, the long process of balance sheet repair in Japan is well and truly over. Arguably for many companies balance sheet health is “too strong” which points to a level of inefficiency. In fact companies are now focused on improved capital efficiency; generating significant cash flow; and applying renewed balance sheet strength to pursue sensible expansion strategies. This fundamental change remains underappreciated in the share prices for many Japanese companies.
On the other hand, unlocking balance sheet cash is seen as a potential longer term value driver: in 2014, total share buybacks were JPY4.2trillion, up 86% from 2013, and the trend has continued into 2015. In the past 12 months to 10 August 2015, companies have announced ¥4.5tn in buybacks, a six-year high and equivalent to a 0.75% buyback yield for the TOPIX.
In addition, the introduction of the new Corporate Governance Code may encourage a move toward higher pay-out ratios that started in 2014. There is admittedly ample scope for pay-outs to improve. However this is an example of positive structural change we observe in corporate behaviour which is supportive for sustainability of returns and therefore the longer term rerating for Japan equities.
The wider lesson to draw is that, in general, the finance industry focuses on the very near-term, rather than look for stocks with significant difference between share price and value of the company, which is determined by the returns the company can generate on a sustainable long-term basis.
By identifying the most mispriced opportunities and conducting a deep due diligence to confirm that value exits, patient investors can wait for significant value to be realized. This also means taking long-term positions without being forced to close them in response to excessive volatility like near-term focused investors.
Understanding the fundamentals of each company considered as an investment opportunity, including changes in governance and market context impacting them, as mentioned above, is crucial to determine the longer term sustainable earnings potential of the business – and make the most out of the new opportunities offered by a changing Japanese equity market.
There is therefore a range of unexpected investment opportunities in Japan – if you are willing to avoid the herd, let cheap share prices take you to opportunities, confirm that value exists and be patient.