Japan pleases investors with high returns and low correlations

Japanese equities have not offered investors great joy over time – indeed the Topix index’s flat performance this year may cause some celebration compared to the longer term – but fund managers there received at least three pleasant surprises since January.

The most recent was a 13% rise in the Topix in just four weeks, ending on 4 July. This was without doubt pleasing for passive investors as well as active managers, even if the index since gave back 2.5% from its July peak.

A second surprise was the larger 19.7% leap in the first quarter, before the Topix hit its 2012 peak so far, on 27 March.

One surprise – particularly welcome for Japanese stockpickers yet less commented on – came in February.

Around the time investors in some other developed world markets were struggling with equities moving in lock-step, but in Japan internal correlation of shares hit a 10-year low.

Correlations in Japan have since reverted to nearer their longer-term average.

Melissa Brown, senior director, applied research at analytical software provider Axioma, noted: “In February the 20-day correlation hit a 10-year low, and the 60-day [correlation] was close. While correlations have risen since that bottom, they have only reached average levels, which suggests markets do not seem to be driven by one unifying theme, which should be good news.”

Towards the end of July, Japanese stockpicking managers at Sumitomo Mitsui Trust Group commented that two factors stemming from uncertainty in the global economy seemed to have contributed to the low intra-stock correlation.

“The first is that the market is now focusing more on financial stability of companies than book value.

“In the past, some investors regarded PBR falling below 1 as in investment opportunity, however this is no longer the case, PBR for many stocks currently remains below 1.”

The Japan analysts also noted export-oriented stocks were being sold, while companies relying on their domestic market, and nascent internet-related companies, were “relatively strong”.

“The importance of the stock picking is now more evident than ever,” they said.

Sumitomo downgraded its 2012 earnings forecasts, “mainly driven by revisions in the manufacturing sector. Following research on the global electronics supply chain, their forecasts for the electronic appliances sector were widely cut back due to a bleak PC market outlook.

“Tightening of margin expectations in materials related companies, for which general-purpose items account for a large portion, also contributed to the decline.

Masashi Oda, Sumitomo’s chief investment officer, said: “The Japanese equity market still offers attractive investment opportunities and we strongly believe that current share prices do not reflect the healthy fundamental position that most companies enjoy.”

The market consensus on earnings forecasts continues to be revised downwards, he said, however the estimated PER gap between the TOPIX and the S&P 500 is still negative.

But Oda cautioned: “Corporate earnings may lose their momentum especially in the electronic appliances sector as our analysts anticipate that demand for technology products may miss the market’s expectations.

“Against this background, we have focused our efforts towards picking up companies linked to domestic demand, which are expected to post a higher earnings growth; whilst we remain cautious on technology related stocks.”

Oda suggested some companies are focusing their efforts ever more on their shareholders.

He said the recent spate of cross-border M&A initiated by Japanese companies “shows a shift towards taking shareholder opinion seriously and as a result, many are working on issues such as improving ROE and efficient cash utilisation”.

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