2018 saw a record amount of foreign investment flows abandon the Japanese equity market. But the flight of capital is not a new phenomenon - Japanese equities have been routinely shunned by global allocators for decades. It has become a consistent mystery of asset allocation: why are fund buyers underweight to the asset class with the least correlation among large global markets?
One - perhaps more prosaic - reason why investors are underweight Japan is the market is often viewed as peripheral for westerners; it has far less weight than the US or Europe in global indices. But Japan has also become victim of behavioural finance and investors' home market bias. After all, Japan is very remote from developed market global capital hubs and investors typically have more appetite for high beta emerging markets and China in particular.
Yet, Japanese equity as an asset class is a powerful diversifier. With a respective correlation of 0.66 and 0.70 to the US and Europe, Japan is less correlated to other equity markets. And as contradictory as it may sound, emerging markets are actually not as diversified from European markets, with a correlation of 0.79. In this context, Japan stands out as a relative beacon of diversification for global allocators.
A large part of this lower correlation comes from the currency component. The yen has its place in a global asset allocation thanks to its risk-off optionality. Therefore, European investors and asset allocators would be wise to add Japan to diversify their core European and de facto euro allocations. Viewed globally, the Kabuto-cho represents an attractive source of diversification to confront potential risks in Europe such as Brexit and Italian/French political instability.
Japan also has diminished exposure to the market squalls that often beset emerging Asia. On aggregate, Japanese companies have little exposure to China. Indeed, the most popular smartphone brands in China are local and the most popular foreign cars are German. Even though China is the largest global car market, less than one out of ten Toyota cars are sold there.
Having said that, the Chinese economic slowdown is weighing on some cyclical sectors that are more difficult to substitute, like robotics, factory automation and commodities, such as steel. In our portfolio, we only hold three companies, including Toyota, out of the fifty Japanese constituents of the Nikkei China Related Index. Thus, our exposure to China is low.
Japanese equities are also currently inexpensive and valuations already integrate a slowdown in global economic growth and downward revisions to consensus earnings estimates. The price-to-book multiple in particular is at a six-year low, at about 1.1x - down by about 15% since last summer. At such low P/B, the Japanese market is quite attractive; investors could expect annual gains in line with the Return on Equity at more than 7%.
Separately, the market dividend yield is about 2.5%, to which we can add another 1% in share buybacks for a total return to shareholders above 3.5%. During this current earnings season, many companies announced significant and unexpected buyback programmes like Softbank and Sony.
And contrary to the Federal Reserve or the ECB, we have a very good visibility on the future actions of the Bank of Japan, which is in ‘stand still' mode. In 2019, the advantage compared to other major equity markets will be Japan's stability.
Given the ongoing global economic slowdown, we prefer domestic companies and multinationals exposed to the US market. Public works and infrastructure-related companies offer attractive valuations and good visibility without being exposed to the global cycle. And, as always, we like companies with strong balance sheets, those paying good dividends while having low payout to ensure a sustainable payment, with the buyback optionality as icing on the cake.
By Joël Le Saux, portfolio manager of the OYSTER Japan Opportunities at SYZ Asset Management