In the 17th century, Japan experienced a long period of isolation from the outside world, known as sakoku. Now, it is contending with a different type of seclusion, as international investors continue to ignore the archipelago.
Japan is unloved and oversold by investors. The average exposure of 318 funds in the Investment Association's global sector is under 5%, despite a 7.1% weighting for the country in the MSCI ACWI World Index.
But with a thriving domestic economy, valuations at historic relative lows, rising yields and sweeping corporate reforms shaping more shareholder-friendly boardrooms, are investors leaving themselves vulnerable to a sharp revival in Japanese equities?
International investors have experienced false dawns before where Japan promised but ultimately failed to climb out of economic stagnation. However, now the Japanese economy has finally emerged from a spiral of deflation. Economic conditions are robust; Japan's real GDP grew by 2.1% in the first quarter of 2019, recording growth in positive territory for the second consecutive quarter. Meanwhile, jobless numbers are at a 40-year low.
Company estimates for the upcoming financial year have been modest - with a forecasted 2% growth and flat operating profits - but this owes more to the usual conservativeness of Japanese companies. Having exercised caution on cyclicals, consensus expects the aggregate operating profit of companies in our portfolio to grow by high single digits in 2019.
By digging deeper, investors can see company fundamentals have vastly improved. While the Topix is at the same level it was four years ago, company margins and cash holdings are much higher, shareholder equity has increased by 20%, and cash deposit by 25%. We expect share prices, which came down in line with the global economy, to rebound - in some companies the unrealised gain could be as much as 50%.
The escalation of trade tensions has real world implications, but we believe fears are overdone. As for automakers, we have companies with a very low exposure to Europe and China, and the complexity of the supply chain means Japanese exporters are less vulnerable than many believe. For example, many Japanese brands, who control 40% of the US car market, are serviced by US-based manufacturing plants.
Tough trade rhetoric is providing the opportunity to find attractive valuations. Domestic plays underpinned by secular trends, which have been a victim of indiscriminate selling, provide another route to growth. For example, Japan's rapidly ageing population is lending support to the railway sector, as the older demographic increasingly chooses to travel within the country.
We are also taking advantage of land shortage in booming cities - namely Tokyo, which is attracting a growing number of workers into a scarce amount of land. As rents rise and salaries increase, we see a long-term opportunity in residential REITs.
At 1.4%, inflation is below the Bank of Japan's 2% target, and the Governor of the Bank of Japan, Haruhiko Kuroda, missed the window of opportunity for hiking rates a year ago when economic momentum was strong. However, by also maintaining optionality through selected Japanese banks, we will benefit from any potential movements in the yield curve or rates, which could occur next year.
Land of rising income
Another underappreciated trend in Japan is the developing corporate governance story. With the adoption of Japan's Corporate Governance Code in June 2015, investors took note, but pay-outs remained low, as did buybacks. But we are now on the cusp of a step-change in shareholder friendliness.
The pay-out ratio is at 35% and growing, with market dividend at 2.5%. Our portfolio dividend is at 2.9%, due to our exposure to above-average sectors - 3.5% for automakers, 3.6% financials and 3.4% for REITs. Moreover, the amount of share repurchases announced in April and May has been twice as large as last year, and at the highest level in over a decade - likely to exceed 1% of the Topix market cap. At the same time, the Bank of Japan continues to purchase ¥6trn Japanese shares per annum, about 1.5% of market capitalisation.
The government also recently explored the removal of the ‘poison pill' or takeover defence which gives current holders the right to buy more shares of a company being acquired, to dilute the acquirer's holdings. The pill has been retained by Japanese companies for years and is seen as a major impediment to improved governance - but this is now beginning to change. Last year, 20 Japanese companies with market capitalisations over ¥50bn scrapped this measure, and one of our top holdings, Keisei Electric Railway, recently followed suit.
As Japanese corporate governance is reshaped, shareholders have a unique window of opportunity. By identifying opportunities in diverse companies and sectors benefiting from the positive domestic story in Japan, and implementing optionality, investors can access a plethora of long-term return generators. As the tailwinds gather for Japan, investors and fund selectors must consider the downside potential of ignoring the archipelago.
Joël Le Saux, portfolio manager of the OYSTER Japan Opportunities fund at SYZ Asset Management