On the surface Japan is in terminal decline, an investment story that very few understand. False dawns have benefited few, and many long term investors have suffered from years of pitiful returns.
However, over the last two years a handful of brave warriors (fund managers) have argued that this perception is wrong and that Japan offers an excellent long term investment opportunity.
The setting of the sun…..
From the 1950s through to the end of the 1980s Japan enjoyed an explosion of growth delighting many investors. This all came to an abrupt end in 1989.
Japan now has a debt mountain larger than Greece, its balance sheet doesn’t balance, deflation has crippled growth, property values have crumbled and the population is aging. The banking sector best sums up the decline, from 19 major banks in 1989 there are just seven and none of these have the same name
The facts are there for all to see – Japan is broken, and so why would anyone say it offers long term investment opportunities?
The rising of the sun….
For Japan to continue along the same path there is only one outcome – destruction. What has changed, and is underestimated by the market, is a willingness to change and a desire for stability. Japan now has a majority Prime Minister, the first time in 25 years – during which time they have seen 17 different leaders.
But Japan has not stayed still over the last 25 years which a terminal decline would suggest. The Tokyo skyline has changed significantly in a positive direction and Japanese companies are more multi-national, deriving only around 25% of earnings from domestic markets.
What hadn’t changed (and what investors focus on) was a significant policy shift to tackle the problems including the budget deficit, deflation etc which would enable them to build on the positives and reverse the structural decline.
Today Japan is a very different place to where it was even three years ago. There is a real sense of optimism and this is attributed to two things. Firstly in December 2012 Prime Minster Abe was voted in with a mandate for change.
This is significant because not only does he have full control of the party but he has a good majority in the lower house but a workable majority in the upper house.
And secondly for the people there is a belief in the future, and a belief that they are recognised by the global world, mainly driven by the hosting of the Olympic Games in 2020.
These points do not make it a rising sun but the significance should not be underestimated.
The investment case
The reason to invest rests on a belief that this time is different.
There are three arrows to reform.
The first was to pump enough money into the system so there was no issue with the credit supply. Quantitative easing aims to double the monetary base in two years, which effectively aims to halve the value of the Yen. We are halfway through this process.
The second is borrow and spend to get the economy going and hold the line before corporate earnings pour back into Japan. This process is progressing with investment in infrastructure projects and defensive……
The third arrow will take longer and is the deregulation of the supply side.
How does this play out in practice, below are two examples:
Over the last twenty years many businesses have become global multi-nationals deriving most of their profits from overseas with only around 25% from domestic Japan. In Europe / US companies are more domestic focused with around 50 to 65% focused on their own markets.
If the Yen weakens (and it has already decreased by 25%) it increases the corporate profits derived outside of Japan. This in turn increases the tax revenue coming in and helps to reduce the budget deficit.
The second part of this is that as corporate profits increase companies can increase wages and create more full time employment. In turn this then feeds back into government as more people should be paying tax etc.
Some argue that the reforms are moving too slowly and they are running out of steam.
2013 demand was driven by foreign investors looking to take advantage of the reforms and then taking profits at the end of the year. However, the demand / supply is not balanced so effectively there are not enough domestic buyers to offset the foreign sellers. So this creates a negative impact on the market.
The domestic buyers need to take control of the market and not be beholden to foreign investors. We are starting to see this change.
Japanese investors have favoured bonds and moved away from equities but two things are starting to reverse this trend. Firstly a new Nippon ISA offers investors tax free returns if they buy and hold for a period of five years. The issuing of these has been slow but the demand is significant. Secondly pension funds have just started to increase their weightings to equities, this is significant because over the last 25 years the weightings had decreased. This increased demand by domestic investors should start to reduce the impact of foreign investors’ desire to make quick profits.
Another significant move is to drive investors out of cash by creating negative real interest rates by creating inflation rather than deflation.
We are starting to see this take hold.
But what about…..
There are many elements which would derail change – we have taken three examples – aging society, the deficit and a change in leadership.
Aging society – this is something faced across the globe, Japan is the first developed nation to tackle this head-on. This means making it easier for foreign workers to come in, easier for female workers and also enable people to work for longer. These policies are coming in to place.
Deficit – this is a big headache but steps are in place to tackle this. Increased corporate profits, increased consumption tax, and more personal tax are all steps to reduce the deficit. It won’t change overnight but it will make the long term prospects better.
Change of leadership – Abe has a three year mandate. This is effectively until the end of 2015. If he remains popular then he could be elected for a second term, if not it will be difficult to unwind the policies now they are in full swing.
Is there anything else to consider?
The examples demonstrate how the structural changes will make a difference, and are already. For investors Japan is relatively cheap. The long term average price-to-book ratio is 10 x earnings and average dividend 2 to 3%.
The real challenge for investors is whether to hedge the Yen or not.
The reason is that if the Yen devalues investors will lose some of the gains because of the currency. As an example, in the last six months of 2013 those with a Yen hedge would have seen the greatest returns (so weaker yen, better profits = stronger return). This has reversed this year as the devaluation of the Yen has slowed and in fact the losses on a hedged asset class have been magnified.
If investors believe the Yen will play a significant part of the recovery story then hedging has to be the best route. However, this is likely to be more volatile and some may argue that investors should blend with a non-hedged fund to reduce the volatility.
Choosing the right fund
Most funds offer a hedge share class but these tend to be offshore funds. Neptune has an offshore hedge fund. Well respected non-hedged funds are GLG Japan CoreAlpha and the Baillie Gifford Shin Nippon Investment Trust. Other respected managers include Legg Mason and Schroders.
Within these funds they offer access to multi-nationals, new Japan and domestic companies; investors will need to decide for the new Japan who the winners will be.
Investors are impatient and Japan is one of those regions where investors are used to making short term raids and then bailing out. Japan has not stood still for the last 25 years and there is a lot of positivity; combine this with a prime-ministerial mandate for change and this offers an exciting story for investors.
However, there are significant risks and although a lot has happened a lot more is still needed. For some investors a focus on a single country may seem too risky against the potential reward.
NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.