20 Jun 2010 | World

Japan - an Investment Opportunity? 

Baillie Gifford’s proprietary research process tries to find attractive investments by looking at 5 fundamental factors – Industry Background, Competitive Position, Financial Characteristics, Management and Valuation.

I thought it might be interesting to try and apply the same framework to an entire equity market, in this case Japan, in the hope that it might be of interest to investors and asset allocators wishing to take a longer-term view of the risks and opportunities of investing in the market.  
 

Industry Background

Domestically, Japan faces a number of challenges.  These include the large amount of government debt, the mature and over time likely shrinking population and persistent deflation.  However, a large level of government debt does not make disaster either certain or imminent.  Japan’s population may be old, but it is now maturing at a slower rate than many other more mature economies, so the negative impact on growth caused by demographic headwinds may begin to decline over time, having already reached its peak.  In the longer-term immigration remains an obvious part of the answer.  Finally, we believe that the DPJ (Democratic Party of Japan) is making increasing efforts to end the persistent deflation, which has provided a difficult backdrop for the Japanese economy. 

However, many companies, especially the larger ones, are international in nature so need to be analysed on a case by case basis depending on where their end markets are.  It is important to remember that Japan’s Asian neighbours are in many cases developing at a rapid rate, which provides substantial opportunities for Japanese companies.  Japan is a large investor in China and many Japanese companies have already moved very substantial amounts of manufacturing to cheaper overseas locations.  Meanwhile, the cyclical rebound in domestic economic activity provides an additional shorter-term boost to demand.    

Broadly, this suggests to us that the strongest growth opportunities are likely to be either smaller domestic names (which have an opportunity to take market share) or in companies with a good proportion of operations in overseas markets with attractive characteristics.  Both of these are areas that we have tended to find opportunities to invest in over time and are particularly enthusiastic about at the moment.
 

Competitive Position

Domestically, as with anywhere in the world, some of Japan’s companies enjoy durable competitive advantages and some don’t.  We try to focus our investment activity on those businesses that we believe have entrenched competitive positions that will allow them to earn good returns on capital over the longer term.

Exporting companies need to deal with a wide variety of competitive threats, both from other developed nations, and newer still emerging competitors.  It is in this area that we believe there is most concern surrounding the durability of Japanese companies’ competitive advantages, some of which is justified and some of which is not.  When thinking about this debate it is important to remember that Japan’s major exporters typically do a lot of production outside Japan already – limiting the scope for emerging competitors to undercut them on price.  Additionally, many of Japan’s manufacturing companies have made very substantial investments in intellectual property and management know-how.  Finally, we believe that for many companies the sales and servicing networks that have been built up globally will be especially challenging for competitors to replicate.  We are selective in this area and unless we can clearly identify durable competitive advantages we are very reluctant to invest our clients’ money. 
 

Financial Characteristics 

There is an ongoing debate, both in Japan and globally, about the appropriate balance sheet structures for listed companies.  Many Japanese companies have been criticised by Western investors for holding large amounts of cash or cross-shareholdings which act as a drag on returns for long-term investors.  However, many have started buying back shares and raising dividends and we expect this trend to continue, providing an opportunity for Japanese dividends to grow faster than underlying earnings for some years to come.

Additionally, it is interesting to note that Japan has not yet adopted the IFRS (International Financial Reporting Standards) standards for accounting, but uses Japanese GAAP (Generally Accepted Accounting Principles.  Our view is that Japanese accounting is generally rather conservative in nature.  Any exceptional or extraordinary losses are taken off the reported net profits for the year, which in a downturn can make the results of some Japanese companies look dramatically bad, even though the underlying earnings of the business have held up rather better.  Goodwill is still amortised in Japan, which depresses the reported profits of companies that have grown by making acquisitions.

In our research efforts we take into account the value of non-business related investments and make appropriate adjustments for accounting treatments that obscure the underlying economics of businesses.  This helps us to try and identify the most attractive investments for our clients. 
 

Management

As would be expected, there is a diverse range of management styles in Japan.  It is a crude characterisation but we believe that many Japanese companies are very strong at managing their operations but less good at managing for the benefit of shareholders.  Some companies focus either on the greater social good or the needs of their employees more than is helpful for shareholders.  This is the main reason that we own no shares of the electric power utilities for example, where our perception is that managements continue to invest shareholder’s money at very poor levels of expected return. 

On the other hand, unlike in many Anglo-Saxon economies, options issuance to management is rare in Japan, so per share earnings growth is not diluted over time.  We also believe that it is easier for managements to continue to re-focus on increasing returns on assets through better balance sheet management than it is for them to struggle to turn around a business with a poor competitive position, providing optimism for further improvement.
 

Valuation

Estimating the intrinsic value of a company or market is a challenging process and one that is prone to much uncertainty.  The comments below are simply intended to give some perspective in weighing the opportunity presented by the Japanese market with other available alternatives.  Broadly, we can apply three methods of trying to value the market – assets, earnings power and income. 

With the Topix at around 900, the index trades on a price to book value of about 1.1x, which is low relative to most developed markets.  Is it really the case that the listed Japanese sector is only worth slightly more than the conservatively depreciated asset values?

Ideally, in terms of earnings power we would try to estimate the potential earnings power of the market going forward.  However, we can get a conservative view, that requires fewer assumptions, by looking backwards.  Looking at a 10 year average of earnings has been emphasised by academic researchers, notably Richard Shiller, as providing some helpful indication as to the potential long-term future return from a market.  In the case of the Topix this number is currently around 22x.  When making international comparisons we need to note that in many cases there has been clear growth in earnings power over that time, Japanese accounting is somewhat conservative and corporate balance sheets often have additional financial assets of value. 

Although it does not make for such a strong case, the comparison between domestic bond yields and equities is made by domestic investors.  Again, the result is much more favourable for equities than bonds in our view.  Even after some savage cuts to dividends, which we expect to reverse over time, the domestic equity market yields about 1.6%.  This compares with a 10 year Japanese government bond yield of less than 1.4%. 
 

Conclusion

Our team is focused entirely on trying to find fundamentally attractive companies that are listed in Japan.  At the current time we are able to find many companies that we believe have fundamentally attractive prospects, and at current market levels we believe that they are in many cases available at good prices.  To us, that gives a solid foundation for a satisfactory long-term outcome for investors. 

Finally, to finish it may be interesting to reflect on Sir John Templeton’s timeless words:- “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.”  Investing in Japan over the last 15 years or so has rarely been an especially fruitful experience for investors.  Hopefully, the reader will agree with me that we are certainly not in a stage of euphoria; and I sincerely hope that the above may assist in one’s ongoing deliberations of the opportunity presented for investment in Japan.

Author: Matt Brett
Matthew graduated with a BA (Hons) in Natural Sciences (Psychology) in 2000 from Cambridge University.  He holds a PhD in Psychology from Bristol University and is a CFA Charter Holder.  He joined Baillie Gifford's graduate scheme in September 2003 and is an Investment Manager in the Japanese Investment Team.

 

Topix 500 Past Performance

31/05/05 - 31/05/06	31/05/06 - 31/05/07	31/05/07 - 31/05/08	31/05/08 - 31/05/09	31/05/09 - 31/05/10
29.7%	-1.9%	-7.3%	-14.4%	13.8%

Source: Morningstar, share price bid to bid, net income reinvested
 

Investment markets, including currency exchange rates, can go down as well as up and market conditions can change rapidly. Past performance is not a guide to future performance.

The views that are expressed in this article should not be taken as fact and no reliance should be placed upon these when making investment decisions. They should not be considered as advice or a recommendation to buy, sell or hold a particular investment.

This article contains information and opinion on investments that does not constitute independent investment research and is, therefore, not subject to the protections afforded to independent research.