By MARCEL PORCHERON 31/10/2008
The Japanese equity market touched a historically low valuation recently when it traded below book value (the value of tangible assets). The Topix index closed at a low of 746 on the 27th October following a 32% decline from 1101 early in September and has since rebounded to close at 867 on the 31st October as the Bank of Japan announced its first interest rate cut for seven years. October saw the index fall below its 2003 low. At the same time extreme volatility in currency markets has led to a 17% appreciation in the value of the Yen, which has helped compensate sterling based investors. Is now the time to buy Japan?
The latest estimates put the Topix index on a price to earnings ratio of just 9.3 times (Source: Financial Times) when loss making companies are excluded. That compares favourably with international markets, where the Japanese index has usually been more expensive (which is sometimes explained through the more aggressive way in which depreciation of assets is charged in Japan). In late September 60% of the companies in the Japanese market were trading at valuations below their book value, which fund managers generally accept as a fair reflection of the market value of a company’s assets.
Source: Lipper
Corporate Japan is in relatively good health
The Japanese equity market is distinct in that it is very heavily export related. When global growth slows Japan tends to sell off as a result because slowing global growth normally means lower sales for Japanese companies. However, Japan boasts some world leading companies, which are now trading on relatively low valuations.
One of the Japanese equity market’s other attractions is that its net debt as a percentage of shareholder equity has fallen considerably and is now below 50%. That has meant lower shareholder returns in the past, but in the current environment lower borrowing and higher cash levels are seen as strengths. Shareholders are generally also seeing rising dividend payments from the Japanese equity market, whilst the dividend yield has risen to 2.9%, also helped by a falling market. That is still low by international standards, but a big improvement for Japan!
Scott McGlashan and Ruth Nash, managers of the JOHCM Japan fund estimate that 50% of companies in the Topix Index have net cash on their balance sheets whilst an estimated 334 companies are trading below book value with net cash on the balance sheet. That compares to just 3 in the MSCI Europe and the S&P500 respectively and just one company in the FTSE 100.
In the long term Asian equity investment specialists like Aberdeen’s Asia Pacific Team, who value corporate governance and shareholder returns highly, tend to find more opportunities in the Asian markets outside Japan because Japanese corporate culture is bad at prioritising the needs of shareholders. However, even they have raised their Japan allocation - Aberdeen Asia Pacific & Japan has more than 30% of its portfolio in Japan compared to just 22% a year ago.
What have fund managers been doing?
The better performing managers reduced their exposure to cyclical companies prior to the recent market falls. As in other markets there has been a flight to defensive names like utilities and pharmaceuticals. However, a number of fund managers still have exposure to cyclical names like Toyota, Nissan and Sony, which they believe are on attractive valuations and will benefit when stock markets, which are forward looking, start to price in the benefits of a global recovery. In some cases these companies are in much better shape than their global peers and relative valuations are now more attractive than they were. Global fund managers are generally more circumspect, however. Simon Edelsten, manager of the THS International Growth & Value Fund told us “the yen has gone up a lot which is not great for a fragile economy. We are reducing our exposure to Japan”.
Stephen Harker, manager of the SG Japan Core Alpha Fund is relatively active in shifting his portfolio allocations to different companies and sectors around and he is still avoiding companies exposed to emerging market demand as he still thinks there is more pain to be felt here and valuations are too high; global export demand is clearly decelerating.
Most recommended fund managers have been underweight Japanese banks for some time and this has helped most recently as Japanese banks’ shares have been sold off after three of the mega banks announced equity fund raisings, leading to concerns over their funding. Many Japan managers such as Andrew Rose (Schroder Tokyo Fund) have remained underweight banks for some time, although the mega banks may become more attractive in future if they can benefit from grabbing market share from the foreign banks which have run into trouble. SG’s Harker notes that “the Japanese banking system has [already] been completely restructured and consolidated” which leaves it in a relatively strong position.
There is a common thread with all the Japanese equity mangers we are meeting. Like their counterparts in other global markets they blame forced selling for excessive declines in the domestic stock market which they believe is great value at current valuations. However they also note that many Japanese companies are cash rich and in better financial health than their global peers.
Fund flows
With the Japanese equity index yield above the ten year Japanese Government Bond yield (now about 1.5%) it’s hoped that domestic investors will begin buying Japanese equities again in earnest. However, the flow of foreign funds into and out of the Japanese market has long been an important factor in determining the index’s performance. Recently foreign selling has continued, where foreigners are estimated to have sold more than £3bn net of Japanese equities in the four weeks to mid September and almost £5bn since the start of 2008 (Source: JPMorgan). That has presented a strong headwind to the Japanese index. Historically foreign investment has been needed to sustain increases in the Japanese equity market.
What should you do?
At current valuations Japan’s stock market presents an investment opportunity for long term investors. Investors should be prepared for potentially high volatility in the Japanese equity market which could be compounded by aggressive fluctuations in the yen. However, there are some high quality companies across the market cap range currently trading on low valuations and we advise investors who want exposure to select a fund manager with a track record of investing in Japan. Our top rated funds are as follows:
JO Hambro CM Japan - 4 stars
Schroder Tokyo - 3 stars
SG Japan Core Alpha - 3 stars