Four reasons to include Japanese investment funds in your portfolio

The weekend saw Japanese Prime Minister Shinzo Abe’s Liberal Democratic Party (LDP)-led coalition cruise home to a landslide victory in the country’s snap general election. Jason Hollands examines the reasons to include Japanese equities as part of your portfolio and gives his top investment fund picks from the sector.

Jason Hollands Jason Hollands
25 October 2017

With a continued two-thirds majority of the Japanese lower house and a four-year term of office ahead, Shinzo Abe is set to become Japan’s longest standing Prime Minister if the LDP reselect him as leader next year.

The win for Abe is broadly positive for Japanese equities. Assuming his ally at the Bank of Japan, Governor Haruhiko Kuroda, agrees to serve another term (or is succeeded by another advocate of reflation), the road ahead is one of policy continuity in the form of aggressive monetary and fiscal stimulus, combined with reforms to encourage greater labour market flexibility and improved corporate governance.

If you have avoided Japan, should you think again?

Yet Japan is a market that many investors have long shunned. This is often because either they got badly burned in the late 1980s and so have an ingrained aversion to the market, are sceptical because of previous false dawns, or they simply ignore it because of its well-highlighted ageing population and hierarchical culture, which has been an impediment to labour market flexibility and dynamism.

Yet despite these factors there are good reasons why investors who have avoided Japan should seriously think again. These primarily centre around unlocking value and dividend growth. We believe there are four reasons to include Japanese equities as part of your portfolio:

1.    Policy is highly supportive (and increasingly divergent from elsewhere)

Central bank policies have been hugely supportive for financial markets since the financial crisis, injecting vast amounts of liquidity into the system. But across most of the world, that is starting to change. The US Federal Reserve is already hiking interest rates and is soon set to begin unwinding the enormous balance sheet it built up during its quantitative easing programmes. The Bank of England is edging towards an interest-rate rise for the first time in a decade. And this Thursday we may hear more from the European Central Bank, which is expected to begin tapering its bond-buying programme. Against this developing backdrop, the Bank of Japan is increasingly looking like an outlier in continuing to pursue ultra-loose monetary policy aimed at keeping long-term borrowing costs close to zero.

Alongside this, the Japanese Government is also implementing fiscal stimulus measures, including major infrastructure projects, and investment is also being boosted by preparations for the 2020 Olympics in Tokyo. Other structural reforms include measures to improve labour market flexibility, such as improving female participation in the work place, and improvements in Japan’s corporate governance code that are making Japanese companies more shareholder friendly. The reforms have seen more independent directors added to Boards, commitments to reduce cross shareholdings, and importantly measures to encourage improved returns to shareholders through raising dividends and share buybacks. The last point includes the creation of the JPX-Nikkei Index 400 of companies, which must meet strict criteria on return on equity. The index has become the equity benchmark used for the massive Japanese Government Pension Fund, which has also had its strategic asset allocation to equities substantially raised.

2.    Japanese shares are relatively cheap compared to other developed markets

 Value is hard to find in financial markets at the moment, which is fuelling fears of a correction at some point. While most developed equity market indices are hovering at record levels and valuations in these are above long-term averages, Japanese shares in contrast look relatively good value. On a forward Price/Earnings basis, Japan is the only major market currently trading below its long-term average since 2004 (14.3x v 15.4x) and it is also the cheapest developed market when measured on a price to forward book value (1.3x).  As global investors hunt for value, Japan has the potential to see significant increases in interest from overseas investors. 

3.    Japanese market composition is geared towards a cyclical recovery

With the global economy now showing signs of a broad based recovery, it is worth noting that the composition of the Japanese stock market is arguably more sensitive to a cyclical upswing than other developed markets. Around 60% of the Japanese stock market – which includes leading car manufacturers and exporters – would be broadly classified as cyclical stocks versus defensives. This is a much higher ratio than either the US, UK or Europe.

4.    Dividend growth potential could drive a re-rating

One of the most compelling reasons to consider Japan is its scope for dividend growth, albeit from a low base. Historically Japanese companies have been notorious for hoarding cash – they remain cash rich with low pay-out ratios. For example, while UK companies paid out 90% of earnings in 2016, Japan had one of the lowest pay-out ratios of all at 35%, while also having the highest proportion of companies with net cash on their balance sheets of a major market. But change is already taking place. In US dollar terms in 2016, Japanese companies paid out 23% more in dividends than they did in 2015 – the biggest percentage increase of any region. The positive trend of dividend growth has carried on into 2017 with a headline dividend growth rate of 4.2% year on year in the second quarter (the peak pay-out period). In local currency terms, underlying growth has actually been higher (11.8%) but currency effects have trimmed this in US dollar terms. If Japan can keep making progress on this front, it could potentially lead to a rerating of the market over time.

In terms of fund choices, our top picks are the CF Morant Wright Nippon Yield and Baillie Gifford Japanese funds.

CF Morant Wright Nippon Yield

Morant Wright is a boutique exclusively focused on Japanese equities founded by some of the City’s leading veterans in Japanese equity investing. The CF Morant Wright Nippon Yield fund invests across the market-cap spectrum, including small and mid-sized companies, but the team have a strong value discipline and the approach is quite defensive, targeting companies with good cash generation to pay dividends.

Baillie Gifford Japanese

The Baillie Gifford Japanese fund is much more weighted towards larger companies. While the longstanding co-manager of the Baillie Gifford fund, Sarah Whitely, is set to retire in 2018, co-manager Matthew Brett has been in situ for nine years. Baillie Gifford has long had a team-based approach in Japanese equities and we see no reason to change our view. 

Investment trust – CC Japan Income & Growth Trust

For investment trust fans, the relatively small CC Japan Income & Growth Trust, launched two years ago and managed by Asia-focused manager Coupland Cardiff, is unique in the Japanese investment trust space. This is because it specifically targets Japanese companies with consistent dividend growth, though it is trading at a small 3.3% premium.

As always, if you have any questions about this or your investments, do get in touch on 020 7189 2400, request a call back at the top of this page or email best@bestinvest.co.uk.

Important information 

The value of investments, and the income derived from them, can go down as well as up and you can get back less than you originally invested.

This does not constitute personal advice. If you are in doubt as to the suitability of an investment please contact one of our advisers. Past performance is not a guide to future performance.

Different funds carry varying levels of risk depending on the geographical region and industry sector in which they invest. You should make yourself aware of these specific risks prior to investing.

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