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Japan - time for a reappraisal?

04 August 2011 Ashburton
Jonathan Schiessl

Jonathan Schiessl

We thought it high time that we update clients on our views on Japan and the performance of our Japan Equity Fund this year. Plenty of water has flowed under the bridge since our last note in March (shortly after the terrible earthquake that struck north eastern Japan), and we now feel able to comment on the country’s outlook without the emotion that was so evident at that moment.

To start with, I think it’s worthwhile to highlight a quote from our note of 15 March 2011:

“For the short-term traders who are thinking of buying Japan for a trade, I wish them luck. There is simply far too much uncertainty in my opinion to risk any short term capital. For the longer-term holders the case becomes a little more interesting. Current valuations are now extremely attractive when looking a little further out. But investors have not been prepared to do that in Japan for many a year, and so it will be interesting to see how far the inevitable bounce will take us.”

So what actually happened to the markets since March? If we look at Chart 1 below, it is plainly obvious that investors piled into Japan immediately following the earthquake, as shown by the huge volume traded during that time (red bar chart).

Chart 1: Topix Index (blue line RHS) and volume traded (red bar chart)

Source: Bloomberg

This vast buying was primarily foreign led, for two main reasons. First simply because Japan was looking cheap, and secondly because there were hopes that the disaster would finally lead to political reform. However, looking at Chart 1 again you can see the rally was short-lived, with the index falling over 7% from the end of March to mid-June (underperforming the global index again). Domestic politics deteriorated sharply over this period and worries began to surface concerning the potential impact of significant power shortages, due to Japan’s nuclear facilities being virtually all shut down. Whilst I briefly felt rather pleased with myself advising investors to stay away, from mid-June onwards Japan started rallying and outperforming and I had to hide back in my box.

Suddenly, Japan is outperforming again - wow! However, the question we have to ask ourselves is whether this outperformance is going to ebb away, as it has done on countless other occasions over the last few years, or if are we at the start of something more meaningful. My brain and experience are screaming at me to be the old Japan cynic that is the natural demeanour of all Japan fund managers - this has been a brutal learning experience. But my gut feel is quietly whispering something altogether different. Perhaps, just perhaps, we are at the start of something here. Before we delve further into this, it’s probably wise to remind ourselves of the bear case on Japan.

The bears have been feasting on Japan’s carcass for years. There is no point delving too deeply into each reason, as there are simply too many. A good place to start is demographics - enough said. We could then go onto corporate Japan - traditionally not run in shareholders’ interest, poor return metrics, low dividend yields and high valuations. Do we even bother mentioning the joke that is political Japan (the Fukushima disaster highlighted perfectly the dysfunctional political system that operates in one of the world’s most modern economies)? And then we could turn to the potential long-term issue of electricity production, a direct consequence of the recent disaster. Japan needs its current heat-wave like a hole in the head…

Rather than dwelling too long on the negatives, we can identify a number of potential positives that investors need also consider:

· Cyclical recovery - whilst the outlook for the reconstruction process is largely unchanged since the quake, what has surprised many has been the speed that Japan Inc has returned to production. This is happening significantly faster than most observers had predicted, and hence we see room for an upside surprise to the sceptical consensus outlook. Valuations are simply not pricing this recovery in.

· Japanese domestic consumption continues to surprise on the upside. The latest retail trade data was much better than expected. The domestic economy is in fact driving the recovery we are seeing in Japan, not its exporters.

· Impact on GDP - the earthquake caused an abrupt contraction in economic activity on both the supply and demand fronts. On the supply side, auto production was particularly hard hit as a consequence of disruptions to supply chains and power shortages. Now the faster-than-expected corporate recovery, in conjunction with reconstruction demand and strong domestic consumption, should lead to a stage of steep economic growth from September onwards. Chart 2 shows quarterly GDP projections from Nomura.

Chart 2: Quarterly projections for the Japanese economy

 

Source: Nomura

 

· Corporate results - we are just entering the first-quarter results season, and results to date have shown remarkable resilience. For example, the automaker Nissan’s 1Q operating profit came in a whopping 60% ahead of consensus expectations – this in spite of having a strategic engine plant knocked out by the earthquake and the yen moving ever higher. Other companies reporting better numbers include the bellwethers such as Canon, Fanuc and Hitachi. It is obviously early days, however.

· Corporate restructuring - many Japanese companies have paid lip-service to the notion of genuine restructuring for years (we should highlight Sony here). However, the quake has led to genuine reappraisal of the merits of restructuring. This particularly applies to the exporters, who are in serious danger of losing global market share as they simply cannot risk too much productive capacity located in a quake prone zone. They have also obviously been hurt by the appreciation of the yen. Hitachi is an example of successful and ongoing restructuring.

· The yen - the appreciation of the yen has certainly hurt exporters over the last couple of years, particularly when compared to many of their competitors in Korea. Although the strong yen has certainly helped importers and kept commodity prices down, we feel we are nearing a top for the currency. One of the reasons for the yen’s strength has been that real interest rates have been higher in Japan than the US. However, now that Japan is once again out of deflation (as shown in Chart 3), the relative attractiveness of the yen should lessen.

 

Chart 3: Japan CPI National (to May 2011 year-on-year)

Source: Bloomberg

· Action from the government - dare I say it, but news out this week that the Japanese government is considering selling its stakes in Japan Tobacco and the telecom giant NTT is potentially massive. Whilst it’s too early to get carried away, this development is worth watching as Japan has excessive assets on its balance sheet which could be used to pay down debt.

There are a number of other points we could raise, such as cheap valuations and improving ROE’s, but we have probably already gone too far. Briefly turning to the Ashburton Japan Equity Fund, we are focused on four main themes - external growth (exporters and world beaters), valuations (value stocks), technological innovation and what we call deflation busters (companies successfully dealing with Japan’s demographics and low prices). Year-to-date (to end July) we are over 7% ahead of our benchmark and compare very favourably against our many competitors.

We are hopeful about the period ahead for Japan. Obviously, there is plenty of global uncertainty at the moment and Japan should stand like a positive beacon in this environment, even if just for its strong GDP recovery in the next few months.

Jonathan Schiessl, Investment Manager

Ashburton Japan Equity Fund

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