The Japanese stock market barely moved in 2016, with the Topix index rising just 0.3% in local currency terms, but thanks to a plunge in sterling UK investors benefited from a 23% return. This was a year of two halves for investors in Japan, largely driven by currency movements. At the start of the year, the Yen stood at ¥165 to £1, by mid-year it had appreciated to ¥125 to £1, only to fall back to ¥145 to £1 by December.
This coincided with market weakness in the first half – the Topix fell 19% in local currency terms, and strength in the second half, a gain of 23. The exchange rate matters enormously to Japan as it remains one of the world’s major exporting countries, with a stronger currency tending to hurt profits of large exporters, such as Toyota and Honda, and vice versa.
Another key characteristic of 2016 was a reversal in sector leadership in July and August. The valuations of defensive, low-volatility areas of the market such as foods, pharmaceutical, and information and communication became overstretched after many years of outperformance. As a result, market leadership switched instead to more cyclical areas, such as materials, machinery and electric appliances. This rotation was further reinforced by the Bank of Japan’s change of policy in September. The focus on the yield curve over monetary policy provided a strong tailwind for financials, which were among the strongest performing stocks in the second half of the year.
In terms of the outlook for 2017, most commentators believe that Japan’s domestic environment remains encouraging. The coordinated fiscal and monetary policy should continue to provide strong support for equities and economic data appears to be moving generally in favour of Japan. PMI indices have been moving up, unemployment rates are low, with indications that wage rises will continue into the future, and a weaker yen should boost inbound tourism.
From a valuation perspective, Japanese equities remain among the cheapest in the developed world, both relative to their history and compared to other developed countries. Japanese stocks currently trade at a 1.4 price-to-book ratio, compared to 2.2 price-to-book ratio of global equities.
Most Popular Funds by Size
Man GLG Japan CoreAlpha carries a Morningstar Analyst Rating of Gold. The fund has been managed by an experienced team in Stephen Harker and Neil Edwards since early 2006. The managers use a rigorous process that draws on their extensive knowledge of the Japanese market. Focusing on the largest 300 listed companies in Japan, they look for those that appear to be undervalued when compared to rivals. They also favour quality companies with strong management that are dominant in their sectors, but valuation tends to be the overriding factor.
With the clear focus on value, long-term horizon and benchmark-agnostic approach, the portfolio can often exhibit sizeable deviations from its peers and the Topix index. As a result, investors should be prepared for performance that can vary intermittently; however, since launch investors in the fund have been well rewarded. Such performance success has seen the strategy gather considerable assets over the years, but we do not have concerns over capacity as the group has been disciplined in closing the fund in order to protect the interests of existing investors.
The Vanguard Japan Stock Index fund has a Morningstar Analyst Rating of Silver. The fund offers investors exposure to the Japanese equity market by tracking the performance of the MSCI Japan index. The fund fully replicates the index by investing in all its constituents and has a bias towards mega- and large-caps at the expense of mid-caps, which shouldn’t be overlooked by investors.
The fund management process is geared to delivering the index returns at the minimum possible cost and, with this fund, Vanguard has done a very good job. With an ongoing charge of 0.23%, it is one of the cheapest available funds when compared with its peers in the Morningstar category and even relative to other passive offerings. This has contributed towards an impressive long-term performance on a risk-adjusted basis.
Eastspring Investments - Japan Dynamic holds a Morningstar Analyst Rating of Bronze. Singapore-based Dean Cashman has managed this strategy since its inception in July 2006, and has dedicated most of his 28-year investment career to managing Japanese equities. Cashman is part of a five-member Japan equity team; although small relative to some of its peers, we think the team’s deep experience supports the strategy well, especially given the fund’s benchmark-agnostic approach, resulting in a high-conviction, concentrated portfolio of 30-50 names.
The fund employs an unconstrained strategy towards investing in stocks that are trading at a discount to their intrinsic value. The portfolio may have considerable allocation to stocks in the smaller end of the market spectrum, which tends to be relatively inefficient and offers the ideal opportunity for skilled active management. The strategy has delivered excellent returns since its inception and has been soft-closed to new investors since late 2015.
The Orbis SICAV Japan Equity (Yen) fund has a Morningstar Analyst Rating of Silver. The fund has been managed from inception by Orbis’ well-resourced and experienced management team. William Gray, who leads Orbis’ investment team, has ultimate accountability for the fund and relies very closely on the recommendations of Brett Moshal, who leads Orbis’ Japan-equity team, which comprises five other analysts. Contrarian thinking lies at the heart of the fund’s investment philosophy.
The process is primarily bottom-up, harnessing high-conviction stock ideas generated by the research team. The portfolio is concentrated and typically features 30 to 50 names. There is a distinct bias towards mid-caps and more than half of the portfolio is concentrated in its top 10 holdings, illustrating high conviction. The strategy boasts an impressive long-term performance record, while the focus on good-quality, undervalued companies results in below-average risk and a lower downside capture ratio compared with peers.
A version of this article was published in International Adviser
