The Best Way to Invest in Japan

The Silver Rated Mid Wynd International Investment Trust (MWY) last year said it took profits from its holding in Amazon and recycled the proceeds into Japanese firms.

The arguments for investing in Japanese equities are; profits growing quicker than most other markets, Prime Minister Shinzo Abe’s economic reforms are positive and corporate governance is improving, leading to better outcomes for minority shareholders.

Value, or Growth?

One question remains, and it’s a pertinent one in the current investment landscape; should investors seek a growth-oriented strategy, or a value-oriented one.

Since the financial crisis of 2008, growth has outperformed value across the board, and Japan in particular has opposing dynamics at play in this regard. Its stock market is split between the old industries that would be classified as value plays in many areas. These include car makers and banks, in particular.

But it is also packed with companies plugged into the so-called ‘New Japan’ economy, or Shin Nippon. Examples include tech firms, robotics companies and emerging brands that are increasingly becoming world leaders in their fields.

Shigeru Aoyagi, manager of the Nikko AM Japan Value fund, says he’s “convinced that the value strategy is the strategy that is most tailored in terms of how the Japanese market is”.

Certainly, the case many make for Japanese stocks is a valuation-based one. Both relative to its developed market peers, and relative to its own history, the Japanese market is glaringly cheap.

But Richard Kaye, manager of the Comgest Growth Japan fund, says this has been the case for almost three decades now, and that it is “bound not to be successful”. “We think that profits define share prices,” he explains. “That doesn’t sound very profound, but a lot of people that invest in Japan don’t. They think that Japan is a valuation market.

“They think that if you can buy something for 0.7 times book, someone’s going to come along one day and buy it off you for 1 times book. The problem is that trade has been out there for 25 years and it’s never really worked.”

All of Comgest’s funds have a “quality growth perspective”, and Kaye says he thinks he’s “one of the luckiest people in Comgest because I’ve got the market that’s most responsive to quality growth investing”.

Aoyagi, though, believes that “something has changed” that suggests the persistent cheapness of the Japanese market is about to reverse. “What I think is different from, say, five or 10 years ago, is that the catalyst is there to turn the situation around from an undervalued stock to a more highly valued stock.”

The first part of Aoyagi’s investment process is identifying companies that are going through down periods and have the potential as a result to be undervalued. His team does a thorough analysis of a company’s past performance, in order to ascertain management’s past success in turning fortunes around.

Then, he seeks to understand why a company is in its current down period, what steps they have undertaken to attempt to turn things around, and any valuable assets the market has yet to uncover.

There are nuances, then, to the value process. “Just being cheap is not enough,” continues Aoyagi.

Kaye, too, does not focus solely on his quality growth criteria, although he accepts that his 39-strong portfolio tends to have a high-looking price/earnings ratio; this, though, is justified by the balance sheet quality and the earnings growth.

Still, valuation is a key component of his process, but he looks more at the price/earnings-to-growth metric. “We’re not a value investor, but a lot of our quality growth is actually plain cheap. You can simply say this thing is 13 times price/earnings but it’s generating 18% profit growth.”

Value Stock Picks

One of Aoyagi’s two value stock picks is well known to UK consumers – electronics maker Sony (6758). Previously a world leader in its industry, it’s since been well and truly overtaken by the likes of Apple and Samsung Electronics.

“Up to the 1980s, Sony came up with lots of products that the world had never seen before,” Aoyagi explains, “so they really established themselves as a premium brand.

“But becoming a mass market brand leads to competitors coming in and corporate earnings going down. During the 1990s up to about 2010, Sony went through a very difficult period.”

Since around 2012, Sony has gone through a major restructuring, transformed its portfolio and is now on the path back to the situation it was once in, says Aoyagi.

Nippon Sheet Glass (5202) is a less well-known brand, but one that has history in the UK. It bought British glass maker Pilkington in the early-to-mid noughties in order to establish itself in Europe.

However, it took on a lot of debt to make that acquisition and the management structure caused Nippon problems. Over the next decade or so, it had a tough period, like Sony.

But since 2010-2011, things have started looking up. It carried out a very thorough restructuring and now has a very good sales network. It is one of the few companies in the world that is capable of producing glass for assisted driver-assistance systems used in cars around the globe.

“We think that this company has a lot of potential,” Aoyagi concludes.

Growth Stock Picks

One company Comgest has invested in for over a decade is Fanuc (6954). Kaye says it’s been a “wonderful company” and has delivered 40% operating margins, high return on equity and consistently outperformed its global, developed market peers.

But there’s been a big change since 2015 in governance, as management have understood the importance of interacting properly with foreign, minority shareholders, after its major investor, Fujitsu, recently heavily reduced its holding in Fanuc.

“For many years, they used to have aggregated investor meetings where you’d go out to their headquarters at Mount Fuji and they’d sit you in a room and as soon as the chairman had finished his monologue, you were whisked onto a bus back to the nearest train station.”

Since 2015, Kaye adds, Comgest has had great dialogue with Fanuc. “Fanuc is a clear example of a company that’s changed its modus operandi. It’s gone from the mono-lithic fairly exclusive Japanese company to one that’s started to want to meet foreign investors. I can give you similar stories from Suzuki, Don Quixote and Hoshitaki.”

Elsewhere, Obic (4733) is a peer to better known European companies like Oracle and SAP. It provides enterprise resource software for companies to help them automate tasks like payroll and inventory control that until now had been carried out manually by workers.

Now, Japan’s labour force is shrinking due to its ageing population. Obic, then, is a company in high demand for Japanese businesses, particularly small and medium enterprises. Consequently, Kaye shows, the four-quarter moving average pre-tax profit growth from 31 December 2016 to 31 December 2017 for Obic was around three times higher than Oracle’s.