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It's been a powerful start to the year for value in Japan. Indeed, January heralded the best relative performance by value since May 2000 – almost 22 years.
Notably, performance has been very broad across the value spectrum, which is a departure from the reflation trade last year, which was more confined to certain areas of the market.
Value has failed to perform for long enough in recent years for people to take notice, though. Even with last year – which was a very good one for the factor – accounted for, it remains to be seen whether the current rotation persists. But we believe there are good grounds for optimism.
Notably, despite the rises, valuations remain broadly depressed. And, while last year was strong for large-cap value stocks generally, the performance was front-loaded, with markets in the first part of 2021 focused on the "great reflation", rising interest rates, and economic recovery from Covid-19. That then petered out, with big tech re-emerging later in the year.
Consequently, value stocks in Japan remain very porly-rated relative to growth stocks. For context, the price-to-book of large cap value stocks compared to the wider market remains below the levels of the technology bubble in 1999. At the same time, dividend yields are relatively high. The dividend yield of the TOPIX now stands at 2.3%.
US Bond Yields Still Key
Perhaps the key tailwind, however, is rising US bond yields. Japanese value stocks have shown significant correlation with US 10-year Treasury bond yields ever since quantitative easing (QE) was introduced by the US Federal Reserve more than a decade ago.
In January 2019, the 10-year US Treasury bond yield was touching 2.8% and set to rise. Then the Fed unexpectedly said it would pivot towards easing monetary policy, triggering a significant move down in the yield to 1.5%.
This marked the beginning of a difficult run for value stocks, even before Covid-19 emerged and caused 10-year Treasury yields to collapse to around 0.6%. Covid-19 was particularly tough for autos, banks, steel, and energy companies. Some of the most popular Covid-19 "winners" were not options for value managers in Japan.
We are now in a different world. If you assume we are moving more towards the endemic stage of Covid-19, you can draw parallels with the QE environment preceding the crisis, when the US 10-year Treasury yield moved within a range of 1.5% to 3.5%. We are roughly in the middle of that range today, but the yield is generally moving higher, and that has pulled down valuations of growth companies and raised the valuations of value names.
Inflation is the key driver in our view, so it will be interesting to see the extent to which this issue becomes political in Japan. As is the case elsewhere, energy and food prices are causing a standard-of-living crisis, particularly for lower-income groups, and that could influence policymakers.
Simultaneously, the middle classes, whose life savings are typically tied up on deposit with near-zero interest rates (most people in Japan have little exposure to equities or property), might start to complain about inflation running at 5% for two years and wiping 10% off their savings. We will see what happens, but with US 10-year bond yields still relatively low, we think there is still a lot of potential for value to move higher, particularly with no clear path to lower inflation unless energy prices crater.
Shades of Value
Value follows a spectrum. "Deep" value, the cheapest part of the market, is often vulnerable to structural problems. "Quality" value, meanwhile, is typically where business models are more resilient.
Managers should be very mindful of this, and should seek to ensure they avoid value traps in favour of companies at the quality end of the scale. We believe others will take a similar view as they transition from very expensive growth names into value. Investors will simply feel more comfortable owning robust companies with clear potential for share price appreciation than those more at risk of remaining cheap forever.
Activists, Assemble!
For some time now we have been enthusing about the corporate governance reforms in Japan. They are having a profound impact on the market. Increasing numbers of activist investors are targeting Japanese companies perceived as laggards in terms of governance and share price performance.
Seven & i Holdings, for instance, has activists on its register seeking to force action to improve its share price, arguing it has been too slow to reform. Pressed into a strategic review that could ultimately lead to it being taken private, Toshiba is a high-profile example of how activists have very much arrived in Japan – a development we believe can only be good for value as boards are finally forced to engage in more shareholder-friendly activities.
The Price Rebound
After a long period where it seemed not to matter to investors, price is once again becoming a central part of the investment equation. For years investors were willing to buy high quality stocks without regard to valuation, adopting a ‘best of breed’ buy-and-hold investment style. We think that trade may be over. The multiple expansion of the big growth names since early 2019 created extraordinarily rich valuations. For some of them, valuations have come back down now, and we believe similar pain is likely to come for many growth names as investors refocus on what they are prepared to pay for stocks. That can only be another tailwind for value in Japan.
Jeff Atherton is portfolio manager and head of Japanese equities at MAN GLG
