While our eyes have been firmly fixed on the European markets, inflation and war, the Japanese index has steadily worked away and hit a 33-year high.
With corporate governance reforms and a post-Covid-19 reopening, returns have followed. In a market often overlooked by investors, however, does that mean there are any opportunities left?
As Nicholas Price, portfolio manager, Fidelity Japan Trust explains, global equity portfolios have been underweight in the Japanese stock market, despite it being the second largest country in the MSCI World Index. That reflects misplaced presumptions dating back to Japan’s "lost decades", he says.
"That hasn’t been Japan for some time," he continues.
"The Japanese economy has been riding a recovery since around 2012 that has been as steady as it is low-profile, while a structural improvement in operating profitability remains underappreciated".
In fact, in the past year, Japanese equities just grew earnings at 10% compound over the past 10 years for the first time since World War II, surpassing other indices like the S&P 500. What’s more, a wealth of overlooked and differentiated opportunities remain.
"Many Japanese stocks are undervalued due to a lack of sell-side coverage and limited disclosures, especially in the mid/small cap space," Price says.
As we know, past performance is no indicator of future growth. Can the growth be sustained? Carl Vine, manager of M&G Japan, believes so. Speaking at a London event last week, he told us margins are still low overall, at around 7% (almost half of the S&P 500).
"I think the same forces and drivers that delivered the last decades worth of growth are totally relevant for the next decade. It’s all about self-help. It’s about corporate reform. It’s about optimising commercial playbooks within the corporate sector," he said.
That said, Japanese GDP has not followed suit. In nominal terms, GDP was largely negative over the past decade. Even if that trend continues, though, Vine believes in equities.
"When I look forward 10 years, even without trying to build any particularly optimistic macroeconomic case – and there may be some arguments in favour of a slightly more forgiving economic environment with the inflation backdrop maybe changing – this nature of corporate behaviour hasn’t stopped," he said of Japan.
"It’s really accelerating, and the institutional framework within which Japanese companies operate has evolved tremendously in the past decade. I think that the current environment and the environment that will persist in the next 10 years is probably more conducive to earnings growth than it was in the last decade.
"And with margins still quite low, there’s still so much low-hanging fruit throughout the corporate sector."
Productivity, Tech and Demographics
The Japanese stock market holds several technology, auto and manufacturing giants. Moreover, Price notes it offers a wealth of smaller market leaders in growing niche industries that often fly under the radar.
It also benefits from some of the wider trends in Asia, such as a growing middle class, but struggles with demographic issues like an ageing population which could work against long-term economic growth.
Vine argues, however, that the potential for increasing labour productivity is overlooked. The country ranks somewhere in the bottom 30th percentile globally.
"If Japanese labour productivity was the same as the US, Japanese GDP would be about 40% higher," he said.
Five Undervalued (and Moaty) Japanese Stocks
Using Morningstar metrics, we’ve identified five stocks that have carved out their own space in the market and are trading at discount prices.
To identify the stocks, we selected companies with a wide economic moat, making sure they have a strong competitive edge, and have Morningstar Star Ratings of 5 or 4, indicating they are trading below their fair value.
Among these there’s one 5 Star company, and another with an exemplary Capital Allocation Rating – a judgement on how the company’s management is able to increase shareholders’ return through good capital allocation (while the rest is rated standard). All five have a stable moat trend, meaning they should be able to maintain their competitiveness.
Kao
Kao (4452), the 5-star stock in the mix, is the largest manufacturer of household and personal care products in Japan, but with an international footprint.
Kao recently laid out a long-term plan to guide its growth to 2030, aimed at heightening its global presence and achieving JPY 2.5 trillion in sales with a 16% profit margin.
Our analysts believe the margin goal seems viable and that innovation endeavours and growth outlook of China and precision healthcare will play crucial roles in accellerating group growth overall. It did see a plunge in first quarter profits, but senior equity analyst Jeanie Chen believes new product launches should instil some confidence in its future.
Daifuku
Daifuku (6383), meanwhile, is the one among the five with an excellent capital allocation rating. It provides manufacturing, engineering, design, installation, and after-sales services for material handling equipment and logistics systems.
In simpler terms, it works with warehousing, semiconductor production, automation solutions, airport baggage handling and car-washing machines, and with companies like Toyota, TSMC, Intel, Dell, and Fanuc.
Daifuku’s fiscal 2023 (ending March 2024) revenue growth guidance of 0.5% year on year was below our expectations, equity analyst Jason Kondo says, and near-term headwinds will continue. But he also believes this could change at the end of the calendar year, and maintains Morningstar’s longer-term outlook and fair value estimate of JPY 3,500 per share.
