I’m very much looking forward to next year’s holiday in Japan, so much so that I’ve been considering taking out some yen now, six months ahead of when we plan to go, just in case the exchange rate moves against us more than it already has.
I’d considered doing so in July, when £1 bought 207 yen, but since the Bank of Japan (BoJ) raised interest rates for the first time in 17 years, that has come in to about 190 yen.
The next question on Japan is unrelated to the holiday, but, if anything, perhaps even more important: is there still a buying opportunity in Japanese stocks? The blink-and-you-miss-it market plunge that happened early in August is well and truly over, but perhaps investment companies investing in Japan still represent good value.
At one point in early August, the Nikkei 225 index of large Japanese multinational companies had well and truly fallen into a bear market, down as much as 26.5% in the space of three and a half weeks.
The bounce back was almost immediate. By the end of the day after it hit its trough, the Nikkei was up 11.3% from its low. At the time of writing, it is 22.6% higher. That the Nikkei recovered so quickly made complete sense, making the plunge look like an overreaction.
The unwinding of the yen carry trade was seen as a major event that would send the yen soaring. The carry trade was linked to the fact that investors had borrowed yen at historically low levels to invest in other currencies in countries with higher interest rates and, thus, returns. If Japanese interest rates move higher, the potential returns on this trade are much lower.
A higher yen in theory means that exporters, which account for a decent portion of Japanese large-caps, will get lower-than-expected profits because they are converting foreign cash into a stronger home currency.
This is, of course, true. Stocks dependent on exporting products will become much less attractive as the yen rises, prompting many to sell out. Yet, the long-term investment case, which remains centred on corporate governance reforms first enacted by former prime minister Shinzo Abe over a decade ago, remains intact. Any yen-driven weakness would surely be an opportunity to add exposure.
The reforms are aimed at improving the governance standards of listed Japanese companies, emphasising improvements in growth prospects and capital efficiency, but also making them more shareholder friendly. Historically, Japanese companies preferred to hoard cash instead of reinvesting it or returning it to shareholders.
In the past few years, this mindset has shifted, helped both by a new guard taking charge at the top of Japanese companies as well as by regulators.
Last year the Tokyo Stock Exchange (TSE) called on companies to improve capital efficiency, particularly those with a price-to-book (P/B) ratio below 1.0 and a return on equity (ROE) of 8%. This means that it’s the value-oriented companies (those with low valuations) that have initially benefited the most.
The reforms are certainly having an impact. We’ve seen consecutive record years for both dividend pay-outs and share buybacks, while Japan’s stock market has gone from a P/B of 1.2 to around 1.6.
That valuation may have improved, but it certainly doesn’t suggest that those of us without specific Japanese exposure in our portfolios have missed the boat.
Indeed, MSCI Japan’s P/B ratio of 1.6 is lower than the MSCI United Kingdom’s P/B ratio of 1.9. The forward price-to-earnings ratio of the Japanese market, meanwhile, is 15.2x, about an 18% discount to the MSCI World.
In addition, there are more than 1,600 companies that still trade below the P/B and ROE requirements. This is going to be a multi-year opportunity – with, of course, temporary setbacks along the way.
CC Japan Income & Growth and AVI Japan Opportunity were both set up to take advantage of the corporate governance reforms, and these two could be a good two-pronged approach for investors seeking exposure to Japan.
The former’s income-focused remit should benefit from a continued resurgence in shareholder returns through dividends and buybacks, while manager Richard Aston’s exposure to the small- and mid-cap space should also pay dividends.
The latter is a purer small-cap play and its activist strategy of constructive engagement with investee companies should continue to reap rewards for shareholders.
A new enhanced dividend policy enacted by the board of Schroder Japan makes it interesting, too. The board will now aim to pay 4% of the trust’s average net asset value (NAV) each financial year, meaning the trust’s portfolio of high-quality, undervalued companies will offer a higher and more predictable income stream going forward.
Japan’s chequered history will, I’m sure, be in the back of some investors’ minds as the end of the yen carry trade continues to play out, but the underlying investment premise behind the corporate governance story remains unblemished.
David Brenchley is an investment specialist at Kepler Partners. The views expressed above should not be taken as investment advice.