For a long time, Japan was one of the world’s economic powerhouses until an asset price bubble in the early 1990s plunged the country into a period of economic stagnation known as ‘the lost decade’.
However, the country has recently begun to emerge from the economic doldrums and Comgest Growth Japan managers Richard Kaye and Chantana Ward believe that there are potentially great returns to be made as it continues to recover.
Ward said the Japanese economy started to rebound during the second half of 2012 as the reforms of prime minister Shinzo Abe started to take hold.
As the below chart shows, since January 2012 the TSE Topix index – the main Japanese benchmark – has made a 147.24 per cent total return.
Performance of index since 2012
Source: FE Analytics
“It has stayed more or less stable until now. But the rebound we saw in 2012, is less than 60 per cent of the 1989 rebound,” she said. “However, the profits of Japanese companies are now 2.5 times the 1989 profits.”
In addition, the country has now begun a new era, according to the fund manager, following the abdication of the former emperor who held sway for much of the post-war period.
The new imperial era is known as Reiwa – “beautiful harmony” – and Ward said it may now be time to forget old preconceptions about Japan.
Ward said conventional wisdom has it that Japan is plagued by a weak macro environment, adding that this assessment fails to take into account the many positive developments taking place in the country.
She said the quality of Japanese companies has improved a lot in the last few years. This is both in terms of corporate standards and investor returns.
"Return on invested capital and return on equity have almost doubled in the past few years,” she said, adding: “Companies are focusing more and more on profitability. They are concentrating more on their core businesses and are discarding non-core and unprofitable operations.”
The Comgest Growth Japan co-manager said Japan remains an undervalued and underappreciated market, even as the country is a huge beneficiary of the Asian consumer’s rising purchasing power.
“Japanese companies’ earnings have been quite exceptional over the last couple of years. In fact, in terms of EPS [earnings per share] growth between 2012 and 2020, Japan is the only country that was able to deliver really high EPS growth,” said Ward.
In addition, she said, the trend of return on invested capital is catching up to other developed markets. And the return on equity, which was 4.4 per cent in 2012, is now between 9 and 10 per cent.
In terms of capital allocation, Japanese companies are becoming more and more efficient. They’re using cash from the balance sheet to pay dividend, to increase dividend pay-out, or to buy back shares, Ward said.
“Back in 2017, buyback shares accounted for only 4trn yen [£29.6bn], then in 2018, they rose to 7trn yen [£51.9bn]. Now, only two months into the new fiscal year, the amount of buyback shares is already 3.8trn yen [£28.2bn].”
Companies are starting to use their cash more efficiently, she said. And they are paying more attention to shareholders.
Ward highlighted another significant development in Japan: the rise of tourism. She said the country has become a trendy place to visit by millions of middle-class Asians.
“From 2012 to 2018, the number of tourists coming to Japan has increased from six million to 30 million, with the government aiming to increase that number to 40 million by 2020,” Ward said.
She explained that these middle-class tourists, trend setters in their home countries, export Japanese brand products when they return home, making “Made in Japan” products a highly sought-after in other Asian countries, thereby increasing sales in these countries as well.
“Japanese products, from cosmetics, to apparel, to baby products are experiencing huge commercial success in the Asian region, especially in China,” she said. “For example, Uniqlo, the casual-wear designer, manufacturer, and retailer, has consistently placed in the top-10 brands in China in terms of clothing sales for five years in a row.”
Performance of Uniqlo-parent Fast Retailing over 1yr
Source: Yahoo Finance
Ward’s Tokyo-based co-manager Richard Kaye said there are other changes happening on the ground
“Japan is changing at the macro level, but also at the micro level for those of us who live there,” he explained, noting that these changes are both regulatory and social and represent enormous investment opportunities “for investors who can find the companies that are benefiting from them”.
What makes these changes particularly significant, according to Kaye, is that they are driven, not just top-down by prime minister Shinzo Abe, but by Japanese institutions.
“Domestic institutional investors, after two decades of hibernation, are finally demanding these changes,” he said. “Why have the Japanese institutional investors finally got religion, as the saying goes?”
The reason is quite simple, said the portfolio manager, explaining that Japan domestic institutional investors have been significantly underperforming and in order to address this, institutions are returning to their market with a focus on governance and capital discipline.
“This is the reason we believe that these changes are not a one-off or temporary phenomenon,” Kaye said. “This time the changes are sustainable and enduring.”
Another aspect of these sweeping changes in the country is the lack of labour force. “Simply put, Japan is running out of people,” Kaye pointed out.
Because of supply-demand tightness in the labour market, he explained, wages have gone up. “It shows that deflation, a two-decade phenomenon in the Japanese economy, is at an end now.”
Kaye rejected the contention that this might be because the Bank of Japan (BOJ) engaged in massive liquidity provisions. He countered that the BOJ has been engaging in massive liquidity since 1985 and that the growth of monetary supply is a three-decade phenomenon which doesn’t explain these recent behaviours.
“Rather, these recent data represent the social change in terms of lack of labour and the natural reflection in rising wages.”
The offshore Comgest Growth Japan fund of which Kaye and Ward are the lead managers, alongside Makoto Egami, targets capital growth over the long term, investing in a portfolio of high-quality, long-term growth companies, is an all-cap fund, “well balanced between large-cap and small-cap companies”.
Kaye said the team doesn’t care about the index, which he called a “dinosaur”.
“The index is not really a thing to beat. It’s already beaten, because it has a lot of old companies in it that we probably don’t want to invest in anyway—these include banks, old car companies, heavy machinery, chemicals companies, and so on,” he explained.
Also discounted by the investment team are the sector designations, which are “virtually meaningless”.
As such all the themes in the portfolio revolve around capturing “the new Japan stories”.
A combination of high active share, low beta, ignoring the ‘stupid’ index, Kaye said, has allowed downside protection but also good upside participation.
Performance of fund vs benchmark & sector over 5yrs
Source: FE Analytics
Over the past five years, the £1.4bn Comgest Growth Japan has made a total return of 130.39 per cent against a 73.57 per cent gain for the TSE Topix index and a 68.32 per cent return for the average FO Equity – Japan peer. It has an ongoing charge figure (OCF) of 0.97 per cent.