Maybe, just maybe, this time it really is different for Japanese equities. Over the past few weeks, indicators suggest we might finally be at the point where these stocks are the place to be.
The Nikkei 225 last month punched above the 30,000 level for the first time since September 2021. Its surge makes for some interesting comparisons.
Plot the S&P 500 index return against the Nikkei 225 from just before the pandemic. The popular narrative is that the US index has been the star turn of the market, but map over the Nikkei chart and you’ll see something amazing: Japanese shares have kept up with, and depending on the exact numbers and dates, beaten US shares.
Why the positive momentum? It helps that Japanese shares have long been regarded as cheap — and this for a market that until the last few decades was always regarded as hopelessly expensive. Andrew Lapthorne, head of quantitative research at Société Générale, marvels at how inexpensive Japanese shares have become. He points to numbers that show in aggregate 60 per cent of Japanese companies have net cash with very low levels of gearing.
That number might indicate a business that has run out of ideas for growth and is accumulating cash. However, many value investors reckon that as long as a business is profitable and has low debt, it has room to grow even faster if it can leverage up.
Another metric is the median price to book — a measure of value based on the balance sheet — which for Japanese equities as a whole is running at 1.48, well below levels in the US and Europe, although still close to the Japanese long-term average. At a cash flow level, SocGen finds Japanese corporations are distributing as much of their cash flow in dividends and buybacks as European peers, and paying out more in dividends than US counterparts.
As for more widely-used measures like the forward price/earnings ratio for the next 12 months, the current level is below the world average at around 12 times earnings, and not too far off UK levels. (Remember, the UK is regarded by most international investors as the land that time forgot.)
There’s also evidence that the Japanese economy, long mired in deflation, is now looking up. Recent data showed that the economy grew at an annual rate of 1.6 per cent in the first quarter of 2023, beating expectations of 1.1 per cent. Driven by surging energy prices and supply chain issues, Japanese prices are rising at an annual 3.5 per cent, a big increase on recent years.
When talking about the cheapness of Japanese stocks, arguably a more important factor is that the yen has this month fallen to a 20-year-plus low against the US dollar, which makes Japanese goods and stocks cheaper in US dollar terms.
So after decades of waiting for Japan’s moment in the sun again, are we there yet? Or have we already passed it? One cause for hesitation is that on many technical measures, Japan’s markets look a tad overextended and more generally overbought — some reckon the most overbought in five years.
And that currency tailwind can also switch very quickly. Cut away the complexity and it seems that the yen and the Nikkei have something approaching an inverse relationship; a weakening yen makes local equities cheaper. It also helps that a weak yen makes Japanese exports cheaper. If the dollar weakens, this whole trade could unwind.
I’d also observe that not all Japanese stocks behave in the same way. Looking at broad indices such as the MSCI Japan index, it is noticeable that value stocks have significantly outperformed growth stocks.
Take the Japanese export sector. Shares in more than a few businesses trade at historical all-time lows despite bulging order books. China is Japan’s biggest trade partner and in 2021 sent $153bn in exports to China. China sent $168bn in exports to Japan and Japan is China’s third-biggest trade partner. If China-US relations go badly wrong, then Japan is in deep trouble.
The elephant in the room is Japan’s massive government debt and the prospect of rising bond yields pushing up government borrowing costs. A recent Barrons article by former IMF and Wall Street economist Desmond Lachman reminds us that, according to the IMF, the ratio of Japan’s gross public debt to its gross domestic product is some 260 per cent, double the US level. Much of that debt is locally held but if interest servicing costs were to jump (via higher interest rates) then government spending would be hit.
Stepping back from the blizzard of data I’m inclined to be wary of the current rally but I’d also note that Japanese equities are undervalued and much more diverse in industry sectors than they used to be.
Remember that if you invest in any world equities tracker fund you will already have some exposure to Japanese equities as they comprise 5.6 per cent of the MSCI ACWI index, for instance.
If you do decide to take the plunge, there are lots of options. For large-caps, there are more than 60 UK-listed Japanese equity trackers or ETFs. I like MSCI Japan as well as something called the JPX Nikkei 400 index, which focuses on Japanese mid- to large-caps that go the extra mile in terms of corporate governance.
Funds wise, I’d go for the Xtrackers Nikkei 225 UCITS ETF, which charges just nine basis points, or the L&G Japan Equity UCITS ETF. A side point — if at all possible, I’d always opt for a currency hedged version of a Japanese large-cap tracker. These cost slightly more in terms of fees but take the risk out of the currency fluctuations.
An alternative strategy might be just to buy a couple of the best-known, large-cap names, such as Sony or Keyence, and be done with. These two firms tend to keep cropping up as the top holdings in most ETFs anyway. UK advisers such as Killik & Co rave about Keyence in particular, an industrial sensor manufacturer that is grabbing ever more business globally as a factory automation expert. Sony needs less explaining, given its huge content businesses, its hugely profitable games business and its massive export book.
I’d be inclined to stick with the value strategy of selectively buying certain types of bargain basement stocks, many of which aren’t the very biggest corporates. They’ve had an amazing run in the past year and there are real doubts that this run can continue. But my sense is that there’s still bags of value up for grabs.
I’d also suggest focusing on actively managed investment trusts such as Nippon Active Value and AVI Japan Opportunity. At some stage, as investors regain their confidence globally, my sense is that a different type of Japanese stock might then start to prosper, one with a technology-driven vision. If that happens, I would look at investing in a fund like Baillie Gifford Shin Nippon, a specialist fund that targets more tech-oriented growth companies.
David Stevenson is an active private investor. Email: adventurous@ft.com. Twitter: @advinvestor
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