Investing in Japan: a triumph of hope over experience

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How much would you pay to have schools go back tomorrow? Here’s my portfolio — take it. I fantasise about quiet offices sans children every night. Long summer holidays will be the death of working from home.

It’s been four weeks of screaming and tears since I wrote about selling US equities. It’s three since I made the follow-up point that if I’m bearish on the biggest market in the world, I should logically ditch my other stocks too.

In the end I decided to keep my Asia ex-Japan fund. Now, let us turn to Japan. Unlike me, hopefully you’re not dealing with endless tantrums and will have seen that the country released a bumper second-quarter growth figure on Wednesday: up 6 per cent year-on-year, twice what economists had predicted.

That must be good, right? Sure, the number was pumped up by a weak yen and a rebound in car exports. But Japanese corporate earnings are highly sensitive to output growth — with almost double the so-called “beta” of US companies. So yes, it helps.

But I’m the last person you should ask. If you believe in behavioural biases when it comes to finance, nothing has distorted my view of the world more than managing pure Japanese equity portfolios between 1995 and 2000.

Me and my ex-teammates were broken. Whereas our US equity or fixed income colleagues are long retired, we became gibbering teachers, landscape gardeners or journalists. Nowhere destroyed value, careers, and hopes quite like it.

So why is 11 per cent of my pension fund in a Vanguard FTSE Japan ETF? Probably because I cannot let go — the place still intrigues me. Or maybe I’m extrapolating recent gains while seeking redemption after losing clients half of their assets all those years ago.

Valuation also has something to do with it — though Japan has mesmerised smarter investors than me before poleaxing them. The main Topix index is still a fifth cheaper than other developed markets on an earnings basis — probably more given Japanese accounting’s harsher depreciation charges.

The latter can skew the pitch so much in fact, particularly versus US companies who are prone to overstating their profits anyway, that if you want to do global comparisons I recommend focusing on cash flows — which come before depreciation.

The price-to-cash flow ratio for the Topix index is still around 10 times, depending on how you measure it, which is anywhere up to a third cheaper than the S&P 500. For those of us who care about absolute returns, that is also significantly lower than at the start of 2021.

Personally I care less about price-to-book ratios than the average investor who falls in love with Japan. They are incredibly low, with half of all names in the Topix trading below one. Roughly the same proportion of companies have more net cash than their liabilities.

But the ratio is irrelevant in aggregate. I have long argued the same for European banks, some of whose price-to-book ratios have also flirted around one over the years. In theory, you could sell their assets and make a profit. But if everyone did this, prices would tumble, taking book values with them.

No, buying Japan on this basis only makes sense if you think there will be a renaissance in profits. That’s because finance theory tells us that shares should only be trading on a price-to-book ratio below one if investors think returns on equity will remain below their cost of equity capital.

Indeed, an earnings recovery is why I bought my Japan fund originally, as did many others — including Warren Buffett — who have taken a punt in recent years. But the Topix at multi-decade highs has already discounted a big rebound in profitability.

The environments when Japanese equities did produce positive returns when global stocks were weak were remarkably similar to today

Can it continue to rise? And how will Japan cope if US shares take a tumble? I started to crunch the obvious numbers — easy but laborious and the sort of thing AI should be able to do if it is worth a damn — when I discovered that someone has already done it for me.

Yippee! More time to clean ice cream off my son’s face. UBS analysts (including James Malcolm with whom I used to work and so can vouch for his wisdom on Japan) analysed three-month returns for Japanese stocks under different S&P 500 scenarios going back to 1990.

Past performance is no guarantee, blah blah. However, there were no periods when the Topix rose if US shares had fallen more than 8 per cent. And Japan stocks only managed a positive return less than a quarter of the time if the S&P 500 declined by even the tiniest margin.

On a relative basis, Japan underperformed the US when the latter declined more than half the time as well. Against European equities the story is a bit more encouraging: when they dropped, the Topix beat them on a relative basis in two-thirds of the periods.

See why my ex-colleagues and I went mad? UBS drills down a bit further and offers some hope, however. The environments when Japanese equities did produce positive returns when global stocks were weak (2005-06 and 2012-16) were remarkably similar to today, with elevated inflation expectations and profits.

That’s about as positive as it gets, I’m afraid. And it hasn’t stopped my ETF from dropping in value by 5 per cent since late July, which is another reason to keep it, I suppose. Likewise, a good friend I’ve been holidaying with has just returned from Tokyo and says it’s buzzing.

Straws. Clutching. There are other reasons to buy Japan of course. But as I said, you’re better off listening to anyone but me on this one. I’m too close. Too damaged.

The author is a former portfolio manager. Email: stuart.kirk@ft.com; X: @stuartkirk__