Janus Henderson: Japanese stocks - more favourable fundamentals

The fundamentals of Japanese companies have seen significant improvements over recent years. Unlike the period from 2012 to 2015, when corporate earnings were mainly driven by the weakening yen, Japan’s current phase of earnings growth is being driven largely by internal factors, such as growing private capital expenditure and domestic consumption. As a result, market sentiment towards Japanese equities has been more positive and, despite the fact that the market has soared to a 30-year high and its value has more than doubled over the last five years, the current price-to-earnings (P/E) ratio of 15 times is reasonably attractive, particularly on a longer-term historical view (chart 1).

Chart 1: Japanese stocks still attractively valued despite strong appreciation

(Source: Bloomberg, Janus Henderson Investors. Nikkei 225 Index monthly data from 31 December 1980 to 28 February 2018. Yields may vary and are not guaranteed, past performance is not a guide to future performance.)

Monetary policy still providing a boost

Supportive to our generally bullish view of the Japanese stock market this year is our expectation that the Bank of Japan is unlikely to follow in the footsteps of the US and Europe and begin winding down quantitative easing anytime soon. Instead, we think that any central bank policy change may only happen after 2018 because current core consumer inflation at 1.4% year-on-year is still below the central bank’s target of 2%. 

Progressive and progressing corporate culture

A key tenet of the Japanese Smaller Companies Strategy is that we focus on seeking to invest in companies that are improving corporate governance standards and rewarding shareholders. We continue to see a significant positive shift in corporate culture since Prime Minister Shinzo Abe’s introduction of the corporate governance code in 2015. Abe’s solid victory in the October 2017 snap election looks set to ensure this becomes a continuing trend. Meanwhile, corporate reform is being boosted by the increasingly large cash piles of Japanese companies (see chart 2); indeed this is providing ample opportunities for shareholders to benefit from rising dividend payments and share buybacks. 

Chart 2: Plenty of scope to increase shareholder returns

Left chart source: Bloomberg, Janus Henderson Investors. Market cap and cash balances as at 31 December 2017.
Right chart source: Company Data, Goldman Sachs Global ECS Research, as at 29 August 2016.
Note: Based on 1,787 Tokyo Stock Exchange 1st section (TSE1) companies, excluding consolidated subsidiaries, for which consolidated financial data are consistently available from financial year 2010.

The investment case for Japanese smaller companies

The reasons for investing in Japanese smaller companies remain compelling in our view. These companies tend to be more domestically focused and, in that respect, are generally more protected from external macroeconomic ripples compared to their larger, more globally-exposed counterparts. Smaller companies also stand to gain more from a domestic recovery in corporate capital expenditure and domestic consumption than larger companies.

Smaller firms by nature continue to be under-researched by investment analysts making the potential to uncover undiscovered ‘gems’ very strong and potentially more rewarding. Our fundamental, bottom-up research-driven investment approach focuses on stock valuation, investment catalysts and structural growth, which is key to finding the most attractive opportunities in Japanese smaller companies.

According to Nomura research, operating profits of smaller companies rose by 4.0% year-on-year in the 2016 financial year and this is expected to rise to 8.0% in 2017, and 10.2% in 20181. In tandem, earnings growth for these companies is also expected to accelerate.

Risks on our radar

A caveat to our positive view on smaller companies is that if the yen were to weaken, this could lead to the outperformance of more globally-exposed larger companies at the expense of largely domestic-focused small caps. Another risk to be mindful of is that while Japan’s consumer price index has remained positive for more than a year now, the pace of economic recovery is moderate and there is always a risk of a return to deflation, which would impact the stock market. 

How are we positioned?

We have a positive view on consumption recovery as the current labour shortage is likely to drive wages growth, while continuing stimulative monetary policy should support domestic consumption, drive higher investment activity and bring an end to deflation. To reflect this view we are invested in Isetan Mitsukoshi Holdings, a major Japanese department store with an overseas presence, with the potential to benefit from business reforms and a recovery in domestic and global consumption.  We are also hoping to benefit from rising private capital expenditure and have invested in companies such as Tokyo Steel Manufacturing, which is enjoying tight supply and growing demand for construction steel and is improving shareholder returns backed by strong cash accumulation. The company’s main focus is on the Japanese market; therefore we think the recently announced tariffs on steel and aluminium imports by US President Trump may only have a limited impact on Tokyo Steel.

We are avoiding several crowded and what appear to be overvalued sectors such as factory automation and staffing services. Despite strong performance from these sectors last year, we prefer sectors that are more in line with our strategy’s focus on identifying mispriced opportunities based on relative valuations and ‘unloved’ companies. Here, we seek to make use of in-depth proprietary fundamental research to discover incremental changes that may impact the growth potential and share price of an underappreciated company.