Capital Group Financial Advisor: Active Investing in Japan

Many stock markets around the world offer active managers room to generate superior returns. Among them, Japan stands out. Its equity market appears particularly inefficient. Reforms are also shaking up the once stagnant economy, creating new winners and losers in the corporate sector. That said, stockpicking still demands skill and discipline. We believe that managers will need nothing less than exceptional research and a long-term perspective to come out ahead.

Prime Minister Shinzo Abe’s reflationary policies have brought Japan’s stock market to a level of health not seen in decades. Even with the pullback earlier this year, the TOPIX has gained more than 70% in Japanese yen terms since end-2012, when ‘Abenomics’ started raising hopes for Japan’s economic recovery. Investors are rightly interested in gaining exposure to Japan. But how they do so matters.

Adopting a passive strategy may seem attractive. An exchange-traded fund, for instance, would simply track a stock market index in Japan. But why should investors settle for market returns? Japan has traditionally been a stock picker’s market, and it still is. Active managers that are adept at identifying opportunities and managing risks stand a good chance of beating the index over time. The sheer size of Japan’s stock market makes it a fertile hunting ground. It is the third-largest in the world by market capitalisation (US$5.2 trillion) and comprises more than 3,800 listed companies. But there are more reasons why conditions in Japan favour an active approach.

Information advantage

Japan’s stock market appears highly inefficient. Mispricing opportunities can be captured by active managers armed with superior research and insights. What drives stock market efficiency? Research coverage is key. The more analysts there are following a company, the faster information is likely to be shared. In that respect, Japan trails other developed markets like the US and UK significantly. On average, 12 analysts follow each company in the Nikkei 225 index, compared with 22 for the S&P 500 Composite Index and 21 for the FTSE 100 index.1 Research coverage tends to be even thinner for small- and mid-cap companies in Japan (see Exhibit 1). After the global financial crisis, many securities houses cut their research in this space to focus on larger companies instead. Within the electric appliances industry, for example, as many as 12 major securities houses track conglomerate Hitachi. But just two follow commercial kitchen equipment maker Hoshizaki.

Small firms, big reach

Japan’s small- and mid-cap sector is also home to numerous quality companies with leading positions in niche industries. This means there are ample opportunities for extensive bottom-up research to pay off.

Hoshizaki is a case in point. It receives little analyst coverage, yet it dominates the market for ice makers both domestically and abroad. Its energy-saving technology is a key competitive advantage as it eyes a bigger slice of the market for other appliances like refrigerators.

Likewise, few investors may have heard of Sysmex. But it is the world’s leading supplier of blood tests, ranking above healthcare giants such as Abbott. Over the years, Sysmex has gained market share with its highly efficient medical diagnostic tools and is pursuing further growth across various geographies and product lines.

Many small- and mid-cap companies trade at a discount to the market, making them seem even more attractive. But it pays to be careful. Certainly, some companies are undervalued because the market has overlooked them. But there are also those that simply have poor prospects. Active managers make a real difference when they can separate value finds from value traps.

Abenomics effect

In recent years, Abenomics has become a chief driver of investment opportunities in Japan, across companies large and small. Part of the agenda involves long-term reforms that are difficult to price into the stock market. This makes Japan a prime venue for forward-looking stock pickers that can identify companies poised for change.

Already, new corporate governance measures are starting to have an impact. They take aim at low profitability, ineffective boards, and other forms of poor corporate behaviour that have undermined investor confidence for years. Most companies that pledged to adopt these measures have been rewarded by the stock market. But anticipating which companies will do so is no mean feat.

Local insights are critical. Knowing a company’s financials is one thing, but understanding its culture and focus is quite another. It takes on-the-ground research, including regular meetings with top executives, to discern management’s views on Abenomics and detect potential changes in corporate direction.

Some companies that took steps to shape up were once seen as unlikely reform candidates. Fanuc, a world-leading industrial robot maker known for its reticence, surprised the market when it raised its dividend payout ratio and proposed share buybacks last year.

Still, overhauling corporate mindsets across Japan will take time. Its corporate governance still lags behind other developed countries. The discovery of accounting irregularities at electronics group Toshiba last year is a reminder of the gaps that exist. Active managers that can harness research to spot – and avoid – questionable firms have a valuable role to play.

Risk management

Indeed, limiting losses matters. But a passive approach provides no protection in this regard: investors tracking an index fully capture the market’s decline.

Passive investors are also vulnerable to unintended exposures. In February 2011, for example, investors mirroring the MSCI Japan Index would have had a 1.43% exposure to Tokyo Electric Power (TEPCO), whether they were positive about the electricity provider or not. It was then the ninth-largest company in the index. In March 2011, a massive earthquake set off a nuclear disaster at TEPCO’s power plant in Fukushima. As the company sank into the red, its share price plummeted. Today, TEPCO makes up just about 0.19% of the index.

In contrast, an active strategy can better protect against downside. The most successful managers consciously manage their exposures and invest according to their strongest convictions – not the index. They have the flexibility to avoid companies in the index with lofty valuations, or invest in non-index companies that show resilience. They can also hold cash to preserve capital during downturns. In fact, it is often during broad market declines that these managers deliver exceptional value.

Selecting an active manager

Historical data present a compelling case for long-term active investing in Japan. Over five-, 10- and 15-year periods, the median return from Japanese equity active managers handily outpaced the TOPIX (see Exhibit 2). Capital Group’s Japan Equity strategy also beat the TOPIX to rank within the top quartile of the universe over its lifetime.

Of course, not all active managers beat the index in the long term. It is therefore crucial for investors to identify those with the qualities to come out ahead.

Strong research skills are a prerequisite for success, especially in Japan. Given the stock market’s inefficiency, quality research goes a long way towards uncovering attractive opportunities.

This is why we commit huge resources to mine for insights on the ground. Our industry analysts research companies from the bottom up and maintain frequent communication with managements. They monitor not just companies based in Tokyo, but also lesser known firms in other parts of Japan.

The Capital Group Inc Singapore: A tale of two US economies

For the US, the second half of 2016 was a tale of two economies, with a strong domestic economy and weaker industrial sector. These trends are largely unchanged, but are now set against a very different political backdrop. While the impact of Donald Trump’s election as US president remains unclear, the improving economy should be supportive of US equities in 2017.

One economy, two inflation levels

Robust US consumer spending continues, with indicators showing encouraging data for areas such as retail, housing and auto sales. However, this sits alongside a relatively lacklustre industrial sector, driven by two factors:

1. Weak export growth because of sluggish non-US economic activity and a strong US dollar.
2. The collapse of the US energy sector, which followed the sharp decline in energy prices.

This split economy subsequently led to different levels of inflation in services and goods. As shown in the first chart below, service prices (which are largely determined by domestic economic conditions) have been rising around 3%, while goods prices (which are more a function of global economic conditions) have been flat or falling.

What this means for the Fed

The bifurcated nature of the US economy presented the US Federal Reserve (Fed) with a challenge: how to account for the fact that one half was growing at a rate better than expected while the other was showing the opposite trend. In response, the Fed chose to raise interest rates in December, while its rate-setters forecast further rises in 2017, contingent upon positive incoming economic data. We anticipate, however, that if additional rate rises do take place in 2017, these will be small and the ‘lower for longer’ scenario will remain intact.

Strengthening macroeconomic conditions

In a positive development, the two headwinds facing the industrial sector in 2016 have abated. Energy prices have rebounded, bolstered by the agreement between OPEC and other oil-producing nations to cut oil production. At the same time, the US dollar has weakened since the beginning of the year. This should lead to the industrial sector posting stronger growth rates in 2017, and in turn allow overall US economic growth to reaccelerate to a rate of 2%-2.5%, which we saw after the recession ended in mid-2009.

The Trump factor and policy uncertainty

The big change for the US has been in the political arena. President Trump’s bold proposed policies have already affected markets in anticipation of their implementation, but much remains uncertain.

If Trump’s fiscal policies were to be fully implemented, we could see stimulus reaching a level of around 3% of GDP, which may be problematic in the longer term. US unemployment is now below 5%, which is what most economists consider to be the economy’s natural rate. As the unemployment rate has moved further below 5%, wage growth has accelerated in a typical way. In past cycles, wage growth has accelerated every time the unemployment rate has fallen below 4%. If the economy does 3 indeed reach the 2%-2.5% growth rate, and there is a further 1%-1.5% of additional stimulus in 2017, the unemployment rate would likely continue to fall further, triggering a further acceleration in wage growth. This would result in a stronger economy in 2017 as consumers benefit from wage growth, but it may also cause the Fed to respond more aggressively than what the markets have currently priced in, by raising interest rates higher and faster.

Higher US interest rates would likely lead to higher bond yields, albeit within limits. Despite rising since the election, real yields have remained very low, at just above zero. This seems inconsistent with an expected economic growth rate of 2%-2.5% plus additional stimulus. These low yields are likely a by-product of policies implemented by other central banks around the world. Quantitative easing, by which central banks create money to purchase bonds, has directed vast volumes of money to the US Treasury market, driving bond prices higher and yields lower. While the US may have ceased its bond-buying programme, other markets, including the EU, have continued theirs. So while we can expect higher US Treasury yields, there will probably be a limit to how high they go, making them unlikely to pose a risk to the economic activity of 2017.

The costs of economic stimulus

Before the presidential election, the Congressional Budget Office had forecast that the federal debt-to-GDP ratio would increase over the next decade, reaching around 80% by 20251. However, if Trump’s proposals were fully implemented, that ratio would exceed 100% during that period2, reaching the same levels as in countries affected by the European debt crisis countries. If the growth in US debt continues along this trajectory, concerns about debt sustainability could increase over the next decade. This, coupled with a less favourable supply-and-demand balance within the Treasury market, could ultimately put upward pressure on yields. However, these are potential areas of concern that will have an impact beyond 2017.

The other key area of concern for the US economy is Trump’s policies on trade. There are currently trillions of dollars of goods that flow into and out of the US economy on an annual basis. Should significant tariffs on imports be levied, US consumers would lose purchasing power, while other countries could implement tariffs in retaliation. The result would be much higher prices for US consumers and so reduced consumer spending, as well as dampened export growth. Finally, there are well-entrenched global supply chains that rely on the relatively free movement of goods between countries. To disrupt those supply chains would no doubt have a negative impact on economic activity. Again, however, none of these outcomes are likely to play out in 2017, but rather in 2019 or 2020.

Realistic expectations

There are significant obstacles that President Trump would have to face should he push for his full proposed stimulus and policies. Firstly, many of the policies would require congressional approval, which is not guaranteed. Even if they were approved, it would then take time to implement them. For example, a large infrastructure spending package would take a significant amount of time to execute as projects have to be identified and resources mobilised. The same goes for trade policies.

A supportive backdrop for US equities remains despite uncertainties

The US equity market currently appears fully valued, with the price-to-earnings ratio at a level that has rarely been exceeded. As a result, we believe a reasonable expectation is for total return over the next 12 to 18 months to be driven by a combination of earnings growth and dividend yield.

Fortunately, with an economy that is improving, an industrial sector that is recovering and the possibility of corporate tax cuts, the outlook for US earnings is positive. In our view, it is also reasonable to expect solid earnings growth over the next 12 to 18 months and, if you factor in dividend yield on top of that, there is the potential for positive equity market returns as we go through 2017 and into 2018.