Near-term challenges bring long-term opportunities
The outbreak of the COVID-19 pandemic has led to market volatility not seen since the Global Financial Crisis (GFC). Governments around the globe have had to impose measures restricting the movement of people in an attempt to curtail the spread of the virus and this has led to severely disrupted economic activity.
There are no assurances that the Japanese economy will pick up where it left off before the pandemic; with the demand-side heavily affected, we do not expect consumption to normalize any time soon and a quick “V” shaped economic recovery appears unlikely.
This presents long-term opportunities for value investors in Japanese equities, despite challenges in the near term. The current market crisis has caused a massive demand side shock and therefore it is not easily comparable with the GFC. Furthermore, the Growth-Value spread, which had already been widening due to the sharp decline in long-term interest rates and the fact that abundant liquidity had made it easier to justify higher premiums on growth stocks, reached historical levels during Q1 2020. There has only been one other time over the past decade where we have seen value underperformance on the scale of these past few months, and we are confident that these distortions will be temporary. Over the longer term, we expect the Japanese equity market’s attractive valuations and a number of structural themes to favour value investors.
Japanese equities are undervalued
Japanese equities are significantly undervalued relative to their peers in other major markets. Furthermore, the current earnings yield for TOPIX is at a historical high while the P/B ratio is at its lowest level since the GFC and the earthquake and tsunami of 2011. Since 1985 a value approach in Japanese equities has delivered superior performance relative to growth. We believe the current underperformance of value will be short lived and this adds to our conviction that now is an opportune time to embrace a value investing approach.
Chart 1 Dividend estimate pathway
Source: FactSet, Nikko AM
Structural themes supporting Japanese equities
In addition to the attractive valuations, we highlight three structural themes which we believe favour Japanese equities.
Ongoing corporate governance improvements: More companies are focusing on value creation and capital efficiency. We are seeing ROE improvements along with increasing shareholder returns. As an example of the structural change, the number of companies employing takeover defense measures continues to fall.
Demand for new technologies: Many Japanese companies offer promising and monetisable solutions in areas such as 5G, IoT, EVs and MaaS (mobility as a service), environmentally-friendly materials and hydrogen energy—all vital building blocks for future social infrastructure. Already, demand from manufacturers of 5G base stations and mobile phones is increasing, with further demand expected across these transformative technological platforms.
Asia now part of Japan’s domestic demand: Japan is increasingly interlinked with Asia, the world’s fastest growing region. Yet value opportunities are often overlooked as the Japanese equity market is still under-researched despite the increase in Japanese companies benefiting from this connectivity to Asia.
While the above-mentioned themes will act as a tailwind for Japanese equities in 2020 and beyond, we believe that an active value approach works best in capturing evolving investment opportunities. The broader Japanese equity market is under-researched, so applying a time-tested contrarian value approach to proprietary on the-ground research is critical to long-term outperformance, in our view. Examples we uncovered include:
The well-known gaming industry brand is increasingly providing societal value in helping people feel connected through family-friendly games during turbulent times. The company has seen a rise in the ratio of sales from downloads of highly profitable games, an increase in paying users of the Nintendo Switch Online platform and greater brand recognition in China.
The runaway success of its software sales has created stronger demand for its hardware. Boosted by this software-hardware synergy effect, the company’s stock surged when the market plunged in Q1 2020 and saw profits increase 41% year-over-year. We believe investors in both Japan and broad are only just beginning to recognise the potential for Nintendo’s share price to be re-rated on the strength of its compelling intellectual property and strong business fundamentals.
A leading Japanese manufacturer of high-end glass fibre used in printed circuit boards. After a round of structural reforms, the firm is now approaching a new phase of earnings growth. The company is increasingly benefiting from its high heat resistance and insulation products that feature prominently in 5G-related fields. Nitto Boseki also stands to benefit from its role as a manufacturer of antibody test kits with demand for such products increasing due to the COVID-19 pandemic.
Uncovering attractive value opportunities that can deliver stable excess returns will continue to require careful bottom-up research from experienced investment professionals. We believe that an important catalyst for the market to re-evaluate an undervalued stock is efforts by the company to have positive social impact; as such, ESG factors have always been incorporated as part of bottom-up company research. Such efforts allow for the discovery of undervalued Japanese companies with the potential for positive impact on society and enterprise value.
Reference to individual stocks is for illustration purpose only and does not guarantee their continued inclusion in the strategy’s portfolio, nor constitute a recommendation to buy or sell.