As an investor in one of their funds, I follow the comments of Stephen Morant and Ian Wright, founders of the specialist Japanese investment management boutique Morant Wright, with interest. Their latest quarterly market review provides a useful snapshot of the state of play in the Japanese stock market. Anyone hoping for a sustained recovery from the 20 year bear market in equities has long since learned to live with disappointment. The down-up-down market cycle in Japan has offered regular trading opportunities, but for many years, despite looking cheap at face value, nothing more in the way of a permanent recovery.
The 20-year graph of the Topix index (above) tells the story. Recent stock market action however has been more encouraging , with both the shorter and long term moving averages moving higher since the summer last year.
There is the added lure, for contrarian investors, that institutional and private investor interest in Japan remains at a historically low ebb and valuations for many companies look attractive in both absolute and relative terms. These are exactly the kind of market conditions from which a roaring bull market could one day emerge. At least one of my regular professional investor contacts has recently upped the Japan weightings in his global portfolio to more than 15%, its highest level for a long time.
In their latest quarterly review, Morant Wright take a characteristically measured view. Here is an extract:
Individual involvement in the stock market is low. Equities account for just 6% of their total financial assets of ¥1500trn whilst cash holdings are around 55%. These figures are similar to the levels at the lows in 2003. There is little margin trading and IPOs last year were at the lowest level for many years. Over time individuals will come back to the market.
Institutional exposure to the equity market is also low, but it is perhaps more difficult to see this changing in the near term. Trust banks, on behalf of pension funds, were big buyers early in 2009 as their equity weightings fell below target, but more recently they have been quiet. There is discussion of the Government Pension Investment Fund taking a more active approach with its holdings of domestic equities, but this may well become mired in bureaucracy. Banks are structural sellers as equities still represent 40% of Tier I capital – too high for most – and the insurance companies still seem keen to reduce risk despite the obvious value. It will take time for confidence to be restored and for institutions to take a proper role in the stock market, as seen in other countries. On the other hand, share buybacks by companies are likely to recover, which might absorb any institutional selling.
The corporate sector has responded in a very positive way to last year’s crisis. Considerable restructuring has been undertaken and some harsh decisions have been made. Not only has there been a reduction in the temporary work force but permanent jobs have also been lost. This looks to be continuing with many companies having early retirement programs in place. Factories have been closed down; for example, Panasonic Electric Works has closed 5 of their 15 domestic plants and Sekisui House has shut a major prefabricated housing factory. This rationalisation and better utilisation of assets seems to be a continuing theme.
The corporate sector continues to reorganise, with mergers and acquisitions occurring across a wide range of sectors. Sumitomo Trust and Banking is merging with Chuo Mitsui Trust. The non-life insurance sector is effectively reducing to three companies as Mitsui Sumitomo combines with Aioi and Nissay Dowa, and Sompo merges with Nippon Koa. Hitachi has bought in a number of its subsidiaries at large premiums. Companies are also looking overseas for acquisitions, with, for instance, Shiseido recently taking over Bare Escentuals in the US.
Companies are also in a very strong financial position. Debt has fallen significantly and 43% of Japanese companies now have net cash on their balance sheet. Free cash flow has also expanded over the last two years as capital investment has fallen. There is a big question as to what companies will do with this money. Final dividends this year have increased by 5% but it is not clear by how much dividends will rise next year when earnings recover. Still the yield on the stock market at 1.9% is comfortably ahead of current bond yields. Buybacks have naturally fallen sharply this year as uncertainty over the outlook gave rise to caution, but as mentioned above they could increase again next year.
Restructuring has had a significant effect on earnings with many companies revising profit forecasts upwards despite fairly lacklustre sales. Earnings for this fiscal year are obviously depressed as a result of the poor first half but brokers are expecting a significant recovery next year and for TOPIX as a whole the earnings per share is expected to be above ¥50. The historic book value of TOPIX is about 820, and the current value is probably a little higher given the recent upward movement in the stock market. The return on equity is thus over 6% and with the price to book a little over 1.2 times the valuation feels very comfortable. Operational gearing appears high and further profit growth is also forecast for the year to March 2012 to well over ¥60 EPS, which should take the market higher over time.
We have all been to Japan recently and also had a significant number of conference calls with companies. We have been impressed by the restructuring and earnings recovery, with nearly all companies increasingly confident about the outlook for profits. Many are emphasising Asia in their longer term plans. Although the market has moved higher it is still modestly rated by historic standards on a price to book basis. The sell off in the autumn of 2008 and early 2009 allowed us to purchase many quality stocks, including some exporters, but we remain mainly domestically focused with a mid-cap bias. Our portfolio trades at around 0.85 times book value, a significant discount to the market.
What is noticeable from the charts is that the recovery in the Japanese market continues to lag significantly behind the MSCI World index. It would be no surprise to see that gap start to close in due course, and for my money it is certainly no time to be reducing exposure to Japan, serial disappointment though it has been.
