Legg Mason Equity Japan manager expects trend favouring domestic-oriented small-cap growth to continue
What is your investment process and current outlook on Japanese equities?
My investment strategy is always bottom up and growth oriented. I only buy stocks showing very strong profits growth and selling on low P/E multiples. Usually I look for companies with a profits growth rate of more than 20% per annum over a combined four years – two years in the past and two years in the future – and selling on an attractive PEG ratio.
Many companies with these characteristics fall into one of two sectors – domestic-oriented service or distribution sectors meaning I rarely invest in financials or cyclicals.
However, our investment strategy suffered between early 2006 and August of 2008 when the only strength in the Japanese market was large-cap cyclical and large-cap exporters.
This was because the macro environment at that time was very unusual in the sense that commodity prices, particularly oil, were shooting up, exports were growing very fast and the yen was weakening.
Since then the yen has started to strengthen and Japan’s exports and commodity prices have started to go down.
This has led to market sentiment in Japan changing in favour of domestic-oriented small-cap growth stocks away from large-cap exporters and large-cap cyclicals. That is why since September 2008 to end November 2009 we have been outperforming the Topix Index.
I think this trend should continue over the next 12-18 months because small-cap domestic-oriented companies are continuing to show very strong performance.
Has your strategy changed recently?
Over the past year, I have not made any changes to my strategy. I continue to find companies that are showing strong profits growth. I have increased exposure to internet-related stocks, particularly companies who engage in e-commerce, because e-commerce business is expanding very fast despite sluggish consumer spending. In fact, internet-related stocks account for about 29% of the total portfolio.
Elsewhere, healthcare-related stocks account for about 16.5% of the total portfolio. By market cap we invest about 15% of the portfolio in large caps, about 20% in mid-cap and about 45% in small caps and about 18% in micro cap.
My strategy is to concentrate the portfolio on a relatively small number of stocks.
At the moment we have 27 holdings and the top 10 holdings account for 60%. Usually the top 10 holdings account for half the portfolio.
What is your outlook for the Japanese economy over the next 12 to 18 months and how is this likely to impact your portfolio?
It is generally expected that GDP growth may become negative during the first quarter of next year. However, I think the GDP growth rate will be around 1%, which is positive although still low, because I think capital investment remains weak and consumer spending will continue to be soft.
The newly elected Democratic Party of Japan’s main policy focus is on increasing household incomes, so they are placing more emphasis on improving people’s living standards. Long term, the new Government policy favours our strategy of investing in smaller companies. Their policy is to transform Japan’s economic structure from export orientated or manufacturing orientated to domestic orientated.
Also it seems that the new government is more in favour of a strong yen rather than a weak yen. Previous governments have always favoured a weak yen so large-cap manufactures would benefit.
What is your view on the yen and on Japanese retail investment flows impacting the market?
From early 2006 until August 2008, the yen was weakening so a substantial amount of money went abroad, outside Japan, investing in overseas fixed income or investing in emerging markets such as Shanghai, India, Hong Kong, Indonesia and so on.
If the yen continues to remain strong or strengthens further, some of this money which went overseas will be shifted back into Japan because otherwise they will suffer from currency losses.
Since the end of 2008 until the summer of 2009, money invested in overseas fixed income and emerging markets has gone down, but recently because of sharp growth or a very fast price appreciation in China, India and so on; money has started to go back into those emerging markets.
However, I think with a strong yen, some money may be shifted back into Japan and if Japanese markets start to behave much better, and investors start to regain confidence, I think they might become much more active participants in the Japanese stock market.
Of course, if the yen strengthens very sharply in a short period of time that would give concern to investors about economic growth. But I see the yen strengthening gradually,
not sharply.
