This year has been characterized by very large swings in market sentiment for Japan equities. Increasing market volatility has coincided with shorter term news flow linked to the "comforts" and "concerns" for the global cycle.
Patience is a virtue for contrarian stock pickers in Japan
Investors who have focused on the ever changing daily macroeconomic news flow have found it a big challenge to inform their investment decisions. Amid this market uncertainty, investors have been chasing investment returns over shorter and shorter time frames, which can lead to disappointing results.
Attractive starting prices lead to an opportunity - not the headlines
We believe it is almost impossible to consistently forecast the effects of short term news flow on markets. Forecasting also relies on an ability to "time the market" in a world that holds an uncertain future. We actively avoid the economic news headlines. Share prices inform you about how much the "news headlines" are discounted by the market. The cheaper the share price the more the news headline is discounted!
Starting company valuations are extremely important to future shareholder returns. We let very cheap share prices lead us to investment opportunities. Today, there are many attractively valued companies in Japan.
Japan's Smaller Companies offers a wide universe of mis-priced opportunities
Japan's mid and smaller companies investable universe is the widest market segment with about 2000 stocks. However you only need to focus on outliers that are often ignored by the market, this approach brings a wealth of mis-priced opportunities. Whilst the mid and small cap universe is wide it has a distinct lack of analyst coverage by the brokerages. The result is there is great potential for stock pickers to find and exploit extremely mis-priced stocks that may be out of favour with the market.
Many companies are mis-priced because they are misunderstood
A focus on company specific issues has revealed some very encouraging behavior which is far more informative about the drivers of company earnings that lead to shareholder returns. Our job is to deeply understand the health of a company - or its fundamentals - and observe each company's ability to adapt to a tough, competitive and uncertain world that exists beyond the headlines.
For example, after the BOJ announced a move to a negative interest rate policy, shares for regional banks in particular, fell materially reflecting the market's beliefs that earnings were likely to be permanently impaired. Ironically, recent of interest rates bottoming out have led the market to worry about the performance of the large bond portfolios that many regional banks hold. This market behaviour presented a price episode for our approach to exploit. Tokyo TY Financial Group is a regional bank that has had to operate in a tough low interest rate environment for many years. It has taken steps to diversify its loan book by industry and maintains a relatively high exposure in higher margin loans to the small to medium enterprise market segment, which is supportive for longer term sustainable returns and capital adequacy ratios. The bank is also located in the growing Tokyo area and has been a consolidator of other banks, which is expected to deliver significant cost savings next year. Our analysis suggests that the market's pessimistic expectations have already priced in a significant contraction in domestic net interest margin.
Timeframe helps to put probability of outcomes in our favour
By applying our conservative trend margin earnings assumptions, there is significant valuation upside from today's share price. Even if it takes a number of years for the market to realize value then our approach would be amply compensated for our patience.
We accept that the future is uncertain, market behaviours may persist, and assets may remain out of favour for an indeterminate length of time. Significant valuation upside compensates for the time it may take for the market to realise value in an asset.
Unlocking value in Japan
We want to understand company behavior and its attitude towards shareholders. Rising equity returns can be unlocked by a company's ability and willingness to increase their payout to shareholders. The evidence is clear that Japan's corporate behavior is improving and shareholders are benefitting from increased payouts in the form of higher dividends and more share buybacks - both of which are supportive for equity returns.
What about the opportunities we see in Japan today?
Company health is sound in Japan after years of ongoing restructuring and adapting to a tough market environment.
Most importantly, there is significant upside potential in the market which is far greater than last year when the market consensus was far more positive on Japan.
The stand out investment opportunities are found by going against the herd. It requires patience and a deep understanding of the drivers of trend earnings but also offers the greatest potential rewards.
Find out more at Eastspring.com/jsc
This material is produced for professional clients and information purposes only, it does not constitute an offer to buy or any investment advice, nor shall it be relied upon as including sufficient information to support an investment decision.
This material is issued and has been prepared by Eastspring Investments (Luxembourg) S.A., authorised and supervised by the Commission de Surveillance du Secteur Financier (the "CSSF"), acting through its UK branch, 125 Old Broad Street, EC2N 1AR, London, in relation with the management of Eastspring Investments - Japan Smaller Companies Fund, a sub-fund of Eastspring Investments, a Luxembourg based umbrella Société d'Investissement à Capital Variable (the "SICAV") regulated by CSSF and qualifying as UCITS. The SICAV sub-funds may only be offered in a limited number of jurisdictions where the sub-funds have been locally registered, please refer to www.eastspring.lu for the full list of SICAV sub-funds and relevant share classes available in your country. The value of an investment is subject to investment risks, including the possible loss of the principal amount invested. The value of shares in any sub-fund of the SICAV and the income accruing to the shares, if any, may fall or rise. Past performance is not necessarily indicative of the future or likely performance of the SICAV. Eastspring Investments (Luxembourg) S.A., including its UK branch, is an ultimately wholly-owned subsidiary of UK based Prudential plc, whereas such entities are not affiliated in any manner with Prudential Financial, Inc., a company whose principal place of business is in the United States of America
