The past year has been characterized by very large swings in market sentiment for Japan equities. Increasing market volatility has coincided with short-term news linked to both comfort with and concern for the global cycle.
Investors focused on the ever changing daily macroeconomic news have found it a big challenge to use this often contradictory information to inform their investment decisions. Amid such market uncertainty, investors have been chasing investment returns over shorter and shorter time frames, often leading to disappointing results.
Attractive starting prices lead to opportunity - not the headlines
It is almost impossible to consistently forecast the effects of short-term news on markets. Forecasting relies on an ability to "time the market" in a world with an uncertain future. Instead, we actively avoid the economic news headlines. Share prices tell us how much the market is discounting the headlines. The cheaper the share price the more the headline is discounted!
Rather than looking at headlines, we focus on starting company valuations, which are far more important to future shareholder returns. Very cheap share prices can lead to many investment opportunities for patient investors.
Smaller companies offers a wide universe of mis-priced opportunities
In the Japanese equity market, mid and smaller companies is the widest market segment, with about 2000 stocks. Yet it has a distinct lack of analyst coverage by the brokerages. By focusing on outliers that are often ignored by the market, we can find a wealth of extremely mis-priced opportunities in this segment.
Many companies are mispriced because they are misunderstood
A focus on company-specific issues can reveal encouraging behavior that is far more informative about the drivers of company earnings than short-term news. This requires a deep understanding of the health of a company, its fundamentals and its ability to adapt to the tough, competitive and uncertain world that exists beyond the headlines.
For example, one of Japans largest national drugstore chains, Cockakara Fine was experiencing significant disruptions and profitability headwinds from an ongoing restructuring process. This was creating shorter term pain and put significant pressure on its share price. Meanwhile, Cocakara Fine were standardizing and consolidating the front and back office systems to remove inefficiencies. It was looking to benchmark all of its stores to introduce best practice. Additionally it was looking to bring superior economies of scale in terms of purchasing power, improve logistics, open new stores, and facilitate staff training.
While we could not predict when the company might begin to benefit from this transformation, we saw the potential for long-term gain and bought shares at very attractive valuations. The significant valuation upside from the purchase price meant that, even if it took years to release value, we would be more than compensated for our patience. We were ultimately rewarded as the market began to realize the positive changes that had taken place at Cocakara Fine as it translated into improved trend earnings some time later.
Unlocking value in Japan
It is crucial 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. When we focus on the extremes of valuation, we find plentiful opportunities across the Japanese mid and small cap space. The improved trend earnings in Japan has yet to be priced by the market at a time when: corporate leverage has fallen materially; corporate investments have fallen to converge with other markets; and non-financial companies return on assets have risen to converge with other markets.
In this environment, the stand-out investment opportunities are found by going against the herd. This requires patience and a deep understanding of the drivers of trend earnings, but it also offers the greatest potential long-term rewards.
For more information please visit: eastspring.com/jsc
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