Strong case for value investing in Japan

John Authers, Financial Times, 27 January 2016

Is there value in Japan? International investors have asked this question for a quarter of a century now, and are tired of getting the same answer. After flirting with recovery for a brief period, Japan reconfirms itself as the world's biggest value trap.

That may just have happened again. Japanese stocks enjoyed a sharp rebound at the end of last week, but the Topix and Nikkei 225 indices remain about 20% below recent highs set last summer. They are also, of course, some 55% below their peak amid one of history's most insane bubbles at the end of 1989.

That means they again look cheap. According to Research Affiliates, Japan's cyclically adjusted price/earnings multiple, adjusting for the business cycle by taking an average of the last 10 years' earnings, stands at 25. This is far below its median since 1969 (which should not be affected by the few years of ridiculous valuations in the late 1980s) of 38.

Most Topix sectors are trading lower than their average for the years since 2000. Steel, wholesale trade, marine transport and mining, all badly affected by the global trade downturn, have only been cheaper than this 5% or less of the time since then.

The renewed sell-off is at least in part due to a sense that Abenomics, the premier's plan for growth and the latest reason for optimism, is coming off the tracks. The slide took shape as it became clear the government intended to go through with raising the consumption tax next year, despite the disastrous reception for the last such rise three years ago. Japan's exports have suffered as its neighbour China has decelerated.

Yet, there is a decent case for value investing in Japan.

It starts with the surprising fact that while Japan as a whole has been a value trap, the value style of investing has worked well when it comes to choosing between Japanese stocks, and has done so throughout most of its post-bubble malaise. Nicholas Smith, strategist for CLSA in Tokyo, notes that small-cap value stocks outperformed the Topix 300 per cent since 1985. Even mega-cap value stocks beat the Topix by 150%, even if that outperformance has petered out badly over the past few years.

The reason for this is that Japan is highly cyclical. That tends to mean, according to Mr Smith, that cyclical sectors get badly battered in down cycles. Once they become too cheap, they deliver great returns for value investors when the cycle turns positive, and mean that Japan has delivered returns for value more reliably than any other market.

Second, there is the issue of cash. Japanese companies have a lot of it - Y110tn - sitting unused on balance sheets. Jesper Koll, head of WisdomTree in Japan, says the money will have to move somewhere, and that both dividends and share repurchases have begun to rise from low levels.

Dividends rose to Y11.6tn last year, but this is not much higher than the 2007, pre-crisis, level of Y8.4tn. Share repurchases have risen post-crisis to Y6tn, but again this is not far ahead of pre-crisis levels of Y4.7tn. As their total cash doubled over the same period, this leaves ample room for companies to distribute more to shareholders.

Third, Japan offers at least a partial refuge from the greatest macroeconomic concerns of the moment. It has no big energy companies. It has no capital expenditure dependent on oil, and so has everything to gain from cheaper crude. Its markets' correlations with the level of the Chinese currency are negligible.

Finally, corporate Japan has found ways to be more profitable. Profits are 3.5% of GDP, their highest for the entire malaise era and double their level of 20 years ago. If the much-hoped wave of mergers and acquisitions transpire, allowing them to reduce capacity and limit competition in their home market, that would be great news for investors - if not for Japanese consumers.

Value investing always needs a catalyst, otherwise stocks just stay cheap. There could be one in the improved corporate governance that the government has fomented as part of the Abenomics reforms.

"They have no alternative," says Mr Smith. As Japanese companies have spent 20 years repairing their balance sheets, they are now if anything overweight in cash. Also, Japan has deep debt capital markets to help out that come to regret paying out their cash.

The case for a long-term position in Japan, centred on the cheaper stocks that offer value, is a strong one. The sell-off of the last few months has strengthened that case.

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