3 min read 1 Dec 22
For us, Japanese equities represent a highly compelling long-term investment opportunity. There exists a powerful, structural earnings growth story in Japan, which has good potential to extend many years into the future, in our view. This is not widely appreciated. As a result, the price investors must pay to own that growth today is very modest. We believe Japan is simply no longer a “value play” or a “leveraged play on global growth” – which are the views still held by many casual observers.
Japanese earnings and dividends together have performed as well as those of the S&P500 in the last decade, in local currency terms, growing in the region of 10% annualized, as at 31 October 2022. This impressive performance was delivered in volatile macroeconomic conditions and in the context of very little revenue growth. Instead, profit growth has been the result of deliberate efforts from the corporate sector to improve, to become more effective and more competitive.
This underappreciated transformation started over a decade ago, with the introduction of the now-familiar “Abenomics.” This major turning point in Japanese corporate history re-wrote the social contract in Japan. Having been the execution limbs of industrial policy for more than a decade, Japanese companies have been successfully shifting to self-regulating capital and resource allocators, driven more than ever by the need to secure appropriate levels of profitability and economic return. This is not only bullish for owners of equity, but for the competitiveness of the economy as a whole.
Overseas investors were quick to recognise the significance of Abenomics, as evidenced by the circa US$250 billion of foreign inflows into Japanese equities in the two years following Abe’s election win. However, stock market time horizons don’t always sit comfortably with the timelines required in the real world to bring about significant institutional and behavioural reform. Seemingly upset by the gradual pace of improvement, foreign investors have spent the last seven years unwinding this $250 billion buying spree. Ironically, as investors have gradually been selling their initial euphoria, corporate Japan has been gradually delivering, each year becoming a slightly better version of itself.
In the past decade, the Japanese corporate landscape has undergone significant change, much in line with what Abe imagined. The Companies Act has been overhauled, new stewardship and governance codes were put in place, new proxy-voting guidelines were developed, new M&A rules and a new tax code were implemented. These changes have delivered not just the ‘carrots and sticks’ to shape intentions, but also the tools to execute policy.
Today, despite a decade of solid earnings growth, the scope for further improvements remains significant, in our opinion. Japanese balance sheets remain awash with excess assets in the form of working capital, real estate, net cash and other miscellaneous items. This excess capital is gradually being returned to shareholders or re-invested, with meaningful return implications.
Turning to corporate income statements, Japanese margins at 7% are still less than half of those in the US and have significant scope to improve, in our view. Talking to Japanese companies, we find, anecdotally, that many have not raised product prices in 20 years. Companies have been slow to digitize and, they are only just ending remuneration policies based on length of service and so on. The corporate landscape is littered with low hanging fruit, all offering material upside for profit margins, in our view.
Industry structure is another important and changing element of corporate Japan, where gradually we are seeing excess industry fragmentation give way to consolidation and margin repair as duplicated costs are eliminated.
With so many positive factors in play, we suspect that the self-help phenomenon will be at least as powerful in the coming ten years as it was in the past and we estimate that this could easily mean another 10% compound earnings growth to come. With returns potentially boosted by another 3% from dividends and 3% from buybacks, compound returns could very plausibly reach 16% annualised, before any uplift in valuation or any benefit to equities from inflation.
Investors should remember that past performance is not a guide to future performance.
Just as we hope to be seen as the fiduciary of choice for our clients, we also want to be seen as the shareholder of choice for companies we interact with. There are various ways we try to do this. For example, we leverage M&G’s massive network of corporate relationships across the globe, connecting investee companies with one another to drive new customer or supplier relationships, or perhaps to foster transformational M&A. We work with companies on their ESG credentials, quietly encouraging changes that can drive long-term value creation.
This “servant-leadership” model, where we seek to use service as a way to exercise a leadership position in the companies we invest in, is how we try to add value and impact investment outcomes. In turn, we hope to be able to make our investors proud not just thanks to strong returns, but the way they were created.
Serving companies, however, is no easy task. Our investment philosophy leads us to research companies, rather than investment ideas. As such, we tend to ask different questions. Different questions drive you to different places for the answers. We have created a differentiated ecosystem for discovery. Over the years this has generated a superior dialogue with companies which in turn, drives a better understanding of the risk of ownership. We believe the perspective we initially sought to help guide decisions of risk and reward has also put us in a good position to serve the companies we track, to challenge and/or support their decision making and to make value-adding introductions to other companies.
M&G has been investing in Japanese equities since 1971. The investment team is made up of 11 investment professionals (fund managers and analysts) and their dedicated supports, located across London and Asia. In total, the team has more than 200 years of combined investment experience, with a significant portion of that in Japanese equities. We have worked hard in the past two-plus decades to put ourselves in a position to plausibly claim that we can price the risk of ownership for a given business in a superior fashion compared to the market. We pride ourselves on being truly active managers. Our engagements in Japan have added value not only to our portfolio returns, but also to the companies we have invested in.
Engagement is only a part of our day-to-day investment activities. Given the large opportunity set in Japan, we feel that this is not only an asset class that has great potential to give investors positive returns in this uncertain world, but it also produces significant active return opportunities for stock pickers like ourselves, with a long track record in investing in Japan. The opportunity set has never seemed more appealing to us.
The value of a fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested.
Past performance is not a guide to future performance.
The views expressed in this document should not be taken as a recommendation, advice or forecast
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.