Recently we met with a global equity manager who’d had the misfortune of starting his fund in 1987. The fund’s analysts at that time had little experience with Japan and, along with other fundamental reasons, decided not to invest in the region. At its peak in 1989 Japan represented 44 per cent of the world MSCI Index notwithstanding its much smaller 17 per cent of global gross domestic product. It was hardly surprising that this fund hugely underperformed over its first years, before its mojo and that of Japan realigned with reality.
This tale has multiple lessons. When any sector or country is over-represented, compared with the logic of its contribution to its industry or economic weight, investors should take heed as the circumstances rarely last. There are obvious issues here for Australian equity investors and also in global markets.
The intersection of global sectors with country weights can be argued in a number of ways. Nestle, as an iconic example, is listed in Switzerland yet, given its fortunes have practically nothing to do with Swiss consumption behaviour, noting that your portfolio has a Swiss allocation is unquestionably distorting. Today the US equity market accounts for a disproportionate number of high-flying IT companies whose reach is global, not local.
Which brings us back to Japan.
Fund managers and investment banks are currently positive on Japanese equities – from subtly to prominently. Any cursory reading of the economic outlook for the country would make an investor somewhat aghast at this positive view. After all, the demographic profile is startling, with projections the population will fall by 17 per cent by 2040 and over 75-year-olds will then be 20 per cent of the population. Government debt is fantastic at 240 per cent of GDP – although a somewhat more sobering 140 per cent if measured by net debt. By any standards Japan requires a change in direction and it is in the corporate sector that the most promising signs are emerging.
A combination of government direction and shareholder activism has revived interest in Japanese companies. For example, in the recent round of annual meetings, influential proxy adviser Institutional Shareholder Services (ISS) recommended voting against director reappointments where the return on equity (ROE) has been below 5 per cent for five years.
Japanese companies pay attention to any hint of disapproval on such issues and already some changes are in the offing. Further, the government has introduced the Corporate Governance Code, where companies are required to justify the rationale for shareholdings in other corporations. Many large companies have long held passive positions in others as an unspoken way of supporting fellow organisations. The new code has already prompted the release of some of this inactive capital – capital management or investment may follow.
Equity markets have embraced the change along with the supportive monetary policy and fall in the yen, pushing the Topix to a multi-year high. While the easy money has therefore arguably been made, most global managers are still finding attractive investments in Japan. The structural shifts mentioned above are stock specific, most affecting financials and insurance companies and should result in higher share prices even with slow earnings growth, due to greater capital efficiency. Themes such as a substantial growth of inbound tourism, auto and high-end manufacturing companies attract those looking for revenue potential.
Japan represents 7.9 per cent of the MSCI All World Index and should not be ignored. Familiar names abound – Mitsubishi, Nintendo, Toyota, Sumitomo, Honda; others perhaps less so such as Fanuc, an iconic robotics company that displays much of the growth potential and activism mentioned earlier.
This economy is on the leading edge of many developed-world countries with its significant changes in demographics and push for renewal. It would likely pay to watch it unfold. In the meantime, fund managers are generally holding their exposure to companies in Japan; much as a Swiss company may not represent its home economy, many Japanese companies are also global.