Investment Ideas – a quick deep dive into Japanese equities

Is it really different this time for Japanese equities? We review the arguments! For the bulls, we also run through the indices, as well as the main funds, both ETFs and investment trusts

Photo by Jase Bloor on Unsplash

Japanese equities are back in favour. Warren Buffett is buying aggressively into Japanese businesses and one of the main indices tracking local large caps, the Nikkei 225, is outperforming its peers. Not unsurprisingly this led to increasingly bullish narratives from market observers who reckon that key barriers are being broken. Here’s Bloomberg’s John Stepek just last week talking about a key barrier being broken on a major local index, the Topix: “And yet now, with very little fanfare, it really does look as though the Topix has finally done it. The post-pandemic rally has taken the Japanese market well over the 1,800 level, and after a brief retest in March 2022, it seems to have broken out definitively.”

It’s not all just technical of course. There really is a feeling that this time it is different – take the big moves in corporate governance. For years Japan was famous for its opaque corporate governance and intensely hostile to foreign shareholder activists. That seems to have changed, not least because of prodding by the Japanese government. As Stepek at Bloomberg reports: “there has been a significant change in attitude towards governance in recent years,” as broker Numis points out in a recent note. “This is positive for the outlook for equity investors as management teams have become more focused on shareholder returns.”

The challenge of course is that Japanese equities have been the comeback kid for as long as I’ve been writing about investment i.e. decades. After a massive bubble and then an even bigger bust, the bulls have been waiting for the Japanese narrative to change.

One argument in favour of Japanese equities is that they are perennially cheap. Analysts at SocGen have long been bullish about the value characteristics of Japanese equities: only this week they summarised their position as follows:

“Japan is a persistently cheap equity market, so much so that the authorities are asking companies to do something about it. But……..the issue really isn’t the cheapness of Japanese or European stocks – it is the excessive valuation of US stocks. Japanese corporates are already distributing as much of their cash flow in dividends and buybacks as European peers, and paying out more in dividends than US peers. But US companies conduct over 2.5 times more share buybacks, often borrowing to help fund them. And this seems to be the main issue – leverage – after all, Japanese companies have significantly improved return on assets, but it is return on equity that is lagging. The hope is that this changes, with underleveraged and high ROA Japanese companies outperforming recently”.

The problem with this positive narrative is not only that we’ve been here before – with rallies evaporating after a few months – but that Japanese equities may not be quite as cheap as some maintain. John Authers (also at Bloomberg) quotes Matt Maley of Miller Tabak who, on a relative value basis says that “the Nikkei is its most overbought in five years; and on a Bollinger Band basis (looking at how far an index is from its short-term trend, in terms of standard deviations), it is its most overextended since 2013. Back then, as the excitement over the new premier Shinzo Abe’s campaign of “Abenomics” died down, the index eventually dropped 20% in a matter of weeks in a violent correction. So piling in at just this moment may not be such a great idea.”

Authers I think also nails the key big picture issue – do we really believe that the bigger Japanese national narrative has changed i.e that deflation is under control, that wages are rising, that government debt is under control?

In reality, currency also counts Authers observes that “the yen and the Nikkei have a strong inverse relationship, in part because investors assume that the country’s companies are reliant on exports and need a cheap yen. Rallies for the stock market tend to be driven by a cheaper yen. When the “carry trade” — borrowing in yen and parking in another currency to pocket the difference in yields — is popular, the Nikkei can surge in yen terms without making much money for foreigners.”

I have no fixed view either way in this debate. I see the merits of the value argument, especially when it comes to mid to small-cap equities, which I think favors an aggressive active value strategy.

But I’m also wary of calling a bull run, especiallh after so many calls in the past. I would also observe that if you invest in any World equities tracker, you will already have some exposure to Japanese equities – Japan is 5.6% of the MSCI ACWI index for instance.

That said, I also think that some increased exposure – possibly above the background 5% level – makes sense if you want increased exposure to industrials as a global sector (and robotics companies ) as well as increased exposure to the structural growth story that is Asia.

On the downside, I’d also note that China really is Japan’s biggest trade partner and in 2021 sent $153 bn in exports to China (China sent $168bn in exports to Japan and Japan is China’s third biggest trade partner). If China-US relations do go badly wrong, then Japan is in deep, deep trouble.

In sum, my position is that for most of us, we already have some exposure to Japan and you should probably just leave it there. On the other hand, there’ll be some of you who think that there’s much more to go in the value rally. Alternatively, many of you will buy into the idea that Japan is the best way to buy into the re-industrialization narrative alongside the Asian growth story and thus want increased Japanese equities exposure.

In that case, read on…

Key decisions – which index/ETF/Investment trust

OK, so the first decision you have to make is what kind of Japanese equities you want to buy into. There are two decisions at this stage: first, do you want to go mainstream, large/mid cap equities or do you want to focus instead on small cap or style (value/growth) equities? If it’s the former, stick with ETFs. If the latter, go for investment trusts (see below).

Assuming you go for mainstream large-cap Japanese equity exposure, the next question then becomes which index to track. In the box below I’ve listed descriptions of the main indices (from the index developers) as well as the number of constituent stocks and sector exposure. I don’t have a strong view on the indices but if pushed I’d probably go for MSCI Japan for broad exposure although I really like the idea behind the JPX Nikkei 400 index which focuses on Japanese mid to large caps that go the extra mile in terms of corporate governance.

So, given this huge choice of indices, what about the ETFs that track the main indices? By my count, there are 66 ETFs tracking mainstream Japanese equities listed in London. In the box below I’ve listed my pick of the various tracker funds.

I realise the list above is very long and so I’d make what I suspect are a few obvious comments on the ETFs available.

The first is that when it comes to Japanese equities, I always have a bias toward hedging out the currency risk. In the last year that’s really paid off – you’ll notice that all the currency hedged (to GBP) ETFs listed above have massively outperformed their local currency (or $) versions. Clearly, this can work in the opposite way too, but my strong preference is thus to stick with currency hedging.

The next comment is that most of the money in Japanese equity ETFs is following indices such as MSCI Japan or FTSE Japan which tend to have similar-looking holdings, especially amongst the top three holdings – Toyota, Sony, and Keyence. The big exception to this is the Nikkei 225 which has a radically different makeup with top holdings Fast Retailing and Softbank (!).

I’d also observe that if you want to focus on smaller cap stocks or stocks with a particular growth/value bias, you’re probably best off focusing on actively managed investment trusts. See below for a list of my favorite trusts.

Last but by no means least, I’d suggest that if you want ‘bog standard’ mainstream large-cap Japanese equity exposure (MSCI Japan, FTSE Japan, Topix) then logic suggests sticking with a cheaper ETF to minimize any drag from expenses. On this basis, you’d avoid the Topix and probably go for Xtrackers Nikkei 225 UCITS ETF 1D at 9 basis points or L&G Japan Equity UCITS ETF.  As an aside I also quite the like strategy behind the active ETF from JPMorgan – the ETF is called the JPMorgan Japan Research Enhanced Index Equity (ESG) and has the ticker JRJE.

So much for ETFs, what about actively managed investment trusts that focus on the Japanese markets? The good news is that there are more than a few funds, many of them widely used by private investors.

In the box below I’ve listed what I think are the most interesting – there’s a range of approaches from the large-cap through to value and small-cap. One last observation – value-oriented funds have been spectacular outperformers in the last 12 months. In that respect, the stunning outperformance of Nippon Active Value really stands out. Can this value outperformance continue? History suggests that this kind of value-driven rally tends to be short-lived (usually months and occasionally a year or so) but then again Japanese equities have been undervalued for so long that maybe we’ll see continued outperformance.