Value investing in Asia: Japan is well positioned for long-term outperformance

As COVID restrictions are lifted, fiscal support is implemented and supply chain issues are worked out, the Japanese market could see many supporting factors for future outperformance. Our focus remains on identifying the many mispriced Japanese companies with good quality income streams that are yet to be recognised by the market.

The Japanese market recorded double digit returns in 2021 with MSCI Japan rising by 13.81% in local currency terms. Despite respectable returns, Japan was a laggard versus other developed markets. This was likely driven by a multitude of factors such as delayed COVID outbreak and containment, political uncertainty as the country leadership transitioned to the new Prime Minister Fumio Kishida, the pandemic-induced China economy slowdown and supply chain disruptions, and the increases in material costs.

Despite the strong earnings revisions and improved companies’ fundamentals, the market did not re-rate and it is now trading at very attractive valuations versus its global peers. See Fig. 1. Lower starting valuations are supportive of likely future outperformance for the Japan market.

Fig. 1: Japan is attractively valued versus global peers

Graph showing how Japan is attractively valued versus global peers

That said, the global recovery momentum has been impacted by the Russia-Ukraine war. This conflict has cast a shadow on financial markets; global equities have declined by 5%1 in the first quarter of 2022.

Japanese corporates are in good shape

With no meaningful resolution in sight thus far and the likelihood of a prolonged war, it is important to note that the direct exposure of Japanese corporates to both countries is small. This is hardly surprising due to the low direct dependence of Japan on Russia’s economy. Japanese car manufacturers, for example, sell only around 1-3% of their consolidated sales volumes to these countries. However, the secondary effects of the war to the companies’ profitability, namely through increased energy, commodity, and other input costs need monitoring.

The good news is that Japanese companies are coming into this crisis in a relatively good shape. Profitability has improved on a trend basis; even during the height of the pandemic in 2020, the operating profit margins only fell to the peak level of the previous cycle. See Fig. 2. This was achieved by the companies managing capacity and cost base well which resulted in lower break-even points.

Fig. 2: Corporate profitability is improving

Corporate profitability is improving

Corporate governance reforms a key profitability driver

Corporate governance reforms have also been a big driver of this improvement, in particular the trend of bigger independence of boards and the unwinding of cross-shareholdings. See Fig. 3. Japan’s corporate governance reforms only took off in a big way following the adoption of the Japan Revitalisation Strategy in 2013. The Strategy’s purpose is to increase the sustainable growth and medium-to-long-term corporate value of Japanese companies. The Corporate Governance Code was compiled in 2015. These were likely turning points for changes in Japanese management attitudes to capital efficiency and corporate profits. The reforms continue to gain momentum with the pandemic accelerating the changes.

Fig. 3: Growing independent Director representation on boards

Growing independent Director representation on boards

Japanese companies also boast much improved balance sheets. See Fig. 4. In fact, more than 50% of non-financial companies in Japan have net cash on their balance sheets, far more than rest of world, resulting in a continued record level of dividends and share buybacks even during the pandemic.

Fig. 4. More Japanese companies are “cash rich”

More Japanese companies are “cash rich”

Another interesting but less known factor driving corporate reforms is Japan’s aging demographics, long considered a scourge. It is slowly becoming a force of change. Japan’s corporates are now being forced to give priority to the shareholders. This is not merely driven by the need to keep up with the global competitive markets but also from domestic social pressures, especially from the government pension funds which need to deliver returns to their stakeholders. As the population gets older, the demographics increasingly favour the interests of pensioners who tend to be shareholders.

Inflation may not be a bad thing

Rising inflation is a major concern in major advanced economies but in Japan it seems to be still well contained. To be sure, prices have risen, driven by energy and the pass-through of cost increases in processed food. Inflationary pressures also seem to have become more broad-based in consumer goods and services. Some macroeconomists think that core CPI inflation could hit +2% year-on-year in the coming months.

But inflation is not always bad news; a little bit is healthy, especially for Japan. It may not only stimulate private sector consumption and investment borrowing but also start to challenge deeply ingrained views of deflation and low interest rates continuing in perpetuity. Moreover, companies are seeing pricing power after years of not being able to raise prices without impacting volumes or losing market share. For the first time since the 1980s, the Tankan survey of the output price diffusion index, which indicates the number of companies that have been able to raise prices, is at its highest level.

Our focus is on mispriced assets

Within the attractively valued Japan market, we see significant relative valuation bifurcation between growth and value indexes. See Fig. 5. This bifurcation was accelerated during the initial pandemic period in 2020. It was driven by the market’s inclination for quality and thematic growth, while the indiscriminate sell down of other more cyclical assets or assets that faced short-term headwinds due to COVID was seen.

Fig 5: Valuations for growth style versus value surpass Dot com bubble peaks

Valuations for growth style versus value surpass Dot com bubble peaks

While we have observed some normalisation, these relative valuations are still at extreme levels. The current backdrop of an early US Fed rate hike cycle and global economies reopening is supportive for Japan equities and value investing.

However, the more important point is that there are many companies in Japan with mispriced but good quality income streams that remain out of favour with the market. There are cyclical tailwinds, but companies have also made a significant progress in improving their returns structurally. This still seems unrecognised by the market.

As we do not try to time the cycle, we look through the whole market and try to identify outlier stocks where the market might be making a significant mistake regarding the future trend returns of a company. With a disciplined valuation approach and willingness to be patient we rely on our durable investment process to identify these opportunities.

This is the fourth of a series of eight articles which examines the different investment strategies investors can adopt to tap on the opportunities that are emerging in Asia.

For Use with Professional Clients / Qualified Investors Only. Not Approved for Further Distribution or Use with the General Public.

1 MSCI World from Refinitiv Datastream as at 31 Mar 2022

The information and views expressed herein do not constitute an offer or solicitation to deal in shares of any securities or financial instruments and it is not intended for distribution or use by anyone or entity located in any jurisdiction where such distribution would be unlawful or prohibited. The information does not constitute investment advice or an offer to provide investment advisory or investment management service or the solicitation of an offer to provide investment advisory or investment management services in any jurisdiction in which an offer or solicitation would be unlawful under the securities laws of that jurisdiction.

Past performance and the predictions, projections, or forecasts on the economy, securities markets or the economic trends of the markets are not necessarily indicative of the future or likely performance of Eastspring Investments or any of the strategies managed by Eastspring Investments. An investment is subject to investment risks, including the possible loss of the principal amount invested. Where an investment is denominated in another currency, exchange rates may have an adverse effect on the value price or income of that investment. Furthermore, exposure to a single country market, specific portfolio composition or management techniques may potentially increase volatility.

Any securities mentioned are included for illustration purposes only. It should not be considered a recommendation to purchase or sell such securities. There is no assurance that any security discussed herein will remain in the portfolio at the time you receive this document or that security sold has not been repurchased.

The information provided herein is believed to be reliable at time of publication and based on matters as they exist as of the date of preparation of this report and not as of any future date. Eastspring Investments undertakes no (and disclaims any) obligation to update, modify or amend this document or to otherwise notify you in the event that any matter stated in the materials, or any opinion, projection, forecast or estimate set forth in the document, changes or subsequently becomes inaccurate. Eastspring Investments personnel may develop views and opinions that are not stated in the materials or that are contrary to the views and opinions stated in the materials at any time and from time to time as the result of a negative factor that comes to its attention in respect to an investment or for any other reason or for no reason. Eastspring Investments shall not and shall have no duty to notify you of any such views and opinions. This document is solely for information and does not have any regard to the specific investment objectives, financial or tax situation and the particular needs of any specific person who may receive this document.

Eastspring Investments Inc. (Eastspring US) primary activity is to provide certain marketing, sales servicing, and client support in the US on behalf of Eastspring Investment (Singapore) Limited (“Eastspring Singapore”). Eastspring Singapore is an affiliated investment management entity that is domiciled and registered under, among other regulatory bodies, the Monetary Authority of Singapore (MAS). Eastspring Singapore and Eastspring US are both registered with the US Securities and Exchange Commission as a registered investment adviser. Registration as an adviser does not imply a level of skill or training. Eastspring US seeks to identify and introduce to Eastspring Singapore potential institutional client prospects. Such prospects, once introduced, would contract directly with Eastspring Singapore for any investment management or advisory services. Additional information about Eastspring Singapore and Eastspring US is also is available on the SEC’s website at www.adviserinfo.sec. gov.

Certain information contained herein constitutes "forward-looking statements", which can be identified by the use of forward-looking terminology such as "may", "will", "should", "expect", "anticipate", "project", "estimate", "intend", "continue" or "believe" or the negatives thereof, other variations thereof or comparable terminology. Such information is based on expectations, estimates and projections (and assumptions underlying such information) and cannot be relied upon as a guarantee of future performance. Due to various risks and uncertainties, actual events or results, or the actual performance of any fund may differ materially from those reflected or contemplated in such forward-looking statements.

Eastspring Investments companies (excluding JV companies) are ultimately wholly-owned / indirect subsidiaries / associate of Prudential plc of the United Kingdom. Eastspring Investments companies (including JV’s) and Prudential plc are not affiliated in any manner with Prudential Financial, Inc., a company whose principal place of business is in the United States of America.