Rising sun set to shine again

THERE is a strong argument that Japanese equities are undervalued. Although the macro situation remains bleak, this doesn’t preclude companies from turning a profit – particularly on the back of Chinese demand.

A GOOD DEAL
Ben Seager Scott of Bestinvest says “Japan is looking like a fairly attractive investment opportunity at the moment, with cheap valuations on a historic basis and corporate earnings that continue to be solid.” June Yon-Kim, portfolio manager of the FAST Japan Fund, explains: “The price-to-book ratio for the Japanese market currently stands at around one times, with more than 60 per cent of the benchmark universe trading below book value.” He says that with a forward price-to-earnings ratio of 13 times, versus a 20-year average of 30 times – “Japan offers attractive upside once the market starts to discount a V-shaped recovery through fiscal 2012.”

“The topix index, a barometer for Japanese equities, is currently trading around the market lows of 2003,” explains Simon Finch of Ashburton, “a low which signalled the start of the most successful bull market in Japan since the heady days of the late 1980s.” Finch thinks “it would therefore be wise for investors to reassess their current underweight to Japan.”

STOCKING UP
If you are bullish on Japanese equities as a whole and want to keep investing costs to a minimum, Jason Whitcombe of Evolve Financial Planning recommends the low-cost Japanese equity index tracker funds from Vanguard, Legal & General and HSBC. For those looking to discriminate there are plenty to choose from.

Yon-Kim says his stock selection remains focused on oversold large-cap stocks with strong balance sheets and highly cash-generative business models – capitalising on recent market sell-offs to add weight in the chemicals, oil, coal, and mining sectors. He notes Japan Petroleum Exploration is the cheapest oil company in the world on an enterprise value/reserve basis. Yon-Kim also favours major banks including Sumitomo Mitsui Trust and Mitsubishi UFJ Financial, which are trading below book value. He remains underweight in defensive stocks in the power utilities, pharmaceuticals and foods sectors, as he thinks they continue to offer little in the way of relative valuations.

Senior portfolio manager Adrian Hickey of Pictet’s Japanese Equity Opportunities fund thinks it’s a “stock pickers market”, having fallen off analysts’ radars. He likes Arnest One, the Japanese low-cost housebuilder, which is currently trading on a price-to-earnings ratio of four. With house prices coming down, he thinks the country’s huge private savings could find their way into new homes. He says Arnest One’s competition is limited and notes that the gross margins on their condominiums are around 30 per cent.

This year’s Japanese earthquake has overturned Japan’s plan for nuclear to meet 50 per cent of its energy needs. As such, Hickey likes the prospects for the liquefied natural gas (LNG) market, particularly the company Chiyoda, which is a leading player. The earthquake has also highlighted the need for energy conservation and Hoshizaki has delivered a new commercial refrigerator that is 40 per cent more efficient than its previous model. Demand for more efficient refrigeration is not just coming from Japan, as Chinese companies look to cut energy costs.

Whichever fund you choose, Richard Troue of Hargreaves Lansdown advises investors to consider currency movements. He says “there has been much debate over the strength of the Japanese yen and whether it is set to weaken significantly against other currencies.” He says that on the face of it this would not be good for foreign investors, although he also points out that many argue that any impact of the yen weakening could be offset by strong performance by export companies, benefiting from a weaker yen. Either way, for investors wanting to avoid currency risk, Troue says look for funds that hedge out currency exposure or offer a currency hedged share class.

MACRO DISCOUNT
Growing public sector debt, schizophrenic monetary policy and timid domestic investors have weighed on Japan throughout its lost decades. Bestinvest’s Seager notes the broad economic picture for Japan continues to look bleak, with GDP data in the second quarter revised down, back in line with expectations. Seager thinks “the long-term domestic situation remains dire, with high levels of government debt and an expensive currency that is expected to depreciate in the long term.” There is certainly no shortage of pessimism on the country’s future. However, Seager remains bullish on equities: “Many companies have been able to adapt, moving operations and operating costs overseas.” Also, slowing exports to the West are being replaced by increased demand from the emerging affluent classes in emerging Asia.” For example, Hikey points to Musashi Seimitsu, a Honda affiliate in the motorbike industry that gets the bulk of its earnings from Brazil and Indonesia.

Statistics from Japan’s ministry of internal affairs and communications shows that Japan has become increasingly less reliant on the stagnant over-indebted US. In 2001 ¥3.7 trillion of exports went to China, while in 2010 this had reached ¥13.4 trillion. Over the same period Japan’s trade with the US declined from ¥14.7 trillion to ¥10.3 trillion.
There is no doubting that Japanese equities are cheap. Troue thinks “with valuations low this could be a good opportunity for investors to pick up companies with good long-term prospects at bargain basement prices.” Although he cautions that “just because the Japanese market is currently cheap it doesn’t mean it can’t get cheaper.” Many seasoned and otherwise successful investors have been predicting that Japanese equities will bounce back for a while now – it hasn’t happened yet, but Japan’s sun could be about to rise once more.