Is there a good case for Japanese equities?

One reason that this has not attracted more attention is that few global portfolios have a high weighting to Japanese equities, but also those that do have seldom hedged the currency.  

The yen over the same period had fallen by around 23 per cent, leaving investors in unhedged funds only enjoying half the return.

The sharp rise in Japanese share prices seems related to governance changes. After many years of waiting, some of the key changes that started with ‘Abenomics’ seem to be taking place: higher return on equity targets, smaller cross shareholdings and higher shareholder returns through dividends and share buy-backs.

The rise in the market reflects a substantial increase in price to book ratios – a key value investor metric that had identified value for money in Japanese equities for some time. 

The price to book ratio of the TOPIX is now around 1.5x and price-earnings ratio is around 15.9. These ratios continue to be lower than many equity markets – indeed, quite similar to the UK equity market.

Comparisons need to bear in mind high weightings in Japan and the UK to lowly valued sectors such as financials and the motor industry in Japan, and oil and mining in the UK.

Now that a number of the very lowly valued shares in Japan have risen, is there a good case for holding them? 

In many cases, management teams have committed to target higher profitability in years to come.  

The yen story may be cyclical, but the corporate governance changes are likely to be a structural positive for the asset class.

Many Japanese companies have prioritised market share and sales growth over profit growth in the past. The rise in returns on equity seen across the market may have a number of years to come purely through the execution of recently announced business plans. 

As returns on past investments have often been low, and the return on cash close to zero, even modest returns on new capacity are likely to lead to increases in earnings for shareholders.  

The lower level of the yen increases the competitiveness of Japanese exports, and for the companies themselves, more economical to open new factories in Japan rather than in emerging economies. 

Many sectors where Japan has leading skills are also important to the global economy. 

Taiwan Semiconductor have decided to build two new plants in Japan, rather than the one originally planned. The infrastructure to support advanced chip manufacturing is already in place. 

The Japanese motor industry seems to be regaining ground as hybrid cars seem less likely to be superseded by all electric vehicles.  

Japan has range of medical expertise to care for its ageing population. Also, as the US's key Pacific ally, the Japanese defence sector may also grow from here.

Some of the key changes that started with ‘Abenomics’ seem to be taking place.

The Japanese economy as a whole remains somewhat subdued, not least overshadowed by slower growth in China.  

Despite a protracted period of low-level inflation, the Bank of Japan has been slow to raise interest rates in case this causes deflation to return. 

As months go by and some domestic wage growth is seen, it seems more likely that the BoJ will raise rates, which, if nothing else, will reduce the selling pressure on the yen. 

A higher valued yen could then undue some of the gains mentioned above. 

There seems to be a case then to invest in the export sectors where Japan has leading global businesses, and the domestic stocks, mainly smaller companies, where very low price to book ratios still offer compelling value.  

The yen story may be cyclical, but the corporate governance changes are likely to be a structural positive for the asset class.

And the yen? Personally I would not bother to hedge at these levels. For those who have few investments in Japan, the low yen allows them to invest with sterling, which has risen against the yen.

From my own point of view, I would also take advantage of the lower yen by taking another holiday there while it’s a more affordable destination.

Simon Edelsten was a global equity fund manager for 40 years