Opinion: Avoid chasing earnings momentum in recovering Japan

The Japanese economy has marked its 60th consecutive month of economic recovery, the second-longest period since the second world war, thanks largely to strengthening global growth prompting an export boom.

This has kickstarted manufacturers’ capital spending, estimated to rise 17% this year – exceeding their initial budget, rare for the typically conservative Japan Inc. At the same time, the Bank of Japan’s Tankan survey reached its highest level in over 25 years in the fourth quarter.

This positive picture is finally being reflected in the inflation figure with a headline CPI reading of 0.4% in 2017, the fifth consecutive positive reading. Even excluding the volatile components of fresh food and energy, core CPI was up by 0.5% last year. Wage rises for full-time employees had been the missing part of this picture. However, these now look set to recover, prompting higher spending by working households, which account for 70% of private consumption. The future looks rosy for investors in Japan – however, several unique factors mean that investors should avoid timing this market.

Interventionist incidents
In January 2013, the Bank of Japan set the “price stability target” at 2% – it has since introduced quantitative and qualitative monetary easing in April 2013, expanded it in October 2014, introduced a negative interest rate in January 2016 and yield curve control in September 2016. However, none of these policies have brought inflation near the target. With the bank running out of ammunition, 2017 was a quiet year with no official policy change. Instead, the BoJ’s purchase programme of JGB diminished to around ¥60tn vs. a target of ¥80tn, making the market nervous of a stealth tapering by the bank.

Meanwhile, the central bank was the largest buyer of the equity market throughout 2017. It introduced an ETF purchase programme in April 2013 and in July 2016 it doubled its purchase target to ¥6tn p.a., around 1.5% of the total market capitalisation. With an estimated ownership of 3%, the sustainability as well as the rationality of this policy is highly questionable.

Rising market tides
Despite the strengthening yen against the US dollar, the Topix Net Total Return jumped by 22% in 2017, its sixth consecutive gain and its second-best year since 2005. The market reached higher than in January 1989, the year of Emperor Akihito’s accession to the throne, a welcome change from the property crash that happened at the beginning of the Heisei era and the following 13-year long bear market.

Listed companies’ fundamentals are particularly strong at the moment with both margins and profits at their peak. For the 17th consecutive month, the consensus on 12-month forward earnings estimates was revised upward in December, driven by good earning conditions in 2017 and forecasters betting against an acceleration in growth in 2018. However, the sell-off in early February 2018 has shown the fragility of these assumptions.

Treading carefully
Higher than expected earnings could be achieved with a continuation of the strong global cycle after this corrective period and/or a further weakening of the yen vs. the US dollar, but these factors would not feed through to sustainably higher valuations in our opinion. TOPIX’ valuations rose in 2017 to 15.4x 12-m forward P/E, near to its post-global financial crisis high. The price-to-book ratio is also at a decade high of 1.45x. These metrics seem fair, as the return on equity remains below 10%. For significantly higher valuations to come about, a structurally higher RoE is a must. Even though this could be reached with more leverage, most companies seem satisfied with their typical 40% shareholder return policy.

This picture is further complicated when valuation patterns in different segments of the market are taken into account. The distinguishing feature in Japanese markets since the end of the global financial crisis has been the 235% rise of mid-caps, significantly outpacing the 172% and 126% gains for large and mega-caps respectively.

Indeed, hidden mid-caps, a Japanese characteristic described as the Kabutocho, is not so anymore with almost none selling below book value and an average valuation of 16.4x 12-month forward P/E. Similar valuation gaps can be found between the four largest industries, with cyclicals machinery and electronic components at 20x and 21x 12-month forward P/E respectively, while banks and automobiles are at 11.4x and 10.5x.

Under these market conditions, trying to time style and market cap rotation is highly risky. It is paramount in our opinion to have a disciplined investment approach that focuses on those companies selling at discount to their fair value, instead of chasing earnings momentum. A balanced portfolio between mid-caps and large/mega caps is also wise considering the 12-year rally and high valuations of the former.

Joel Le Saux manages the OYSTER Japan Opportunities fund at SYZ Asset Management

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