Selective opportunities seen in Japanese equities in 2022
Asian equity markets were ill-favoured in 2021 and Japan was no exception, nevertheless investors have been ready to weigh in again as improved corporate governance contributes to earnings prospects, and the semiconductor industry continues to be in focus.
But Covid-19 outbreak remains a big uncertainty that could delay domestic reopening, as Japan faces a sixth wave recently with over 50,000 Omicron cases a day in the past weekend.
In 2021, Japan equity funds saw an outflow of 9 billion yen ($79 million) driven by outflows from small and mid-cap funds and other active funds, Morningstar data released on January 11 showed.
But the market, meanwhile, was not performing that badly. The Nikkei 225 rose by 5% in 2021, while the TOPIX rallied 10%.
As M&G Investments put in a recent note, whilst most global investors have been comfortably underweight, Japanese equities have been performing rather well in recent years. Over the 10 years to December 31, 2021, the TOPIX generated a compound annual total return of 13%, in local currency terms.
“Outside of the S&P 500 Index, which returned 16.5% compound, this is well above the mid-single digit returns of other markets,” noted Carl Vine, fund manager for Japanese equities at M&G.
“For a long time, Japan has been out of favour (among foreign investors), and often ignored as a potential area for investment, due to ageing demographics, lack of innovation, unfriendly shareholder company management and so on.
"However, those stereotype views are already factored into share prices, and in some cases, stock valuations are relatively inexpensive when compared to the US or other European peers,” said Akira Fuse, institutional equity portfolio manager at MFS Investment Management.
“If global investors recognise the change in efficiency levels at Japanese corporations or the change in behaviour of domestic consumers, it would be a wake-up call for global investors to reassess the asset class.
"Japan is the least held asset by global investors and rebalanced trades would have a huge impact on asset prices and could surprise the market in a positive direction,” Fuse told AsianInvestor.
He favoured the information and technology (IT) services industry, because Japan has been underinvested in IT for a long time and is facing the requirement of massive capital expenditures (Capex) for digital transformation.
“Those in the IT service industry or system integrators are enjoying long-lasting demand from a wide variety of system investments, such as automation, digitalisation of financial systems, cloud solutions, data centres and so on,” he added.
SMEs INTO PLAY
However, as the recent valuations have become “extremely high” of those quality companies that have strong pricing power, sustainable business and growth opportunities, Fuse said MFS has been pre-emptively reducing positions in those names and reinvesting in relatively inexpensive companies as compared with their fundamentals value.
Holding similar views, Bill Maldonado, head of equities at Eastspring Investments, believes valuations are relatively cheap in Japan among mid-cap and small-cap names and is “very positive” on Japan, noting that it is a stock pickers’ market.
“I think for investors who can take the additional volatility that comes with those mid-cap and small-cap names, there are very attractive opportunities in Japan, because that's actually the market that has really struggled during this Covid emergency, and is now only just beginning to stabilise and come back into focus for a lot of investors,” Maldonado said in a recent outlook webinar.
“If we do get a bounce back in investment, that will help Japan significantly, particularly in the tech and semiconductor space,” he said.
“There’s going to be a lot of investment in additional semiconductor capacity. Japan doesn’t have many manufacturers of semiconductors but has some of the most important suppliers of equipment for semiconductor manufacturing, so should benefit strongly from that trend.”
Agreeing with Maldonado, Sébastien Page, head of global multi asset at T. Rowe Price thought Japan could offer potential attractive valuations, as it has a strong outlook for global trade, and improved corporate governance standards are tailwinds, but Covid-19 uncertainty could delay domestic reopening.
PRICING POWER
As inflationary pressure hits the world economy, the stock market will see higher volatility associated with tightening monetary policies. But this could benefit Japan’s domestic consumer sector.
“Inflating input costs will hurt the profitability of manufacturing companies. However, we believe inflation is a positive trigger for Japanese domestic companies to review their pricing strategy for goods and services.
"Under deflationary pressures we have seen over the past two decades, Japanese companies did not take full advantage of their pricing power and failed to pass on the cost increase to the retailer, which squeezed profitability. However, we are now seeing many companies starting to hike the price of regular goods, such as essential daily items,” MFS’s Fuse said.
“This new inflationary environment could be a good opportunity for Japanese companies to improve margins within their domestic business,” Fuse added.
However, as the market faces higher volatility, some money may flow back to the yen as a safe-haven currency.
“If we have a strong yen, it is the most important single risk factor for Japanese exporters' earnings in the short term,” he warned.