These are unprecedented times for global markets.
Over the past three years, investors have had to navigate the unchartered territory of the global pandemic alongside the myriad side effects that have spawned from it, such as the global supply chain bottleneck.
So far in 2022, conditions have tilted towards the extreme, with inflation figures routinely reaching all-time highs while central banks contort in response, raising interest rates and tightening monetary policy. Currency powers have fluctuated and much of the global economy remains under significant strain.
In Japan, echoes of the pandemic still reverberate, as elements of the domestic economy continue to operate on a restricted basis while the country gradually opens its borders to the international community.
As investors, it is our job to look beyond the headlines and assess the landscape through the lens of both capital preservation and growth.
While we are not unsympathetic to the challenges experienced globally, we do believe that the current domestic story in Japan may provide an enticing entry point for growth investors.
A bruising period for domestic growth investors
For many, Japan has long been considered a haven for value investing, owing to its perceived low economic growth, although we feel this notion centres solely on GDP and does not factor in the country’s corporate earnings.
However, over the past 18 months, value has certainly had its time in the sun, not just in Japan but on the global stage. For growth investors, this has been an uncomfortable period indeed.
Domestically, the gap between value and growth has been significant, with the disparity between the MSCI Japan Value index and MSCI Japan Growth index reaching its highest point in twenty years during Q1. This trend has continued into Q2, albeit at a slower rate.
This dynamic has been paired with significant weakness in the Japanese Yen, which has been mostly driven by Bank of Japan (BoJ) monetary policy, rising commodity prices and a slow reopening of Japan’s borders. We believe this triumvirate has created a perfect storm for Yen depreciation.
Now a weaker domestic currency is not unusual for Japanese investors and has historically had its benefits. For example, Japanese exporters have typically benefited from a weaker Yen.
Over the past two decades, however, much of the export sector has shifted production overseas, thus dampening the positive attributes of Yen weakness. While still supportive of Japanese corporates, a weakened Yen is now less positive than it was even ten years ago.
Market conditions provide an enticing entry point
The MSCI Japan Index is trading at the lower end of its average price-range for the past 10 years, despite a marked improvement in corporate earnings.1
In fact, across the past decade, Japanese corporate profits and margins have steadily improved, and although we are currently in a period of rising interest rates with peak globalisation potentially behind us, this trend has continued.
The valuations of domestically-orientated Japan equities remain reasonable, particularly in the small-cap space which, having traded at premium for the past several years, is now comparatively cheaper than large-cap stocks.
We see this as a unique opportunity to gain exposure to internally-focused companies poised to benefit from the full reopening of the economy. In addition, we have noted an uptick in venture capital investment in Japan, which in turn has pushed start-up companies to publicly list their shares at a far earlier stage than would previously have been the case. We believe this presents an exciting opportunity for investors to participate in the early growth phase of domestic companies.
More broadly, we are mindful of Japan’s rising prominence as an export market for tech and health care. Much has been made of the country’s aging population, but this has necessitated innovation within the health care space to satisfy the demands of this demographic. In our view, Japanese corporates are now well positioned to export this expertise to overseas markets, at a premium.
How do we approach growth investing in Japan?
The Matthews Japan Fund is a high conviction growth strategy that invests across all-cap stocks.
We approach growth investing from a bottom-up perspective by dividing companies into three distinct growth categories: linear, cyclical and idiosyncratic.
Linear growth companies generally skew towards tech and, as such, tend to be more widely owned and subject to premiums. These companies can provide a degree of comfort, however, given their earnings growth trajectory tends to be more transparent and forecastable.
Cyclical stocks are typically centred around sectors such as machinery and automotives, areas which can offer a greater breadth of opportunity but whose cycles are less predictable. Finally, idiosyncratic growth stocks are agnostic to industry or theme, and alpha generation may be supplied by research via management access.
This methodology requires patience but ultimately can provide investors with the full spectrum of domestic growth opportunities within the region, responsive to different points in the investment cycle.
Fundamentals remain sound
There can be no doubt that recent years have been challenging for the Japanese growth investors.
The investment cycle has rotated towards value, leaving growth stocks in the cold, while the Yen has plummeted against international currencies.
The fundamentals have remained in play, however, and we are now seeing potential opportunities to invest in strong corporates with positive earnings data and strong balance sheets, at attractive valuations in our view.
Over the past ten years, the country has built a positive track record in earnings data, and we believe the trajectory of corporate margin improvement should continue.
From a diversification perspective, it is worth noting that global investors have been net sellers of Japanese equities, despite the backdrop of strong earnings per share (EPS) figures and improved margins in recent years.
As growth investors, we are excited by the opportunities on offer within the Japanese equity market and feel the region can present a strong case for inclusion within a diversified asset allocation.
© Matthews Asia
Read more commentaries by Matthews Asia
