Could Japanese equities lead the way in 2023?

Japan was one of the surprise packages of the 2022 World Cup in Qatar. The underrated team stunned everyone by beating Germany and Spain on the way to the knock-out stages.

Even though they suffered the heartbreak of losing a penalty shoot-out against Croatia in the Round of 16, their performances made everyone take notice. They also impressed off the pitch with supporters clearing the stadium of rubbish after the matches and the players leaving the changing rooms spotless.

With all those factors in mind, we thought it was the perfect time to look at why putting money into Japanese equities could provide some unexpected benefits for investors.

Are Japanese equities popular with UK investors?

UK investors have £20.1bn in the IA Japan sector – and a further £800m in IA Japanese Smaller Companies, according to the most recent data from the Investment Association*.

While this is significantly less than in the most popular areas, such as the £155.3bn in IA Global and £140.9bn in IA UK All Companies, there have been increases in recent weeks*.

In fact, IA Japan enjoyed net retail sales of £48.4m during October, making it one of only 16 out of almost 50 sectors to have seen positive flows*.

Why invest in Japanese equities?

The football team may have surprised viewers but investors in Japan have been aware of the country’s opportunities for some time, according to Carl Vine, manager of the M&G Japan fund.

He believes Japanese equities represent a “highly compelling” long-term investment opportunity, with loads of potential for the future.

“Powerful, structural earnings-growth drivers exist in Japan, and they appear to have the potential to extend many years into the future,” he said. “Profit growth has been the result of deliberate efforts from the corporate sector to improve, to become more effective and more competitive.”

Looking ahead, Carl sees material upside for profit margins and economic returns from improvements in capital allocation, business strategy, and industry structure. “With so many positive factors in play, we suspect that the self-help phenomenon will be at least as powerful in the coming ten years as it was in the past,” he said. “We estimate that this could easily mean another decade of 10% compound earnings growth ahead, if not better.”

His colleague Sunny Romo told us more in this video interview:

Is corporate governance better?

Coronavirus and the falling yen have overshadowed improvements in corporate governance, according to Daniel Hurley, who works with Archibald Ciganer on the T.Rowe Price Japanese Equity fund. “This has been a long and successful story and yet we continue to find that is not fully appreciated by foreign investors,” he said.

The “very encouraging improvement” in governance comes despite the current uncertainty that has been affecting the global economy during 2022. “Japan’s corporates continue to buy back stock and return capital to shareholders at record levels, and pressure from management teams to be more shareholder focused is relentless,” he added.

Japanese economic health

Daniel also pointed out that Japan’s recent earnings season was “strong and encouraging”, having been aided by the economic backdrop. “The weak yen, which has fallen to 30year lows versus the US dollar, has provided a particularly strong tailwind for Japan’s exporters, which represent a significant weight in the TOPIX [the Japanese index, similar to the FTSE 100],” he explained. “These factors create considerable opportunity for long term investors.”

He also believes the low relative level of inflation in Japan should support economic growth and provide a buffer against the policy-tightening impacts other developed markets will suffer in 2023.

The combination of the Bank of Japan’s “ultraeasy policy”, company valuations trading below the country’s long-term average, and Japan being fully open postpandemic, are positives. “These aspects make Japan an attractive market for fundamental investors, a case made even stronger when considered in light of the global recession anticipated by many next year,” he added.

Stable political backdrop

Unlike other major economies, Japan also benefits from relative political stability, according to the latest quarterly update from Comgest Growth Japan. The team believes the incumbent Liberal Democratic Party – having secured another landslide in the Upper House elections during the summer – helps reaffirm this situation.

“We believe the Japanese market is particularly suited to investors seeking a portfolio built on company-specific themes and premising a stable regulatory context,” wrote the managers. The fund, which is managed by Richard Kaye, Makoto Egami and Chantana Ward, invests in a portfolio of high quality, long-term growth companies.

World leading companies in Japan

Fortunately, the country is home to a string of such businesses, including video game producer Nintendo, car manufacturer Toyota, and Canon, which makes cameras and other electronics goods.

It’s a point acknowledged by the Comgest Growth Japan team. “We believe Japan’s opportunity is in its globally leading companies which capture the growth of Asia, the normalisation of the world economy, as well as the changes taking place in Japan itself,” the managers wrote.

They believe Japan’s market was wrongly perceived as the next inflation play earlier this year, with too much attention on banks, property companies, shipping firms and energy companies. “This quarter, active Japan equity investment has again become one of the highest-return equity vehicles globally, as has been the case predominantly over the last seven years or so,” they added.

Improvements to payment systems

Japan is clearly embracing digital changes – as noted by Donald Farquharson, head of Japanese equities at Baillie Gifford, on his first visit to the country since Covid-19.

“The most striking and evident change I saw from my visit in early 2020 was in payments,” he said. “Card and contactless are ubiquitous, though the choice can still feel baffling and the processing far from seamless.”

Donald pointed out the cashless percentage of payments had risen from 13% back in 2013 to just under a third by 2021. The Ministry of Economy, Trade and Industry (METI), meanwhile, is promoting a figure of 40 per cent by 2025.

“The President of Z Holdings, the main shareholder of PayPay, Japan’s leading payment platform, reckons the number could be closer to 80 per cent by then,” he added. “PayPay is already used by more 50 million people and has a two-thirds share of all QR-code payments.”

Baillie Gifford is a prominent investor in Japan. Its portfolios covering the country include Baillie Gifford Japanese, Baillie Gifford Japanese Income Growth, Baillie Gifford Japan Trust plc, Baillie Gifford Japanese Smaller Companies and Baillie Gifford Shin Nippon plc.

*Source: The Investment Association, October 2022

_{Photo by Clay Banks on Unsplash}