Japanese Equities - Is now the time to invest
18 Jun 2010
Paul Chesson, Head of Japanese Equities at Invesco Perpetual, is still very bullish about the outlook for the Japanese equity market, and thinks that the current correction is a great opportunity for those who are not yet up to weight in this asset class. In this article he outlines his reasons for this.
Maintaining a bullish stance
We are still very bullish about the outlook for the Japanese equity market and we think that the current correction is a great opportunity for those who are not yet up to weight in this asset class. Since the last call on 3 December, the market is down 4% in local currency terms and our fund price is up 10%. That outperformance comes partly from our performance and partly from the weakness in sterling.
To recap from December, I was very bullish about the market. The economy and corporate profits were more clearly in recovery and the market was trading very cheaply - at around break-up value on an asset valuation basis - and very cheaply on earnings measures, assuming a recovery in corporate profit margins over the next few years. Those are still the two main reasons why we are bullish, but in fact today we have even more positive evidence than we had last December, so, if anything, the investment case has become stronger.
Profit recovery
Perhaps the most powerful new positive is the fact that we now have the full‑year numbers to March 2010, representing the first financial year of this recovery. Although sales fell by more than 10% over that period, pre‑tax profits grew by more than 10%. I think it is worthwhile pausing to digest that. Sales fell by more than 10% but profits rose by more than 10%. Imagine what is going to happen when sales start growing year‑over‑year, which is our expectation.
This impressive profit performance over the last year is largely a result of aggressive cost‑cutting by Japanese companies. It has also resulted from the fact that in spite of the turmoil in markets at the moment, we are seeing steadily improving economic conditions and it is not just a bull market in Asia driven by the Chinese economy. We are seeing signs of recovery in Europe and further improvement in conditions in the United States.
This is a representative sample of large companies, ex‑financials. Analyst expectations for this year are for pre‑tax profit growth of about 60% and that figure is being fairly continuously revised up.
One fact that gives confidence in this profit growth being achieved is the experience of the last economic upswing. It is important to remember that in 2002/2003, as the economy emerged from recession, it was not coming from as low a point as we have experienced this time, so the base for comparison was not quite so low. Also, I think it is fair to say companies have been more aggressive in their attitude towards cost and asset impairment this recovery. Therefore, if anything, the recovery this time ought to be even better. You can see that in 2002, 60% profit growth was achieved on virtually no recovery in sales and yet this year sales are expected to recover, even by companies themselves based on conservative forecasts, by about 5%. Thus, we think that this 60% figure is pretty conservative and this is an important reason why we remain optimistic.
Why has the market not reflected this improvement?
The simple answer is that the current conditions in the Japanese equity market are not unique to Japan. We are obviously seeing fairly significantly weak conditions in nearly all markets. Therefore, I think we need to run through the main reasons why the market, particularly the Japanese market, is not responding to this attractive outlook and try to work out whether these things are durable or whether they are short‑term in nature. In my opinion, they are either short‑term in nature or not fundamentally meaningful to the ongoing recovery that we are already experiencing.
Firstly, we have probably reached the end of the first phase of recovery everywhere in terms of momentum. When you compared things in the first quarter of this year with the beginning of last year, the comparisons were very strong. When compared with later periods through 2009, the momentum of improvement is not going to be as great so it is unsurprising that after a very strong year for equity markets we are seeing some sort of digestion of that fact.
Point two is that people are worried about China. China has had some very strong growth but it is experiencing a little more inflation and a little more asset price strength in things like property than it would have liked, and so it is making an effort to cool its economy. China has been a major part of Japan's recovery, accounting for around 25% of Japan's exports. We think this cooling in the Chinese economy is a short‑term phenomenon and is absolutely essential to China meeting its medium‑term goals. It is so important to Japan that if it meets those goals, it will be a very good medium‑term positive for Japan.
The third point is that all markets have had a very strong rally except Japan, but because it is so sensitive to the external environment it is unlikely to be able to rally in a situation where global markets are correcting.
The fourth point is the focus of attention on Europe and the contagion aspect of the fiscal issues, because as we know, Japan has its own fiscal problems, but I think it is important to say it is not these fiscal problems that are troubling Japanese markets. The Yen has not seen particular weakness, unlike the Euro, nor has the Japanese government bond market. The Eurozone problems are not really important to Japan. China is very important to Japan's exports, and looking at Asia as a whole, it now accounts for over 55% of Japan's exports. Japan is much more of an Asian market than it was 10 years ago, so it is not appropriate to make a connection between what's happening in Europe and what is going on in Japan.
The final point is that investors are not yet entirely confident that the risk of renewed economic weakness everywhere has completely passed. However, I believe that we are in a steadily building economic recovery globally and so most of the reasons why the Japanese market is weak at the moment are temporary in nature.
Summary
The market is as cheap now as it has been in the last year and is still trading at around break-up value. It is about at a 3% premium to break-up value and we now have profits growth of over 10%.
In addition, the economy is recovering and corporate profits are already growing at double‑digit rates. With the market trading at this level we believe this is a great opportunity to buy into Japanese equities over the next few years. We have taken significant profits from what has been a successful strategy over the last year or so, but we remain positioned for what we believe will be some very strong returns over the next couple of years.
Where Paul Chesson has expressed views and opinions, these may change and are not necessarily representative of Invesco Perpetual or TQ Invest views.
