March 20 2017
The best investment decisions are almost always those that feel most uncomfortable at the time they are made. George Soros says he gets terrible backache when running his biggest positions. ‘If it ain’t hurting, it ain’t working’ is a good motto to put on your computer screen.
Those who think Japan is an excellent home for their money at the moment (as I do) are very familiar with this phenomenon. It is 28 years since the Japanese stock market touched its all-time high and today the Nikkei index remains at barely half that level. So many professional investors have suffered losses over the intervening period, either hoping that Japanese shares were about to rebound or betting that Japanese government bonds must fall in value, that the latter trade has earned its very own market monicker: ‘the widowmaker’.
There have been false dawns before, but the case for having a significant chunk of your long-term portfolio invested in Japanese equities as we go into 2017 is a compelling one. According to Hugh Sloane — co-founder of hedge fund firm Sloane Robinson, who cut his teeth as a fund manager in Tokyo — Japanese equities are currently the ‘trade of the decade’ for UK investors.
Put out of your mind, though, the thought that Japan is by popular repute something of basket case, a hidebound deflationary dinosaur that has terrible demographics, the highest debt of all the developed economies, rigid employment laws and a consensual low-risk business culture that discourages innovation and pays scant heed to shareholder interests. Yes, most of these criticisms remain valid, to varying degrees. But the case for investing in Japan rests largely on two other simple propositions.
One is that this picture of a stagnant and change-resistant economy is finally starting to shift, if only because it has to. For the first time in a generation, says Sloane, Japanese ministers, monetary authorities, business leaders and voters are wholly aligned in seeking to drive through a radical reflationary programme that will, among other consequences, shake up the ways that businesses in Japan operate. In time, that will feed through into significant gains for patient investors.
The second and equally important fact is that nearly all the bad things about Japan are already in the price. Despite rebounding from its 2012 lows, the Japanese stock market is still the most miserably valued of all the world’s major markets. In consequence — both absolutely and in comparison with Wall Street or the FTSE 100 — it has the potential to produce the greatest returns of all of them over the next decade.
Take Professor Robert Shiller’s cyclically adjusted price-earnings ratio analysis, which has a good record in estimating future ten-year stock-market returns: the projected annualised return from Japan over the next decade could be in the order of 11 per cent a year. By the same metric, comparable figures for the European and US markets, which are much more richly valued, are 6 and 4 per cent respectively.
The profitability of Japanese companies, properly measured, is already at the highest it has been for the past 45 years — but unlike in the past, companies are increasingly aware of the need to share those returns with shareholders. The payout ratio — how much of a company’s earnings are paid out as dividends — has been rising, but remains low by international standards. There’s plenty of room to grow that figure and many more companies are making use of it.
At the same time, the Japanese equity market is also being supported both directly and indirectly by the policies and buying power of Japan’s government and central bank. As well as pursing the biggest and longest-running QE programme anywhere in the world, the Bank of Japan is directly buying company shares in an effort to stimulate growth and stave off deflation; that’s further than either the US Federal Reserve or the Bank of England has dared to go. The state-backed pension fund is also being required to buy greater quantities of shares.
A final feature of the Japanese market is that it offers diversification benefits. The correlation between the Japanese stock market and other things you are likely to hold in your portfolio is lower than for other developed markets. Even if the market itself disappoints, a decent allocation to Japanese equities will reduce the overall riskiness of your portfolio.
Of course there are always risks in any investment proposition. There could be conflict in the South China Sea and trouble from a protectionist Trump administration. Oil prices could rise and hurt Japan’s notoriously commodity-deficient economy. Healthy expectations of inflation may prove hard to raise, despite all the policymakers’ efforts. And how the yen will trade against sterling — two weakening currencies — will always be an important factor for UK investors.
Nevertheless Japan has set itself on a new course from which there is no turning back, and its stock market remains cheap and is still shunned by many battle-scarred investors with long memories. The time to worry will be when everyone is once again telling you how wonderful everything is in Japan, just as they did in the late 1980s when the Japanese stock market went into extreme bubble territory. Rest assured, that moment is a long way off.
This article by Jonathan Davis first appeared in Spectator Money in March 2017. Link here.