Revisiting the case for Japan

Fidelity Japan Trust PLC’s Nicholas Price discusses some of the key issues currently facing investors in in Japan. After a challenging last 12 months, he outlines why a more favourable risk-reward profile is now emerging and reveals the areas of opportunity he is seeing on-the-ground in Japan.

Key points

  • Japanese equities have continued to lag global markets over the first half of 2019.
  • Attractive valuations, benign policy and progress in structural reforms suggest a more favourable outlook from here.
  • We continue to identify significant investment potential among Japan’s under-researched mid and small-caps.

Japanese stocks have lagged their global peers so far this year, as uncertainty over US-China trade frictions and the impact on the global economy have clouded the outlook for corporate earnings. While earnings trends should stabilise in the coming quarters, share prices are likely to remain volatile amid a steady stream of political newsflow.

Global trade growth has already slowed and trade tensions have impacted sentiment, particularly in the manufacturing sector. However, policymakers across the globe are seemingly taking a more flexible approach and a global recession seems unlikely at this point.

While not immune to external headwinds, the Japanese economy remains stable. Confidence among Japanese manufacturers has clearly weakened, but sentiment in the non-manufacturing sector is holding up. Employment conditions remain tight, with the job-offers-to-applicants ratio at record levels, and capex plans are supported by non-cyclical factors such as investment in labour-saving technology and Research and Development (R&D). The Bank of Japan remains highly accommodative and counter measures will be deployed to mitigate the effects of the October 2019 consumption tax hike.

From a valuation perspective, Japanese stocks priced in a lot of the risk in late 2018 and continue to look undervalued at around 12 times forward earnings. With valuations testing historical lows in some parts of the market, there are opportunities to capitalise on disconnects between near-term sentiment and mid-term fundamentals.

The high level of buyback activity that we have seen so far this year is also encouraging. Corporate balance sheets are healthy (more than 50% of non-financial companies are net cash and debt levels continue to decline) and Japanese companies are more focused on delivering higher return on equity (ROEs) and shareholder returns. We are also seeing more activist investors seeking positive change via proposals to corporate boards.

Navigating the way ahead

Against this backdrop, I am inclined to see how stocks behave in relation to earnings announcements and selectively add names at trough valuations and where fundamentals are trending at cyclical lows. New ideas are also coming from stocks with the potential to rerate as internal change leads to renewed growth.

In running Fidelity Japan Trust PLC, I remain focused on mid and small-cap growth stocks as I believe this segment offers a rich source of under-researched investment opportunities with superior alpha generating potential. In line with this approach, areas where I see investment opportunities include:

  • Stable growth companies that can increase earnings as the global economy slows
  • High quality machinery and innovative services companies geared to structural growth trends, such as recruitment, MedTech and automation
  • Under-researched companies with new and interesting business models, and unlisted opportunities

In the absence of a global recession, Japanese companies should deliver moderate earnings growth. Combined with attractive valuations, a benign policy backdrop and progress in structural reforms, the risk/reward balance for Japanese stocks is favourable over the mid-to-long term.

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Alpha: A measure of an investment’s performance compared to a benchmark, such as the Japanese Nikkei or TOPIX index. The excess return of the fund relative to the return of the benchmark index is a fund's alpha.

ROE: Return on Equity (ROE) is the amount of net income returned as a percentage of shareholders’ equity.

Important information

The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Past performance is not a reliable indicator of future returns. Fidelity Japan Trust PLC can use financial derivative instruments for investment purposes, which may expose it to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Overseas investments will be affected by movements in currency exchange rates. Investments in smaller companies can carry a higher risk because their share prices may be more volatile than those of larger companies. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

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