Nicholas Price, portfolio manager of Fidelity Japan Trust PLC, discusses why he continues to see strong opportunities in the underappreciated Japanese stock market. In particular, he highlights the Japanese pre-IPO market, where a surge in entrepreneurial activity is creating a new generation of growth companies.
Strong corporate earnings
Since 2010, corporate profits in Japan have tripled, alongside a rise in free cash flow. At the same, companies’ debts have been repaid and their cash balances have increased.
There are several factors driving strong corporate earnings. Firstly, Japan is home to a number of global companies such as Sony that have a significant presence outside Japan. So even though the domestic market may be flat, these companies are able to continue to grow strongly overseas. Additionally, Japan is on the doorstep of fast-growing and thriving markets in Asia, predominantly China - which has also helped these companies.
Another big driver has been the corporate governance reforms that have been introduced over recent years, which have forced companies to restructure and focus on core areas - thereby moving towards more rational balance sheets and free cash flows.
While Japanese equities have generally performed well versus most other developed markets over the past five to ten years, the returns of Japanese small-cap companies have outstripped the performance of larger companies in the last decade. We believe these smaller companies offer a richer source of excess returns. As a result, the Trust tends to invest in these companies where there's a long runway of growth.
Additionally, the mid/small cap space is not widely covered by sell-side analysts compared to other developed markets such as Europe and the US.
An example to highlight here is JustSystems, a software development firm focused on education and enterprise software that we invested into in 2017. The company had no analyst coverage and had a
market capitalisation of £600 million. Market cap is now over £2.5 billion, and its share price has increased four-fold.
Another area that we’re seeing strong opportunities is the pre-IPO market. Over the past few years, we have seen a sharp rise in entrepreneurial activity in Japan with a number of new growth companies coming through, creating opportunities in the pre-IPO market
Unlike in the US, there is very limited institutional participation in late-stage pre-IPOs in Japan, which means that there is less competition and valuations are more attractive. We see the sweet spot as one to two years prior to IPO as there is very limited competition at this stage.
In this space, we invested in a company called Coconala, an online C2C freelancing platform that enables users to trade knowledge, skills and experience.
Generating excess returns
Overall, we believe there is a wealth of under-covered companies in Japan that represent a significant source of potential excess investment returns for investors that are willing to turn over enough stones and find the undiscovered or underappreciated gems.
In the current uncertain macro environment, our strong research and on-the-ground knowledge is invaluable when looking at the micro level and speaking to company management to fully understand the current dynamics. We believe this puts us in a strong position to continue to identify mispriced winners which should create positive long-term outcomes for investors.
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