Hugh Sloane of Sloane Robinson (SR), one of Cerno Capital’s Investment Advisory Board Members, has recently published a comprehensive note, summarising his bullish view on Japan. The note was written in collaboration with his Japan co-portfolio manager, Alex Kydd and is captioned with this note.
Hugh Sloane has been portfolio manager of the Sloane Robinson Japan Fund since he co-founded the firm in 1993. Hugh started his investment career in Hong Kong in 1979.
Their view, which we also share, is that deflation in Japan is over and this has positive consequences for the equity market.
Core CPI might not be moving up yet, however other indicators are supporting this argument; for example, a tightening labour market and rising wages and income. Also, the GDP deflator has increased well into positive territory for the first time in 18 years, as SR points out.
The driver of Japan’s recent bull market is the improved profitability of companies, born out of the change in management culture. As a consequence, SR forecasts Japanese ROE levels to permanently grind higher, eventually closing in on US levels.
Graph 1: Return on Equity – Japan and US:
We have already observed numerous examples of changes in managements’ attitude to support this argument. Fanuc, for example, a US$42.8bn market cap robotics company, has in the last months disclosed its intention to set up an investor relations department; normal for US and European standards, not so for Japan, until now. The company was previously well known for ignoring its external investors.
Another interesting point made in SR’s note, was on the topic of increased shareholder total returns and the associated volatility of the Japanese equity market.
A new focus on income generation of Japanese corporates, resulting from higher levels of profitability, should allow shareholders to participate to a greater extent. Two arguments for higher pay-outs were brought forward.
First, the flow argument: As ROE increases, cash generation increases, ultimately leading to higher share buybacks. Of course, there are other ways for companies to spend their cash, but SR argues for the aforementioned, noting the following: Japanese pension funds are requesting higher levels of buy backs, the government encourages this form of action and a number of companies have promised not to increase cash levels. Share buy backs are an easy way to achieve this.
Second, the balance sheet argument: cash levels and securities on Japanese corporate balance sheets are at an all-time high. Should corporates simply reduce these levels back to 2008 levels, pay-outs of close to US$325bn could be made.
A consequence of a higher share of income as part of investors’ total returns, is a lower expected volatility of the overall equity market, SR argues. Previously, small changes in interest rates have meant higher swings in stock market returns. Higher levels of income should dampen the volatility of investors’ total returns.
Source: Morningstar Direct
The table above demonstrates, the Japanese market has consistently delivered lower returns with higher volatility for the past 25 years. Risk adjusted returns have therefore been much lower for Japan. However, we also argue with SR that these will improve.
On a relative basis, Japan’s Price-to-Book ratio as measured by the TOPIX index is about half that of the S&P 500 at the moment. The TOPIX index currently displays a P/B ratio of 1.4x, whereas the S&P500 P/B ratio is 2.9x.
Graph 2: Difference in Price-to-Book Ratio – Japan and US:
Japan continues to be our largest single country equity allocation. We are exposed via a passive index tracker and an actively managed fund.