Japanese equity, which has been a consistent allocation within our client portfolios since 2011, now stands at a twenty percent weight. Within this allocation, the precise expression has changed over time.
Our approved list provides us with the necessary toolkit to alter allocations in response to changing drivers of the Japanese stock market.
At present, half of our Japanese allocation is to the Lyxor JPX Nikkei 400 tracker.
This ETF is assembled of companies, predominantly large caps, which score favourably on a shareholder value creation ranking. The Japanese equity market is attractively valued and we anticipate further improvement in return on equity (ROE), which currently averages nine percent across the corporate universe.
With his triumvirate of ‘arrows’, Japanese Prime Minister Abe introduced measures to reform corporate governance and refocus corporate attention to the shareholder. These aim to prompt companies to allocate capital more efficiently and target returns on equity above the cost of capital, or to return cash to investors in form of higher dividends and share buybacks.
To encourage companies to adhere to these principles, the Japanese Exchange Group (JPX, world’s third largest bourse operating the Tokyo Exchange amongst others) and Nikkei have jointly created the JPX Nikkei 400 Index. This index explicitly selects companies which focus on the efficient use of capital, specifically referring to ROE, as well as those promoting good corporate governance.
It excludes companies which have been listed for less than three years, have liabilities in excess of assets during any of the past three fiscal years, those which had an operating deficit in all of the past three fiscal years and those which are designated for delisting.
Eligible companies are scored and ranked according to the following criteria:
- 3 year average ROE
- 3 year cumulative operating profit
- Market capitalisation on the base date for selection
Point one and two are each given a weighting of 40% and market cap is only weighted with 20%. In contrast, the TOPIX is a market cap weighted index and the Nikkei 225 is a price weighted index.
To encourage adoption of corporate governance standards, scoring based on qualitative factors is also applied and focuses on the following three items:
- Appointment of independent directors (with the requirement of at least 2)
- Adoption or scheduled adoption of International Financial Reporting Standards (IFRS)
- Disclosure of English earnings information via TDnet (company announcement distributions service in English)
Whilst these features are common in companies listed in the US or Europe, to the majority of Japanese companies, these are rather uncommon features to date, even for some large multinationals.
The 400 highest scoring companies are selected for the index, subject to buffering rules to minimise turnover. Constituents are reviewed once a year in August and companies can be dropped if they no longer comply with the criteria. This is consequential in a country with a shame culture, such as Japan. The index has already been dubbed the ‘Shame Index’.
To compliment this broad exposure, we are invested in two mid to small cap specialists: Polar Capital Japan and Michinori Japan Equity.
James Salter, manager of the Polar Capital Japan fund runs an all cap strategy, but typically with a mid to small cap bias. James’ experience in the Japanese equity market is long standing and he has managed the fund since inception in 2001.
To direct his research efforts, the manager first analyses strategic macro trends, both in a domestic and global context, to establish broad sectoral consequences. The bottom up stock analysis is done with a bias to value and growth characteristics.
Allocations are typically geared towards exporters, financials and cyclicals (or defensives depending on the prevailing environment). Domestic exposure is typically low.
Michinori’s fund manager, Sean Lenihan, has spent the better part of his career focusing on the local Japanese small cap market. He is based in Japan and his language fluency gives him an edge over international fund managers as many of his holdings’ management teams are not equipped to deal with international investors and few of the small cap holdings are covered by analysts.
The manager builds his portfolio entirely from a bottom up basis. He believes the Japanese equity universe offers the value investor companies with strong balance sheets, earnings growth and shareholder focus which provide higher ROE characteristics than the overall market, irrespective of macro influences.
In the recent restructuring of positions, we have split part of our active allocation between the existing Polar Capital Japan fund and the less well known Michinori Japan Equity fund. The reasoning behind this shift is Michinori’s strong domestic exposure versus both the large cap index we hold and the Polar Capital Japan fund.
To give a flavour of the portfolio, 73.5% of the revenues of Michinori’s underlying holdings are domestically derived and those that are international have very little revenue exposure to either China or the emerging markets in general. Investments are focused in companies with good visibility on the outlook for increasing expenditure by customers.
42% of the portfolio is invested in companies with a market cap of below £1.5bn. Noteworthy is the 11% of holdings of companies below £350m. Polar’s small cap exposure currently focuses on the £350m to £1.5bn range.
Commonality between our large cap index tracker, Michinori and Polar is as little as 11% and 12% respectively, as would be expected. However, the overlap between Polar and Michinori is not large either. Less than 10 names are shared in both portfolios. The latter fund has an industrial bias, a higher exposure to technology stocks and puts less weight on financials and materials on a relative basis.
Our allocations across all investments are geared toward companies with sustainable ROE growth and shareholder friendly management. We have modest exposure to consumer staples, healthcare, materials and utilities.
Portfolio construction is also a point of differentiation between the two active managers. Due to the difference in assets under management (Polar Capital Japan manages US$2.8bn and Michinori less than US$150mn), position sizes in the latter are much larger and the portfolio is much more concentrated. Sean Lenihan tends to hold around 35 positions, top ten names make up close to 50% of the portfolio. Polar holds 70 to 100 holdings depending on the prevailing opportunity set.
Having successfully managed the portfolio since 2001, Polar Capital has soft closed the strategy to retain its agility to invest across the entire market cap range. Michinori intends to close the strategy at around £600m to retain its small cap bias.