Value investing in Japan will have its day in the sun again

A Nomura report claimed a couple of years ago that ‘Japanese value investors are extinct.’  That is not quite true but, since the Global Financial Crisis, only the most determined investors have kept going.  Relative returns from value stocks actually bottomed out in 2016 but there is little sign of any escape from the value trap which scornful commentators like to refer to.   The cause is not hard to seek: Japan has endured ultra-low interest rates for nearly 30 years and negative nominal economic growth for the first 20 of them.  Investors have responded by putting a huge premium on those stocks who have been able to demonstrate growth and/or a sustainable yield.  The dispersion between growth and value has therefore risen to extreme levels. And yet, and yet… since 2001 Japan Inc. in aggregate has consistently generated positive free cash flow, the economy has generated positive real growth over the past three years and where else in the world can you find thousands of companies on a Price to Book of less than 1.0? One clear message from history is that when relative valuation measures become stretched (for example 2001 and 2008) there are excellent returns for value investors who are prepared to stick to their last.  We believe that will happen again but, as ever, patience will be required to benefit. Our friends at Arcus Invest, one of the Japanese value survivors, have written a further instalment of their regular white papers - Fortune Rota Volvitur (loosely translated as ‘value investing will have its day in the sun again’) - on this subject with much more detail.  Please let us know if you would like to see a copy.​

Hold on to your hats!

We make no apologies for returning to the same theme as two weeks ago, when we commented that the global tide of liquidity was rapidly retreating.  The US 10 year Treasury yield has fallen from above 3% to 2.87%, which in our view is further corroboration that investors are moving back to safe havens.  It is all the more interesting that this is happening while Japan and China have stopped investing in US Treasuries.  The two countries’ combined holding is just under 36%, compared to 40% three years ago and 46% seven years ago.  China is recycling excess cash into its Belt and Road policy, while the driver in Japan is a recognition that China is now its most important trading partner.  The more rapid escalation of trade sanctions driven by Trump is further exacerbation. China’s action over the weekend to cut bank reserve requirement ratios by 0.5% is further evidence of the stresses which are building up.  The PBOC is attempting to deleverage over-exposed parts of its domestic economy, while avoiding too much of an economic slow-down, much as it did in 2016. The signal from global liquidity levels is unambiguously negative, as we commented in our last blog.  We said then that what happens in China would probably determine how quickly the next major economic downturn would hit the world.  The latest action can be seen as a positive in that it is effectively monetary easing, but negative in that it highlights the problems. At Linchpin, against the background of tightening liquidity, we are bracing ourselves for a much more serious market downturn than the one experienced earlier this year, and are firmly Risk Off. Expect US rate rises to be muted, and possibly a bearish inversion of yield curves (ie. where short rates are higher than long term bond yields). Linchpin provides experienced advice from our 35 years of investing including how to invest successfully in market downturns.  Find out more here.

Could Asia be different this time?

That the rise of China is leading to shifts in the tectonic plates which link economies together is broadly acknowledged by most.  And yet most presentations I hear about global economics barely, if at all, make mention of Chinese influence. Our friends at CrossBorder have published an interesting strategic paper making the case that the trajectory of Asia will differ significantly from the West over the next economic cycle.  While Asian markets may not be immune to a downturn in markets, they expect them to behave differently and recover much more quickly.  Their first piece of evidence is the rise of a distinct Asian liquidity cycle.  This can be seen statistically in the collapse in the correlation between US and Asian liquidity, and is a result of a clear change in Chinese priorities.  Beijing’s long-term objective is to have the yuan replace the dollar as the major global trading currency.  Today they have switched to spending surplus cash on their Belt and Road project in Asia – effectively their version of the post-war Marshall Plan – rather than investing it into US Treasuries.  This is a factor behind the rise in US yields over the past year and can be seen in the fact that aggregate Chinese holdings of Treasuries have flat-lined over the past 18 months. The Bank of Japan has reacted by switching from its traditional targeting of liquidity to targeting the yen’s currency rates against a basket of currencies including the yuan.  The yen has traditionally been highly volatile against the US$, for example almost halving between 2012 and 2016.  Over the past two years it has traded in a much narrower range.  Tokyo has, like Beijing, stopped purchases of US Treasuries over the last two years.From a market perspective, we think this makes Asia relatively more attractive as a long-term investment, albeit Japan in particular will be more pro-cyclical because it will now be more closely aligned with China.  Lower correlations are also attractive from a diversification perspective, even disregarding potential returns.  On the negative side US Treasuries continue to be vulnerable to further ‘buyers’ strikes’, let alone selling, and the US$ is potentially vulnerable. As background to the interactions between the US, China and Japan, I thoroughly recommend Richard McGregor’s book ‘Asia’s Reckoning’, which gives a sense of the three-way power games these nations have been playing since the last war. Find out more by purchasing the report here (and spot the mis-spelling of linchpin in it!).​

Are we at peak global, and do markets care?​

Trade wars are in the headlines again, as Trump and Xi exchange threats.  For investors the big question has to be whether these will lead to a reverse of globalisation.  One commentator http://petertasker.asia points out that there are parallels but also big differences with the US-Japan friction of the 1980s.  China, unlike Japan then, is an important part of the US supply chain and hiking tariffs will simply hurt US producers.  Secondly, the US has no big stick to use against China, because it doesn’t provide any form of defence shield as it did for Japan.  Thirdly, China has broader military ambitions which may create additional causes of friction. The base case has to be that Trump’s comma-head advisors head him off actually implementing his threats.  They’ve done a good job over the past 15 months but that’s no guarantee it will happen again.  I say that is the base case because it’s so clearly in everyone’s interest.  Even if this goes in a different direction, it is likely to take time to play out and increased military spending will certainly have a positive impact on some parts of the stockmarket, in Japan, the US or China.  We may indeed have reached ‘Peak Global’, but at least in the short-term trade friction is more likely to be used as the post hoc excuse for a market setback than actually be the primary cause.​

Where to find value in markets today?

Value depends first and foremost on your time horizon - how long are you prepared to wait to get your returns?  Having said that there are pockets of value even in today’s extended stockmarkets.  You can choose to pay 30x for a ‘safe’ dividend earner or a high-flying tech giant, or you can look at some of the following.  None of them are risk free and most are unpopular, but that’s what value is all about – looking where the herd isn’t.  I hasten to add that I do put my money where my mouth is and may well have positions in stocks in these areas.   Quoted infrastructure – under threat from McDonnell’s pronouncements and dented by the Carillion collapse, but trading at discounts to NAV of up to 10% and offering inflation-correlated yields of 5% or more.  That’s a real yield of 7% more than index-linked gilts.  What’s not to like? Quoted private equity - trading at discounts to NAV of up to 15% and in a good position to pick up smaller and mid-size quoted companies where MIFID2 will have the unintended consequence of reducing, even eliminating, research on them resulting in their becoming extremely cheap.  Of course, you could simply buy the companies but that requires significant analysis and I expect them to become a lot cheaper first. Woodford Patient Capital Trust - Neil Woodford is under the cosh at the moment but if you read the commentary on his exemplary website you will see that a lot is going right as well as a few high-profile things going wrong.  His portfolio is heavy on bio-tech, where most trusts trade at a premium rather than a 10% discount to NAV.  But the clue is in the name – you do need to be patient. Japan - I am not a huge bull of the Japanese equity market but to my mind it is exposed to a lot of the right dynamics at the moment: the domestic economy recovering after 25 years, China’s economy reaccelerating, higher military spending in the region etc.  It’s also still a highly inefficient market and in this respect may foreshadow European markets now that MIFID2 is  eviscerating research.  See my comment about private equity above, which equally applies in Japan. If current market trends continue, the first three could all get cheaper in the short term as the lemmings gallop over the cliff.  But at Linchpin we think that they offer a lower risk way of generating returns when the next bear market, as it undoubtedly will, descends on us. Feel free to email or pick up the phone to discuss any of them in more detail.

After a 50% rise in 18 months, William Bourne looks at the future for Japanese equities

In September last year I came off the fence on the side of the bulls in Japan.  I pointed to the likelihood of another four years of Abenomics to wear down any opposition at the Ministry of Finance, the revival of the Chinese economy and a change in monetary policy to target the yuan rather than the US$. Four months later, the market is up around 50% in yen terms since mid-2016, and the very smallest companies in the JASDAQ index by much more.  It is time to review how much further Japanese equities might rise. It is clearly one of the cheaper of the developed markets, with an average TOPIX price to book of around 1.4x (half the US S&P 500 index at 2.8x), but that alone is not sufficient.  Value has had a rough near decade in the QE environment and while that trend may have ended it has not obviously reversed. There are some encouraging signs domestically.  I have written before about the gradual renormalisation of risk-taking - call it the return of animal spirits if you like.  That seems to have spread to the financial markets, with domestic investors once again raising equity weightings.  The Deputy Governor of the Bank of Japan in November 2017 called for ‘fair remuneration for financial intermediation services’, which is banking to you and me, to prevent a collapse of the financial system. I would suggest that the two largest influences, however, are outside Japan.  The first has to be China.  Japan’s relationship with China is multi-dimensional: on the one hand it is deeply connected economically as an investor and as a supplier of intermediate goods; on the other is the stand-off between the first and second regional powers, typified by the dispute over the Senkaku/Diaoyu islands.  I would argue that both are positive for Japan’s corporates: on the one hand Japan will share from the Chinese recovery; on the other defence spending is rising steeply. The second is the path of global interest rates.  This is more nuanced but if the trend to higher rates rises we can expect investors’ appetite for duration, whether in bonds or equities, to fall.  In such a case, Japan’s low valuations will be more attractive relative to other markets.  I accept that does not necessarily mean a higher market level and it may simply mean that Japanese equities fall by less than other markets.  However it almost certainly does mean a swing back to value at the same time and that is where Japanese equities score highly.  So I remain on the front foot. To find out more about Linchpin's advice and support in Japan click here.​

Why the TOPIX index might finally make new highs after 25 years

Peter Tasker's article reflects on what is going right in Japan and why after 25 years the TOPIX index might finally break upwards through the 1800 barrier. At the very least, it should be food for thought for those who are still bearish on Japan's future.

Colour coded queues

Back from six days in Japan, I never cease to wonder at how central Tokyo functions so efficiently.   Imagine Shinagawa Keihin Kyukoo (ie. Tokyo Yokohama express) station, where one of the Haneda airport shuttles departs from.  Trains depart from each platform every three minutes and passengers queue in one of four colour coded areas on the platform at each door, with a separate area for those exiting the trains.  When the train comes in, the appropriately coloured queue streams on board.  The station announcer sits on a dais a few feet higher so he can see what’s going on.  I did notice green coloured ‘walkways’ on the Victoria line platform at King’s Cross on my return but they were broadly ignored by Londoners.  It is two years since I last visited Japan.  There’s no doubt more of a spring in their feet: the crane count is up, employment is close to full in real terms and there is more appetite for risk taking at the individual level.  But there is a greater realism that Japan’s future depends largely on what the US and China decide and, as elsewhere in the world, the millennial generation is choosing not to make large purchases, which makes it more difficult for companies to incentivise them. Out in the boondocks, it looks much more subdued.  We drove down empty motorways and stayed at onsen (hot spring resorts) which had as many foreigners as Japanese staying.  Local town centres continue to hollow out and the number of uncultivated paddyfields - unthinkable ten years ago because of the tax advantages of being a ‘farmer’ – continue to grow.  When a mountain road was closed for repairs, there was a female (again, that would not have been thinkable ten years ago) construction worker there to tell us which way to go, despite there being a map as well.  You can read that as hidden unemployment or as a sign of Japanese attention to detail.It is also not a revelation that Japan is much better at dealing with its elderly population.  My mother-in-law, who suffers from a mild form of dementia, lives with my sister-in-law and husband. Both have jobs, so she is picked up from home every day by carers and taken to a day care home, where she can have a bath, is able to do a range of activities and, above all, can socialise.  In the evening she is delivered back home just before my sister-in-law returns.  The cost is below £50 a day.   It must be a kinder way of dealing with the problem than what happens here in the UK. Whither Japan?  In my last blog, I came off the fence on the side of the bulls, mainly because I believe Japan is so connected to the recovering Chinese behemoth.  My visit confirms that the recent encouraging macro-economic domestic data is consistent with what is happening on the ground.  However, demographics and a less than entirely functional financial system – even after many bank mergers – may hold it back. To find out more about Linchpin's advice and support in Japan click here.​

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