Private banks confident sun due to rise over Japan

Ratings agency Fitch recently downgraded Japan from AA to A+, warning of possible further downgrades on the country’s escalating debt to GDP ratio.

Of late, Japan has underperformed other major markets, while going through a deleveraging process and dealing with a strong yen. The country has also been beset by natural disasters with the Tohuku earthquake and the Thai floods, which led to losses in manufacturing. Moreover, huge public debts, an ageing population, an ineffectual government, a history of weak corporate governance and deflation fuelling Japanese companies’ decade-long battle against falling prices hardly adds to the country’s investment appeal.

Private banks, however, remain bullish on Japan. There are several potential catalysts, feels Sam Perry, senior Japanese equity investment manager at Pictet Asset Management, which manages $83.4bn (€66.3bn) in assets.

“The post-earthquake reconstruction plans signals a recovery in domestic demand,” he says, referring to the Japanese government’s $19tn reconstruction programme, which according to official estimates will lift economic output by 1.7 per cent in 2012 and create around 600,000 jobs.

Also, Mr Perry thinks the Bank of Japan’s announcements earlier in the year of targeting inflation in order to stem deflation, and extending the quantitative easing programme to increase the flow of credit to households and businesses will boost Japanese equities.

“The Bank of Japan’s Valentine’s Day message seemed to indicate a new determination to end Japan’s deflation. However, even without the Bank of Japan, the economy was already slowly moving towards inflation,” he says, stating the gap in the yield between inflation-linked and nominal government bonds show a steady rise in inflationary pressures over the coming five years.

Adrian Hickey, head of Japanese equities at Pictet Asset Management, says the Bank of Japan’s aggressive monetary easing is also helping stem an appreciation in the yen. “This should brighten the earnings prospects for Japan’s export-dependent companies,” he says.

As firms continue to recover from last year’s natural disasters, corporate earnings are expected to rise by an annual 28 per cent over the next two years, says Mr Hickey. “The dividend yield on companies in the TOPIX is a respectable 2.2 per cent and projected to rise to 2.6 per cent in 2012, compared to S&P’s 2 per cent.”

Not all banks are united. Geneva-based Reyl & Cie does not recommend exposure to Japan to its clients. “Japan is not in our portfolios right now for our European clients. On a geographical basis, we currently prefer US and emerging market equities over Europe and Japan,” says Daryl Liew, senior portfolio manager at the family firm.

The strong yen and its position as a safe haven currency, he says, are strong positives. “Because of the eurozone crisis, funds have flowed into the yen. But at below 80 against the US dollar, it is relatively expensive.”

The main risk, according to Mr Liew, is whether the Bank of Japan can unilaterally push the yen down without help from other central banks. “With other central banks facing domestic issues, it is unlikely they will provide any assistance.”

However, Rob Taylor, director of international research at investment manager Harris Associates, says 20 per cent of their assets in the international space are invested in Japanese equities. “There are globally strong companies Japanese companies with a large exposure to emerging markets, such as Canon, where 80 per cent of the business is outside Japan and Toyota, where 35 per cent of the business is in emerging markets,” he says.

Mr Taylor says these companies are trading at low multiples and have strong cashflows, and net cash on the balance sheet.

Nevertheless, Kerry Goh, head of Asia Investment Solutions Europe at Julius Baer, has a different opinion. “A slowing global growth does not bode well for Japanese corporate earnings, even though the stocks are attractively priced,” he says.

For global clients, the private bank does not recommend a core investment into Japan like most global investors. Japan’s investment weight within client portfolios is largely a tactical investment decision.

Julius Baer recommends thematic investing to private clients for exposure to Japan. The current theme is robotics. “Japanese robotic companies are truly global and command a lot of respect in terms of market share or technology. Going forward, robotics will play a crucial role in helping countries,” Mr Goh says.

Investors have been concerned about the strength of the yen, and the impact it has on Japan’s export sector, says Tony Roberts, fund manager of Japanese Equities at Invesco Asset Management. “Investors have also been concerned about the strength of the yen and the impact it has on Japan’s export sector. A strengthening currency does have a negative influence on the earnings of export companies.”

But the real impact is lower than is generally perceived. Japanese companies have been coping with a strengthening currency for a very long time and have become adept at mitigating the impact through operational changes. “Strategies of moving production offshore and procuring more from overseas, where a strong yen is a benefit, have helped to limit the currency’s impact on profits,” Mr Roberts explains.

Toru Ibayashi, chief investment officer at UBS, says Japanese equities offer attractive returns, especially as Japanese equities have underperformed for five years, from 2006 to 2011. “Given the strong earnings rebound, solid domestic economy and weaker yen, we expect Japanese equities offer international investors a unique opportunity,” he says.

Last year’s earthquake, Mr Ibayashi says, changed Japan’s energy policy, as the country stopped all nuclear power plants, which left a 20 per cent supply gap. This gap was filled by importing tonnes of gas and oil to keep thermal power plants running. Increased import of gas and oil resulted in a reduced trade surplus. “For the first five months in 2012, our trade balance is largely negative. We believe this will eventually lead to a weaker yen,” he says.

Mr Ibayashi believes a weaker yen and strong earnings rebound in 2012 should create investment opportunities in Japan. He is particularly bullish on exporters which can grow in emerging markets. “Though some exporters lost earnings power, some remain strong, particularly auto and tire manufacturers,” he says.

Mr Ibayashi feels Japanese government bonds and most of Japanese yen denominated bonds are not a good idea. “The only choice for international investors is whether to buy Japanese equities or not, in my view.”

The Japanese government’s $19tn post-earthquake reconstruction programme is predicted to lift economic output by 1.5 per cent, according to offical estimates

Japan stopped all nuclear power plants following the earthquake, which left a 20 per cent supply gap, filled by importing tonnes of gas and oil to keep thermal power plants running

Still home to world leaders

Despite adverse news about Japanese companies, such as Sony and Panasonic, which are losing out to overseas rivals, Pictet Asset Management’s Sam Perry says there are stocks where Japan still has its global leaders.

These stocks are companies which manufacture components of smart phones and iPads, such as Murata and Sumitomo Bakelite, which invest heavily in research and development. “There is a Japanese oligopoly in this sector. These products would not exist without Japanese companies,” he says.

Mr Perry recommends energy efficient companies, such as Daikin, Nippon Ceramic and Hoshizaki Electric. “The need to conserve energy in Japan is leading to their strong demand,” he says.

He recommends manufacturers of automobiles and its components, such as Honda, Denso and Daihatsu. “The Indonesian auto market is to show strong growth and these companies are set to benefit from growth in global demand for small, efficient vehicles,” Mr Perry says.

Also amongst his top stock picks are digital SLR camera manufacturers, such as Canon and Nikon and companies involved in factory automation and robotics, such as Fanuc and Mitsubishi Electric.

Adrian Hickey, Pictet Asset Management