Japan - staying calm amid the panic

If we the use the maxim applied by Sir John Templeton that the best time to buy is ‘the moment of maximum pessimism’, then Japan must be set for a buying spree sometime soon. The stock market appears to have discounted a severe economic downturn. The yield on stocks is higher than 10 year JGBs. The recent appreciation of the Yen is truly damaging for the corporate sector in the short term.  It all begs the question of whether the current pricing of the markets is due for revision.

David Jiang, chief executive officer for BNY Mellon Asset Management in Asia, says that, from a fundamental standpoint, “the Japanese stock market has already dropped significantly compared with the other major markets. We think much of the drop and the Yen appreciation is priced in to the near term outlook.”

Yasuhiro Kato, executive portfolio manager with DIAM in Tokyo believes Japanese companies will prove their resilience: “Japanese exporters have been dealing with Yen appreciation since 1973 and they have proved they could deal with it. On top of that, the Yen’s appreciation, with declining oil and grain prices, will bring benefits to the Japanese economy. Moreover, foreign investors can enjoy the currency gain if they invest in Japan, rather than investing in countries with weakening currency trends.

Templeton said to buy when others are despondently selling and to sell when others are greedily buying requires the greatest fortitude “and pays the greatest reward”. Contrarians could soon be rewarded for showing such fortitude with regards to Japanese stocks, according to Akira Onuki, senior fund manager at Sumitomo Mitsui Asset Management: “Investors are extremely pessimistic about Japanese equities at the moment and there are abundant reasons for them to feel that way. But the greater the pessimism, the less room there is for negative surprises. However, you should keep watching out for turbulence. Because we are anticipating the worst period for the world economy and corporate earnings is still to come in the second quarter.”

Japanese equity analysts have revised down their forecasts for growth and corporate earnings ferociously. The majority of research institutions are now expecting negative economic growth for Japan in 2009. They are forecasting two consecutive years of contraction in corporate earnings and so it goes on. The gloom is unremitting. Is this the bottom? The consensus would seem to be that the Japanese equity market will start to climb in the second half of 2009.

A high dividend yield would normally be supportive of stock prices, but this feature is being neglected in the current environment. Onuki suggests this might be because the market is discounting dividend cuts in the future. Another factor he is keen to stress is the shortening of the time horizon taken by investors. DIAM’s Kato adds, “this kind of thing always happens in the typical panic phase. It seems that de-leveraging by hedge funds causes a huge selling pressure”.

On two previous occasions in the last ten years the yield on stocks rose above the yield on 10 year Government bonds. In 1998 and again in 2002 Japan had severe deflation and fundamental problems with financial institutions that were facing a capital crunch in coping with the massive write-down of bad debts. Now again, the yield on stocks exceeds that of 10 year JGBs. Onuki believes this is an unreasonable anomaly: “In the midst of this global financial turmoil, the Japanese financial system and corporate balance sheet is relatively sound. This twist will be corrected as the equity market starts to realise the good growth potential for Japanese companies.

While US and European companies are preoccupied with restructuring their balance sheets, many Japanese companies have a healthy cash position and are poised to use it. They might deploy excess cash by buying back their outstanding shares, investing in new plant and machinery or in acquiring other companies. BNY Mellon’s David Jiang says, “Cash rich companies are able to acquire other companies to enhance or diversify their current business.  We see this happening now.

Onuki observes, “Deployment of cash depends on where the company is in its development, but with a malfunctioning financial system in the background, companies are inclined to retain a high cash position. The equity market might give a high score to those companies with a low “price/net cash ratio”, but it will be only temporary.

“Japanese companies tend to prefer organic growth, but we think they should look more closely at M&A opportunities. Among those companies with a lot of cash and sound balance sheets, there are some companies taking a major step forward by acquiring overseas companies. This environment is providing them with some historic opportunities.

An improving cash position will certainly lead to an increase in share buy-backs. Kato says this will bring two benefits for companies in the short term: “The first and more direct one is the supply and demand balance improves. The second, a more indirect one, is return on equity improves because the Yen cash return is below capital cost. Until 1989, most of Japanese companies didn’t mind capital cost.  Since then, foreign investors have become significant shareholders, requiring higher ROE. In that sense, foreign investor participation has encouraged Japanese companies to pursue higher ROE.

What does the increasing activity in buy-backs mean for the long term performance of the market? Jiang says, “Our observation is that share buy-backs have a positive impact on short-term price movements, but we are not so sure about the impact on mid to long-term price movement. A share buy-back is appreciated in value-oriented markets, but not so much in the high growth phase. Investors prefer to see companies invest cash into the business itself, not in the financial assets.”

Onuki: Whether share buy-backs are good or not depends on the growth stage which the industry or the company is situated. The only important point is whether excess cash is deployed effectively to enhance growth or better profitability. Returning cash to shareholders is good for mature companies that don’t have enough growth opportunities to deploy cash. On the other hand, there might be a case where a company which explicitly goes for external growth conducts share buy-backs only to shore up its share price. The market doesn’t appreciate that.

In terms of the macro picture in Japan, it is clear that external demand will be weaker in 2009. If Yen continues to appreciate, it would affect not only Japanese company earnings but also consumer spending. The biggest risk is global deflation leading to the prolonged economic slowdown.  SMAM’s Onuki says, “We have not experienced global deflation for a long time, and we need to pay close attention to the various monetary and fiscal stimulus measures introduced globally. Once the economy falls into a serious deflation, it takes a long time and extraordinary remedial measures for the recovery. In Japan, we have a vivid memory of how nightmarish it was to struggle to escape from the claws of a serious deflation.”

For Japanese companies, international markets and especially the Asian emerging markets, have become increasingly important. Also, Japan has little natural resources, so to ensure a stable supply, Japanese companies have worked on building relationships. DIAM’s Kato observes that “the emerging countries have been used to establish factories to reduce production costs, and now as their local economies grow, they have become important as consumers. Onuki adds, “China and other Asian economies are growing in importance to Japan. China stands out for its growth and political stability.  Looking at specific industries, companies in the auto and infrastructure related industries are well positioned. The big three automakers in the US are struggling in the current financial and economic crisis, which will be favorable for the Japanese automakers. Europeans are good at luxury cars and Japanese autos have more strength in the small to middle-range models. Europeans have diesel whereas Japanese autos have hybrid as environment-friendly technologies.”

The fund managers also suggest that infrastructure investment related industries can expect steady demand from emerging economies. Among them, construction machinery industry, which has high global market share, and the iron and steel industries are well positioned to increase their market share, with their advantage of superior technology. Japanese companies involved in environmental businesses will be able to benefit from the growing demand for their technology. Japanese electronics companies have strength in technologies and brands, but they are facing price competition from Korean and Taiwanese companies. The case of Sony shows how Japanese companies have a tendency to make over-spec’ed products. To adapt to the demands of the emerging Asian nations, they need to produce simpler products at the right price.

The Japanese institutional investor has shown a marked reluctance to fully embrace the equity culture. What will it take for Japanese institutions to shift their asset allocation more towards equities? Kato suggests they have already done so, spurred on by the market valuations. Onuki observes that: “We can expect some inflow from public pension funds in order to adjust to their policy asset allocations. On the other hand, corporate pension funds are shifting their policy asset allocations away from Japanese equities. This movement could be rewound in the future, but it is unlikely to happen until they can confirm the bottom of the recession.”

Regarding pension fund investors, David Jiang says: “The trend of their asset allocation is already to diversification. They had begun to reduce the exposure Japanese stocks, with many pension funds increasing exposure to emerging markets. Also, we see a trend to alternative investments, including private equity investments.  Post turmoil, though, this trend is unclear.”

Jiang suggests that, with the current situation in world markets, it is better to keep the equity portfolio more defensive until the volatility subsides. “While the market volume is extremely low, it is very difficult to invest in small cap stocks. The currency volatility impact on exporters is still hard to quantify. So the current idea is to find large cap names with attractive valuations, which are well positioned to benefit from the domestic and defensive growth, for example, staples and healthcare.” 

Noriyuki Kato, General Manager of Institutional Marketing at DIAM, says, ”Japanese institutional investors are still in the risk averse regime and projected to be so until the fiscal year-end (March 2009). Most investors perceive below 8000 on the Nikkei to be a very promising level to buy. But given that the equity market is vulnerable to the strength of the Yen, the stability in the foreign exchange market remains the key factor inhibiting institutional investor behavior.”

Japan is undeniably cheap, but the market has shown a long term ability to disappoint investors. How can they be sure that this time will be different? DIAM’s Kato says: “It took almost 13 years to solve the credit crunch and excess capacity in Japan. Now Japanese companies have more solid and sound balance sheets compared with others in the advanced countries.

Jiang’s view is that after experiencing the lost decade of the 1990s, and the continuous yen appreciation, many Japanese companies are positioned perhaps better than those of other regions. “Some exporters are less reliant on US and are diversifying their exposures to Emerging markets, particularly China and other Asian countries. As companies build up a huge amount of cash, they have chance to participate in M&A activities by using that cash to accelerate their growth.

Onuki acknowledges the problem for foreign investors: “We admit that the high expectation of the Koizumi revolution fell apart and was major disappointment. But we believe that a paradigm shift is happening now in evaluation of corporate management. Until recently, a management style of taking high leverage to maximise ROE was regarded as an excellent way of managing companies. Japanese companies, which tend to have a rather high cash position and low leverage, were criticised as being inefficient. Japanese companies have been working on improving efficiencies by better utilising their cash and they have been making progress on this front. It is now widely acknowledged that the companies which adopted an excessive level of leverage were underestimating the huge potential risk attached to it. Undoubtedly, the model for proper management style as “a going concern” came closer to that of Japanese companies in general, and they deserve re-evaluation in relative terms. Fingers are crossed that many Japanese companies will take the current crisis as a big opportunity, which enables them to establish a bigger global presence and improved profitability.”