Cover Story: Getting a slice of the samurai pie

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on September 17, 2018 - September 23, 2018.

We continue to like Japan because of Abenomics. After more than two decades of downturn, it has a leader who has managed to hold politicians and parliament together to push through various economic obstacles. We feel there are investment opportunities. > Lim

Robotic process automation is a big trend in Japan. So, the systems integrator industry will benefit from growing IT investments in the country. > Yamagata

The target fund currently invests in 80 stocks that are cheaper than the value of their future earnings growth. When investors ask about the best time to invest, we say any time because they are all cheap — the current share price does not reflect the future earnings growth. > Ishihara

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Hot on the heels of the revived Look East policy, Malaysians are turning their gaze to potential investments in Japan. And things are looking up in the Land of the Rising Sun after two moribund decades of downturn and deflation.

For starters, it experienced eight uninterrupted quarters of growth for the first time in 28 years as at December last year. This was attributed to the policies implemented by Prime Minister Shinzo Abe (popularly referred to as Abenomics), which increased money supply and government spending on top of bringing about much needed structural reforms.

Japanese equities — be they small, mid or big caps — are set to be the flavour of the year.

UOB Asset Management Bhd CEO Lim Suet Ling feels that things are looking up for Japan and Prime Minister Tun Dr Mahathir Mohamad’s call to look east, could not have come at a better time. “We continue to like Japan because of Abenomics. After more than two decades of downturn, it has a leader who has managed to hold politicians and parliament together to push through various economic obstacles. We feel there are investment opportunities,” she says.

Japan, the world’s fourth largest economy, has a population of about 127 million. That means, it has a big enough domestic market to ride out external factors such as the trade war tensions between the US and China, says Lim.

A Sumitomo Mitsui Asset Management report on Japan’s economic conditions shows that the country’s gross domestic product increased for eight consecutive quarters as at 4Q2017 — the first time in 28 years. It also points out that the recent unemployment rate was the lowest in 26 years (from October 1992 to May 2018) while wage and compensation increases for Japan’s full-time workers have been consistent after the 20-year on-and-off deflation.

Nikko Asset Management chief strategist Naoki Kamiyama says Japan has a strong interest in natural resources such as liquefied natural gas (LNG) and resource-related infrastructure may be one area of focus for investment. “There is no clear direction yet, but we can point to LNG-related infrastructure, plant engineering and related sectors,” he says when asked about specific sectors the fund house favours due to the revival of the Look East policy.

The fund house expects the Nikkei 225 to rise about 10% over the next 12 months as earnings reported in the interim results season (October and November) are expected to be positive. “Strong exports will lead the positive direction. We are constructive on Japanese corporate earnings and looking at high single-digit growth for the Tokyo Stock Price Index (Topix) over the next 12 months,” says Kamiyama.

He believes that retail participation in Japan will continue to support the Abenomics rally and that investors there have been cautiously optimistic. “But if increasing trade volumes lead to inflation in the near future, Japanese investors will be more confident of putting money in an economy expanding for the first time in two decades,” he says.

Kamiyama points out that stronger expectations of inflation are likely by the fiscal year-end (March 2019), though the signs are still weak. This should be led by an increase in export volumes, to expand inventory and production for corporate Japan and raise wages as well as capital expenditure, he says.

These two factors — recent export volume growth and expectations of inflation — are good reasons for investors to buy into Japanese equities. “Exporters will stabilise after the mid-term elections in the US. Financials are the major area of interest when inflation in Japan is the story in the market. For the time being, high return on equity (ROE) and buyback potential are from the perspective of stock choice,” says Kamiyama.

He also believes that in the short term, mid and small caps are fine as they are not impacted by trade tensions and other global noise while large caps — which in the context of Japan refers to banks and major exporters such as automakers — can be better at the year-end.

Eliza Ong, managing director and regional director at RHB Asset Management Sdn Bhd, views the revival of the Look East policy positively, especially with the possible new tax incentives for foreign investments. She says it would encourage increased trade across the region and possibly open new doors and opportunities for companies.

“We believe this [the policy] will be more business-friendly and entice a more skilled labour force to start working in Malaysia. This will benefit local companies as they will be able to hire from a larger pool of talent and benefit from the increase in foreign investments. The foreign investments could also lead to more transfer of knowledge, which could benefit both parties,” she adds.

Japan has been Malaysia’s leading source of foreign direct investments (FDIs) in the manufacturing sector since 1980, according to Ong. She says the Japan External Trade Organization (Jetro) has stated that the electrical and electronics (E&E) sector is the biggest investment made by Japanese companies.

“Low technology and low value-added companies should be avoided as the E&E industry has evolved to higher value-added products and front-end activities such as design, research and development. Japanese companies are looking for opportunities to invest in sectors such as aerospace, automotive components, medical equipment and renewable energy,” she adds.

Ong points out that cyclical sectors such as technology and consumer discretionary would be preferred over defensive ones such as telecommunications. “Small and mid caps have outperformed large caps over the last three years. These small companies have been under-researched or not covered by brokerage firms and remain a good play for value investing,” she says.

 

Hidden gems

Investors who prefer long-term capital gains from Japanese equities should look to stocks that can provide earnings growth regardless of the global noise and those that could benefit from structural reforms. According to Lim, Japan is at the forefront of automation and miniaturisation, so there are pockets of companies related to this demand that look interesting.

“The Japanese equity market has about 3,600 stocks. When Japan is mentioned, everybody thinks of the Nikkei. But it consists of only 225 stocks and they are all big caps, whereas UOB Asset Management’s United Japan Discovery Fund — MYR Hedged Class invests in mid and small caps. We avoid the top 100 stocks as well as the micro ones [less than US$100 million in market capitalisation],” she says.

The fund house avoids the big caps because they are too globalised. “Currency movements usually affect their earnings,” she points out.

That still leaves more than 3,000 stocks to choose from. UOB decided to partner Sumitomo because it has the means and opportunity to detect “unpolished gems” as its Japan-focused funds invest in stocks that are unheard of outside the country. “These fund managers are really in the market,” says Lim.

“Fast Retailing Co Ltd, whose primary subsidiary is Uniqlo, is one example. I bought my first Uniqlo product 25 years ago before it entered Malaysia because my Japanese colleagues raved about the quality of its products. Over the 25 years, the company’s share performance has outshone the Nikkei’s. So, we look for these types of stocks, which go in a different direction from the broader market,” she adds.

Launched in October 2015, the United Japan Discovery Fund is a wholesale growth fund that has delivered an annualised return of 20.14% since its inception (as at July 31), according to its fund fact sheet. Its top five allocations are industrial (32.90%), consumer discretionary (26.08%), IT (16.43%), healthcare (7.14%) and materials (7.13%).

The equity fund, which had RM58 million under management as at July 31, had delivered returns of -1.2%, 3.24% and 17.81% over the previous 3, 6 and 12 months respectively. By comparison, the average returns of the Lipper Asia-Pacific Small and Mid Cap Equity category were-5.94%, -6.58% and -2.47% respectively.

The United Japan Discovery Fund feeds into  the United Japan Small and Mid Cap Fund, which is sub-managed by Sumitomo Mitsui Asset Management. The target fund aims to achieve long-term capital growth through its investments in small and mid-cap companies listed, domiciled or have substantial operations in Japan.

Daisuke Ishihara, deputy general manager of international business at Sumitomo, says the fund house uses the bottom-up approach, so the sector allocations of this fund are always similar. “There is a 20% turnover ratio. So, I would say that the allocation may be 20% different from last year. But all in all, it has been consistently similar each year.”

He adds that one of the key factors that could influence the fund’s portfolio is Japan’s deregulation and structural reforms, which could create new business opportunities. The fund managers may detect small businesses that could potentially show significant growth as they progress from small-cap stocks to mid or large caps.

“We can capture this kind of investment opportunity when the company is still small, like the Uniqlo story. One of the stocks included in our portfolio is called GMO Payment Gateway Inc, which provides credit card services to small businesses. Our portfolio manager started investing in this company in 2008, when the stock price was just ¥300. But now, it is ¥13,000, which means it has increased 4,000%,” says Ishihara.

He also cites Daito Pharmaceutical Co Ltd, which manufactures raw materials for generic drugs, as an example of a company whose earnings have grown due to the structural reforms of the Japanese government, such as its aim to reduce welfare costs and increase the use of generic drugs.

Ishihara points out that Daito is the only listed company that manufactures raw materials for generic drugs in Japan. So, regardless of the stock market conditions and the country’s economic growth, the government needs to achieve its target of increasing the use of generic drugs to 80% from 60% currently.

“Daito is benefiting from this structural reform and its sales and operating income is increasing every year. Our portfolio managers have been very confident that this company will show earnings growth, even after it was hit by two fire incidents,” says Ishihara.

“Eight months after the last negative event brought down its share price, its earnings as well as sales and operating income increased. This shows that the company has managed to capture the tailwinds of the structural reform.”

He adds that this sort of policy change may also be a catalyst for the creation of new small businesses.

Ishihara says it is important to understand that there are companies in Japan that are reaping the benefits of the structural reforms regardless of the economic cycle, oil price and other geopolitical risks. “We cannot say there are no effects from the stock market conditions. But in the end, these companies will show very strong earnings growth. So, our portfolio managers do not discuss foreign-exchange movements, US President Donald Trump’s tweets and energy prices, but instead focus on companies that can show earnings growth no matter what happens,” he adds.

Ishihara says Sumitomo identifies the mispricing of stocks by looking at the sell-side analyst coverage (those who evaluate companies for future earnings growth and other investment criteria). He points out that in the large-cap space, the average number of analysts that cover a company is 15, compared with 7.7 for mid caps and 1.2 for small caps.

“We believe that this is the area to look at and our portfolio managers, through their research, estimate the companies’ earnings over the next three years and calculate the current value of their earnings growth. If the current share price is far cheaper than our target price, we will invest,” says Ishihara.

“The target fund currently invests in 80 stocks that are cheaper than the value of their future earnings growth. When investors ask about the best time to invest, we say any time because they are all cheap — the current share price does not reflect the future earnings growth.”

He adds that the yen’s depreciation does not have a strong influence on the fund. “If the depreciation is very sharp and sudden, however, the fund will underperform large-cap funds. But if it is more gradual, it will typically outperform the MSCI Japan Small and Mid Cap Index.”

 

Trends

Taisuke Yamagata, a fund manager at Sumitomo, says the fund house is positive on systems integrators (SI) this year as Japan plans to improve productivity to boost the economy. He says Japanese companies will increase IT investments by 10% to 12% this year to improve productivity, according to a Tankan survey by the Bank of Japan.

“I think this trend will continue. For example, robotic process automation is a big trend in Japan. So, the SI industry will benefit from growing IT investments in the country,” says Yamagata.

“Business processing outsourcing (BPO) is another big trend as it allows companies to outsource their non-core businesses to BPO service companies so they can focus on their core business and improve productivity. This means companies that provide customer relationship management solutions such Prestige International — which is also one of the fund’s top holdings — will benefit from the BPO demand in Japan.”

He says it is not easy for foreigners to invest in small and mid-cap companies in Japan as most of their management cannot speak English. “Even the content on their websites are in Japanese. So, it is very difficult to get information on these small and mid-cap companies. It is, however, much easier for Japanese investors to pick up these ‘treasures’ or undervalued stocks,” he adds.

UOB’s Lim says there is a consistent profit-taking to a certain extent as it is part of the fund’s strategy to be as equal as possible among the 80 stocks it holds. She suggests that those who are keen to invest in the fund take a long-term view.

“Do you think the mid-cap Japanese companies have growth potential? Because it is not a view of ‘buy Japan, sell Japan’ due to some big event. You must think of the 20-year downturn and whether it has sort of reached a plateau,” she adds.

“So, for anybody who buys into the Japan-based fund, you must have the conviction that the small and mid-cap universe has unpolished gems. If you think there are companies similar to Fast Retailing that could grow over the next 5 to 10 years, then you will want to participate in this fund.”

The fund is currently not accessible to retail investors, but Lim says she is “seriously thinking about” changing it to a retail fund. “There is demand [from retail investors]. Technically, after three years, it qualifies to be on the Employees Provident Fund list so that EPF members can invest in it as well, since the fund is suitable for long-term investors,” she adds.

 

Local funds with exposure to Japan

The United Japan Discovery Fund — MYR Hedged Class, which had a one-year return of 17.81% (according to Lipper data as at Aug 31), outperformed other local funds with substantial exposure to Japanese large-cap equities.

The Affin Hwang World Series – Japan Growth MYR Hedged fund (fund size: RM72.53 million) invests in undervalued Japanese companies with growth potential. According to Lipper data as at Aug 31, the fund delivered a one-year return of 8.46%. Its top five sector allocations, according to its August fund fact sheet, were industrial (25.1%), consumer goods (22.3%), financial (13.6%), basic materials (7.3%) and technology (5.5%).

The RHB Entrepreneur fund (fund size: RM42.83 million) invests in companies that possess entrepreneurial characteristics and has 79.84% exposure to Japanese equities, according to its August fund fact sheet. The fund delivered a one-year return of 10.49%. Its top five sector allocations as at July 31 were consumer products (40.07%), consumer goods (10.22%), technology (8.66%), trading/services (7.92%) and real estate investment trusts (7.34%).

The Eastspring Japan Dynamic MY-JPY fund (fund size: RM25.9 million) invests in the Eastspring Investments – Japan Dynamic Fund (target fund), which invests primarily in companies that are incorporated, listed in or have their area of primary activity in Japan. According to Lipper data as at Aug 31, the feeder fund delivered a one-year return of -1.22%. Its top five sector allocations, according to its August fund fact sheet, were consumer discretionary (22.9%), financial (22.7%),

IT (17.5%), industrial (16.5%) and materials (10.3%).