Unlocking Japan—Why Go Active

Japan’s equity market has the potential to offer robust total returns through earnings, dividends and buybacks over the medium to long term. Over the past 15 years, Japanese equities have generated double-digit annual returns—one of the best among non-U.S. markets.

There is a perception issue among many global investors because Japan is a country which for years has delivered anemic economic growth. At the macro level, the era of stagflation now seems to be coming to an end. Meanwhile, Japanese companies continue to demonstrate impressive profitability and, perhaps more importantly, recent corporate governance capital reforms are unlocking additional value.

For investors willing to dig deeper, Japan represents an attractive opportunity for active investing—one where local insight, rigorous research and disciplined execution can uncover untapped potential in one of the world’s most underappreciated equity markets in our view.

Japanese equities offer total return opportunities. The most obvious driver is earnings and net profits, which essentially derives from global growth and ongoing improvements in domestic labor productivity. In recent years, total returns have also been supported by dividends and stock buybacks, partly as a result of capital efficiency changes. This is very idiosyncratic to Japan as many companies have strong balance sheets, often with substantial cash, which we believe provides further opportunities and potential for improving capital allocation.

Our Active Approach

There are three reasons to go active in Japan, in our view.

First, Japan is a developed economy but it is an under-researched equity market. For example, almost 80% of the small cap market in Japan has zero or very little analyst coverage, compared with about 30% in the U.S. and 50% in Western Europe. This creates a significant opportunity for bottom-up investing.

Second, Japan's major indexes are relatively diversified compared with developed market peers. For example, the top five constituents of the TOPIX represent about 12.5% of the index. By contrast, in the U.S., the “Magnificent Seven”—a small group of large-cap technology companies—represents about 50% of the NASDAQ and more than one-third of the S&P 500 Index. In our view, this relative diversity offers opportunity for active investors.

Third, many international investors remain underweight to Japan which can lead to significant volatility induced by foreign currency movements and internal value-to-growth rotations. This can be a blessing in disguise as active investors can take advantage of dislocations that present selective opportunities to identify and invest in quality companies at more attractive valuations.

Our investment philosophy in Japan is rooted in providing core growth exposure through an all-sector, all-cap strategy. To support this approach, on-the-ground research and direct company engagement is essential. In many ways, we are research analysts before we are portfolio managers. For every holding, one of us maintains responsibility for engaging with the company on a quarterly basis to ensure we stay informed through regular updates and direct insights into their operations.

This research isn’t limited to Japan. About half of Japanese corporate earnings are generated from outside the country, which requires us to conduct extensive company visits across the U.S. and in other regions. We also collaborate closely with colleagues managing other country and regional funds to gain a broader perspective of how Japanese businesses integrate with global economies and trade. Additionally, our San Francisco office benefits from opportunities to hold one-on-one meetings as a high volume of Japanese C-suite executives regularly visit the city and other hubs in the U.S. throughout the year.

Takeaways

Corporate profit is usually central to the performance of individual stocks in Japan, especially earnings per share of growth. We leverage our research capabilities to identify underappreciated growth opportunities across various industries and market capitalizations. To guide this process, we apply a set of key guard rails:

• We don't want to overpay for growth opportunities. We use proprietary capital models to find intrinsic value and exercise discipline in terms of trimming or adding positions when the market price deviate significantly from our intrinsic value.
• While companies in Japan are often labeled as growth or value, we don’t pigeon-hole companies this way. Many Japanese companies are currently undergoing transitions, in terms of their business models and their corporate and capital structure. Companies traditionally viewed as value are exhibiting growth characteristics, and vice versa. We believe that company-specific or idiosyncratic factors offer a more meaningful framework for assessing potential performance and investment return.
• Many equity investors remain underweight to Japan. As market prospects improve, as we believe they will, this in itself is a reason to be constructive on the asset class.

It’s an exciting time for Japanese equities, as companies that have once been slow-moving are accelerating growth through acquisitions, divestitures, restructuring and enhanced shareholder returns. In many cases, these changes are driven by activist investors and constructive dialogues with investors like ourselves. We believe this positive momentum has a long way to go.

Definitions

NASDAQ: Originally an acronym for the National Association of Securities Dealers Automated Quotations, the NASDAQ was the world’s first automated stock exchange and now lists more than 5,000 companies, many of which are technology companies.