We have witnessed a drastic style rotation in Japan's equity markets between the first and second halves of 2016. After a strong start in the first half of the year, quality growth companies underperformed sharply as investors shifted into value-oriented stocks trading at lower valuation multiples following Britain's EU referendum. So what are the prospects for Japanese quality stocks in 2017?
In Matthews Asia's experience over the past 25 years, junk rallies tend to be quite transient. For example, some of the strongest recent performers in the MSCI Japan Index have been companies in the marine transport sector that consists of three large shipping companies, all of which have been losing money and are heavily indebted - even if shipping rates doubled, these companies will struggle to generate meaningful profits.
Despite the challenges of last year I remain bullish on our long-term themes of healthcare, business-to-business services and automation, while steering clear of those areas directly linked to macroeconomics, such as energy. I look for Japanese companies that represent the real growth story in Japan today: Companies that can capture domestic demand, tap into Asia's ongoing evolution and take global market share. I believe Japan is home to many such excellent companies.
Quality is the hallmark of our approach to investing in Japan. An emphasis on quality investing can provide the benefit of possible capital preservation during more volatile times; something which is not always appreciated by the market. Whether they are value or growth, I look for businesses led by competent management teams with established track records that are able to generate a sustainable return on capital over longer periods of time.
As long-term investors, we want to be sure the companies we invest in are able to thrive even in a difficult economic environment, so we look at how much cash they are generating year in, year out. Over time, companies that can steward their capital efficiently and have good return on invested capital are the ones that survive and thrive with lower volatility.
As a seasoned Japan investor, I believe there are several reasons to be much more optimistic not only for the year ahead, but much further beyond. The first things to say is that yen weakness is not a requirement for Japanese equities perform. However, we do acknowledge that a slightly weaker yen can be somewhat of a tailwind, owing to its effect on corporate earnings.
Another factor to be positive about is fund flows into Japanese equities. By the end of October last year, international investors had sold almost two-thirds of what they purchased since the start of "Abenomics." Meanwhile, the Bank of Japan will be buying 6 trillion yen of Japanese equities annually, while corporate share buybacks have been robust, hitting 5 trillion yen in 2016 and can be expected to continue apace this year.
At the same time domestic pension funds are short of their target allocations for Japan, all of which combined means there is likely to be around 10-15 trillion yen of domestic buying into the asset class this year. If international investors change their attitude to Japan and decide to up their weightings, it could really propel the market upwards.
So-called flights from quality in markets can test portfolios. The best are those that shoulder the short-term pain and stick to long-term convictions—and at Matthews Asia, we believe that for those seeking good long-term performance, sticking with good businesses and management is critical.
For our latest views on investing in Japan, please visit https://global.matthewsasia.com/japanfund/
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