James SullivanThe ‘widow maker’ trade was to short Japanese bonds. A generation of investors believed the bond market was irrationally expensive, and they may be right one day, but the ‘greater fool’ theory is a powerful one.

Instead of wasting too much energy on whether prices across the asset class spectrum are irrationally expensive, we have focussed more on where we believe prices are irrationally cheap. The by-product of this approach tends to avoid momentum driven participation, and permits a greater focus on managing the downside risk paired with potentially significant upside when the market revaluates risk and reward.

This isn’t a blog about ‘value versus growth’, a subject matter most of us are beyond debating. This is about investing in solid companies and good themes that trade below or close to their intrinsic value. How one pigeon holes such companies, is largely irrelevant.

Take Japan as a case in point. Japan’s slow and steady corporate evolution appears to be largely unrecognised or rewarded by the market.

Despite dividends and share buybacks continuing to surpass previous highs and Earnings Per Share (EPS) growth of 82% since the start of 2015 (beating the S&P growth rate of 69%) only calendar year 2017 witnessed (modest) positive flows from overseas investors.

Year to date the TOPIX is up just 5.2% (in yen), compared to the S&P that has appreciated 21.5% (in dollars). This, however, is not representative of underlying earnings. EPS growth has in fact been almost identical, circa +22% in both cases.

The apathy towards the Japanese market is quite something.

Toda Corporation, for example. Toda is a general construction company specialising in schools and hospitals. Despite quadrupling dividends in the last 5 years, and yielding 3.9%, it trades at 70% of tangible book value and is on a P/E multiple of 7.5x. In fact, Toda even trades at a discount to its own balance sheet.

With the TOPIX yielding 2.5% and a forward price earnings ratio consistently lower than at any point during the past 20 years, Toda is far from an isolated example.

There remains room for much improvement, but pair the bottom up data with the top down macro observations and the story becomes more compelling.

In the 10 years before Abe’s 2012 appointment, nominal GDP averaged at -0.4%, and since then a positive figure has been posted every year. It is unlikely the BoJ will hit its “above 2%” inflation target anytime soon, but an upward trajectory has been witnessed and has been stable around 1% for a few years, which is no mean feat. The labour market is very tight with unemployment at 2.4% , yet admittedly there remains the challenge to convert this into wage growth. However, what has been, and may continue to be, a tailwind, is the real effective exchange rate of the Yen, close to 77, which is notably cheap relative to history. With the dollar trading close to its 10 year high, this is potentially the ace in the pack.

This isn’t meant to be about comparing Japan with the US, but it does help contextualise the status of the Japanese market, whilst going some way to rationalise why we allocate a grown up percentage of our risk budget to Japanese equities.


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