Japan’s new-year drop is not a buy signal
But bargains are available in sectors where momentum is strong Headlines on Tuesday’s Reuters news blog said nearly everything that needs to be said about investing in Japanese equities. The first read: "Nikkei drops to four-month low on strong yen triggered by weak US data." The second read: "Toyota says expects record annual profit, maintains outlook."
This is a problem for those trying to invest in Japan.Currency moves overwhelm everything else, and are seldom driven solely by domestic factors. Earlier this week, the yen was driven up as part of a "risk-off" move as managers attempted to repatriate their money out of emerging markets. A strong yen is taken to be bad for Japanese stocks – even those that do not rely on exports – and so Japanese equities sold off dramatically, leaving the Nikkei 225 down 14.3 per cent from its high set at the turn of the year. Wednesday’s trading saw a calmer foreign exchange market, and a weaker yen, and Japanese stocks regained some 2 per cent – notably Toyota regained 6 per cent. But the problem remains: there is a disjunction between top-down global macro factors, which give cause for alarm at present, and bottom-up micro factors, which in Japan are arguably more encouraging than anywhere else in the developed world. Has the international turbulence created a buying opportunity in Japan? Almost certainly not. However, the possibility that the turbulence will create some bargains is growing. Why not enter now? During times of volatility, it is often best just to cling to chart patterns. Tuesday’s sell-off brought the Nikkei 225 and the Topix index below their 200-day moving averages for the first time since Shinzo Abe was elected as premier in 2012. Once a technical pattern like this is broken, the selling can continue for a while. and of course the ramp up in Japanese share prices has been swift – a gain of 74 per cent in barely a year at one point – creating plenty of room to fall. Technical factors are unhelpful. The end of the Japanese financial year is approaching, giving many investors the temptation to lock in profits ahead of time by selling. In a generalised sell-off, investors from outside the country will want to take profits where they have them, which at present means Japan. Meanwhile, "Abenomics" – the aggressive policies to shake the country out of deflation that were adopted late in 2012 – is yet to affect the behaviour of Japanese institutions. Jesper Koll, head of equity strategy in Tokyo for JPMorgan, points out that Japanese pension funds have been net sellers of equities for 23 consecutive weeks. The emerging markets sell-off could easily continue and the yen could keep appreciating, which would mean further falls for Japanese stocks. Finally, there are domestic "macro" reasons for caution. The notion is creeping into the market bloodstream that Japan’s financial officials are complacent. Abenomics is supposed to raise inflation to 2 per cent. And yet the Bank of Japan’s own forecast for inflation this year is 1.5 per cent. That is being interpreted by some as signalling that there is no need for extra measures to hit the 2 per cent mark. Earnings growth Why, then, is there cause to believe in a buying opportunity? The main reason is thatAbenomics does appear to be delivering the one thing that should matter most to equity investors: earnings growth. Since Mr Abe won his election, 12-month trailing earnings for Topix companies have risen 123 per cent, according to Bloomberg data. That is in yen terms. Plainly earnings strength owes much to the weak yen, but not everything. When Topix earnings are denominated in dollars, they have still gained 78 per cent in the past 15 months. US earnings, for S&P 500 companies, have over the same period gained about 8 per cent, as have western European companies. Japanese profits fell more than US companies during the Lehman crisis, but even over five years, profit growth is in line with the US in dollar terms. Further, Japan is the only country in the world where earnings momentum is positive – or, in other words, where a majority of companies are revising forecasts upwards, rather than downwards. According to the tally of earnings momentum kept by Andrew Lapthorne of Société Générale, positive upgrades accounted for 58 per cent of total estimate changes for next year in Japan over the past month. Traditional exporting powerhouse sectors such as electronic and electrical equipment, cars and industrial engineering all appear very bullish. Strong earnings growth like this means valuations are not stretched, even after such a rally. The Topix machinery sector, for example, trades at exactly the same book multiple now as it did three years ago, pre-Abenomics. Combine decent valuations with recent falls and strong earnings momentum, and a central bank that remains keen to print money, and Japan could well soon produce a buying opportunity. Financials look cheap Where exactly might be cheapest? The sectors to have sold off most dramatically in the last few weeks have all been financial. The Topix "other financials" index is in a bear market, down 20.8 per cent for the year after Tuesday’s sell-off. Banks, real estate and insurance also suffered falls well into double figures. Banks begin to look unduly out of favour. Mizuho, for example, trades for less than its book value. Real estate companies, where they are not unduly leveraged, also present interesting opportunities. Note also that earnings momentum in financials is extremely positive – all estimate changes for non-life insurance in recent weeks have been upgrades, but momentum is also strong in banks, real estate and other financial services. Japanese banks have earned a global label as "zombies" over the last two decades. This sounds like a classic case of a sector that has fallen so far out of favour as to make them a value opportunity. Another interesting idea is to focus on an area where Japan’s ageing demographicsare an advantage. As Alex Treves, who heads Fidelity Worldwide Investment’s Japanese equities business, puts it, Japan has "the world’s largest test-bed of ageing wealthy people". Japan has fostered a powerful medical products industry, with opportunities to export to the rest of the world in due course. There also remains a case for exporters, even if the worst-case scenarios for the developing world come about. Mr Treves points out that many had brought down costs so as to be profitable with yen at Y80 to the dollar – if the yen stays comfortably above Y100, they should still be in a strong position. None of this argues for diving in while the market turmoil continues. And if the worst predictions for China and other emerging markets come true, corporate Japan will suffer as well. But if the foreign exchange market does not deliver the yen back to its levels of 15 months ago, and sap any chance of growth from Japan’s export markets, there are areas where value might easily be found.
