Japan is on track to deliver stellar performance; are investors ready to reap the rewards?

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I’m James Yardley, and today I’m joined by Sunny Romo, investment specialist on the M&G Japan Fund. Sunny, thank you very much for joining us today.

[00:08] Thank you for having me.

So, maybe if we start with inflation. Obviously, it’s a huge topic at the moment. What’s actually happening in Japan at the moment? Because obviously Japan has suffered from deflation for such a long time. Is Japan now happy to see a bit of inflation?

[00:27] Yes, absolutely. I think that’s what differs for Japan against the rest of the world. While everyone else is really worried about this inflation piece, for Japan this is actually positive news. And of course, there’s cost pressure and there are concerns about it, but all in all, Japan has been doing everything it can, to actually produce some inflation, and we’re finally seeing that come through on the core inflation level.

And this is very much PM [Prime Minister] Kishida’s focal point as well. He wanted [the] Japanese economy to have inflation, because this was part of his focus on wealth creation through investment. Without inflation, that saving[s] was earning no money, and, as you know, Japanese investors have a lot of savings that’s lying around in the bank account. So, I think this will be a positive push for investment in Japan in general.

And I guess one of the things we have seen recently though, is a big weakening in the Yen; obviously the Bank of Japan [is] essentially still doing quantitative easing while the rest of the world is tightening. Does this become a problem at some point though? Or is Japan quite happy with this at the moment? I mean, obviously we’ve seen also intervening in the currency markets recently, so they can’t be that happy with it.

[2:02] Exactly. Yes, I mean, it’s really difficult to comment on FX moves. Whatever I say, I’m bound to be proven wrong! But having said that, if you look at the sort of recent appointment[s] Kishida has made for [the] Bank of Japan board, they are decidedly hawkish people who are taking on responsibilities. So, as we see Kuroda [current Governor of the Bank of Japan] retiring next Spring, it’s quite likely we’re going to see a different tack from the Bank of Japan. But it’s very difficult to predict the short-term, what changes may happen.

And your fund was recently awarded an Elite Radar by FundCalibre. Can you tell us a little bit more about what makes your fund different, versus your average Japanese fund?

[03:01] Yes, absolutely. You know, everyone manages money differently and there’s different ways of extracting alpha. But I think there are two points that differentiate us from the others. A) I think we have a very different idea-generating engine that comes from our core research programme that’s been gradually built up over the last 20 years. So, we are not constrained by factors. We are truly stock pickers. We look for opportunities, where we have a superior view on our ability to price risk, rather than forecasting earnings, as you see a lot of researchers would do.

So, the second differentiating point that basically came out of our research programme, is the fact that we really do understand our companies deeply, and we realise that over time, we can build almost a consultative relationship with our investee companies. And we call this value-added shareholdership. It just means, rather than passively owning a stock, we do quite often step in, have in-depth conversations with company management, whether it be on business strategies or M&A possibilities. These are value-added sort of engagement that we do with companies, and that really gives us [a] better relationship with the companies, but also make us very often the catalyst of our own investment return.

[Can you] give us some stock examples which show your process in action?

[04:55] Yes, absolutely. I mean, as stock pickers, we look for situations where there’s specific debate or controversy or [a] blind spot, that really drives a wedge between the price and sort of the risk of owning a company. And ,to that end, we do have some interesting or differentiated perspective[s] in how we look at some stocks.

I mean, a recent example is Hitachi Zosen. That’s one of the stocks we’ve owned for  the last several years. They extract energy from waste incineration, amongst a few other business segments. So, our differentiating factor with how the market views them, where we had really dug deep in our research in terms of the European operation, which was a drag on their valuation, but we did the research, and realised that we were the first people who even asked to meet their European business leaders. And [we] came to the conclusion that really, the market had completely priced this stock wrong. And that’s an example of identifying a blind spot by the market, I suppose.

And for a more interesting stock example; Nintendo, for example. That’s where we had a very differentiated perspective from the market, where the Switch console, when it came out, you know, obviously that was considered a console that you attached to your tv. And that tends to be quite cyclical. The product lifespan tends to be limited. But the way we viewed it, we realised that actually what they’ve done, is bringing out a handheld console and selling it as a desktop.

And what that meant, is that the margin increase for the games were significant. And if we were right, that the cyclicality of this console will be much less because it’s much more comparable to a handheld.

The market hadn’t appreciated that fact. Obviously, we monitored our thesis through again, that meant, the data points we focus[sed on] would’ve been different. We looked at more [than] the software sales and the margin growth from the software. And really that confirmed our thesis. So, that’s an example of how we view a company differently from the rest of the market.

Yes, I can certainly appreciate the high margin on Nintendo games, given the ones I’ve been buying for my son recently, <laugh>, their prices certainly seem to hold up well!  And looking a bit longer term, I mean, your team is on the record now as saying they think Japan is going to grow faster over the next decade than any other market. So, that’s quite a big claim, so can you tell us why you think that’s the case?

[08:12] Yes, absolutely. I think, you know I can’t say that is for certain because nothing is for certain, but I think that the likelihood of Japan achieving a higher growth than a lot of the developed market is quite high.

You know, people seem to look at Japan, and have this assumption that Japan is this low-growth market. It has been for some time. It’s struggled with deflation, as you mentioned earlier, but really, if you look at the last 10 years, it’s been able to deliver 10% compound annual growth in earnings. That’s per year. That’s an amazing growth. And I don’t think many other markets can beat that.

And this growth happened during a time where, just over 10 years ago, Abe [former Prime Minister, Shinzo Abe] came in with his Abenomics. He really started this reform [prioritising], laying down the plumbing for corporate Japan to act more like profit making businesses, to become more westernised, and really facilitate this positive change, not only on paper, but in the mentality of management. So, that was a change of social contract. Companies were expected to be profitable, rather than just produce full employment.

So, that mindset change happens – as anything in Japan, [it] happens slowly – but it’s happened where we’ve passed the inflection point now, this sort of corporate reform is no longer a political issue. This is something that’s going to continue.

Now, if you think that Japan’s been able to deliver 10% CAGR [compound annual growth rate] over the last 10 years while this has been happening, there’s no reason to think that this trend won’t continue. There’s plenty of companies who are still going on the beginning of this journey, this corporate improvement journey.

Yes, I think a lot of people will be surprised to hear that earnings growth has been just that fast. And are there any other reasons why investors should consider Japan? I mean, where are we in terms of valuation at the moment, relative to the rest of the world?

Yeah, I think Japan still has compelling valuation, and that’s always been the case, right? So, when I meet with investors, I’m often asked, “Okay, Japan is cheap, but it’s been cheap for a long time, what’s different now?”

What’s different now, is all this self-help story that’s coming through. As you can probably tell, I’m incredibly bullish about Japan as an asset class. I think looking around the globe, there are very few other asset classes that offer such compelling risks/reward opportunity as Japanese equities. So, from that perspective, I think you know, Japan will deliver a lot of value for investors with all the self-help, self regeneration happening in Japan.

But another point on top of that is, because of the way we really dig into a company, and we, as I mentioned earlier, we’ve been able to sort of help companies and be a catalyst for returns in some cases, for us, we see a wealth of opportunity as stock pickers to really add alpha.

And I think again, that is a unique opportunity in Japan, as a developed market. Very few other markets offer such rich alpha-generating opportunities. And serendipitously, our investment programme has put us in a really good position. So, I think that’s really exciting from a stock picking and an engagement perspective.

And you know, all this improvement in earnings that I was talking about, we haven’t seen rerating for Japan that’s happened yet. So, this is to your point about valuation in Japan. Even without rerating, we think that Japan is on track to deliver stellar performance. But once people’s assumptions about Japan change, I think we are quite likely to see some rerating from this current very low valuation. And when that happens, that’s basically another layer. You’ve got the index return – well, you’ve got the earnings return, you’ve got alpha, and then you’ve got rerating for the entire market. So, from that perspective, I think Japanese equities deliver amazing investment potential right now.

Sounds good. Well thank you very much for joining us today Sonny, that’s been really interesting.

Thank you for having me.

And if you’d like to learn more about the M&G Japan fund, please visit FundCalibre.com