Japan’s growth vs. value debate: is the tide turning?

In spite of a few wobbles as interest rates rose, growth investing has been in vogue across the world. From the Magnificent Seven in the US to the GRANOLAs in Europe, stable high growth stocks have led markets higher, fuelled by long-term structural trends such as AI and anti-obesity drugs.

The exception has been Japan, where value stocks have dominated. The country’s top performers have tended to be index heavyweights such as carmakers and banks, while growth areas such as technology, and smaller companies have languished, barely participating in the Japanese market’s recent strength.

The scale of the outperformance has been significant. The MSCI Japan Value index has delivered an annualised return of 8.2% over the past three years*. This compares to just 2.7% for the broader MSCI Japan index*. The MSCI Japan Growth index has dropped, seeing an annualised fall of 3% over the same period*. This weakness has persisted, with the growth index trailing the value index by an astonishing 15% over the past 12 months*.

This has also been reflected in fund performance. Value managers dominate the top of the performance tables, while many previously top-performing, but growth-orientated, managers have struggled, including Baillie Gifford Japanese, Comgest Growth Japan, and AXA Framlington Japan.

Just as investors are now asking whether the elastic has stretched too far for growth stocks in many other markets, they are also asking the opposite question in Japan. Is there now significant opportunity in the ‘growth’ parts of the Japanese market?

Value or growth?

The strength of value companies in Japan has had a number of drivers. The first is the weak yen. This has favoured exporters, such as carmakers, and consumer electronics groups, which are big index constituents. Also, new entrants to the Japanese market have tended to gravitate to the index rather than looking at smaller or more complex parts of the market. Warren Buffet, for example, whose renewed interest in Japan has helped galvanise the market, took exposure through a number of large trading companies**.

The Japanese banks have benefited from a slow change in monetary policy from the Bank of Japan (BoJ). After years of negative interest rates and quantitative easing, in March, the bank raised its interest-rate target for the first time since 2007. Admittedly, it only rose to between zero and 0.1%*** and the BoJ said policy would remain accommodative, but it also committed to abolishing its yield-curve-control framework, a tool to cap long-term bond yields.

However, these factors are unlikely to persist and, increasingly, value companies look less compelling on price. While they always trade at a discount to growth stocks, that discount has narrowed significantly in recent history****. Areas such as smaller companies now appear to offer lower valuations and higher growth, which should be a winning combination.

Carl Vine, fund manager on M&G Japan says: “We have a lot of small-cap companies and a lot of them have got coverage of zero [from analysts]. And so, in the large caps, we have to do really clever things, like, find out when the consensus is using the wrong logic for Honda’s earnings. In the small caps, you have to be no more clever than being the only one looking.”

That said, Carl looks to ensure that there isn’t too much style risk in the portfolio. He adds: “I don’t want to have conversations with the clients where I say, “Sorry, tough year, quality wasn’t good this year.” Equally, he sees mispricing across the market, not just in growth stocks: “We see mispricings in growth, in quality, in value, and then we see mispricings around change. We’re seeing a lot of it around change at the moment, because there is so much change.” This means that alongside small and mid cap companies, he is still holding the automakers, for example, which have struggled with supply chain disruption and the move to electric vehicles, but have a brighter outlook from here.

The team on the Baillie Gifford Japan Trust is more focused on the most obvious growth parts of the market including digitisation, AI and smaller companies. Manager Matthew Brett believes this is the more exciting part of the market, and valuations are compelling: “In many cases Japan is coming from a place that’s not as advanced as in the West. We’ve got companies at an earlier stage of development. In the internet area, a couple of the companies we’re really excited about at the moment include GA Technologies, which does online real estate sales and also bengoshi.com, which is a forum for lawyers…We believe they’ve got good competitive positions and a lot of growth ahead of them.”

Within the Baillie Gifford stable, the Shin Nippon Trust is perhaps the most extreme version of this growth strategy. It focuses on high growth smaller companies and is currently trading at a 13% discount to net asset value^^, reflecting the weakness of this part of the market.

There could well be a change of market leadership in Japan, particularly if the domestic economy improves, and if the yen strengthens against the Dollar. Should this happen, investors may start to look at some of the unloved parts of the Japanese market afresh.

*Source: MSCI index factsheet, 28 June 2024

**Source: The Japan Times, 25 February 2024

***Source: The Economist, 19 March 2024

****Source: Jupiter, 14 November 2023

^Source: fund factsheet, 31 May 2024

^^Source: AIC, 8 July 2024