The past few years have been a fairly hostile period for value investing among Japanese large-caps,” reflects Robert Macrae of Arcus. Value investing rules, like buying lower price to earnings stocks, have performed best among smaller stocks, where the Arcus fund generated significant alpha. Last year it outpaced the market return of 18%, despite running beta exposure of only 50%. The fund was also relatively resilient in 2011 when the Nikkei dropped nearly 20%.
Arcus, of course, do not select their long picks solely on value criteria. Quality also counts, and Japan is so under-analysed that cheapness need not indicate low quality or slow growth. A nose for takeover targets has helped the Arcus fund, which has received bids for 11 holdings over the last two years. Japan’s fourth mobile operator, E-Access, was one; Softbank also started running the slide rule over the firm’s neglected 3G license and mounted a takeover at a 250% premium. Another case of corporate activity involved a group of low-cost housing companies. The six so-called Power Builders are joining forces in a new holding company that will soon be one of Japan’s biggest builders. The fund owned three of the six.
Purchases of subsidiaries can swiftly produce accounting profits, since many stocks trade below book value, but cheap valuations are not the only spur for mergers. Corporate culture is also changing and the old Japanese stereotype of profit margins being slaughtered on the altar of sales growth no longer applies. Cash flows that were once workhorses for debt service are now being returned to shareholders through buy-backs, dividends, takeovers and management buy-outs.
This virtuous cycle could soon be accelerated by a better macroeconomic outlook, thanks to Abenomics. New prime minister Abe is unique in recent history in seeing his popularity go up after his election increasing his chances of longevity in Japan’s fickle politics and improving his leverage in the policy battles ahead. If the drop of the yen is maintained this could do a lot to reflate the economy and help to reverse deflation, taking real interest rates negative for the first time since the bubble. Over a few yearsthat in turn should transform investor psychology as cash stashed in government bonds would no longer protect purchasing power.
Arcus’ strategist, Peter Tasker, thinks Abenomics represents the first really constructive economic policy in years. Stimulating economic activity will be good for a very wide range of Japanese companies. Exporters such as Sony or Panasonic are the most obvious winners from a lower yen expanding their profit margins but all kinds of economic sensitives and operationally geared companies could be great investments whether their focus is domestic or export-driven. Arcus are much more cautious on sectors with defensive, bond-like characteristics. For example, firms in food, pharmaceuticals and consumer non-discretionary sectors command premium valuations due to their predictable earnings. Amongst these “expensive defensive” stocks, private railways are perhaps the most over-priced and are a rich source of shorts.
Despite all of the encouraging domestic news, Japan has not yet started to outperform world markets in dollar terms. Headline Nikkei performance is of course quoted in local currency terms. Macrae contends that “either the FX market or the equity market is wrong”, as the FX move has been far too large to have such limited impact on relative earnings prospects. He also notes that value has historically done best at critical turning points when old beliefs are challenged and market leadership passes to previously disliked companies.
The Arcus Long/Short fund has advanced by 240% in 14 years, over a period when the local market lost 30% of its value. This monster bear market leaves few hedge funds in Japan and a dearth of sell-side coverage. Because investor attention remains so low Arcus continue to expect to find overlooked value.
Fund manager: Arcus Investment Limited
Portfolio manager: Robert Macrae