Japan: A New Dawn

Investing in this most liquid of markets

KEITH DONALDSON, PORTFOLIO MANAGER, MARTIN CURRIE

Japan is one of the world’s largest, deepest and most liquid markets. It offers an abundance of undervalued stocks: on a price-to-book basis Japan currently trades on a 40% discount to the rest of the world. For investors looking to go short, meanwhile, borrowing stock is very cheap.

In our experience, while the cost of borrowing in Europe and the US has risen over the past year, it is largely unchanged in Japan. The Japanese market, moreover, offers diversification benefits, with returns exhibiting relatively low degree of correlation with other developed markets.

Investing in Japan may be rewarding, but it is not for the fainthearted: few Japan long/short equity funds stay the course; fewer still consistently generate positive returns. The Martin Currie Japan Absolute Return Fund is one exception. Since the fund’s launch in June 2000, the Topix has fallen by 40.5%. Over the same period, our long/short stock picking approach has delivered a positive return of 72.0% or 5.9% a year. Over the pst nine years, th eTopix has fallen by an annualised average of 5.4% – Japan is not a market for index trackers.

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Given the series of disappointments that investors have suffered over the past 20 years, a lack of enthusiasm for Japan among long only investors is understandable. What is less readily explained is the hedge fund community’s indifference to Japan. The inability of some Japan-orientated funds consistently to generate alpha may have something to do with that: 32 long/short funds focused on the Japanese market closed last year, having struggled to adjust to an environment in which chasing beta no longer worked.

We believe, however, that the hedge fund industry’s ongoing neglect of Japan is unjustified. In fact, for long/short investors able to exploit predictable inefficiencies, this large, liquid market represents an outstanding opportunity set.

When a shock is not a shock: exploiting market inefficiencies
From time to time, everyone makes mistakes – even fund managers. When analysts make mistakes, however, they create market inefficiencies. And when those inefficiencies become predictable, they can be exploited. I’ve been following the Japanese market since 1988, both as a sell-side analyst and more recently on the buy-side. Over those 21 years, I’ve seen the same mistakes being made, year in, year out.

In part, those mistakes arise from the way in which analysts in Japan form their earnings forecasts. In most other markets, analysts build financial models and arrive at their own best guess of a company’s likely future earnings. Companies’ investor-relations departments then manage those expectations, guiding forecasts higher or lower. As a system, it’s far from perfect, but it does generate a healthy diversity of opinion.

But – as in so many things – Japan is different. There, companies issue detailed earnings expectations via the Tokyo Stock Exchange. They also set out the assumptions behind those expectations with regard to factors such as input costs, currency markets and interest rates. Convinced, perhaps, by this mass of detail, analysts’ earnings expectations tend to cluster around these official forecasts.

This is a classic example of what behavioural economists describe as anchoring: a bullish analyst might take the company’s earnings guidance and add 10%, while a more bearish analyst would tend to start with the company’s numbers and knock 10% off. The views may differ, but the departure point is always the same. The result is predictable: earnings forecasts tend to crowd around the official guidance given by companies. This narrow dispersion creates the potential for earnings shocks.

Opportunities also arise from the tendency of Japanese analysts consistently to underestimate the impact and importance of operational gearing. When output rises, fixed costs can be covered much more easily, thereby giving a dramatic boost to margins. The reverse, of course, is also true. But that relatively simple concept is rarely applied correctly. Whenever things are improving, analysts are usually too slow in revising their earnings forecasts higher. Conversely, when conditions are deteriorating, they underestimate how far margins will fall. For long/short investors alert to this pattern, and with the necessary independence of mind, this leads to opportunities.

The margin cycle in action
In recognition of the opportunities that these inefficiencies create, margin-cycle analysis has been at the core of our investment process since we launched our fund.

Martin Currie’s proprietary margin analysis and sector screening tool, MASS, looks at historic operating profit margins across the Japanese market and compares recent margin trends with those in previous periods, allowing us to see where margins are improving. In a market in which correctly identifying where we are in the business cycle is vitally important, MASS can be an excellent early indicator of positive or negative change.

The enduring importance of the business cycle was underlined last year. In the last few months of 2008, Japanese industrial output plunged as financial markets seized up and confidence evaporated. Because around 60% of the Japanese economy rests on manufacturing, the impact on earnings was catastrophic. Analysts in Japan revised down their earnings forecasts. Predictably, however, those forecasts remained tethered to official guidance. As a result, the consensus wildly underestimated how far and how quickly earnings would fall. This provided us with profitable opportunities to go short.

Similarly, as 2009 has progressed and confidence has recovered, depleted inventories have had to be rebuilt, leading to a sharp rebound in activity across the manufacturing sector. Once again, however, analysts are behind the curve, having underestimated the impact of cost-cutting and the positive effect of operational gearing. At the time of writing, consensus earnings estimates for large parts of the Japanese market appear far too low. This presents opportunistic investors with an excellent chance to go long of very cheap shares that are heavily geared into the global recovery (see Fig.1).

A new era for Japan; new opportunities for investors
At Martin Currie, we’re upbeat on the prospects for Japan. From here, even long-only investors can generate excellent returns in this cheap, liquid market. With many Japanese companies trading at below book value, investors have an opportunity to build stakes in leading global businesses that are free of the debt that weigh on their Western peers. Furthermore, the recent electoral victory of the Democratic Party of Japan, or DPJ, not only drew a line under 50 years of almost uninterrupted Liberal Democratic Party rule, but also heralded a new economic era for this industrial and financial superpower. The DPJ promises pro-growth policies. Its main aim is to increase the disposable income of Japanese households and thereby encourage consumption. In pursuit of these goals, they will abolish road tolls, scrap petrol taxes and increase childcare allowances.

The last of these measures could prove to be of greatest long-term significance. In theory, it should encourage the birth rate to rise, thereby addressing Japan’s single biggest problem – its rapidly ageing population. If persuading the Japanese populace to reproduce proves to be the DPJ’s only achievement, then the long wait for new leadership will have been worthwhile.

But even if the DPJ’s reforms flop and overall market direction disappoints, we believe our stock picking process leaves us well placed to continue generating returns on both the short and the long side. The Martin Currie Japan Abolute Return Fund has a strong record of generating alpha in both bull and bear markets. Its best years were 2003 and 2005, when the market generated a positive return. But it also produced positive returns in 2000, 2001, 2002, 2007 and 2008 – all years in which the Topix fell.

Japan is not a market for the fainthearted. But for investors who can stand apart from the analyst herd and focus on the margin cycle, its potential is vast.

CASE STUDY: THE TOYOTA ‘SHOCK’
Last November, Toyota, a paragon among Japanese manufacturers, said that it expected a stronger yen, higher input prices and falling demand to lead to a 74% drop in net profits—an incident that the Japanese media dubbed the “Toyota shock”. To investors who focus on operational gearing, however, this wasn’t a shock at all, but an inefficiency to be exploited.

In many respects, Toyota is a model company and an example to bloated, inefficient US carmakers. But even the most efficient car maker can’t entirely buck a recession, much less a severe global downturn. We could see US demand for cars plummeting as the oil price spiked and the housing market crumbled. Fully understanding the impact that a sharp fall in demand would have on profits, we went short of Toyota. Japanese analysts, however, remained relentlessly bullish. Even as the crisis unfolded they believed Toyota would prosper as its range of fuel-efficient cars seized market share from US gas guzzlers. Earnings expectations remained far too high and, despite the severe demand recession, it remained a consensus buy among Japanese analysts.

Toyota duly fell by 38% in the fourth quarter of last year. Once the market had discounted the “shock”, we closed our position and took our profits. And, in anticipation of margins recovering as output rose from depressed levels, we moved to a long position. And so the cycle turns…

Keith Donaldson is the co-manager of the Martin Currie Japan Absolute Return Fund with John-Paul Temperley. He has more than 30 years of experience ein the industry and joined Martin currie’s Japan team early in 1997. He also co-manages a number of Japan funds including core and alpha.