So what went wrong? In effect, many Japanese long/short equity hedge funds hadheavy exposure to small cap stocks and were underweight large caps – this strategy was very effective for the period of 2001 – 2006 Q1 until the indices started to reverse. As a consequence of smaller so-called growth or internet stocks suddenly underperforming, triggered by the insider trading incidents surrounding the LiveDoor company, many hedge funds in Japan suffered. Indeed one of the largest, the famous Murakami fund, had to be wound down.
The turmoil in small companies has continued to be marked and the Mothers index which is comprised predominantly of internet stocks has now fallen 19% in local currency terms ytd, following a 56% fall in 2006. A series of very disappointing quarterly earnings results and recurring issues of dubious accounting practices have not helped the smaller companies. TOPIX on the other hand, rose 2% in 2006 – while this may seem paltry by global standards, it is easy to forget that the index rose 44% in 2005 and was almost certainly the best performing developed market in that year. In 2007 so far the TOPIX has moved respectably in line with the rest of the developed markets (See Fig.1).
It is our contention that there are five long running key themes in Japanese equities – themes which were established in the spring of 2003 when the bear market ended and which will probably continue until the end of this decade. We believe that the successful alpha generating Japanese long/short equity hedge funds will be those that recognise these themes and stock pick their way accordingly. The first and perhaps most important theme because it basically ended the bear market, reflation, is especially relevant to Japan due to the prevailing extremely low level of interest rates (See Fig.2).
It can be argued that Japan is the only stock market which will actually benefit from higher interest rates because the problem in Japan since the mid-nineties (in addition to the banking crisis) has been the problem of deflation. In our view Japanese bank share prices, which are the most emblematic of the reflation theme, having languished for many months are now due for another period of outperformance. This is because Bank of Japan governor Fukui looks ready to raise rates possibly even before the elections, at the very latest immediately after in July (See Figs 3 and 4).
The second key theme is Asian growth, represented clearly by the cyclical stocks in Japan. Many including the Japanese themselves, had initially viewed the rise of China as a negative for Japan because the Japanese would be unable to compete with such cheap labour. In fact China has become a major trading partner for the Japanese and a linchpin in the Asian economic growth cycle. We feel the exceptionally lowly valued Japanese trading companies in particular, will continue to enjoy further significant profit growth thanks to the insatiable demand of the Chinese for energy and raw materials. The Chinese stock market may yet see a correction – possibly even a collapse at some point – which would certainly drag down the cyclical stocks in Japan, but we would view this as short term in nature and therefore a buying opportunity.
The third important theme is recovering Japanese property prices; in central Tokyo these only bottomed around 200203 and rents are still languishing well below historical high levels. Not only is Japan far behind the property cycle in comparison to the rest of the developed world, but the success of the Japanese REIT market has now injected liquidity and a much needed transparency that was lacking when the property market went sour in the late eighties. While some of this good news is already discounted in real estate shares and rising interest rates will not be taken as a positive in the short term, the outlook for the next few years remains very favourable for this part of the Japanese equity market (See Fig.5).
The fourth key theme is the search for yield. It is the theme which links the reflation story in Japan with the recovery in the Japanese property market as well as the fifth and potentially most exciting theme of M&A in Japan. It is the one positive aspect of what is probably the biggest negative for Japan (and in a decade or so China), namely demographics, as it symbolises the demand from retiring baby boomers. J-REITs are the obvious beneficiaries of this search for yield. Although the spike in Japanese government bonds could put a dampener on demand for the next few months, we believe J-REITs should not be dismissed – after all the entire market cap of the J-REITs is still less than that of Toyota, and the average yield is trading at a premium to the JGB. Higher office rents will ensure the yields go higher.
And then there is M&A. It is easy to feel downbeat about the apparent unwillingness of Japan to embrace M&A, especially if one reads the foreign press which reports more frequently on the subject of Japanese poison pills and management recalcitrance when it comes to raising dividends (See Figs 6 and 7).
We remain absolutely convinced that there will be a flood of M&A activity in Japan across all major sectors including retail, construction, financials and electronics. While we are unsure of the exact timing, it will almost certainly be sooner rather than later as pressures mount on Japanese corporate profit margins from global competition, Japanese government subsidy cuts, dividend requirements of the pension fund association of Japan, and the cost of rising interest rates. It is clear that the management of stronger Japanese companies are already well aware that higher dividends and a higher share price are the best deterrent of a hostile take over. This awareness will increase further over time. M&A will allow Japanese companies to increase market share, thereby gain control over prices and further expand profits – which will in turn bring down the valuation of the Japanese equity market, which on our estimates is trading on a PER of nearly 18x for 308 (source: Nomura) and is currently the biggest stumbling block on the upside (See Fig.8).
So who will buy into these themes? It is our contention that in the near term it will continue to be the foreign investor and to some degree the retail investor who will drive the market higher. Corporates are also buying back shares but not enough to offset Japanese institutional investors who are currently the big drag on equities and showing very little sign of reversing that trend. But there are a number of significant and large-scale privatisation events that will ensure the government and the BoJ remain 'committed' to support Japanese equity markets through to the end of the decade including the listing of Narita Airport, the Tokyo Stock Exchange, the Tokyo subway, and the Post Office. No doubt Japanese institutional investors, who have largely been inactive or net sellers, may be at last encouraged to participate as buyers when these market events unfold.