23rd January 2013
Chesson says any recovery in Japanese equities depends on its two biggest trading partners China and the US which together account for 42 per cent of exports.
However while China’s slowdown has adversely affected Japan, the upturn in the US is encouraging.
Chesson adds: “Japan's economy had a strong start in 2012, partly supported by post-earthquake reconstruction activity and consumption, but growth then slowed quite sharply, impacted especially by the slowdown in China. China is Japan's largest trading partner, so this is unsurprising, and the lack of domestic drivers of growth in Japan as a result of deflation and lack of population growth continues to leave Japan's economy and its exporters vulnerable to changes in the global economy. The good news is that the United States, which economically speaking is almost as important as China to the Japanese, has continued to recover, especially for key industries such as car manufacturing. With the housing market in the US beginning to show signs of revival, this is encouraging news for the outlook for 2013.”
On that basis, the manager expects growth in 2013 to be about the same as 2012 but it believes that shares are priced for a much gloomier scenario and therefore offer value.
Considering the current territorial dispute over what Japan calls the Senkaku island chain, the manager suggests that trading issues should outweigh other factors demonstrated by the fortunes of Japanese camera makers which suffered a boycott but only temporarily.
“Historically, diplomatic spats between the two countries have been short lived, and in my opinion it is true that the two nations need each other. China needs Japan's technology and inward investment, and Japan needs China's growing market for both consumer and capital goods, and services. The impact of those factors is intangible, but what is clearer is that so long as the Japanese make things the Chinese want to buy, they will buy them.”
He adds: “One area of demand that was affected by the island dispute was Japanese camera sales. Canon and Nikon enjoy more than 90 per cent market share in digital SLR cameras. If the Chinese want to buy such a camera, they do not have a lot of choice other than to buy Japanese. If you make things that people want to buy and you make them competitively, then you have little to fear from politics, so long as markets are open.
“I do not know how this dispute will ultimately be resolved. Within weeks of the consumer boycotts of Japanese goods, Chinese consumers were once again returning to Japanese brands, suggesting the impact has indeed been short lived.” However the manager says it is still important to keep an eye on the dispute.
Chesson argues that the status of the Yen is also being gradually undermined.
“As we move through the economic healing process, especially in the US, and as the risk of ever more aggressive monetary policy subsides, I believe investors will begin to hate the Dollar a little less, and fall out of love with the Yen a little more. The five year high for the Yen against the dollar was back in 2011, which suggests this is already happening. A weak Yen is not a panacea for Japan but, if it proves to be a catalyst for unlocking the value from Japanese companies shares, then I welcome it.”
Chesson notes that corporate earnings have held up and are likely to show about a 5 per cent gain on average, for pre tax profits, for 2012 though this is much lower than the 20 per cent expected. However, he says with a weaker currency and new impetus on cost cutting 20 per cent should be achievable this year.
He adds: “The downside risks to this kind of profit growth seem already factored into many cyclical shares, which in our opinion do not reflect expectations of growth. If we are right about that, then we have some comfort that any earnings disappointment should not have a serious impact on cyclical stock prices, as long as the trajectory of profits is for improvement of some degree.”
However he also points out the risks.
“The problem about valuations, where Japan is concerned, is that while they look cheap, there can always be found reasons to qualify that. So for example, Japan is modestly cheap by global standards on earnings measures such as price to earnings (p/e), currently expected to be 11.5 times for 2013, compared to a global average of 12.9 times. It is also very cheap on asset measures such as price to net assets where it trades below their value, and in fact some large cyclical companies even trade on discounts to net assets of over 50%. But that can be qualified by saying that Japan has low growth, has lower returns on capital, and has deflation. My feeling is that it is just a question of degree, and a question of stock selection; even with these qualifications I think the whole market is cheap, and some shares, which we hold, are even more so.
“I have felt for the last couple of years that cyclicals in Japan factored in a very poor economic environment, poorer certainly than the one that has so far materialised. Japan's corporate profits have only had one down year since the credit crunch and that was mainly because of the earthquake and tsunami in 2011. So if you look back over the last few years Japan's post crisis experience has not been so different from the rest of the developed world, and yet it seems to have borne the brunt of fears about another global economic crisis, when in fact such a crisis continues to fail to appear.”