12 January 2012 In the first of a regular series of views from the Investec Contrarian Investment Team, Alastair Mundy,  Head of Contrarian Investments, answers 10 questions on Japanese equities

 In summary:

• We focus on out-of-favour stocks which other investors believe are going to fall even further out of favour, yet which we believe are significantly undervalued

• Japanese equities are now coming up in reasonable numbers on our ‘out-of-favour’ screen for our global portfolios

• Based on our analysis, we believe Japanese equities are cheap both relative to their history and to other international markets

• We see signs that Japan is finally changing for the better from a corporate governance perspective; cross-holdings have come down significantly, companies are showing increasing willingness to cut costs and reduce bloated staff numbers, and are increasingly demonstrating an increased focus on balance sheet efficiency

 

Q.  Japan? Not again. After 20 years of trying to call the bottom why don’t people just give up…most have

A.   To be fair, I haven’t been calling the bottom for 20 years. However, it is clear from our analysis which takes a value perspective that Japanese equities are cheap both relative to their history and to other international markets. They are also showing up in reasonable numbers on our out-of-favour screen that we run for our global portfolios.  It is true that a lot of investors have given up on Japan – and for us this shows how out of favour it is.  Coverage of Japanese stocks is generally poor (investment banks have packed up and gone home depressed). 

 

Q.  How do you know your process works in Japan?

A. To us, it is essential that we do something different from the herd. We focus on out-of-favour stocks which other investors believe are going to fall even further out of favour, yet which we believe are significantly undervalued. Countless studies have shown that cheap Japanese stocks outperform the market with this applying to a number of value metrics, and the outperformance of Japanese contrarian funds – GLG’s is an example – shows  that a contrarian, value-based approach to investing in Japan can be both successful and repeatable.

 

Q.  Ok, so it is out of favour - no arguments there. But that doesn’t guarantee profits.

A.  Absolutely not. In recent years many investors have tried calling the bottom in Japanese equities and have been burnt. That does not, however, mean it is wrong. There is a very good correlation between the starting valuation and subsequent returns in stock markets and we certainly have a low starting valuation.

 

Q.  Isn’t the Japanese economy doomed to low growth, with inherent governmental problems, a very high level of government debt and an ageing population?

A.  Well the last three are factually correct and the first point may prove to be right. However, that is probably why Japanese equities are so out of favour – none of those points are particularly new. The UK, European and US economies have quite a few problems too, but we (and others) are happy to invest there.

 

Q.  So Japan is the market for 2012?

A.  Hold on. I didn’t say that. We buy all our stocks expecting to have an average holding period of between three and five years. The Japanese equities are no different. They may well go down first even if they produce a good five year return. We view Japan as buying into a developed market at a discount to NAV. We have however hedged the currency exposure. If Japanese equities get cheaper I daresay we will find more opportunities.

 

Q.  Ok, so it’s cheap – but what’s the catalyst?

A.   Sorry, we don’t do catalysts. There is no evidence whatsoever that those catalyst-hunters perform better in the short term. If someone wants to buy a stock badly enough then it is always possible to find a catalyst: new management, potential bid, forthcoming results, the implementation of a share buy-back and so on. Once identified, the alleged catalyst seems to imbue the stock with powers so special many investors believe they need no protective equipment such as a strong balance sheet or good cash flow. Dangerously, potential negatives are brushed aside as the upcoming catalyst takes star billing. Interestingly, there is just one catalyst we have found that works well, albeit not on a time scale that is necessarily attractive to short term investors, and that is low valuations.

 

Q.  What about corporate governance?

A.  In the old days there may have been situations where cross-holdings, jobs for life and little corporate activity cropped up. But in our view things have improved and are certainly moving in the right direction. In the same way as with loss-making divisions, we can build this into our valuations, or avoid the company altogether if these risks are too high. There are also signs that Japan is finally changing for the better here; cross-holdings have come down significantly, companies are showing increasing willingness to cut costs and reduce bloated staff numbers, and are increasingly demonstrating an increased focus on balance sheet efficiency.

 

Q.  Do management teams hold on to loss makers?

Yes, a lot of them may, but we can build these losses into valuations or simply invest elsewhere. We certainly make less aggressive assumptions than we do with our UK or US companies.

 

Q. You’re hedging the currency; doesn’t this mean you’re effectively doubling up on your risk weighting to the exporters, as their profits will suffer as the yen strengthens, but you won’t benefit from this strengthening due to your hedging position?

A.  Most of our exporters have significant manufacturing operations outside of Japan, and so their profits are not as highly correlated to the strength of the yen as you might assume.  They also generally earn a significant portion of their profits domestically, which will be even less affected by the strength of the yen.

 

Q.  Why do you take a ‘contrarian’ approach?

A. We do this for four simple reasons: First, despite the fact that this approach has worked for many investors over many decades, it still remains a well-kept secret. In other words, there continue to be rewards for consistently investing in out- of-favour stocks. Second, it is scalable, and fears of detriment or dilution to the portfolio are mitigated. This is because when we are buying a stock it is very out-of-favour and hence there’s a lot of stock available; conversely when we are selling it there is great demand as it is back in favour. Third, it is hard to replicate. Despite the evidence that it is good to buy low and sell high, people still prefer to buy high and then try to sell even higher. The reason for this is that buying low is very uncomfortable. You feel very lonely. It’s a bit like eating a meal in a restaurant on your own or single-handedly clapping a referee at a football match for what you view as a good decision but which everyone else thinks is disastrous. Finally, we are emotionally suited to it. It’s part of our DNA to be more interested in buying a share as it falls in price, even (or perhaps especially) when things get tough at the bottom of the market.  Whilst past performance is just that – history – we believe that we have in place an approach that can support sustainable outperformance in the future.

 

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ENDS

Notes to Editors

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