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Despite the uncertain global macro environment, Japanese stocks have tested new multi-decade highs as the economy has shown resilience post- Covid reopening. Against this backdrop, Nicholas Price, portfolio manager of Fidelity Japan Trust, outlines why he believes now is the time to buy the transformation that’s currently underway in Japan and highlights the key areas of investment opportunity.
Japanese stocks have seen a resurgence so far in 2023, with investors encouraged by a steady stream of corporate governance related developments, spurred by reform measures from the Tokyo Stock Exchange, and improving earnings revision momentum. The Bank of Japan’s dovish policy stance and a weaker yen have also supported the positive trend in the equity market.
From a macro perspective, due the reopening of Japan’s economy and the return of inbound tourism, which started much later than in other countries, the recovery momentum in the domestic economy has been quite strong. Real GDP growth was over 4.8% on an annualised basis in Q2, with nominal GDP expanding by 11.4% annualised. Some moderation in activity is inevitable, but Japan is still on course for the strongest growth since the early 1990s.
An improving landscape for investors
While this favourable environment has undoubtedly helped investors sit up and take notice of Japan this year, the quiet but steady transformation in the corporate landscape has been many years in the making. There are many drivers for this shift: regulatory reforms, corporate innovation, a stronger economy and a bigger focus on capital efficiency. But it all adds up to a better landscape for investors.
Notably, reform efforts to boost capital efficiency in Japan’s stock market have gained traction. From the first quarter of this year, the Tokyo Stock Exchange required most listed firms, especially those trading below book value, to “properly identify” their cost and efficiency of capital. We are optimistic that this initiative - aimed at Japanese companies’ tendency to de-prioritise cost of equity and returns on invested capital - will foster a change in corporate mentality and create value for shareholders.
Moreover, in recent years Japanese companies have been returning more capital to shareholders than ever. In the last fiscal year, TOPIX companies carried out record levels of share buybacks, while at the same time paying out the biggest amount of total dividends to date. At the same time, shares in Japanese companies continue to look attractively priced on a relative valuation basis, especially when compared with the US equity market, for example.
Pockets of the market offer mis-priced growth
Given these positive factors, Fidelity Japan Trust PLC remains focused on analysis, which focuses on individual companies’ fundamentals, and identifying where the market is mis-pricing or underestimating future growth. In particular, we would highlight the mid/small-cap growth space - an often-overlooked segment - that is currently trading on cheap valuations.
Stock selection has recently resulted in an increase in our active exposure to the electric appliances sector. Electronic component makers have had to deal with a prolonged inventory correction due to a slow recovery in automobile production and weak final demand for consumer electronics. However, there are signs that demand is bottoming out and operating rates are gradually rebounding. At the company level, we have recently moved to add further to holdings in long-standing secular growth names such as Keyence (factory automation sensors) and Mitsui High-tec (motor cores for electric vehicles) following a year of quite significant underperformance in 2022.
Meanwhile, Osaka Soda is an example of an under researched small-cap stock that is transforming from a basic chemicals company to a supplier of value-added functional and healthcare materials. It is the monopoly supplier of high-grade silica gel, a high-margin purification material for diabetes drugs. As the prevalence of diabetes continues to increase globally, Osaka Soda is expanding production capacity to meet the rising demand from major pharmaceuticals companies.
We also hold consumer-related names in the retail and services sectors that will benefit from post-Covid reopening in Japan and China.
A large and diverse opportunity set
Going forward, the uncertain global macro picture is allowing us to invest in strong growth companies at very attractive valuations. Although signs of weakness in China and the risk of a US recession represent potential headwinds, the accumulation of positive domestic factors is supportive of the mid-to-long term outlook for the Japanese market.
Japan offers a uniquely large opportunity set, with around 3,500 listed companies, and a large swathe of those companies, especially in the mid/small-cap space, have little to no street coverage. Being on the ground means that we see a lot of the new ideas and business models that are coming to market first-hand. This creates opportunities for managers like Fidelity, who are willing to do the leg work and identify the most attractive investment opportunities.
We continue to search for under-researched mid/small caps and innovative companies at the pre-IPO stage as a source of differentiated returns. The portfolio will continue to be driven by the careful stock picking to identify, ahead of most other investors, the next generation of great growth companies in Japan.
Important information
The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Past performance is not a reliable indicator of future returns. Fidelity Japan Trust PLC invests more heavily than others in smaller companies, which can carry a higher risk because their share prices may be more volatile than those of larger companies and the securities are often less liquid. Changes in currency exchange rates may affect the value of investments in overseas markets. The shares in the investment trust are listed on the London Stock Exchange and their price is affected by supply and demand. This investment trust can gain additional exposure to the market, known as gearing, potentially increasing volatility. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser. Investors should note that the views expressed may no longer be current and may have already been acted upon.
The latest annual reports, key information document (KID) and factsheets can be obtained from our website at www.fidelity.co.uk/its or by calling 0800 41 41 10. The full prospectus may also be obtained from Fidelity. The Alternative Investment Fund Manager (AIFM) of Fidelity Investment Trusts is FIL Investment Services (UK) Limited. Issued by Financial Administration Services Limited, authorised and regulated by the Financial Conduct Authority. Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited.
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