Conal Gregory: A new dawn or another false dawn in land of the rising sun?

Japan is the world’s third largest economy after the US and China and has an annual GDP of 2.2 per cent with steady if unspectacular growth for the last three quarters. The governor of the Bank of Japan, Haruhiko Kuroda, says that the economy is on track for moderate expansion, largely reflecting the global trade.

The Bank is aiming for two per cent inflation and continues to stimulate monetary policy by purchasing Japanese equities through exchange traded funds.

The country has almost full employment with widespread labour shortages across several sectors. Hourly wages are actually rising faster than full-time compensation.

The election of Shinzo Abe as Prime Minister in 2012 on a platform of radical reform, dubbed ‘Abenomics’ with three arrows of aggressive monetary stimulus, fiscal reform and structural change was initially greeted with enthusiasm by investors.

It involved a massive money printing programme, which has seen the Bank of Japan swallow around 40 per cent of the entire Japanese bond market. The tactic drove down the value of the yen, thereby making Japanese exports internationally competitive.

It was the first credible attempt to tackle Japan’s structural problems in a quarter century but share prices have proved volatile in the process.

However, many savers have grown sceptical in the last two years about the success of this approach, seeing it as another false dawn for the land of the rising sun. Many think the government has become sidetracked building up its military whilst the economy has struggled to compete with China.

Recently, Abe strengthened his coalition’s position in government and has improved corporate governance with almost all companies now having at least one independent director. Surprisingly few management teams own shares in their businesses unlike their Western counterparts.

Despite the challenges, there are reasons to be positive, notably measures to boost growth through the tax system and by undertaking key infrastructure projects. With the currency having such a major impact, Darius McDermott from Chelsea Financial Services suggests savers consider a ‘hedged’ share class which means that if sterling does rise, their investments will not be negatively impacted.

Japan has the highest ratio of debt to GDP, around 230 per cent, of any major economy, warns Jonathan Jackson from adviser Patronus Partners, but notes that its stock market trades 50 per cent its bubble peak.

He says that in many respects, the country has been “the canary in the coalmine” for other developed markets who have been presented with similar challenges since the financial crisis of 2008.

He anticipates equities rising but a weaker yen which sterling savers can exploit through a currency hedged exchange traded fund, like db-x tracker MSCI Japan.

Broker Redmayne-Bentley says that Japan is largely immune from some of the global concerns with its stock market having no large energy companies and no capital expenditure dependent on oil.

“Returns to shareholders in the form of share buybacks and dividend payouts continue to rise faster than all other developed economies. All positive signals for corporate Japan,” says Oliver Tregoning from private stockbrokers J.M. Finn.

He tips Baillie Gifford Japan Trust – also favoured by McDermott – which has beaten its benchmark and peer group average over one, three, five and even 10 years.

“It is also one of the most liquid funds among Japanese closed-ended investment trust,” notes Tregoning. Its manager, Sarah Whitley, has vast experience investing in Japan and her well-defined picking process which focuses on small and medium-sized companies with exciting growth prospects continues to drive long-term performance.

Finn’s other preferred fund is the large-cap value-orientated GLG Japan CoreAlpha Fund. Manager Stephen Harker’s open-ended fund has been out of favour as value stocks have under-performed in recent years as the yen strengthened.

However, as the currency weakens, large cap holdings like motor companies should benefit. Harker adopts a contrarian style but the fund’s overweight position in financial stocks will also perform well from rising bond yields.

Equity valuations look “relatively attractive”, says Martin Payne, Leeds director of wealth manager Brewin Dolphin. He favours Coupland Cardiff Japan Income & Growth, a £321m fund with a relatively concentrated portfolio of high quality firms with the ability to grow their dividends.

It yields 3.1 per cent currently. Payne also likes Baillie Gifford Japan for its “excellent long-term returns” and ability to uncover companies that should deliver sustainable earnings growth.

“Many investors have a deeply ingrained scepticism towards Japan, built on long memories of the dramatic busting of its stock market in 1989 which was subsequently followed by a ‘lost decade’ of ailing growth and deflation,” says Jason Hollands from Tilney Bestinvest, who advise Saga clients.

The country is too frequently dismissed as a low growth economy owing to its ageing population and an overly rigid business culture with an inflexible labour market. The UN estimates Japan’s population could decline by a third by the end of the century.

Hollands says: “There are undoubtedly pockets of investment opportunities to be found in the Japanese equity market which is very under-researched by investment banks.”

He cites healthcare and technology companies which can address the needs of an ageing nation, as well as property firms with exposure to hotels for the explosive growth in tourism. Almost 20m foreigners visited Japan last year, a 47 per cent increase on 2014. Numbers are likely to rise to 40m by the time Tokyo hosts the Olympics in four years.

Japan is home to many world class companies which operate globally and are less sensitive to domestic challenges. Many hoard cash and have the capacity to raise dividends substantially.

Legg Mason IF Japan Equity which focuses on ‘New Japan’ is tipped by Hollands but for a more conservative approach, he suggests both CF Morant Wright Nippon Yield fund and the CC Japan Income & Growth Trust.

From an asset allocation perspective, “there is a strong argument to have exposure to Japan”, says Garry Ibison, Chartered Financial Planner at advisers Chase de Vere in Leeds.

He likes three funds: Schroder Tokyo for “consistent long-term returns and a very experienced manager using the extensive in-house research resources of the investment team”, HSBC Japan Index as a passive fund with a low 0.21 per cent annual charge and Baillie Gifford Japan.

Both the Baillie Gifford Japan and Legg Mason IF Japan Equity are recommended by Neil Craze, investment manager at Redmayne-Bentley. He says the latter rates itself at the higher end of the risk scale but its manager has over 40 years of experience in Japanese equities.