Fortune Rota Volvitur: Part 3

(Sep 2017) Mark's review of recent market conditions in Japan plus an assessment of the improvement in balance sheets and profitability in the corporate sector.

Preface

In February and June of 2016 we thought that the mania for “expensive defensives” and aversion to undervalued stocks such as cyclicals and financials had reached an extreme. This prompted us to write a paper about the then current state of valuations in the Japanese equity market. We argued that the valuation differentials had reached an extreme due to distorted investor preferences, but that these distortions would be repaired, with a corresponding boost to Arcus’ [1] value investment strategy.

In the second half of 2016 our strategy did indeed see a significant rebound. Arcus Zensen Fund NAV rose +22.5%, Arcus Japan Fund (‘AJF’) +30.3%, Arcus Genseki Fund +32.8% & Arcus Japan Value Fund (‘AJVF’) +27.4% (net fund performances from 1st July 2016 to 31st December 2016).

In the first half of 2017, the recovery faltered, as the dispersion of valuations widened again. Not only has the latest value/growth cycle been anti-value for over eight years to date (longer than previously seen in Japan), but the recovery has been slower than in previous recovery cycles. Arcus fund returns were correspondingly subdued (6 months to June 2017, Arcus Zensen Fund NAV fell -4.0%, Arcus Japan Fund rose +4.1%, Arcus Genseki +7.3%, Arcus Japan Value Fund rose +9.0%).

However, while the recovery faltered in 2017, before improving again in Q3 2017, the low point was most likely reached in June 2016. In Fortuna Rota Volvitur Part 2 we highlighted the relationship between the outperformance of low beta stocks and interest rates. On that basis, for the higher beta stocks that we regard as undervalued to go to greater relative discounts than seen in June 2016 would probably require interest rates in Japan to dive deep into negative territory, which seems rather implausible, given an improving outlook for the global economy. More likely is either an extension of low interest rates or the start of an uptrend. Either scenario should be favourable for our value strategy.

Finally, we look at the improvement in balance sheets and profitability of the corporate sector in Japan. Net debt of over Y350 trillion in the early 1990s has been turned into net cash of now Y50 trillion, through improved profits and strong free cash flow. Part of this cash flow is already feeding through to higher dividends and enhancing shareholder value through share buybacks. This trend is entirely consistent with the change over 25 years in the capital structure of Japanese corporations. Where Japanese corporations were beholden to banks both for debt and to related keiretsu (large Japanese business conglomerates) for the majority of their equity, now the debt has gone and the majority of shares are now held outside of the traditional keiretsu relationships. Considering that the change in governance is a natural evolution from this change in capital structure, and not a change imposed on unwilling corporates by government or adversarial shareholders, it seems likely to continue, and should favour value investors.

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[1] Arcus Investment Limited (“AIL”), Arcus Investment Asia Limited (“AIAL”) and Arcus Research Limited, Japan Branch (“ARL”) are hereafter collectively referred to as “Arcus” or the “Arcus Group”.