Early last week it looked as if our long-held views on Japan were finally starting to make sense to other people too. A note from the Himeji Fund in January summed up a new wave of positive thinking. "Industrial production is rising, corporate earnings are on a strong uptrend, and businesses are beginning to indulge in M&A and share buy-backs. This is indeed the right time in the cycle for Japan."
It went on to praise the "genuinely impressive" sales and profit numbers being churned out by Japan's firms "no mean feat, given the strength of the yen." Add in a bit of inflation as a catalyst, said Himeji, and the market "could easily move 20%-30% higher over the next 12 months." The managers of this hedge fund are worth listening to: over the ten years to January they made 92% even as the Topix index lost 45%.
Others agreed. The March Merrill Lynch survey on fund manager weightings was published this week and shows that last week when the data were collected pre-earthquake Japan was the world's second-most favoured equity market after the US. Some of our recent tips had also begun to come good: by the end of last month, the Baillie Gifford Shin Nippon investment trust had risen by more than 35% in six months.
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So much for that. By Tuesday, Japan had suffered a devastating earthquake followed by a tsunami and then a terrifying nuclear alert. The Japanese market had fallen a shocking 17%, making it the biggest two-day drop ever. It rebounded over 5% on Wednesday, but by the end of the day remained 14% down for the month. So what next? Is this a rational reaction to an unclear level of threat or just panic? Probably both. It may be a panic, but given the uncertainty surrounding the nuclear situation and the full extent of the tsunami damage, it is a rational panic. Short-term equity judgements are hard to make with a smoking reactor in the background, so it might make sense for custodians of other people's money (along with the residents of Tokyo) to take the "better safe than sorry" route. At the same time it makes sense for Japan's battered insurers to sell equities to cover their immediate claims.
Now might be the time to buy
But for those prepared to take a deep breath and peer further into the future, now might be one of the best times ever to buy into Japan. Look at the numbers gathered so far on the possible financial costs. According to Goldman Sachs, the damage comes to about $198bn. That's 1.6 times the bill for the 1995 Hanshin earthquake in Kobe. Should the sum be roughly correct, it would represent 4% of GDP and less than 1% of total national wealth. So the fact that the stockmarket has now lost $610bn or the equivalent of 12% of GDP since Friday, as the FT's Martin Wolf points out, suggests something of "an overreaction". The BBC had a "Japan expert" on a few days ago who said we are seeing "the destruction of the world's third largest economy". We aren't. Hideous humanitarian crisis? Yes. Total destruction of the economy? No.
That's not to say there aren't major economic worries. There is the fiscal situation, something Simon Caufield discusses here: Japanese government bonds: could this be the best trade ever? But that needn't necessarily be an issue for equity investors, and a fiscal crisis may still be some years off anyway. The worst earthquake in over 100 years could also offer some impetus to get the government debt side of things sorted out, by printing money to cover it if nothing else. When I contacted one of my oldest investment banker friends in Tokyo this week, he told me that the one thing he hoped for was that the new sense of urgency would stop the government constantly kicking the can of its problems down the road. It could, says another Japan bull, be "the acute, if horribly tragic, crisis that has been needed to galvanise proper Japanese reflation".
The other big worry, next to ongoing power cuts, is the supply chain. How much has that been damaged? The answer is not as much as in 1995. Tohoku isn't a major industrial area. Only 3% of GDP is centered in the area against 12% in Kobe. So it isn't clear that much industrial capacity has been taken out of action. It also isn't clear that a reduction in capacity much matters for stockmarkets at least. As Charles Dumas of Lombard Street points out, Japanese factories were much underused before the crisis: manufacturing capacity utilisation in January was 7.5% below the 1974-2007 average.
Construction activity has also been weak. It is far from ideal that companies and the government will now have to spend to replace destroyed wealth. It is also worth noting that the loss of real assets and wealth when this kind of thing happens is not picked up in GDP. The way it is measured means that initially the numbers reflect the disruption to production caused by destruction, but not the actual destruction itself. They then pick up the reconstruction spending as growth. That's why Chile's GDP fell 1.3% in the first quarter after its 2010 earthquake, but rose 4.5% the next. This can suggest that there is somehow a silver lining to disaster. For the nation as a whole there isn't. However it is true that reconstruction spending, regardless of its cause, will boost demand and profits for many companies. Construction activity isn't going to look weak for years to come. Look at it like that, says Dumas, and Tokyo Electric Power aside, "arguably stocks should have gone up" not down after the quake.
Why this time is different from Kobe
After Kobe, that isn't what happened then. Stocks fell 20% plus in the following five months. But there were two extra factors then. First, the knock-on effects from Nick Leeson's Tokyo trades and the collapse of Barings. Then there was the surge in the yen (it rose over 10% against the dollar in a couple of months). The first of these isn't an issue this time (fingers crossed) and the second probably won't be either. The yen is already very strong, and the Bank of Japan is in a notably easier mood than in the 1990s: it has every excuse to intervene in the currency market, and seems happy to do so.
However, the main point to make on Japan's stockmarket has to be that it is still cheap, very cheap. Dividend yields remain above bond yields while the market's price-to-cash-flow ratio is now around 5.5 times. It has only been that low twice before. Merrill Lynch also points out that if you look at forward p/e ratios (which use estimated earnings for the next year), things look good too. Pre-Kobe the market was on 53 times. Pre-Tohoku it was on 14 times. Then Japanese companies were "deep in the red" and dealing with weak growth. Today they are "generating huge amounts of cash flow" and operating on much higher margins.
At the same time the average price/book ratio in Japan is not much above one. Is Japan's entire listed sector really, even now, worth no more than the depreciated value of its assets? I can't really think it is.
Add it all up and if you were bullish on Japan before the disaster, all this probably makes now, as Dumas puts it, "one of those classic opportunities" to buy. It is worth remembering John Templeton's words. "Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria." Japan was beginning to knock around the skepticism stage last week, but it only takes one look at the huge volumes traded on Monday and Tuesday as the market tanked to see that the skeptics have reverted to full-on pessimism. They could stay there for some time for obvious reasons and that is one of the many things that makes this trade quite risky. The main one, obviously, is the ongoing nuclear disaster. We have no idea how bad it could get. If it replicates the unpleasant fantasies of much of the media, most of this article will be utterly irrelevant.
I asked top investment trust analyst Alan Brierley if there were any trusts he would tip for us right now. His answer? "I'm brave but not that brave." Until he gets more clarity he wouldn't "touch Japan". He may well turn to out be right. But it may also be that once we have clarity, the best bargains will be gone. I am already very invested in Japan, but those looking for new long-term exposure should consider either some of the currency-hedged fundsbelow (which will protect you, should the yen weaken fast as the Bank of Japan prints money) or the very well-run Baillie Gifford Japan Trust (LSE: BGFD). I still think that, barring nuclear meltdown, they will find that these outperform most other developed market funds over the next few years.
The funds to buy now
Three funds currently offer sterling-hedged ways to play Japan. Dalton Strategic Partners offers a sterling-hedged version of its Melchior Japan Advantage fund. Launched in 2007, the fund, along with the Topix, has not recovered to pre-crisis highs. But it has consistently outperformed its benchmark, both during the crisis and after. It is very underweight utilities and energy, which should allow it to recover more quickly from the current crisis. Contact: 020-7367 5400.
Jo Hambro Japan Fund issued an Isa-eligible sterling-hedged version in April 2010. So far the sterling-hedged shares have underperformed the benchmark, but the fund has beaten the index over five years. Manager Scott McGlashan has specialised in the Japanese stockmarket since 1982. He focuses on small and medium-sized Japanese firms. With fewer analysts covering Japanese small caps, McGlashan believes that there are many undervalued opportunities. He cites Aeon Delight, a maintenance service company, as a recent example. He typically holds 40 to 60 companies, and almost 50% of the fund is invested in manufacturing, with transport and finance also taking up big chunks. Contact: 020-7747 5678.
GLG's Japan CoreAlpha fund was launched in 1999 and a sterling-hedged share class was brought out last year. The fund is down 20% since 1999, compared to a 40% fall in its benchmark. A shorter perspective is kinder to the fund it is up 25% in the last five years. Manager Neil Edwards may regret buying Tokyo Electric Power in January, but he is underweight the sector in general, and focuses on banks and ICT. Contact: 020-7016 7000.
