Merryn Somerset Webb talks to fund manager Simon Somerville about investing in Japan, and why things are getting better and better for shareholders.
• If you missed any of Merryn’s past interviews, you can see them all here.
Merryn: Hi, I’m Merryn Somerset Webb, editor-in-chief of MoneyWeek magazine. Welcome to another one of our video interviews. Here with me today is Simon Somerville, the manager of the Jupiter Japan Income Fund. Also, I will tell you that Simon and I sit on a board together at Baillie Gifford Shin Nippon – which, as many readers will know, is an investment trust that invests in Japanese smaller companies – so we have that in common, so we talk relatively regularly about the Japanese market. Now, Simon, the most interesting thing about Japan at the moment, and one of the things that makes the Japanese market, possibly, even more interesting than it’s been for a few years, is some major corporate governance changes that have been happening there, right?
Simon: Yes, I guess the Western world is more used to it, we’ve had big corporate governance changes, and Japan has lagged the rest of the world. What we’ve seen over the last 12 months is some really significant changes driven down by the government.
Merryn: So when we say Japan’s lagged, what has Japan not done that we have done, in the corporate governance sense?
Simon: I think the most simple way of thinking of it is that a lot of companies in Japan have not, historically, been run for shareholders, and…
Merryn: Right. So they’ve been run for who?
Simon: Stakeholders – stakeholders being the employees, being the suppliers – and shareholders really have come further down the agenda.
Merryn: And that’s something that’s been driven by the state or by management itself, that feels a duty to their employees and to their suppliers and to their part in the economy and society, more than they feel a duty to shareholders?
Simon: It is quite complicated, but a simple way of looking at it is that big shareholders in Japanese companies are domestic institutions – these are Japanese institutions, live companies, pension companies – and in the past, they haven’t really exercised their right to vote, or when they have voted, they voted in the favour of the management. So management, therefore, don’t have…
Merryn: And not to keep digging, but they’ve done that why, out of pure passivity, lack of interest?
Simon: Lack of interest, no incentive.
Merryn: No need for themselves to drive good returns?
Simon: They didn’t really have that as a driver. In the UK, we have a code called the stewardship code, which is a code that applies to institutional investors – so pension funds, live companies – that they have to act of stewards of those… of those people’s money, and that requires them to vote, requires them to engage with companies, things like environmental policy, independent director’s policies, and in Japan, Japan didn’t have a stewardship code. Japan’s now got a stewardship code, and essentially what that has forced is these institutional investors to begin to engage with companies, these domestic institutional investors.
Merryn: OK. And this is a legal code put in place by the authorities?
Simon: By the authorities, correct. And it’s actually interesting…
Merryn: Not a voluntary code.
Simon: You can opt out of it, but you have to explain why you’re opting out of it.
Merryn: Embarrassing, right?
Simon: But actually, everyone is opting in, and it is based on the UK code, so actually it’s very interesting that they’ve used UK code to, sort of, apply in Japan. And there’s a good reason, Merryn, why this has happened – I think there’s a good reason – is that the pension fund in Japan, the GPIF, the government pension fund, which is a fully-funded pension scheme… all the other problems Japan’s got, Japan actually has a fully-funded pension scheme for their pensioners.
Merryn: That would seem like a miracle here, wouldn’t it?
Simon: It’s a $1.3trn fund, so this is a massive fund, and this fund, historically, has been invested in bonds. And under prime minister Abe, because of changes in interest rates and changes in returns, they’ve had to sell bonds and buy equities. So they’ve moved from about 11% equities to 24% equities.
Japan’s government has got an incentive to get better returns out of companies because their pension scheme has got such a big stake.
Merryn: And this is because they’re not getting any return at all from bonds any more, so they’ve got to find a way to get some return?
Simon: Exactly, there’s no real returns.
Merryn: So they’ve got to find a way to get some return, if they…
Simon: They’re getting negative returns on bonds, so…
Merryn: So if they want to keep this pension fund fully-funded, they’ve got to find returns.
Simon: They’ve got to take on more risk to get returns, and so they’ve been buying equities. So now, this pension scheme has basically doubled their equity allocation in Japan, and because this fund is so big, that means that they own about 9%, 10% of the stockmarket now. So 9%, 10% of the stockmarket is now invested in people’s pensions. So the government has got an incentive to get better returns out of companies because their pension scheme has got such a big stake. So putting pressure on companies or people to vote, and pressure on companies to have better corporate governance, has got to benefit the stockmarket. So when we say better corporate governance, we mean higher return on equity, that means high returns, better dividends, share buy-backs and, basically, more focus on shareholders. And that’s really what’s been driving Japan so far this year, and we think that continues into 2016.
Merryn: OK. And that’s particularly interesting for you because your fund is focused on trying to produce an income out of Japan, which is very unusual for a Japanese fund, right, because it’s been verging on the impossible to get any income out of Japanese equities for decades now.
Merryn: So it that’s what you’re trying to do, this is a…
With this change in government policy, dividends are back on the agenda
Simon: Yes, the core of our process, of how we run the money, is cash-flow driven. So for 25 years I’ve done Japan – very sad, I know, doing it for 25 years, but I’ve done it for 25 years – is follow the cash and to analyse companies on cash flow. And it’s companies that have cash flow that can produce dividends, and so when I joined Jupiter, nearly 11 years ago, the same processes I used previously but dividends had started to rise in Japan and dividend culture began to emerge. And then, the global financial crisis happened, Lehmans happened, the earthquake happened in Japan, and dividends kind of got put on the side-burner. But now, with this change in government policy, dividends are now back on the agenda.
Merryn: And Japanese companies are sitting on vast amounts of cash, aren’t they?
Simon: They’re very, very highly cashed up, so there’s pressure from shareholders. Foreigners have always pressurised Japanese companies to pay higher dividends, but domestic investors have been more reticent. Now, they’re beginning to engage with investors and say, higher dividends.
Merryn: Might there be special dividends?
Simon: There might be special dividends; more likely to be share buy-backs because what we’re beginning to see, which is really encouraging, is the unwinding of the famous cross-shareholding.
Merryn: Explain that for us.
Simon: OK, so what happened in Japan, and this goes right back to post the Pacific War, the Second World War, is that companies, to grow, used almost their suppliers to help them grow, so they financed their growth by selling shares to suppliers or to customers, and that’s how the businesses grew. So these huge cross-shareholdings began to emerge, which again protected companies in Japan, and with…
Merryn: Because their main shareholders were their friends, basically?
Simon: Friends, yes, and they were not going to vote for change. What we’re seeing with this corporate governance change is that there’s more pressure on these cross-shareholders. So, the biggest cross-shareholdings are the banks in Japan, they own…
Merryn: Holding shares in each other?
Simon: No, they own shares in their customers. So Mitsubishi Bank will own shares in Toyota, for example. And they own about 5% of the stockmarket. All the three major banks have now essentially promised they are going to reduce their cross-shareholdings by 50% over the next five years, so 10% per annum.
Merryn: And that would be a downward pressure on the stockmarket, if a buy-back…
Simon: The good companies can buy back their shares, so if Mitsubishi wanted to sell shares in Toyota, we would expect Toyota to announce they’re buying back those shares, and hopefully cancel them, and that’s a sort of win-win for investors because you get high return on equities on both sides, there are fewer shares in issue, it’s good news. So for these very high cashed-up companies you mentioned, you know, this change is really exciting.
Merryn: OK, so what kind of companies are you investing in at the moment? Where do see this really making a difference?
Simon: Our policy this year has been very domestic – actually, we tend to be generally very domestic – and the reason for that is it comes back to this cash-flow story really. The companies that have the best cash flow tend to be domestic names in Japan. They’re slightly protected by the fact they’re an island nation, you know, that there isn’t… you don’t have, you know, Google, for example, or Amazon, such strong competitors in Japan, you know, they are going to be more domestic names. So our focus is mainly domestic, and when we go into overseas names, they would tend to be…
Merryn: When you mean… when you say overseas, you mean exporters?
Simon: Yes. These days less exporters, actually. They tend to have overseas bases. So Toyota has huge production in the US. But when we go into overseas names, names that are exposed globally, we tend to be going into names that are exposed to the US, just because the US economy looks better than everywhere else at the moment. Asia and China doesn’t look that great.
I am a believer in Abenomics. Some of the reforms he’s pushed through have been incredibly positive for Japan.
Merryn: But the Japanese economy doesn’t look that bad, does it? I mean, you’re a believer in Abenomics, I think.
Simon: I’m not a great believer in the economy. You always have to start with a policy in Japan but don’t expect too much from the economy. You know, they’ve got terrible demographics, an ageing population, a shrinking population, so, kind of, baseline growth in Japan is 1% at best. You’ll get some years better, some years worse, averaging at about 1%.
Merryn: But growth per capita a bit higher. So if you compare growth per capita in Japan with growth per capita in other countries, it really looks just fine, doesn’t it?
Simon: Yes, correct, it does look good. Its overall GDP numbers.
Merryn: Its overall GDP growth…
Simon: I don’t look at anyone’s GDP numbers, Japan’s are bad as China’s sometimes. They’re not real reflections of what’s going on. So not so much about the economy, but I am a believer in Abenomics. Some of the reforms he’s pushed through have been incredibly positive for Japan.
Merryn: What sort of thing?
Simon: A lot of deregulation, so, you know, simple things like he’s eased the visa restrictions for tourists coming into Japan.
Merryn: And tourism is booming in Japan, isn’t it? The Chinese can’t get enough of it.
Simon: China tourist numbers in Japan are growing at about 100% per annum. In fact, they’re a bit more, I think. And they’re spending a lot of money.
Merryn: We were talking about this the other day.
Simon: They’re spending loads.
Merryn: Yes, you were telling me, the other day, the kind of things they’re buying.
Simon: They’re buying necessities; they’re buying nappies, they’re buying condoms, they’re buying cosmetics, they’re buying rice cookers, they’re buying Casio watches. It’s…
Merryn: And this is because they really trust Japanese brands and they trust that if they buy them in Japan, they’re the real thing.
The great news about Japan, which doesn’t apply to most other markets in the world, is that earnings are going up.
Simon: It’s that second point that’s much more important, it’s the provenance of where they’re buying it. If you go and buy a Casio watch in China, even if you go to a Casio shop, you’re not 100% certain, whereas if you buy a Casio watch in Japan, it’s packaged up in the box and everything. When you go back to China and give that as a gift, everyone knows, one, you’ve been to Japan – nice status symbol, you’ve been to Japan – and secondly, everyone knows that this is the real thing.
Merryn: The other thing you were telling me, that I think readers will find quite amusing, is that when the Chinese arrive in Japan to shop, they don’t actually do the shopping themselves.
Simon: There is now concierge services, you hand over your shopping list. And they almost all have the same shopping list. You see them coming into the hotels and they’ve got bags of cosmetics, rice cookers, nappies. I mean, it’s hysterical.
Merryn: Now, the rice cookers – that’s interesting. Why rice cookers?
Simon: Well, obviously they like rice. Rice cookers are extraordinary things. I have a rice cooker at home, I’ve had it for years and it’s great. I can’t believe I spent very much money on it. You can now buy rice cookers in Japan that cost hundreds and hundreds of pounds because they make the best fluffy rice, whatever time of rice that they like. So, you know, a rice cooker could cost £600, £700, and of course the Chinese love this. They take it back and this is something that no one’s got in China. So yes, it is interesting what they buy.
Merryn: Have you invested in the person who makes these rice cookers?
Simon: Unfortunately not, no. I’ve been to see them, and it’s a really interesting company. It was a bit too small when I first looked at it. It’s now a lot bigger because it’s been growing.
Merryn: Now it’s too big and too expensive?
Simon: It’s just too expensive now. But we’ll keep on looking at it.
Merryn: What are valuations like in Japan? What metrics do you use when you look at Japanese companies?
Simon: The measure I’ve tended to use in the past, and again I don’t want to be too complicated about it, but it’s looking at the return on equity, which is the return you’re getting on that business, against the price you’re paying for it, so we use price-to-book, which is basically what price to the value of that business are you paying? Japan, historically, has always been very cheap on price-to-book.
Japan has no oil or commodity earnings, so the oil price falling is a positive for Japan
Merryn: Yes, and expensive on PE [price/earnings]
Simon: Well, it was expensive on PE, but it was cheap on price-to-book. But it was cheap on price-to-book because returns were so low, so you were getting really low returns so you don’t want to pay a premium for those returns. And what we’ve seen, under Abenomics, is those returns go from somewhere around 6%, 7% to more like 9% now, and continually going to the right. And so as you go that way, you would tend to pay a higher price-to-book. So people are paying a higher price for those returns. On PE, Japan looks a fair value at the moment, at around about 14 times earnings, in terms of prospective earnings. The great news about Japan, which doesn’t apply to most other markets in the world, is that earnings are going up. So we’re still seeing…
Merryn: It’s interesting, isn’t it, earnings are stalling or going down almost everywhere else; in Japan, they’re rising.
Simon: There’s one very good reason for that. Japan has no oil or commodity earnings, so the oil price falling is a positive for Japan, whereas obviously in the UK, you’ve got all the oil majors, and in the US you’ve got big oil companies, so the oil price falling is really hurting the whole earnings for that stockmarket.
Merryn: But for Japan, it’s a pure positive.
Simon: It is a positive. So oil price is adding something like, I think, about 4% to earnings this year, just on its own. Commodities and oil price coming down, the yen being weak is adding to earnings, they’re cutting taxes, that’s another one of Abe’s deregulations, cutting corporate tax – very similar to George Osborne in terms of…
Merryn: And corporate tax has been very high in Japan, hasn’t it?
Simon: Very high.
Merryn: So high that everyone’s just avoided it.
Simon: Yes. It’s not a great place to do business because corporate tax is so high. It’s more difficult to avoid, obviously…
Merryn: So where’s it coming down to? Will it meet Western levels at any point?
Simon: Their target is 30% next year, below 30% next year, and they keep on talking it down further, so I think you will continue to see about 1% coming off every year, going forward. And it’s a win-win…
Merryn: And again, that’s great for shareholders.
Simon: It’s a win-win, now. because, one, it’s great for shareholders; two, there’s less incentive for companies to avoid paying tax, they’re getting rid of some of the loopholes, so that’s great, so actually tax revenue doesn’t necessarily fall too far, but, you know, the good companies, particularly I mentioned domestic, the domestic names get the biggest benefit of this tax coming down.
Merryn: You sound, overall, incredibly positive on the Japanese market. Is next year going to be a good year for Japanese stocks?
Simon: Yes and…
Merryn: The right answer is yes!
The problem Japan has is it’s still exposed to the global economy, to China and Asia, Offsetting that, which is much more important, is this corporate governance story
Simon: Yes and no. The problem Japan has is it’s still exposed to the global economy, and its biggest expose is to China and Asia, and those economies are slowing, and so that is going to hurt the Japanese economy, it’s going to hurt some Japanese stocks. However, I think offsetting that, which is much more important to me, is this corporate governance story. They will continue to drive through, we’ll see more and more companies becoming more shareholder-friendly, and I think that’s where we’re going to make the big money over 2016. So I think 2016 will be another good year. Certainly relative to the rest of the world, it will be a very good year for Japan.
Merryn: OK. Tell us your favourite stock in Japan at the moment.
Simon: I think a favourite company for me, and it’s one we’ve owned for a bit, is a small company. It’s not as cheap as it was because it’s done quite well, but to me it just shows what can happen in Japan. It’s a company called Nomura, but it’s not Nomura the broker or the investment bank that we know. It’s got the same name but it’s a very different company. They’re a design company and what they do is design stores, exhibitions, offices a little bit, hotels. And to me, it’s a really neat business because Japan is upgrading a lot of what it’s doing at the moment, and particularly with tourism picking up, stores have to make themselves more attractive for tourists.
Merryn: Yes, a lot of Japanese hotels need a little upgrading, right?
Simon: And hotels, particularly, to attract the tourist. And then, what we’re seeing, with the Olympics coming along, is a lot of new hotels being built. So my favourite hotel has just been knocked down and is being rebuilt, which is a great hotel called the Okura. It’s going to be rebuilt by 2019. I recommend staying there when it gets rebuilt, but…
Merryn: Sad the old one’s gone, though.
Simon: Yes, it was a good old hotel. But of course, Nomura’s going to get their business, to upgrade, you know, to do design work for this hotel. It’s a great little business and it’s just growing like a week at the moment because of these new contracts based around tourism, based around Japan upgrading itself and based around the Olympics. So I think it continues to be a really exciting company to, sort of, play the improvement of Japan.
Merryn: Brilliant. Thank you very much, Simon Somerville.
Simon: Thank you very much.