At one point in my chat with Simon Somerville, he looked a little embarrassed. He had just admitted to having managed Japanese equities for around 20 years. Almost an entire career.
"Bit sad isn't it?" he said. It isn't, of course. If you haven't done something for a long time, then how can you know when it changes (for the better or the worse)? Change matters in investment it isn't where a company starts, but where the market thinks it is going that drives its share price. So we start by talking about just how Japan's companies are changing.
For as long as most Japan old hands can remember, Japanese companies have been run more in the interests of stakeholders (employers, suppliers and the like) than those of shareholders and there has been no obvious reason for that to change (the main shareholders in Japanese companies being other Japanese companies). The result? Japan has long "lagged the rest of the world" when it comes to corporate governance. That's meant that companies have paid little attention to the financial metrics that Western investors obsess over and they've paid very little attention indeed to their dividends .
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However, "over the last 12 months we have seen really significant changes driven by the government". Japan now has a stewardship code rather like the one we have in the UK that forces institutional investors to act as proper stewards of their investors' money and so to engage with companies to push for better performance. It's a voluntary code. You can opt out of it. But if you do, you have to explain why you're doing so. That's embarrassing.So no one does.
Making Japanese companies better
So what's prompted this? Pension money. Japan has its financial problems. But it also has the one thing the rest of us are desperate for: a fully funded public pension scheme backed by a fund (the GPIF) worth an impressive $1.1trn or so. This fund has recently changed its focus: thanks to the complete lack of real returns on offer in the bond market, it is moving out of bonds and doubling its holdings of domestic equities (from 11% to more like 24%). The GPIF now owns some 9%-10% of the total Japanese stockmarket.
That means the government now has a very strong incentive to push for better corporate governance so a "higher return on equity that means high returns, better dividends, share buy-backs and, basically, more focus on shareholders". That's what drove the Japanese market in 2015 and what Somerville thinks will drive it into 2016.
Does he think it really means that we will see rises in dividend payments from Japan's big firms? Yes. Dividends had started to rise in the few years before the financial crisis. They then got "put on the back burner". But "with this change in government policy, eyes are back on the dividend". And Japanese companies are "very, very highly cashed up". They can afford to pay higher dividends and to buy back their own shares from the other companies that hold them often the banks that financed their original expansions in the post-war period.
So at the moment, for example, Mitsubishi Bank owns a huge number of shares in Toyota shares it quite wants to sell (the three major banks in Japan have committed to selling down their market stakes by 50% in the next five years). If Toyota could buy them back and cancel them, you have a "win-win for investors": a passive investor is taken out and the number of shares in issue goes down at the same time.
This is clearly one of Prime Minister Shinzo Abe's initiatives that Somerville approves of. How does he feel about the rest of the "Abenomics" reforms? The key to Japan is to accept that the economy as a whole isn't going to give you much, says Somerville. The country has "terrible demographics an ageing population and shrinking population". That means "baseline growth in Japan is 1% at best" (although GDP per head is better) and that there is little point in thinking that Abe can spark much more.
Profiting from Chinese tourists
On the plus side, "some of the reforms he's pushed through have been incredibly positive for Japan". Take the way he has eased visa restrictions for tourists coming in. That has caused a huge surge in Chinese tourists in particular. And those tourists spend an awful lot of money on the kind of Japanese brands that they trust. "They're buying nappies, they're buying condoms, they're buying cosmetics, they're buying rice cookers that cost hundreds and hundreds of pounds, they're buying Casio watches." They could, of course, buy all these things in China, but "the provenance of where they're buying it is key to the deal. If you go and buy a Casio watch in China, even if you go to a Casio shop, you're not 100% certain [that it is real], whereas if you buy a Casio watch in Japan, it is. When you go back to China and give that as a gift, everyone knows that: one, you've been to Japan nice status symbol, you've been to Japan and two, that this is the real thing."
We move on to valuations. Historically, price/earnings ratios have been very high in Japan, but price-to-book ratios (see below) have been very low (something that suggests they haven't been generating much of a return on their assets). That makes it vital to look at return on equity when you analyse companies: if you are getting low returns from a firm, then you don't want to be duped into paying a premium for those returns by a cheap-looking price-to-book ratio. The good news in Japan is that returns on equity are rising and earnings are too. Why? "One very good reason," says Somerville. "Japan has no oil or commodity earnings, so the oil price falling is a clear positive adding something like 4% to earnings in 2015." Falling corporation taxes are helping too to a target of 30% (from 40%) next year. That's great for shareholders, but it also reduces the incentive for companies to avoid tax, so it won't cut into tax revenues much either.
It'll be a good year for Japan
Overall, Somerville sounds very positive on Japan. Will 2016 be a good year for the market? I'm hoping for "yes". I get "yes and no". On the "no" side is the fact that Japan is hugely exposed to China and to the rest of Asia. Those economies "are slowing" and that is going to hurt some Japanese stocks. On the "yes" side is the corporate governance story. We will "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 certainly relative to the rest of the world, it will be a very good year for Japan".
One stock to buy now
So if he had to pick one stock, what would it be? Fund managers hate this question (for good reason!), but, happily, Somerville does have a favourite. It is Nomura (JP: 9716). Not the stockbroker or the investment bank, but the design company it does stores, exhibitions, offices and hotels. That, says Somerville, makes it a "really neat business... with tourism picking up, Japan is upgrading a lot of what it is doing".
A lot of hotels are being upgraded and new ones being built the Okura, an old favourite of foreigners in Japan (Somerville and myself included), is being knocked down and rebuilt (with the design work being done in part by Nomura) and in the run-up to the Olympics we'll see that happening more and more. "It's a great little business and it's just growing like a weed at the moment because of these new contracts based around tourism, Japan upgrading itself, and around the Olympics. So I think it continues to be a really exciting play on the change in Japan." The new Okura will be completed in 2019.
My final question: should we visit? "I recommend you do," says Somerville.
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