Big (or small) in Japan
David Prosser on the Japanese market’s potential after hitting all-time highs.
After peaking in 1990, it took 35 years for Japanese equities, as measured by the Nikkei 225 Index, to break through the previous market high – disconcerting for investors often told that stock markets tend to rise over the longer term.
Still, having finally made up the lost ground last year, Japanese stocks have been on quite the run, with the landslide election victory of Prime Minister Sanae Takaichi last week taking the Nikkei above 58,000 for the first time. To put that in context, that 1990 peak was just below 40,000.
Japan’s market has cooled a little in recent days, but there is still a sense amongst analysts that further gains are possible. They point to two major structural positives that provide a fair wind.
Japan’s stock market offers exposure to many of the exciting technology companies that investors often assume can only be found in the US.
David Prosser
First, after decades of inaction, Japanese companies are finally responding to corporate governance concerns that have so often weighed on valuations. The very large cross-shareholdings that large Japanese businesses have traditionally held in one another are being unwound. Companies are now paying more generous dividends and even conducting share buybacks. Boards are increasingly conscious of their duty to deliver returns on equity.
Second, Japan’s economy looks in better shape than at any time in living memory, with business-friendly Prime Minister Takaichi likely to make further important reforms. Most notably, two decades of deflation now seem to be behind Japan, with a period of sustained price rises and wage growth continuing. The earnings power of Japanese companies is therefore growing.
It’s also worth pointing out that Japan’s stock market offers exposure to many of the exciting technology companies that investors often assume can only be found in the US. In sectors such as semi-conductors, advanced manufacturing and robotics, Japan has market-leading companies, offering diversification opportunities for investors who want to look beyond America.
There are still risks. Japan is not immune to the geopolitical headwinds of conflict, trade tension and tariffs. Economists worry about the country’s indebtedness – among the highest in the world – and the potential for a rise in the yen, which reduces the attractiveness of investments in the country. There must also be question marks over valuations, given the stellar performance of Japanese equities in recent months.
Still, given that Japan is the world’s fifth largest economy, it’s surprising how few investors have any significant exposure to it. And if you’re looking to increase that exposure, an investment trust could be a good option. There are seven quite different funds to choose from, four in the main Japan sector and three in Japanese Smaller Companies sector.
Investment trusts represent a good way into Japan for a couple of reasons. First, investment trust managers tend to be more active stock pickers – more prepared to diverge from stock market indices to seek out the best performers. This is important in a market such as Japan, where value is often concentrated in certain areas, and where interesting opportunities often go overlooked.
Investment trusts can also take on gearing – borrowing additional funds to increase investment exposures. This is an option not available to other types of collective fund and can enhance returns in a rising market. Plus the closed-ended structure of an investment trust means the manager doesn’t have to worry about distractions from inflows and outflows of investors’ cash; that can be important during periods of market volatility.
One other thought. The small cap sector of the Japanese stock market has not yet recovered at anything like the rate of the Nikkei 225. Japanese smaller companies are a niche asset class for sure, but specialists believe Japan is home to a number of exciting and undervalued businesses that could deliver outsized returns in time. The handful of investment trusts specialising in Japanese smaller companies could therefore be worth a look – and for illiquid areas of the market like this, the investment trust structure is particularly useful.
None of which is to suggest investors pile into Japan. However, for many valid reasons, it’s likely that investors with portfolios of global equities, even when held through funds, are underweight Japan in terms of its size and scale. There are good reasons to think about putting that right.
