Fidelity Japan Trust portfolio manager Nicholas Price discusses the importance of bottom-up stock picking and focussing on companies that can continue to grow over the medium term.
Focussing on what matters in Japan
Amid increased market volatility, Nicholas Price, portfolio manager of Fidelity Japan Trust, discusses the importance of bottom-up stock picking and focussing on companies that can continue to grow over the medium term. In particular, he outlines his emphasis on trying to find long-term winners with durable growth prospects and differentiated products in growing markets.
We have had a turbulent start to the year, with the war in Ukraine, rising inflation and lockdowns in China threatening to derail global economic growth. We have also seen an extreme style rotation in the markets that has led to the outperformance of value names and sharp declines for growth stocks. This was most evident at the start of the year in the buying of low price-to-book (PB) names and the selling of high PB stocks. These sharp market moves have come amid accelerating rate hike expectations that have driven up interest rates in the US.
The Japanese stock market has started to price in these developments, which has seen, for example, banks and insurance stocks outperform quite strongly over the year-to-date period. Conversely, growth-oriented sectors such as precision instruments, services and electric appliances have been the most significant underperformers.
Given the rising momentum for US rate hikes, market volatility is likely to persist for the time being. In this environment, holdings in mid/small-cap growth stocks in the information and communication sector have been among the most significant detractors from performance. At the same time, companies tied to secular growth trends such as factory automation and electric vehicles that performed strongly last year have been subject to profit taking in the year-to-date period.
Another factor of the recent market phase that generated headwinds for performance was the narrowness of price movements. This produced strong intra-sector divergences and as a result, natural hedges have not worked. For example, shares in Toyota Motor, which is an underweight position in the portfolio, are up versus TOPIX over the year-to-date period, but group company Toyota Tsusho, an overweight holding in the portfolio, is down in relative terms. Given the extreme nature of these movements, we expect them to correct at some point.
Importantly, the price-to-earnings ratio (PER) - the ratio for valuing a company that measures its current share price relative to its earnings per share - of the fund has come down considerably and is in line with the market on a forward basis (CY2023). This is unusual given the much higher growth rates and higher returns. The severe correction in growth has largely played out in Japan and it is very unusual for the fund to be at a market multiple despite the much higher levels of growth and returns. Looking forward, we expect the companies held in the fund to do well in terms of relative earnings growth.
While the correction in valuations has largely played out for now (the convergence or crossover of value and growth valuations generally indicates that we are close to a bottom), the unwinding of global monetary easing is accentuating the importance of bottom-up stock picking (focusing on the fundamentals of an individual company rather than the overall macro environment) and a keen focus on companies that can continue to grow earnings over the mid-term.
With this in mind, we are focusing on defensive/sustainable growth names and services companies that can grow earnings in a more difficult environment through the second half of 2022 and 2023, and those that can positively surprise the market on mid-term growth. Additionally, we are looking at oversold growth names that are globally competitive and trading on compelling valuations. For instance, some small-cap growth names have become value stocks, so there is a good opportunity for multiple expansion in the future.
We are also keeping a close eye on the spike in commodity prices, especially oil, as this will exert a further squeeze on manufacturing margins. On the flip side of that, we are seeing opportunities in companies that supply equipment to the energy sector (beneficiaries of energy diversification in Europe) and are at the bottom of their respective cycles.
Rise in entrepreneurial activity
Another area of the market where we continue to see attractive opportunities is in the unlisted sector. There were 125 initial public offerings (IPOs) in 2021, marking the highest number of listings since 2006. Moreover, from a bottom-up perspective, we are seeing a lot more entrepreneurial activity in Japan compared with five to ten years ago. While new listings (both in Japan and globally) are coming under pressure amid heightened geopolitical and inflationary risks, we continue to new growth companies coming through, which will create future opportunities in the IPO market.
Being on the ground in Japan, and seeing many different companies, means that we are well placed to help entrepreneurs in the latter stages of their pre-IPO journey. We expect there to be a further increase in such opportunities, which offer a source of differentiated returns and we are therefore looking to gradually increase the exposure to unlisted securities.
Overall, we continue to evaluate new and under-covered opportunities, while focusing on companies that we believe can grow durably over the coming months.
The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Fidelity Japan Trust PLC invests more heavily than others in smaller companies, which can carry a higher risk because their share prices may be more volatile than those of larger companies and the securities are often less liquid. Changes in currency exchange rates may affect the value of investments in overseas markets. The shares in the investment trust are listed on the London Stock Exchange and their price is affected by supply and demand. This investment trust can gain additional exposure to the market, known as gearing, potentially increasing volatility. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser. Investors should note that the views expressed may no longer be current and may have already been acted upon. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only.
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