Firms undervalued in Japan
Fund managers think Japan’s battered stock markets are good value after poor long-term performance and the March earthquake push prices low
Fund managers are urging investors to take another look at Japan’s battered stock markets after a combination of poor long-term performance and the March Tohoku earthquake have pushed valuations very low across the board. Data from Chuo Mitsui Trust International, the London-based arm of the Japanese fund manager, reveals that 66% of listed Japanese companies are trading at a price to book (p/b) ratio of less than 1 as of April 1.
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The price to book ratio of a company is a means of comparing its current book value (tangible assets minus liabilities) to the price of its shares. A ratio below one implies the company might be underpriced or in trouble. While CMTI’s number is still below the record of 75% reached in 2009, it represents an increase on what was the case before the global financial crisis: between 2005 and mid-2007 the ratio of companies trading at below 1 times p/b was under 30%. Not surprisingly, some Tokyo fund managers believe there are many seriously undervalued firms lurking under that cloud.
Even before the recent disasters, global investors tended to be underweight in their allocations to Japan, reflecting attitudes to a market that has been in steady decline and leading to depressed prices. While Japan accounted for 22.1% of MSCI’s Europe, Australasia and Far East Index as of 2010, it accounted for just 16.6% of the average portfolio allocation among fund managers, according to CMTI. The broad-based Topix index stood at 1,743 at the beginning of April in 2006; it had fallen to 878 at the same point this year. Given the country’s well-known macroeconomic challenges, the costs of restructuring and consistently depressed stock markets, why would investors assume corporate valuations will rise?
“It’s true that the last 10 years have been bad for Japanese equity markets,” says Daiji Ozawa, chief portfolio manager of Invesco Japan’s Value Equity Fund in Tokyo, “but 20 years ago they were among the worst — by which I mean most expensive — of any in the world, with average price/earnings of up to 70 times at the peak of the bubble.”
Now that ratio has come down, Ozawa says, to reflect the low average returns on equity and capital of corporate Japan — around 6% for both.
“Now corporate profits are improving,” Ozawa says, “companies are starting to increase dividends and do share buybacks. This year, if there had been no disaster, we’d have seen average return on equity up to around 8.4%. While topline growth in Japan will be limited, a lot of companies are growing their business outside Japan in markets like China, India and southeast Asia.”
These companies are key to avoiding what Ozawa calls the ‘value trap’ – the temptation to invest in Japanese stocks that look cheap but turn out to deserve those valuations because their businesses are correlated to a domestic growth rate that is expected to be no better than 1% for the next few years. Ozawa says that despite the earthquake, he has made only minor adjustments to his fund’s portfolio, which invests in large-cap listed Japanese companies, because it is already targeted at companies that he thinks can overcome poor domestic prospects by growing their overseas businesses.
Japanese companies have also been improving their attention to shareholders over the last few years, with an increase in the number of companies paying dividends in particular. According to the World Intellectual Property Organization, that number rose from below 25% in 2000 to 37% in 2009, excluding non-profitable companies. While that is good news for shareholders, says one Tokyo based fund manager, dividend yields are hard to predict after an earthquake. If companies hoard cash in the uncertain environment, the encouraging trend of an increase in dividend yields may be halted.
Invesco’s Ozawa argues that once supply chain disruption and rolling blackouts recede in the second half of the year, the country could see positive economic growth because reconstruction efforts will be an important source of demand.
Still, while the earthquake, tsunami and concerns over damaged nuclear reactors appear to have made Japan’s economic outlook worse, some argue that markets have already taken these issues into account.
“Although the outlook for the Japanese market remains uncertain,” says Chris Renwick, head of sales and marketing at Chuo Mitsui Trust International, “we continue to assume that the impact on the Nikkei, currency market and economy will be limited. In our view, the market has fully absorbed the implications of the damage suffered in the region and the direct consequences to firms which were particularly affected.”