Japanese Equity Valuations, Trade Tariffs, and Reform Initiatives

 Hennessy Japan Fund Portfolio Manager Masa Takeda discusses current valuations of Japanese equities and the growth in the factory automation and robotics industries. He also offers his thoughts on the importance of active management, the potential impact of trade tariffs, and Japan’s progress on reform initiatives.

August 2018
  • Masakazu Takeda
    Masakazu Takeda, CFA, CMA
    Portfolio Manager

Why should U.S. investors own Japanese equities today?

We believe Japanese stocks are attractively valued, as Japan currently trades at about 14 times trailing earnings, the lowest level we’ve seen in the last few years. In comparison, the S&P 500 Index trades at approximately 21 times trailing earnings.

Japan has many high-quality, globally oriented companies run by able management and that we believe are protected by high barriers to entry. These are the companies we seek to include in the Hennessy Japan Fund. We believe these stocks offer investors the opportunity to gain exposure to growth around the world, including developing countries, but with better transparency, better corporate governance, good liquidity, and reasonable valuations. A few examples of portfolio companies with these characteristics include Nidec Corp., the world’s largest comprehensive precision motor manufacturer; Recruit Holdings Co. Ltd., Japan’s largest job search engine company; and Unicharm Corp., Asia’s largest diaper maker.

How are Japanese companies benefitting from the fast-growing factory automation and robotics industries?

The growth in demand for factory automation and robotics systems are key industrial trends driving growth for Japanese machinery and technology companies, and we expect them to continue to be durable themes in the stock market. Corporations in both industrialized and developing countries are increasingly utilizing automation products and robotics to keep labor productivity rising and counter higher labor costs, and are turning to Japan, as a leading global supplier, to provide them with these technologies.

For example, two Fund holdings, Keyence Corp. and Misumi Group, Inc., are leaders in the factory automation field, serving a broad range of industries in both domestic and international markets. Both companies have increased their overseas exposure from about 30% of sales to 50%, and have been growing earnings at compound annual rates of 25% and 15%, respectively, over the last five years. We believe both companies can continue to grow rapidly, powered by growth in the factory automation market and gains in market share.

Passive investing has grown in the U.S., but it is less popular in Japan. Why is it important to consider and incorporate active management when investing in Japan?

We believe Japan is a great market for active, research-oriented managers for two main reasons:

  1. The major Japanese indices are dominated by very large, mature, low-growth companies. However, just below this top tier in terms of size, there are many high-growth, large-cap companies that are not well-represented in the indices.
  2. The investor base in Japan lacks expertise. Institutions, such as pension funds, are staffed with managers who typically rotate out of their position after a couple of years. As a result, institutional managers tend to have a thin knowledge base and lack experience through full market cycles. Retail investors do little research and, conditioned to poor returns, trade the market with a short-term orientation. In addition, institutional foreign investors are at a disadvantage as language barriers and a unique corporate culture make Japan a difficult market for foreign investors to understand.

SPARX, one of the oldest and largest independent money managers in Japan, has experienced, locally based, highly trained professional money managers who practice a research-intensive investment process and have a deep understanding of the inner workings of corporate Japan. We believe as research-oriented, active managers we can add significant value over time for our investors.

How might the recently imposed trade tariffs impact Fund holdings?

The companies in the Fund have no direct exposure to the current tariffs on steel and aluminum. In addition, the Fund has only a small exposure to the auto industry, which may suffer secondary effects from these tariffs.

Some commentators have made the case that a trade dispute between the U.S. and China could actually have a positive effect on Japanese exporters. If the U.S. imposes tariffs on Chinese imports, it might leave more room for Japanese imports to take share in markets where they overlap as competitors. However, there could be negative secondary effects for Japanese exporters if the Chinese economy softens as a result of a slowdown in trade because China is Japan’s largest trading partner.

While we will closely monitor the ongoing situation, our focus remains on finding well-run large Japanese companies that can grow regardless of macro factors.

Would you please provide an update of reform initiatives?

The passage of the labor bill in June 2018 will introduce much-anticipated reform including “equal pay for equal work” for non-regular workers, and merit-based pay for highly-skilled employees. We believe these reforms represent an important step for Japan and will help raise labor productivity, which today is lower than in many other developed countries.