Don’t Forget Japan

Don’t Forget Japan

Craig Blessing:            Hi, and welcome to another episode of Away from the Noise, Thornburg Investment Management’s podcast on key investment topics, economics and market developments of the day. I’m Craig Blessing, Client Portfolio Manager for International Equity at Thornburg, and I’ll be your host.  Joining us today is Glen Hilton. Glen is a Senior Equity Analyst at Thornburg, and as is the case with all members of the investment team, is a generalist covering companies across sectors and geographies.  Over his career, one place Glen has spent a lot of time is Japan which makes him ideal to talk about today’s topic, which is don’t forget your pen.  If you look at international equity markets, the largest markets are Europe collectively at 32 percent followed by Japan at 14 percent, and then China and the UK at about 9 and ½ percent.  We found that in recent years, the most common investor question has been why international, which in large part has meant why Europe and why China?  In recent months, we’ve published articles and podcasts on all those topics, but the one country missing in most of those discussions has been Japan. When you look at recent performance, it’s easy to see why.  MSCI-Japan has trailed the MSCI-EAFE Index over the last 1, 3 and 5-years, and over the last 3 years has only returned about 50 basis points a year in dollars, yet in many of Thornburg’s international equity strategies, Japan has been one of the biggest contributors to strategy alpha, driven mostly by bottom-up stock selection. So, while Japan has been an underperformer, its diverse corporate sector has provided us with a wealth of bottom-up investment opportunities.  Let’s begin with a background question.  Glen, I understand that you spent a lot of time in Japan and covering Japanese markets and companies.  That’s not necessarily a widely covered market for western analysts.  What drew you to it?

Glen Hilton:    That’s a great question, Craig, and it’s one that sometimes I ask myself.  It started as an accident really.  I started it, my career at a time, the late 90s, mid-to-late 90s when the Japanese economic bubble of the late 1980s was still deflating, so it wasn’t really a natural market that one would gravitate towards. I was covering, as a sector analyst, I was covering the global auto sector, which as many of you may know has always been amongst some of Japan’s finest companies, and what I found was that they were among a very short list of companies in Japan that actually earned their cost of capital.  They had to do this, really, because they were competing globally.  They couldn’t get by without being globally competitive like many other companies in Japan were doing at the time. This led me to sort of dig deeper, and I found that there were other areas where Japanese companies were actually quite competitive, quite profitable, and quite unique, and this led me to the conclusion, over the course of several years, but I felt that Japan was actually a market that was potentially easier to add investment value than within other markets, but I think you just needed to know what to look for and how to filter out the bad from the good.

Craig Blessing:            Interesting.  So, in your mind, what’s the current state of play with respect to the Japanese economy for this year, and what does that mean in practical terms?  I get the impression that many foreign investigators have a fairly unexciting outlook.  Are there any reasons to believe that outlook might be too pessimistic?

Glen Hilton:    Well, I think first and foremost, you know, you have to appreciate that Japan’s economy is certainly evolving. Inflation, which has been basically nonexistent for years.  It’s something that nobody else had wanted and, in fact, to sort of get Japan out of its deflationary spiral, but inflation has sort of found its way into Japan which has numerous implications for BOJ policy, the direction of the yen, corporate profitability, etcetera, but at the same time, economic growth remains frustratingly hard to come by.  GDP has continued to remain highly stagnant over the last several years, and so you have to ask yourself, you know, what does this all, all this mean in, in practical terms?  And it is kind of alluded to in, in, in your first question.  Japan is an equity market where you have to be very selective about which stocks you own and which, sort of, risks you’re willing to accept.  It’s not a market where I typically make blanket statements about.  You know, you have to, like I said, selectivity is, is very important, and quite frankly, that, that’s not actually much different than the way things have been historically.  But as I said, I think you have to be extra certain that you balance those, those risks I’ve talked about, you know, the, the yen dollar being probably the most prominent amongst them.

Craig Blessing:            So, if I’m reading through, I get what you’re saying is Japan is less of a market in which to buy a Japan ETF and more of a market in which you would want to use an experienced active manager.

Glen Hilton:    Absolutely. I think that Japan is a market with a plethora of highly unique companies that you can’t find anywhere else that have decent growth prospects, healthy profitability, healthy returns and typically, you know, opportunities do come because, as you alluded to, many investors seem to want to just ignore Japan because they sort of cast it in a very uniform light, and that is just, it’s, it’s un-investable as a market.  I think the opposite is true.  I think there are always tremendous pocket of opportunity, and as I said, if you know what you’re looking for, I think you can find them.

Craig Blessing:            So, a minute ago, you also mentioned the foreign exchange and the yen dollar exchange rate. You know, the Japanese market has gained a bit less than 1 percent in yen terms since the end of 2021, but it’s lost 14 percent in dollar terms, with all of those losses driven by the strength of the dollar versus the yen.  What’s been driving the volatility of the yen dollar exchange rate, and do you have an outlook?

Glen Hilton:    Sure, I mean, I think, as you say, I mean the, the, the biggest variable in trying to calibrate investment opportunities in Japan in the last year has been the relationship between the yen and the US dollar without a doubt.  You know, the fact that rates have been rising in Europe, rising here in the US while the BOJ has held rates relatively steady has led to the end becoming less attractive, and that’s driven a pretty substantial selloff throughout, you know, 2022.  That said, the yen did rebound kind of later on the in the year as the BOJ seemed to pivot later in the year, but I would sort of throw the caveat out there that, you know, Kuroda, the Bank of Japan’s governor, was very careful to point out that this wasn’t really a pivot.  It was just trying to help the JGB market become more efficient.  I don’t think investors are buying into that, and I think that the BOJ from here, I think is, is in a position where they’re going to have to raise rates going forward.

Craig Blessing:            So, let’s dig into that just a little bit more as you handed another really big topic in Japan, and related to FX, has been its ultra-easy monetary policy for years and years driven by years of low inflation or deflation, and their attempt to sustainably achieve a 2 percent inflation rate. A key component has been the policy yield curve control where the BOJ purchases as many 10‑year government bonds as they need to to keep the yields at 50 basis points or below.  The market’s been anticipating, and some cases betting, that that policy might prove to be unsustainable. There’s been a recent change in BOJ leadership, but they also recently reaffirmed that 50 basis point target. What’s your outlook for the sustainability or the future of easy monetary policy, and what do you think the impact would be of the BOJ being forced by the market to change it?

Glen Hilton:    As you allude to, you know, we’re about to get a new governor of the, the Bank of Japan coming in April.  There had been a lot of speculation about who would replace Kuroda.  It’s not an easy job ahead, to be sure.  The gentleman that was nominated, Kazuo Ueda, has some experience with the Bank of Japan dating back into the early 2000s, but we really don’t know what his posture will be coming out. He was a bit of a wildcard candidate that nobody seemed to study where his head was, even though I’d say, historically, what we do know is he was quite dovish but again, that was a, a long time ago.  My own belief is that the Bank of Japan will pivot.  It’s a question of when, not if, and I say that because I, I just don’t think they have much of a choice from here. If they fail to act, the yen, in my opinion, is at risk of moving lower, which would only add to the domestic inflationary burden that many Japanese are, are feeling a lot of pressure over because, remember, wage inflation really hasn’t taken off to any extent yet in Japan, and consumers and the Japanese citizenry are, are definitely feeling the pinch, you know, kinda where would rates go, and where would the yen go. That’s, obviously, a tough call to make, but, especially when you look at how dysfunctional the JGB market has become, but I think if you look at sort of the swaps market, you know, it suggests anywhere from 80 to 85 basis points would be the, the yield on the, on the 10-year JGB, and I think that would, in turn, lead to strengthening in the end, all else being equal.

Craig Blessing:            So, another big topic in the news is China’s really challenging demographic outlook as, as its population declined for the first time in more than 60 years.  Another country which has dealt with challenging demographics for years is Japan, and one of the results has been a number of global leaders in industries like automation and robotics.  What other lessons do you think Japan might have for other countries that have declining birth rates?

Glen Hilton:    Well, as you said, you know, Japan has always been a leader in automation and robotics, and I don’t think China is ignoring ways to improve productivity.  That’s something I think they’ve been doing along, but I’d say, you know, Japan as a whole has been dealing with this issue for, for several years now and, and frankly I don’t think they acted as swiftly as they should have.  I think they were a bit complacent, even though everyone knew that the challenge was going to, to build over time.  One of the biggest challenges that the country has faced is a highly, you know, an acute shortage of labor, unemployment, you know, around 2 and ½ percent, very low, has remained that way for many years, and as I said, several years ago, now, you were starting to hear about these acute labor shortages in pockets of the economy, you know, labor-intensive businesses like parcel delivery, for example. But what’s happened, and I think this the lesson for other economies, and kinda going to your question, is that Japan, very surprisingly, in my opinion, finally opened up to the idea of allowing more foreign workers in. If you walked around 10 to 15 years ago, you know, in Tokyo, you’d see, you’d see the occasional foreign worker in, in sort of a in service-oriented jobs.  If you went out anywhere outside of Tokyo, they were nonexistent, and so it was highly unusual to encounter non‑Japanese working in places like convenient stores, hotels, restaurant, you know, that sort of thing.  But today, it’s really, it’s quite common, and I think that’s gonna be an important element going forward for both, you know, Japan and, and other economics. I think in the case of China, you know, it has a similar challenge to what Japan faces. That is, you know, you have a language barrier, and I think you’re gonna need to address that because, you know, just, it’s not an economy that has as many English speakers as you would see perhaps in, in Europe or other places throughout the world.

Craig Blessing:            So, let’s get into the really interesting stuff, which is sort of the bottom-up implications of all of this.  For years, Japanese corporate governance has been seen as not particularly shareholder-friendly, favoring size and growth over return on equity, and not being known for diversity and management and governance. That appears to be changing, at least with some companies, and has been part of the investment basis in our holdings in some companies.  We know that many Japanese companies are focused on the environment, but do you think that they’re improving on the S and G and ESG?

Glen Hilton:    I do, and I think this has been a really important investment theme in Japan that still has, I think, plenty of runway.  The bar was pretty low starting out, to, to be honest.  Things really started to change about 10 years with respect to the S and the G in ESG, and this came about, I think, when Former Prime Minister Abe unveiled his, his three arrows program aimed at providing Japan’s economy, and that included language around improving overall governance.  One of the, the hallmarks was the introduction of a, a stewardship code that essentially called on Japanese corporates to deliver a minimum of an 8 percent ROE, and if they couldn’t, they needed to explain why they were unable to do so, sort of, you know, trying to shame them in some respects, if you will.  Japan still lags, you know, relative to the US for sure. You have seen, I would say, a gradual underlying improvement for Japanese corporates, in terms of both profitability and certainly better balance sheet efficiency, which is, is something that, that, know, Japan was plagued by both poor profitability and laziness when it came to, to balance sheets; cash sitting around earning no return when there was zero interest rate. That was, that was just very capital and inefficient, but there are still a lot of companies that still operate below what they could be from an efficiency perspective, and I think that the opportunity that presents when you get an inflection in better governance is powerful. Investors can not only get better financial performance, better growth, better margins, better returns on investment, but you also have the ability to see these companies award higher trading multiples by the market as, as a result of this so you get sort of that double leverage which could really drive outsize returns and drive the impressive alpha in a market where, again, the perception is there’s not a lot on offer.

Craig Blessing:            So, given everything we’ve talked about, do you think you can really find businesses that will outperform in Japan, or is Japan as bad as conventional wisdom would suggest?

Glen Hilton:    Well, as I’d say, again, I think you’d have to be very selective. There are some incredible businesses in Japan that you really can’t find anywhere else in the world.  You know, you think about robotics. You think about factory automation. There are some really unique businesses here that are, you just can’t replicate anywhere else. The fly in the ointment historically was that, as I said, you’ve had these really good businesses that generated lots of cash, but investors, owners, would never see that cash. They would sit and squander on balance sheets. That is changing, and I think it makes it so much tougher in time for investors to ignore Japan to the extent that they have over the past three decades.  But, you know, when I came up in the industry, as I said, it was sort of an accident that I found my way into the, into this market, but I think there are generations of investors who have done just fine by ignoring Japan as a, as a broad market, and I think it is increasingly a more challenging position to take because, as I said, I think, I think there are pockets of opportunity that do arise that create really attractive pockets of potential alpha.

Craig Blessing:            So, you’ve covered Japan for a while.  What are the biggest differences or similarities to you of investing in Japan today versus in the past?

Glen Hilton:    That’s a fun question, actually, and thinking back about how long I’ve been covering this market.  We’ll go back to the government’s area for starters.  You know, the average ROE of a Japanese company when I started investing, in that market was in the very low single digits. Today, it’s in the high single digits; still not spectacular, but heck of a lot better than it has been historically. I think if things like disclosure, which made analysis very challenging, so you know, things like parent-level accounting where a Japanese company would present parent-level, would have 100 subsidiaries that were very important to the aggregate financial performance, so they wouldn’t give you any disclosure around. Right? You had limited cash flow disclosure. You had very unique accounting, uh, treatment in some cases that was very different from what we were used to here in the west, and as I said, I think that made for a very difficult comparable analysis. The last thing I’d say, I guess, is earnings multiples are just so much more attractive today than they were over time. When I started out, I think the average P/E multiple for the topics was between 35 and 40 times. Right? And, today, it’s a fraction of that, and so you’re no longer paying obscene multiples for companies with poor financial prospects getting, you know, quite the opposite in some cases today.

Craig Blessing:       So, let’s end with kind of a big picture bottom-up question. 2022 was a difficult year in Japan and elsewhere and change in volatility usually create opportunity. What would you say as the best sector in stock opportunities in Japan as we look ahead in 2023?

Glen Hilton:    Again, I think I want to couch this.  You know, going back to that first principle I mentioned when, and that’s to understand the sort of risks you’re taking. Again, I want to focus on bottom-up stock selection, but at the same time, you have to be what I would call macro aware. I want to understand that I’m incorporating the big picture risks, like 4X, that look those risks posed to the equities I would own or, or that I’m considering. My thinking is that BOJ will likely begin tightening at some point over the next 6 months, once Ueda San is put in place at the helm, and I think that all else being equal, this should lead to a strengthening yen, which I believe is fundamentally quite undervalued.  In that scenario, I think domestically focused plays with solid governance and healthy dividend levels are quite attractive. I think of the telecom service basis is one example.  You’re buying really attractive yields with an undervalued currency.  I think that’s quite a unique investment proposition. I think industries like banking and life insurance are kind of the obvious plays on higher rates. They could continue to do well.  That isn’t something that’s gone undiscovered by the market by any means, and I think the other caveat I would throw in there is that, you know, these are business that are still, you know, on an underlying basis not really delivering the type of structural profitability that I usually find attractive. They’re very pedestrian run‑of‑the‑mill banks when it comes to, to returns and growth prospects, etcetera. You know and at a high level, as always, you know, like I say, just what I’m always looking for is to find idiosyncratic investment opportunities where I can buy high quality durable business that are trading with an appropriate level of asymmetric return, and I think Japan is a market, as I said, you know, throughout our conversation today if you know where to look, I think that’s something you can find, and I think it’s a market that if you turn over there right rocks, there is alpha to be had.

Craig Blessing:            All right.  Thanks again to Glen for his thoughts and thank you for listening.  You can find us on thornburg.com/podcasts, as well as, on Apple podcasts where you can rate, subscribe, and review us.  Please join us again soon for the next episode of Away from the Noise, and thanks again.

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