Japan has been the bete noire of many asset allocators’ portfolios for most of my 34 years managing money there, and investors continue to be underweighted from an asset allocation perspective. The throwaway line of ‘it is cheap, but the value cannot be realised’ is no longer true. Change is happening and as Mr Kikuchi the Mizuho Strategist noted, there were 5 activist proposals in 2015 and this had risen to 60 in 2022. The Tokyo Stock Exchange (TSE) clarified what was expected to be considered by Japanese companies, instead of insisting what should be published. Cost of capital, return on invested capital (ROIC), return on equity (ROE), and other appropriate measures came out during March. All these measures are designed to make investing in Japan more attractive.
Investors should be cautious over knee jerk reactions to activist proposals and demands. Using cash to do a huge share buy back in response to an activist, whilst very effective short term, looks more like paying the ‘tanks’ to leave the lawn, and does not help the long-term earnings structure of an unprofitable company. It is positive to look at corporate governance and improve performance so that investors judge the company to be worth more because of improving ROE and profit margins. A two-tier dividend, where one is stable and the other is linked to current operating performance is another good path likely to lead to a more highly valued company.
With questions being raised about the sustainability of the recovery in China, some are seeing investment in Japan as an indirect way of gaining China exposure through its trading links.
Japan remains attractively valued internationally, under invested in by asset allocators, and is changing to be more shareholder friendly. Earnings look to be positive from the outset for March 2024 and the first estimates are for continued momentum to March 2025.
In addition to our equity strategies, Quaero Capital has developed a strategy that should benefit primarily from rising Japanese equity prices but also counts on a second source of returns from rising interest rates in Japan. In simple terms it is a Convertible Bond (CB) portfolio without the Bond portion.
Portfolio construction is a blend of positions with strong underlying equity fundamentals combined with an attractively valued option. One of the most important considerations is to have positions in options which have sufficient duration for the business potential to be realized. If the new Bank of Japan governor, Mr Ueda, continues to normalise interest rates in Japan the strategy should benefit from being able to repurchase the fixed income element at a lower price. Any movement on interest rates in Japan will be data dependent while the BOJ policy review continues and will probably involve further tweaking of Yield Curve Control (YCC) bands, before anything more drastic. The Bank of Japan does like to surprise market participants, and many believe this could happen as early as July 2023.
The mechanics of selling the Bond portion is via an Asset Swap, which gives the strategy the right but not the obligation to recall the fixed income element. The options are known as ‘Ascots’, which stands for Asset Swapped Convertible Option Trade, and although this process looks complicated, it is very mechanical, the CB less the fixed income element is the entry or exit price of any trade. Negative interest rates and tight credit spreads in Japan should make the strategy work particularly well because the fixed income values are so high, and the Option prices are therefore low.