In 1997, Steve Jobs had just returned to Apple, a struggling company whose stock was selling in the single digits. Gas cost $1.20 a gallon. Tiger Woods, then a scrawny 21-year-old, had become the youngest winner of the Masters Tournament ever.
It was also the last time Japan enjoyed a healthy, growing economy for any sustained period of time. Caught in the grip of languishing wages and persistent deflation, the nation’s economy has more or less treaded water for more than 15 years. Since then, the country’s stock market has experienced a few strong surges only to backtrack on disappointing economic news.
The latest round of market exuberance began last year when the MSCI Japan Index appreciated 18.85% in local currency terms, posting its best performance since 2005. The trend accelerated in 2013, when the index rose another 19.67% from the beginning of the year through May 10.
A driving force behind the rally has been a significant weakening of the yen, which occurred toward the end of 2012. The slide of the currency benefits Japanese exporters, who can realize higher profits from overseas sales and price their goods more competitively in world markets.
“For most of the last five years, a strong yen made automakers and other exporters less competitive and drove the economy into recession,” says Taizo Ishida, manager of the Matthews Japan Fund. “Investors realized the significance of the weaker currency and new policies designed to introduce growth into the economy.”
The pattern is not a new one; over the years, there has often been an inverse relationship between the performance of Japan’s equity market and the movement of the yen against the U.S. dollar. When the yen was strong, equities slumped. When it was weak, they rallied.
The current lift could have more staying power than past rallies, says Ishida, because of the bold fiscal policies of Japan’s new prime minister, Shinzo Abe. “What we have now is a new regime, new era and new optimism,” Ishida says. “This time around could be different.”
Unlike his predecessors, who opted for cautious and gradual measures to stimulate the economy, Abe and recently appointed Bank of Japan Governor Haruhiko Kuroda have moved with surprising swiftness to kick-start the country’s stalled growth engine. They showed off their no-nonsense approach in early April of this year when Kuroda announced a broad stimulus package and set a goal of bringing inflation up to 2%. The news sent the Nikkei to a nearly five-year high and sent the yen to a four-year low against the dollar.
But the policies that have inspired such optimism must battle the chronic economic deadweight that continues to plague the country. Over the last 20 years, Japan’s declining tax revenues and rampant government spending have given it the highest debt to GDP ratio of any country in the developed world. Its low birth rate means it will have fewer workers to support government programs for a large elderly population and have less manpower to fuel corporate expansion.
While Japan’s economic problems are serious, Ishida says they are manageable. He is confident that tax revenues from its growing economy, aided by a consumption tax set to go into effect next year, will help alleviate the country’s debt burden. More women are entering the workforce and the country has pursued more liberal immigration policies, and these developments promise to help fill the tax and manpower gap left by retiring Japanese workers. Meanwhile, Japanese companies will be able to expand by moving some production overseas.
Despite Japan’s tough economy and its strong yen for most of the last few years, Japanese companies have managed to maintain their profitability, Ishida points out. He believes the yen could weaken another 10% to 20% against the dollar over the next year or two, giving an extra boost to exporters and the stock market. Despite the recent rally, he views stock prices as reasonable—since profits could improve still further as the economy finds a foothold.
At the same time, he cautions that any rebound in Japan’s economy will depend on the Japanese consumer’s willingness to start shopping again, as well as on the health and profitability of the country’s exporters. And after a long hibernation, he says, Japanese consumers are ready to spend.
“It’s demoralizing to not get a raise in 15 years,” he says. “A major reason for deflation in Japan has been that wages have basically remained flat since 1997 and consumers are afraid to spend. Once consumers get some discretionary income, they are going to want to go on a shopping spree. It’s a sea change in the psyche of the Japanese consumer.”
The observation is supported by government surveys showing a jump in consumer confidence earlier this year. Japan’s stock market rally, which began last September, started with strong performance among exporters but more recently it has come from stronger performance in companies benefiting from domestic demand.
The most enthusiastic shoppers thus far have been Japan’s wealthy, who have taken some of their stock market profits off the table to buy high-end luxury items. Ishida says he’s also seen evidence that companies are giving bonuses and increasing wages, which could eventually give middle-class consumers the courage to crack open their wallets.
Because Matthews Japan invests much of its assets in small and mid-cap names, which sell more of their goods and services within the country than large exporters do, rising internal demand is especially important here. While the MSCI Japan Index has no presence in small companies, the concentrated portfolio of 55 holdings has 22.8% of its assets in companies with market capitalizations of under $1 billion. Mid-cap names with between $1 billion and $5 billion in market capitalization account for 16.2% of assets, while large caps account for the rest. Portfolio turnover is a modest 35%, reflecting Ishida’s and co-manager Kenichi Amaki’s conviction in their stock picks.
Sound stock picking has helped the fund beat the majority of its rivals over the long term, according to Morningstar analyst William Samuel Rocco. “This fund lost far less than the typical non-leveraged Japan stock offering and the MSCI Japan Index in the selloff of 2011, as several of Ishida and Amaki’s health-care and consumer holdings held up relatively well,” Rocco noted in a recent analysis. “And this fund gained far more than its average rival and the index in the rally of 2010, thanks to the strength of the managers’ real estate, industrial and other picks.”
Launched in 1998, Matthews Japan eschews an active currency hedging strategy because its managers believe doing so increases the level of volatility and does not necessarily deliver enough of a benefit to outweigh the additional risk. Because the fund has less of a stake in exporters than the major indexes, its performance can sometimes lag when a weaker yen is driving those stocks higher. On the other hand, a significant presence in small and mid-cap names provides diversification and gives investors a stake in well-run, financially sound Japanese companies that rarely appear in other funds.
Such companies include Nihon M&A Center, which marries individuals and families seeking to sell a business with potential buyers. The stock plays into the theme of an aging population, since many of the entrepreneurs who established these businesses in the 1960s and the 1970s are looking to retire. Nihon, which has a market capitalization of around $600 million, has gained a foothold as the only established player specializing in transactions of under $20 million.
Asahi Intecc, which has a stock market capitalization of $800 million, also stands to benefit from aging populations in Japan and other countries. The company claims one-third of the global market for PTCA guide wire used to place catheters in angioplasties. The product lowers the invasiveness of surgery and helps speed patient recovery time.
One of the top contributors to fund performance since late last year has been Fuji Heavy Industries, which manufactures Subaru brand automobiles. In addition to benefiting from a weaker yen, the company has achieved record sales in the U.S. for four consecutive years, allowing Subaru to reduce buyer incentives, gain more pricing power and increase profitability. Another large-cap holding, Nitto Denko, is the dominant global manufacturer of optical films used for liquid crystal displays and touch panel screens. The technology has been critical in allowing technology companies to produce lighter, thinner products.
The fund’s investment in Mitsubishi UFJ Financial Group, the largest bank in Japan, represents a vote of confidence in the expansion of the Japanese economy. “Until recently, there has been little demand for loans in Japan,” says Amaki. “But we believe the Bank of Japan’s new policies will stimulate the economy and increase demand for loans.”
A number of struggling European banks have pulled out of the Asian market or severely curtailed their lending, leaving a gap for borrowers that Mitsubishi UFJ is ready to fill. “It’s got a higher credit rating and is better capitalized than the European banks,” Amaki adds. “And when borrowers are shunned by a bank, it’s unlikely that they will return.”