Why Japan and Why Now?

Key Takeaways

»    Following the recent market sell-off, triggered by the unwinding of speculative short positions in the Japanese yen,  many Japanese companies with price to book values below 1x were anticipated to accelerate share buybacks.
»    Several positive trends could propel the market higher and Japanese stocks look attractively valued on a price-to-earnings basis.
»    Seven & i Holdings, a holding since 2022, has had challenges, but we maintain high conviction as there appears to be limited downside risk at current stock price levels on various metrics.
»    With our Fund invested in all three listed megainsurance groups, a key concern is the impact a mega-earthquake in Japan would have on the companies’ financials. We believe each insurance company is prepared sufficiently.
»    We believe a successful approach to investing in Japanese stocks requires a deep understanding of these unique characteristics.

How has the yen carry trade affected the Japanese stock market?

August started with an unprecedented market sell-off triggered by the sudden unwinding of speculative short positions in the Japanese yen (JPY) known as carry trades, which had been a factor behind the currency’s depreciation. Carry trades are widely employed by speculative traders where JPY is used as a funding currency to invest in higher-yielding risk assets. The strategy is essentially a bet against the Interest Rate Parity theory, and as such it is only profitable if the theory does not hold over the investment horizon. The risk is that the funding currency, in this case, JPY may appreciate significantly against the currency of the investment, which would reduce a trader’s profit or even lead to a loss. 

On the positive side, Japanese companies that once again fell below 1x price to book ratio (P/B) after the sell-off are anticipated to accelerate share buybacks. This is a driver that could not be relied upon before last year’s Tokyo Stock Exchange announced the “name and shame” companies below 1x P/B.

While the future is uncertain, JPY continues to be the only major currency with negative real interest rates, which creates rate differentials with other currencies. We are biased towards the continued relative weakness of JPY. In other words, we believe the yen’s status as the funding currency for carry trades will remain unchanged. For this reason, it 
is unlikely that JPY will strengthen against the U.S. dollar (USD) as it did in 1995 and 2009-2012 when the exchange rate shot through 80 JPY/USD.

Where could Japanese equities head from here?

We believe the market should move towards its all-time highs given several positive trends: 

•     The progress of corporate governance reforms by Japanese companies
•    Consistency in domestic inflation
•    Normalization of interest rates
•    An increase in inbound tourists to Japan
•     An expansion of inbound foreign direct investments in industries such as semiconductors
•    A potential turnaround in real wage growth

Valuation-wise, Japanese stocks traded at 17x price to earnings ratio (P/E) just before the market crash and by the end of August, was at 16x. This is below the levels before the start of the government-led corporate governance reforms under the Abenomics policy. While the quality of Japanese companies has greatly improved, the valuation multiples have yet to reflect this. We expect the re-rating of market valuation to continue to be a tailwind. 

Would you please discuss Fund holding, Seven & i Holdings?  

We have been continuously buying shares of Seven & i Holdings, the world’s largest convenience store operator, since initiating the position in 2022. As of September 30, 2024, it was one of the Fund’s top holdings. 

However, it does not mean that we approve of the company’s financial performance. It has been far from satisfactory with same-store sales continuing to stagnate in both Japan and the U.S. Low-income consumers are feeling the pinch as sticky inflation has been eroding their purchasing power. Thus, our buying is a contrarian move.
The convenience store business is inherently an attractive retail business that generates high returns on capital and ample cash flow underpinned by stable demand given that it sells essential goods. The company’s long record of accomplishment as a pioneer in this field also gives us a sense of “safe and sound business.”

To address the ongoing challenges, the management is implementing the right strategies to bolster sales at existing stores in the U.S., in our opinion. U.S. convenience stores are often attached to gas stations, and many customers shop there while filling up their tanks. These stores often lack cleanliness and even can make customers feel unsafe at times. There is a lack of incentive for customers to willingly shop at these convenience stores. Recognizing these issues, the company is aggressively renovating its existing stores, i.e., changing the store signage, installing new bathrooms, redrawing lane markings in the parking spaces, etc. 

It is also expanding its product lineup focusing on fresh food. Seven & i is partnering with Warabeya, a supplier for Seven-Eleven Japan, rolling out commissaries to make a wide range of food offerings (i.e. sandwiches, burritos, hotdogs, rice balls, ramen, etc).
While the appearances of Japanese and American convenience stores are vastly different, if the company can successfully apply the Japanese strategies to the U.S., it could significantly open growth opportunities. The Japanese model should resonate with American consumers.
The company is also transferring its operational know-how such as “Tanpin Kanri (Item-by-Item Management)” from Japan. This system traces the movement of each merchandise item and collects extensive demographic data to improve the accuracy of the next order placement for re-stocking and help each store localize its assortment to the needs of customers. 
We are also keenly watching its Japan operations. Japan’s consumer value store (CVS) industry is dominated by three players with Seven-Eleven being the long-term market leader. It is already a mature market but a strong cash cow. Though same-store sales performance has been sluggish, we are sanguine about the company’s prospects. Considering the company’s long-standing track record as an industry pioneer, we believe management will eventually be able to turn around sales.
Another reason we maintain high conviction is that there appears to be limited downside risk at the current stock price levels measured by P/E, EV/EBITDA and free cash flow (FCF) yield.

What are the implications of Japan’s mega-earthquake risk for the insurance sector?  

Our Fund has been invested in all three listed mega-insurance groups—Tokio Marine, SOMPO Holdings, and MS&AD Insurance Group Holdings—since the spring of 2022. A key concern regarding these insurance groups is the impact on the companies’ financials in the event of a mega-earthquake in Japan, which is prone to such disasters.

The good news is that domestic property and casualty (P&C) insurers do not take on the earthquake insurance risk for personal properties and is entirely borne by the Japanese government. The private-sector insurers only underwrite earthquake insurance for commercial lines with the risk being carefully managed using reinsurance. Importantly, while a significant earnings decline for a quake-hit year is inevitable, we believe it is highly likely that the insurers’ financials will remain sound.

If these disasters occur today, there would likely be at least short-term knee-jerk negative reactions on shares of the insurers. Not only will there be a temporary surge in incurred losses, but also there will be a sharp drop in dividend income from policy shareholdings, a significant decline in the market value of the equity portfolio (which is currently in the multi-year process of complete sales), and an event-driven surge of JPY, which will hurt their overseas operations. 

As such, their ESR (Economic Solvency Ratio), a measure of the financial soundness of an insurance company, would fall significantly. However, we believe Japanese insurance companies have the financial strength and profitability to keep their finances from being impaired. Once the fiscal year is behind them, they would likely recover. 

The Japanese insurers have been through numerous natural disasters with a sharp increase in insurance losses at times, yet their share prices have continued to reach all-time highs. We do not think that there is need to worry excessively as each insurance company is prepared sufficiently, precisely because Japan is an earthquake-prone country.

Why does the Fund not invest in real estate stocks as an inflation hedge?  

Our base-case macroeconomic scenario since 2022 has been “higher for longer inflation” and “the normalization of interest rates” in Japan. As such, we find businesses that are resistant to inflation (strong pricing, differentiated products, brand image, etc) and, more recently, the businesses that benefit from rising interest rates, attractive.

Inflation also calls for investments in shares of asset-rich companies that benefit from rising asset values. Specifically, real estate companies come to mind as well as asset-rich companies with non-core property holdings, whose share prices are heavily discounted relative to their property market values. However, our Fund does not invest in these types of companies including the major real estate developers for the following reasons: 

•     The real estate business is inherently capital intensive and hard to differentiate other than geographical advantages.
•     Major Japanese property developers have inferior return on equity (ROE), dividend yields, and share buybacks relative to their market cap compared to the Fund’s holdings such as the non-life insurers, the mega banks (MUFG), and trading companies (Mitsubishi Corp).
•     Generally, we are less attracted to asset-rich stocks with unrealized gains on assets held outside of their main businesses or unrealized gains on assets that are unlikely to be ever sold in the future.

On the other hand, from the perspective of hidden asset value, Fund holding ORIX is a company whose main business model encompasses the process of identifying investment opportunities executing investments and ultimately exiting them. We find businesses like ORIX more appealing, where 
the unrealized gains on held assets are regularly realized through capital recycling.

What is the case for active management in Japan?  

The Japanese culture is unique, both positively and negatively, especially when viewed from 
a Western perspective. Additionally, there is a language barrier. Based on these factors and years of experience, we believe a successful approach to investing in Japanese stocks requires a deep understanding of these unique characteristics.
We also believe active managers can thrive in Japan because the market is still very much inefficient. According to data compiled by Morningstar Japan at the end of January this year, 31.6% of Japanese active large-cap equity funds outperformed the TOPIX over 10 years.  Over 3 years and 5 years, the percentages were 31.6% and 39.7%, respectively.¹ 
For these reasons, we recommend investing in Japanese stocks through active management.