A poor end to the year saw Japanese funds rank among the worst performers of 2018 – but could this year see a turnaround?

Japan’s TOPIX index hit levels not seen since the early 90s in the first part of 2018, while the Nikkei index broke the 24,000 barrier for the first time in years.

Yet by the end of the year the indices had plunged and the average Japan fund lost 11.3% in the year.

WHO PERFORMED WORST?

The worst performers in the sector over the past 12 months are the Neptune Japan Opportunities (B3Z0Y81) and Fidelity Japan Smaller Companies (B73VMD5) funds, down 25.9% and 22.2% respectively. Just one fund, Lindsell Train Japanese Equity (B3MSSB9), is in the black over the past year, up just 1.7%.

But experts say the outlook for the region is still strong: companies are more shareholder friendly than ever before, the stock market is great value and the economy is in decent shape. So, what has caused the poor performance? Largely to blame is the strength of the yen – it climbed around 8% against sterling in recent months.

The Japanese yen is seen as a safe haven currency so tends to rally at times of uncertainty; that is why the strengthening of the currency and the fall in the stock markets were particularly noticeable in October, when there was a global sell-off.

But that’s bad news for corporates: Japan is a big exporter of goods such as cars and electronics, and these products become more expensive when the yen strengthens, which makes them less attractive to overseas buyers – also not helped by ongoing trade war concerns.

POLITICAL STABILITY (UNLIKE THE WEST)

While the country’s economic growth is largely uninspiring – around 1% to 2% a year – Japan has something going for it that much of the West does not currently: a stable political backdrop, reinforced by the re-election of prime minister Shinzo Abe in September 2018.

Michael Stanes, investment director at Heartwood Investment Management, says: ‘The profit picture in Japan is actually very positive. The return on equity of the largest companies is expected to exceed 10% - a record high – as a result of various government measures to encourage companies to  boost returns.’

As well as that, firms are more keenly using share buybacks and dividends to reward their shareholders, where previously they have preferred to hoard cash on their balance sheets. Interest rates in the country are currently -0.1%, and likely to stay that way until at least 2020, which helps to encourage spending and investment among both companies and consumers.

But there are still clouds on the horizon. This year will see the abdication of the current Emperor, local elections and the raising of consumption tax from 8% to 10%. Still, experts focusing on the region are finding opportunities, particularly amid the recent market falls.

ON THE HUNT FOR OPPORTUNITIES

Tsunori Kitakura, lead strategist at Sumitomo Mitsui Trust Asset Management is forecasting that GDP will only rise 0.9% in real terms this year but thinks household incomes are likely to rise as the labour market tightens, which should boost consumption.

Eiji Saito, manager of JPMorgan Japan Smaller Companies (JPS) is particularly excited by innovative tech stocks in the region. ‘Japanese small-caps remain attractive as technological innovation takes hold,’ he says.

Saito looks for companies benefitting from technological innovation, such as those in the retail and autos industries where there is a growing use of online services, as well as those which are not afraid to adapt and modernise.

Top holdings include Bengo4.com, an online service which connects lawyers with people who need legal advice, and payments services firm GMO Payment Gateway.

He adds: ‘The service economy [in Japan] is quite under-developed and many high-growth niches are there to be exploited by companies with the right skills and insights.’ The trust is down 18.9% over the past 12 months, but up 41% over three years.

Kitakura likes businesses in the automation, technology and healthcare industries and believes strong earnings growth could push the Nikkei to 25,000 in the coming year.

‘INNOVATIVE BUSINESSES’

He says: ‘There are many innovative businesses in these areas which offer solutions to Japan’s social problems and will be key contributors to issues such as labour shortages and the country’s growing ageing population.’

He is invested in Keyence, which makes automated equipment to help improve productivity in factories, and Daifuku, which provides e-commerce logistics solutions. Another holding is pharma giant Daiichi Sankyo, which has had successful clinical trials with cancer treatments.

Joël Le Saux, manager of the Oyster Japan Opportunities (B09DHP3) fund, is focusing on undervalued mega-cap stocks because they have underperformed in recent years and look to be good value. He likes service firms, which are becoming a more important part of the stock market while cyclical business and exporters have seen their weightings decrease.

Top holdings in his portfolio include Mitsubishi Financial Group, Japan Electric Railway and Japan Post Bank. The fund is up 17.4% over the past 12 months and up 9.3% over three years.

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