Shake-up in Japan means investment opportunities

Iain Morse reports on major changes that could open up new horizons in the Far East
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The Independent Online

This is a state-run monopoly employing 250,000 people, which he now has a mandate to privatise. "There is a real change in mood, a sense that nothing, no vested interest, is any more immune from reform if this can be justified in the public interest," observes Andrew Rose, manager of Schroder's Tokyo Fund unit trust, one of the longest established and largest in its peer group.

The effect of this can be overstated. But it is accompanied by significant change in corporate Japan. "Corporate management is starting to focus, in some cases has focused, on returning value to shareholders," says Rose. "This is good news for investors."

In the 1970s and 1980s, Japan was a good place to have money. The Topix rose in value, year in and year out. Brands such as Sony and Toyota became benchmarks for quality, exporting huge quantities of consumer durables to the US and Europe. But by the early 1990s things went wrong.

"The economy was dominated by so-called Keirestu groups after the war," says Robert McKillop, head of Japanese equities at Standard Life Investments. Having achieved dominant positions in their respective markets, these groups were slow to evolve, and sluggish in the face of sharpening competition from South Korean and other low-cost Asian companies.

A huge bubble of institutional and private debt emerged in Japan on the back of booming property values; at one time, Tokyo real estate was the most expensive of any city in the world. In the early 1990s, this was punctured by a rapidly slowing world economy. The Keirestu groups were also heavily invested in each other. "These were massive cross-shareholdings," says John Millar, director and Japanese fund manager at Martin Currie. "As much as 75 per cent of the stock market was cross-held."

These cross-holdings created a close, incestuous corporate culture, with takeover deals agreed in boardrooms or on golf courses, rather than by competitive bidding on the stock exchange. But the 1990s forced the Keirestu to pay off debt by raising money from the sale of cross-held shares. The process was painful and now 75 per cent of the stock market is in free float. Japan has never seen a major hostile takeover, but the day when this happens is coming closer. Arbitragers, private equity bidders and hedge funds, Japanese and foreign, are now in this market and making a difference, says Rose, "something that did not happen a decade ago".

This week, MAC Asset Management, a Japanese absolute return fund, revealed that it had bought over 27 per cent of the stock in Hanshin Railway, and as a result, the share price rose 10 per cent almost overnight. "This might seem pretty routine in the US or UK, but in Japan it is new," Rose adds, "and is galvanising corporate managers, focusing them on shareholder value."

So what about the Japanese stock market? It has a structure very different to our own. The Tokyo stock exchange is split into sections. The first holds more than 1,600 shares with a market capitalisation of approximately £2.26 trillion, up 18 per cent this year. The second section comprises 489 shares with a capitalisation of £393bn, which has risen by 34 per cent this year; after which there is the JASDAQ, a small cap segment, listing 872 shares worth just under £100bn, up 12 per cent for the same period.

Last but not least comes the Mothers, similar to our Alternative Investment Market, for fledgling and very small companies, with 100 shares listed, at value of less than £2bn, which has put on only 3 per cent for the year to date.

The composition of the market by industry sector is also different to our own. There are no oil or resource companies. Electrical appliances account for 13.8 per cent of its value, followed by banks at 10.4 per cent, transport and automobiles at 10.2 per cent, and information and communications at 8 per cent. Investors in this market have been rewarded not by dividends but growth in share prices. Even today, the average yield in the Topix is a slim 1.3 per cent, the same as the yield from Japanese government bonds.

"But we expect dividends to increase," says McKillop, a view widely held by his fellow Japanese fund managers. Why? An attempt to buy greater shareholder loyalty is the answer. Japanese companies are cash-rich, the country enjoying an export boom to China, its single-largest trading partner. And despite these low dividends, Japanese companies look no more expensive than US ones.

"The big difference is that the payout ratio, which expresses dividends as percentage of earnings, is far lower in Japan than the US or UK," says Millar. In fact, the average payout in Japan is 24 per cent against 45 per cent in the US. At the same time, many Japanese companies, particularly small- to medium-sized ones, are still undervalued by the market.

"It is not unusual for a company's share value on the exchange to be less than the amount of cash it has in bank accounts," says Rose. Hence the advent of funds such as MAC Asset Management, seeking to exploit pricing inefficiencies that are much harder to find in the US and UK.

Despite this year's high index returns, this remains a market for stock-pickers. In an inefficient market, this is vital. As is knowledge of the way the market works, and who else might own shares with what declared intentions. Although Japanese fund managers are positive on medium-term prospects for the economy, they agree that a period of far slower share price growth lies ahead. With this in mind, there are 18 Japanese companies with secondary listings on the London Stock Exchange, including Sony, Toyota and NEC. But for most, the only affordable way to buy a diversified exposure to this market is by investing into a unit or investment trust. There are 64 unit trusts investing in all sizes of Japanese companies, returning an average of 13.83 per cent during the past 12 months, and seven unit trusts investing in small Japanese companies, which fell by an average of 14.64 per cent over the same period.

If you prefer investment trusts to unit trusts, there are six available, covering small to large cap shares, which returned an average of 18 per cent over the same period, and five investing exclusively in small companies, which grew by 16 per cent.

Wherever you invest, researching a manager's past performance and the quality of research is vital. Many Japanese funds are run from the UK. A minority, such as Schroder, are run from Japan, with a more close-up, granular view of the market.

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