Stock-buying opportunities building in Japan

The 9.0-magnitude earthquake that devastated Japan will also likely leave buying opportunities in its aftermath, even as certain economic indicators are pointing in the opposite direction.

“We haven't seen Japanese stocks this cheap in a long time,” said Virginie Maisonneuve, head of global and international equities at Schroder Investment Management Ltd., London. “They looked quite attractive before (the earthquake) and prices became just absurd afterward. We think it's a fantastic buying opportunity.”

While Schroders is still generally underweight Japan relative to global benchmarks, portfolio managers have continued reducing the underweight position within 2 percentage points of the global benchmarks used in various active equities strategies. In comparison, Schroders was as much as 6 percentage points underweight prior to the 2008-2009 financial crisis. Schroders manages about £26.6 billion ($43 billion) in global equities strategies, part of its £201.4 billion in total assets under management as of March 31.

The consensus view places much uncertainty in the short term because of recovery efforts and in the long term because of unresolved structural problems. But the value of Japanese stocks could have reached a floor in the sell-off immediately after the March 11 quake and tsunami and are poised for a sustained rebound, managers said.

Furthermore, the Japanese equity market generally benefits from expected global growth because of its export-led economy and will also stand to gain if the dollar strengthens against the yen, as some predict.

However, others argue that the low pricing clearly reflects problems that have left Japan as arguably one of the most unloved stock markets in the past decade: high sovereign debt and low domestic growth; a rapidly growing percentage of people over 65; and ineffective government intervention policies, sources said.

Japan's economy has been shrinking in terms of global market capitalization, and was overtaken by China last year. Japan's weight within the MSCI All Country World index, which combines developed and emerging markets, was 7.9% at the end of the first quarter compared to 10.5% 10 years ago.

“These long-term challenges for Japan have mostly been priced into valuations,” said Patrick Moonen, The Hague, Netherlands-based senior strategist for equities in ING Investment Management's strategy and tactical asset allocation team.

On top of that, the earthquake, tsunami and subsequent problems at the Fukushima nuclear power plant damaged an already weak economy at a time when the global outlook — particularly in emerging markets — is less buoyant and inflation concerns are rising.

Following the recent quake and tsunami, the price-to-earnings ratio for Japanese stocks was about 12 or 13, and the price-to-book ratio was about 0.95, according to “Market Implications of the Earthquake in Japan,” published by BlackRock Inc. in March. “Current valuations ... are the lowest seen in Japan in 30 years,” according to the report.

“Just because something is cheap doesn't mean it's a good value,” said Stephen Docherty, head of global equities at Aberdeen Asset Management, based in Edinburgh.

Japan has remained underweight at about the same level within Aberdeen's global, and Europe, Australasia and Far East equity strategies, which total about £20.6 billion out of a total AUM of £181 billion. Separately, Aberdeen also manages about £1.5 billion in a Japan-only equities strategy.

Despite holding “some of the strongest balance sheets in the world,” Japanese companies generally have not been “nimble” in its use of cash to improve returns for shareholders, Mr. Docherty said. The return on equity ratio for Japanese stocks averages about half of that for U.S. companies, according to sources. However, managers including Aberdeen are finding some attractive stocks, particularly those with high overseas earnings potential but also some domestic players benefitting from key demographic changes.

Perhaps one of the most notable challenges for Japanese companies is the rise of the yen, which tends to hurt earnings abroad when converted back to the local currency, managers said. The yen's rise led the Group of Seven industrialized nations to cap the currency's upward trajectory in the week following the earthquake. The yen has since pared its gains, trading at about ¥80 per dollar on May 13, from about ¥78 per dollar on March 17. A year ago, the exchange rate was about ¥93 per dollar.

At the beginning of this year, several managers including J.P. Morgan Asset Management, Natixis Global Asset Management and ING IM held an overweight position in Japan, partly due to strong earnings potential, but have since reduced their respective exposures to neutral.

According to David Shairp, London-based managing director and global strategist within J.P. Morgan AM's Global Market Asset Group, Japan had the strongest earnings momentum among developed markets before the earthquake hit, but estimates have since been revised downward. Mr. Shairp added in an e-mail response to questions that the outlook for Japan depends on a number of other factors, “including global activity and how Japan cyclicals fit into this.”

Nicolas Just, head of core equities for Europe and Japan at Natixis, said the firm would consider returning to an overweight position on Japan if economic indicators improve. Currency volatility was a key factor behind the firm's decision to cut back Japan exposure and remains a key worry.

“Our attitude is very cautious,” said Mr. Just, who is based in Paris. “Next year may be quite different with accelerating growth in Japan and decelerating growth elsewhere. Next year could be a good year to buy” Japanese stocks. Natixis has €8.5 billion ($12 billion) in global equity assets under management out of a total of €530 billion in total AUM.

Hung Q. Tran, deputy managing director at the Institute of International Finance Inc., an association of 400 financial institutions based in 70 countries, said the organization's estimates for Japan's gross domestic product growth for this year were reduced to 0.5% from 1% following the earthquake, but were increased for 2012 by at least 0.5% to 2.5%. The International Monetary Fund also cut Japan's GDP growth forecast to 1.4% from 1.6% for 2011 but increased its estimates for 2012 to 2.1% from 1.8%.

“We saw very strong (economic) momentum” in Japan at the beginning of the year, said Mr. Tran, who is based in Washington. “That momentum, combined with additional expenditure when the reconstruction efforts kick in, should provide a very strong outlook” in the next 18 months.

The positive sentiment for 2012 could be derailed by several factors, among them the slower growth in the rest of Asia and other emerging markets, where Japan is increasingly dependent for exports, Mr. Tran said. Currency issues continue to overshadow Japan's corporate earnings; Toyota Motor Corp. last week announced a 77% drop in earnings for the quarter ended March 31, not only because of heavy losses as a result of operational disruptions, but also due to the high yen during the quarter.

Jane Davies, London-based senior portfolio manager in the global investment solutions group at HSBC Global Asset Management (UK) Ltd., said concerns over the currency have been somewhat tempered by the willingness to intervene to stabilize the yen by the Japanese government with cooperation from the Group of Seven. Combined with other medium-term economic factors, HSBC is holding a “moderately overweight position” in Japan within several different investment strategies.

“We started to overweight Japan at the end of last year,” Ms. Davies said. “We don't think it's time to add, but we've maintained our position in Japanese equities.”

Mr. Moonen of ING IM also had an overweight position in Japan at the beginning of the year mainly due to three reasons: continued devaluation of Japanese equities; strong expected earnings growth; and “the somewhat contrarian view that most investors were underweight in Japan.” After the earthquake, however, uncertainty led the manager to reduce its exposure to neutral.

“The value argument has not changed; Japan is still the cheapest developed market,” Mr. Moonen said. “We expect our next move will be to overweight Japan again, depending on not only on the economic factors but also the value of the yen.”

At London-based Threadneedle Asset Management Ltd., managers decided to reduce an underweight position in Japan to neutral from about 2 percentage points relative to the MSCI ACWI global benchmark when valuations became more attractive following the earthquake. Jeremy Podger, head of global equities at Threadneedle, said the firm took the opportunity to buy more stocks in companies in which the manager already had exposure, rather than investing in new companies. Threadneedle actively manages about $3 billion in global equities and about $1.6 billion in Japan-only equities, out of a total AUM of about $100 billion.

“The negative points are out there, but overall, there are few markets of any size” with low correlation to global averages, Mr. Podger said. “Japan is one of them.”