Though a change at the top can bring uncertainties, Yoshihide Suga, successor to Prime Minister Shinzo Abe, is from the same administration and has been a strong supporter of Mr. Abe's policies and reforms.
Investors should look past the current political situation and focus on the attributes that make Japan an attractive market for active managers.
Though Japan has often been overlooked by global investors, in large measure because of its anemic economic growth and aging population, it offers a deep investment universe of high-quality companies that generate sustainable earnings growth.
Investing in Japanese companies is not equivalent to investing in the economy itself. Since 1994, while nominal GDP has risen just 4.5% through the end of 2019, corporate profits are up 160% in U.S. dollar terms over that same period.
Despite going through decades of economic stagnation, plenty of companies have a strong track record of delivering sustainable earnings and profit growth without relying on macro conditions or leverage.
One of the biggest misconceptions investors have about Japan is that its economy is export-oriented. Exports, in fact, account for 16% of total GDP compared to more than 40% each for South Korea and Germany. More than 75% of Japan's GDP comes from domestic consumption and private/public capital expenditure.
And though Japan's percentage of the population over 65 is the world's largest, Japanese consumer brands have a huge market on their doorstep, with strong demand in Asia, home to 60% of the global population. Products made in Japan enjoy high popularity thanks to their focus on quality and innovation. The companies producing these goods are in a solid position to benefit from favorable demographics and the growing middle classes in these countries.
There are opportunities among purely domestic companies, too, in promising technology areas where penetration in Japan is extremely low. These include e-commerce, digital payments and software-as-a-service. Japan's structural labor shortage and low labor productivity should drive long-term spending on IT services and software, both good hunting grounds for investment opportunities.
Additionally, Japan has strong, global franchises that have dominant market share in industries driven by secular growth in sectors including machine vision, medical equipment and semiconductor products. The country is a global leader in industries that require precision manufacturing and state-of-the-art technology. In fact, more than 50% of industrial robots globally are made by Japanese firms, and we believe that share of the market will continue to rise.
Yet, Japan is very much under-researched by industry analysts. More than 40% of companies do not have any local coverage. Overall, Japanese companies are less sophisticated in terms of investor relations compared with other developed markets. Though this requires active managers to go the extra mile in researching companies, it will reward their efforts. We believe the information gap can be mined profitably by active managers seeking to uncover hidden gems. And it explains why Japan is the perfect country to generate active returns for institutional investors, especially for those with a bottom-up stock picking approach and a benchmark-agnostic investment philosophy.
Occasionally, the Japan market suffers from high volatility caused by the high turnover from foreign investors. Stock performance can deviate significantly from the fundamentals, but that market volatility or equity mispricing is, in our view, a friend rather than an enemy.
The equity correction in the first quarter of 2020 was mainly caused by concerns about the COVID-19 outbreak, which turned into a global pandemic. In anticipation of global market weakness, we are more focused on purely domestic Japanese companies with high earnings visibility. This includes drugstore operators and discounted retailers that offer daily necessities, along with software and IT solutions providers that generate recurring annual income. Most of these companies have benefited from tailwinds created by the pandemic, which has accelerated the adoption of their products and services.
Another advantage of Japanese companies is their strong cash position and aversion to carrying high levels of debt. This allows these firms the flexibility to maintain or increase shareholder returns in a post-COVID-19 environment and provides a war chest to make acquisitions at attractive valuations.
Over the next few years, Japanese companies will be better positioned for industry consolidation, particularly compared with global peers constrained by high debt levels.
Overall, Japanese equities provide a wealth of opportunities for institutional investors, and that will remain the case regardless of short-term political leadership changes.
Sophia Li, portfolio manager, Japan equity strategy, at FSSA Investment Managers, based in Hong Kong. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.