Dearth of sell-side coverage could complicate – or extend – Japan rally

Asset owners looking to boost allocations to Japanese stocks in the wake of Tokyo's star turn this year may increasingly have to take that market's dearth of sell-side coverage into account, whether as an obstacle or an incentive, market participants say.

The spike in institutional interest on the back of this year's world-beating 25% rally by Tokyo-listed stocks has outpaced the ability of sell-side firms to ramp up coverage that lapsed as decades of deflationary pressures and tepid growth made Japan a backwater for asset owners globally.

After decades of being "a forgotten market ... you can't just flip the switch" and have adequate coverage overnight, noted Hayley Tran, managing principal and co-head of equity research with investment consulting firm Meketa Investment Group.

"Global investors have done well by ignoring Japan for decades," rightfully allocating their analyst resources to other markets, agreed Drew Edwards, partner, head of Japan value equities and portfolio manager with GMO.

As recently as the early 2000s, there was a lot more robust coverage of small- and midcap stocks than today, even as companies — in line with their growing embrace now of corporate governance reforms — began providing more disclosure, leaving fewer feet on the ground as well as eyes and ears listening and studying the story, Edwards said.

As a result, investors newly focused on the Japanese market "are not going to be able to just capture reliable investment theses by reading a sell-side" report, he said.

To the extent weak coverage leaves attractive Japanese companies in the shadows, however, active managers will have more opportunity to uncover hidden gems, Edwards said.

Japanese stocks have already grabbed investors' attention this year, with the benchmark Nikkei 225 stock index's 25% year-to-date gain topping the S&P 500's 15% rise, helped by a cocktail of attractions.

Among them — according to Ben Williams, portfolio manager with Japanese equity boutique Arcus — are "a valuation story," with price-earnings multiples dramatically below those of U.S. stocks; "a corporate governance story," with Japan's government, the Tokyo Stock Exchange and increasingly corporate executives working hard to improve Japan's investment landscape; and a "balance sheet story," reflecting Japanese companies' success in paying down debt over the past 20 years.

Portfolio managers see the corporate governance angle as the one most capable of sustaining investor interest over the longer term.

Investors threw money at Japanese stocks a decade ago when then-Prime Minister Shinzo Abe announced his "three arrows" program of aggressive monetary and fiscal stimulus accompanied by structural reforms, noted Nicola Takada Wood, portfolio manager of London-based Redwheel's Japan Active Engagement strategy.

They quickly lost faith when reforms didn't produce near-term results — reflecting unrealistic expectations considering the scale of Abe's ambition: to change "an entire country's corporate culture," she said.

With those reforms really coming through now all these years later, Wood said "this is the most excited I've seen the market about Japan" over her 18-year career.

After decades of being "the sick man of institutional allocations," over the past 12 to 18 months Japan has become a hotspot, agreed Meketa's Tran.

She said Meketa is having active discussions with clients now considering dedicated allocations to Japan in pursuit of alpha as well as moves to narrow or close long-held underweight positions there.So far, market participants say, the lack of analyst coverage has yet to emerge as a major topic, as the bulk of initial institutional flows to Japan over the past year or so has gone to beta products such as exchange-traded funds and futures.

The considerable pickup in interest in Japan this year has been focused on large caps, cyclicals and value — the usual pattern for investors returning to a market of using ETFs to get their initial exposures, said Oliver Lee, client portfolio manager with Eastspring Investments.

Still, some financial firms already spy potential signs of trouble.

An Oct. 6 note on Japan by Goldman Sachs pointed to a 9% correction for Tokyo stocks over the two weeks through Oct. 4 as a possible sign that investors were crowding into an overly narrow group of stocks, leading to greater volatility.

Absorbing continued international flows into Japanese stocks may require "broader sell-side coverage … to encourage less concentrated trading," the report said.

Goldman's report noted that only 230 stocks or so in Japan had average daily trading volume of more than $20 million, a fraction of the 1,480 U.S. stocks and 1,384 mainland-listed China A-share stocks meeting that threshold.

Especially now with investors looking to shift allocations to Japan from China, the lack of sell-side coverage in Japan could prove a "bottleneck that prevents a broadening out (of) foreign investor trading activity in Japan," Goldman Sachs said.

Market veterans agree that the small- and midcap equity space will offer both the biggest challenges and the greatest opportunities.

Residual coverage in Japan has focused on large-cap companies but the loss of small- and midcap coverage has been akin to a "brain drain," said Redwheel's Wood.

If Japan's market proves capable of sustaining its rally, said Eastspring's Lee, investor interest should eventually extend to active, stock-picking strategies — first large cap but then small- and midcap as well.

If and when that happens, decades of cutbacks, which have seen the ranks of sell-side analysts drop by 50% or so over the past 20 years, will force buy-side analysts to work overtime to identify undiscovered diamonds, a quest that Eastspring's six-member Japanese equity team is well placed to take on, he said.

Even in the large-cap realm, however, some market veterans see sell-side coverage as inferior not only to the U.S. market but to some emerging markets as well.

For Suzuki Motor Corp.'s joint venture in New Delhi, Maruti Suzuki India, "you can find 30 different analysts but when it comes to Toyota, I think you can find only 15," noted Daisuke Nomoto, head of Japanese equities at Columbia Threadneedle Investments and senior portfolio manager of the firm's $1.2 billion concentrated Japan equity fund.

"If you go down to the smaller cap space, there are many companies (that) have no research coverage, which is great for us," he said. Even if ETFs were a convenient first step, "the real attraction now is stock picking," he added.

Eastspring's Lee likewise pointed to Japan's small- and midcap equity space as offering the greatest alpha opportunities now.

That segment is trading around a record discount now in terms of valuations compared to their large-cap counterparts, Lee said. And if corporate governance reforms are the prime attraction, small- and midcap companies "are probably levered into that story more than large caps," he said. "They have more cash on the balance sheet, they have more cross holdings, so there is arguably more valuation potential in the small- and midcap space in Japan than last year given those sort of reforms that we've seen from the Tokyo Stock Exchange," he said.

If market inefficiencies are setting the stage for alpha, those opportunities should persist for a while.

"Increasing sell-side research coverage cannot be achieved overnight and will require commitment from both the sell-side and the buy-side if it is to be achieved," according to Goldman's Oct. 6 report.

Portfolio managers and consultants said they have yet to see signs of sell-side firms boosting the resources they're dedicating to the Japanese market yet.

But money managers are devoting more internal resources to get the story out on Japan, noted Meketa's Tran.

"Every once in a while, every couple of years, we will throw a bunch of people at a project" and Japan is this year's project, said Ken McAtamney, partner and head of William Blair's global equity team.

In September and October, the firm sent a dozen team members to Japan to meet with policymakers, government bodies, consultants and domestic asset managers to get their perspective and came away determined to narrow its underweight to that market to perhaps 25% below the benchmark, after 20 years or so of being half the benchmark or less.

"As we analyze more, as we learn more, as we have more conviction, I can see us doing more there," he said.