Japan’s quality-growth stocks are likely to continue rallying over the long term, according to Comgest’s Richard Kaye, as domestic investors embark on a multi-decade return to their home market.
Many investment commentators expect the quality style of investing (or focusing on companies that are highly profitable, boast a strong balance sheet and are not reliant on a surging economy) to endure a challenging period at some point in the future.
This is because quality stocks have enjoyed a strong run in the post-crisis environment and have led the rally, beating the value style – or buying unloved companies – by a wide margin. Over the past five years, the MSCI World Quality index has posted a 101.94 per cent total return while MSCI World Value gained just 61.27 per cent.
Performance of indices over 5yrs
Source: FE Analytics
In Japan, however, quality has outperformed value by a much smaller margin – as can be seen in the above chart. While the gap in the two styles stands at 40.67 percentage points at a global level, it falls to just 20.16 percentage points for Japan.
Kaye, who runs the ¥170bn Comgest Growth Japan fund, believes that Japanese quality-growth stocks are at the start of multi-decade rally and that they are unlikely to be beaten by value any time soon.
“The Japanese domestic institutional investor – the Japanese pension funds and banks – are returning to the Japanese equity markets. It's a trend which began slowly in the mid-2000s and has slightly accelerated in recent years. It's still a slow trend,” the manager said.
“Japanese institutional ownership of their own markets is still only edging up very slightly but it is consistently rising and that, in our view, is a very important dynamic which will probably not go away.”
At the peak of the Japanese equity bubble in the late 1980s, around half of the Tokyo Stock Exchange in market capitalisation terms was owned by Japanese institutions. But by the mid-2000s, this had fallen to little more than 20 per cent as these investors tilted their portfolios towards international equities.
“Much of the story of the last 20 years, where everyone's been saying Japan is a constantly falling market and so on, was actually written by Japanese institutions selling their own market: Japan was selling Japan,” Kaye explained.
“Because the market peaked in 1989 or 1990 and then fell spectacularly during 1990, Japanese institutional investors simply lost faith in their markets and a self-reinforcing cycle set in.”
This has changed more recently, however, and domestic institutions are coming back to their own market. One major reason is the large underfunded problem facing many Japanese pension funds.
Performance of index between 1986 and 1995 in yen
Source: FE Analytics
Kaye argued that one of the easiest ways for Japanese pension funds to close this funding gap is to buy Japanese businesses, with a focus on quality names, then tell management that they need to see better performance, rising share prices and/or dividend payouts.
“The domestic institution has come back into the market with a clear quality focus, a clear demand for returns and frankly an almost activist stance which has never been seen before in Japan. This, I think, is the fundamental story that's driving the market over the last five years,” he said.
The manager added that Japanese institutions still have some way to go before they own anywhere near the amount of the home market that they did in the 1980s. Current data suggests they own around 27 per cent of the Tokyo Stock Exchange’s market cap, but this is rising “steadily but slowly”.
He also added that institutions going back in domestic equities after a 20-year hibernation with a clear focus on returns is “a phenomenon that doesn't exist in other markets”. This is because most other markets already have a high participation by their own institutions.
“The allocation that these Japanese institutions have made to their market is a still embryonic and therefore still has a large scope to grow and to grow in a quality direction,” Kaye added.
Furthermore, the manager believes it is unlikely that the value style will outperform quality-growth in Japan as the institutional investors returning to the country will be reluctant to look at value stocks.
In Japan, the main targets for value investors are banks and car manufacturers but Kaye believes sectors are “serial destroyers of wealth”. Japanese banks, for a number of reasons, seem unable to capitalise on economies of scale, according to the manager, while the auto firms are struggled to cover their cost of capital.
“If people are focusing on those two sectors as the primary as the primary targets of value investing, they will probably visit because disappointed - as they have been for the last 10 years or so later in the Japanese market,” he said.
Performance of fund vs index since Dec 2017
Source: FE Analytics
Kaye has managed the Comgest Growth Japan strategy for the past 10 years, although it was only made available to UK investors at the end of 2016. Since then, it has made a 25.87 per cent total return, which is the third highest in the IA Japan sector.
The fund has an ongoing charges figure (OCF) of 1.15 per cent.