After a torrid 2018, Japanese equities have been trading at valuations not seen since the global financial crisis but this fails to recognise their strong long-term potential. 
That is the opinion of Archibald Ciganer, manager of the £134.9m T. Rowe Price Japanese Equity fund, who believes that the Japanese stock market has been brought down to attractive levels after some of its growth-oriented companies fell 20-50 per cent from their 2018 peaks.
As the chart below shows, Japan’s Topix was hit much harder than global equities in the final three months of 2018 after markets were rattled by the US-China trade spat and concerns over the health of global economic growth.
Performance of Japanese vs global equities in Q4 2018 (in local currencies)
Source: FE Analytics
This has left the Topix trading at around 12x earnings; this is below that of 2011, when the country was struck by the twin crises of the Tohoku earthquake and the Fukushima nuclear disaster, and a level not revisited since the global financial crisis of 2008.
“What was very surprising, however, was the severity of the sell-off, which saw Japanese equities end the year at their lowest valuation levels in a decade – effectively pricing in expectations of a deep global recession in 2019,” Ciganer said.
“This ‘doomsday’ scenario is highly unlikely, in our view. Consequently, the current valuation case in Japan looks especially compelling.”
Japan ended 2018 in negative territory (down around 16 per cent) but has rallied more than 9.5 per cent over 2019 so far.
The T. Rowe Price Japanese Equity manager explained: “What’s happened since the beginning of the year is that people have come to realise that the global economy is probably not going into recession but merely a slowdown and that’s why you’re seeing the rebound and seeing the rebound in Japan as well.”
This outflow of money exiting Japan in the fourth quarter was partly a product of the country’s history and investors’ memories of burnt fingers, according to Ciganer. Between 1986 and 1991, the Japanese asset bubble pushed up the prices of stocks and real estate but left the country with a long-lasting recession and depressed investor sentiment when it burst.
More recently, prime minister Shinzō Abe’s Abenomics stimulus package has drawn people back to Japan as his three-arrow approach of monetary easing, fiscal stimulus and structural reform bolstered the economy and the market.
Performance of Japanese vs global equities in 2019 (in local currencies)
Source: FE Analytics
But the memories of the heavy losses from Japan still lingers on, according to the manager, which leads to a hasty retreat from the country in times of market stress – such as the recent slowdown in Chinese growth and its trade war with the US.
Ciganer, who favours Japanese quality-growth businesses, conceded that low valuations are not enough on their own to indicate an attractive buying opportunity but pointed to a number of structural positives for the long-term investor in Japan.
These include: record aggregate profits (Japan’s company profits have beaten all other major markets); management teams using cash flows more efficiently; a rise in capital expenditure, set to reverse the past decade’s underinvestment; and a greater focus on shareholders through increased dividends and share buybacks.
“The structural reforms taking place in Japan, particularly at the corporate level with improvements in governance standards, have been tangible,” the manager added. “These measures have been pushed through as a priority, with the aim of building a more robust and globally competitive business environment.”
The manager also argued that the traditional image of Japan’s economy being dependent upon export industries is less relevant today thanks to the size of its domestic economy.
“These shifting dynamics mean that Japan is perhaps less vulnerable to the threat of a global trade war than many believe, and maybe even less so than some other markets,” he added.
“As more investors put these macro developments in perspective—and appreciate the many undervalued, quality companies available—there is real potential for an increase in capital inflows and an upward rerating of the market.”
Ciganer is not the only Japanese manager seeing the long-term potential in Japan, especially when it comes to quality-growth stocks.
Johan Du Preez, head of Japanese equities at M&G Investments, said: “For those investors who believe that Japan can make real progress on the corporate profitability front, there are bargains to be had. Better corporate governance is contributing towards an improved bottom line.
“On the whole, return on equity has increased significantly. Both dividend pay-outs and share buybacks are nearing all-time highs. We are starting to see a greater willingness by company management to engage with investors. As long-term investors, we believe this presents significant opportunities for global investors.”
Meanwhile, Comgest Growth Japan manager Richard Kaye recently told FE Trustnet that the return of Japanese domestic institutional investor to the domestic market is one of the trends that will support a long-term rally in quality-growth names.
The T. Rowe Price Japanese Equity manager concluded: “We still believe the world will see economic growth this year, albeit more modest growth on both an economic and earnings basis. This does not imply the need to rotate into defensive stocks or to sell Japan stocks.
“With many of these quality, growth-oriented businesses currently trading at some 20–50 per cent below their 2018 highs, we believe now is the time to invest in Japan to take advantage of the attractive long-term return potential on offer.”
Performance of fund vs sector and index under Ciganer
Source: FE Analytics
Ciganer took over the T. Rowe Price Japanese Equity fund in December 2013, since when it has made a 91.07 per cent total return. This ranks it sixth out of 61 funds in the IA Japan sector.
The portfolio is built around high-quality companies that are leading players in their respective field or are well placed to benefit from long-term structural changes or trends taking place in both the domestic and global economies. Top holdings include Softbank Group, Nippon Telegraph & Telephone and Takeda Pharmaceutical.
The fund has an ongoing charges figure (OCF) of 0.87 per cent.