Increasingly positive earnings forecasts and a growing valuation disparity between different types of stocks has prompted Invesco Perpetual’s Paul Chesson to back cyclical, value stocks in Japan despite the growth style coming back into favour.
Chesson, lead manager of the £332.3m Invesco Perpetual Japan fund, has moved away from a balanced portfolio in favour of cyclical stocks, which he said have more value characteristics in Japan.
In 2016, the value style outperformed growth in global markets for the first time in several years as money flowed into equity markets buoyed by the election of Donald Trump and the so-called ‘reflation trade’.
In Japan, last year, value stocks outperformed growth stocks for the second year running. However, this year growth stocks have delivered much stronger returns than their value counterparts, as the below chart shows.
Performance of indices YTD
Source: FE Analytics
The shift has impacted performance of Chesson’s fund this year.
Having previously held a cautious medium-term outlook on Japan, the fund had been more balanced. However, last year the manager chose to increase its weighting towards cyclicals and financial stocks as fundamentals for the sectors had started to strengthen and market valuations had presented particularly good value to the manager.
“Coming into 2017 we saw no reason to change the strategy,” he said. “As 2017 progressed, although the improving trends in profits and the economy – not just Japan but globally – has continued, we have seen the reversal of the relative performance of cyclicals and financials compared to growth stocks, which has affected our strategy this year.”
Yet, despite the growth style returning to favour in 2017, Chesson has been increasing his exposure to cyclical stocks over the past year.
“Whereas a year ago we had a more balanced portfolio between cyclicals and defensive sectors, we have become more cyclical as the year has progressed,” he said.
There are several reasons why Chesson has stuck by more cyclical stocks, one of which is the continued improvement in profit momentum set against a more positive economic backdrop.
“But [it’s] also because relative valuation disparity between growth stocks and cyclicals has widened once again, leading us to conclude there is a continuous and stronger case for having more of a cyclical portfolio,” he added.
Forward earnings forecasts between cyclical and defensive stocks have moved much wider relative to history, increasing the investment case for the former part of the market.
As such, Chesson has made several changes to the portfolio to take advantage of the disparity between growth and more value stocks.
“As an example, by the middle of this year one of the worst sectors in terms of share price performance had been the steel sector,” Chesson explained. “And yet that is one of the sectors that right through the year has some of the highest net profit growth expectations for the full year. That dichotomy was quite eye-catching and that has led us to make changes to our portfolio.”
The manager said he has stuck by his overweight in Japanese banks despite having a negative impact on the fund.
Chesson said while profit growth at larger Japanese banks is lower than the average for Japanese companies, he believes the discounts they are trading on are too great for current market conditions and would be even in a more modest growth environment.
He said Japanese bank valuations continue to trade at wider discounts to their international peers despite improving fundamentals.
“We think that the case for this overweight position is at least as strong as at any time in the last year when we held it,” he explained, adding that it was “one of the most important calls in the portfolio”.
The manager said he had reduced its overweight position in defensive sectors such as utilities as the investment case for cyclical stocks continued to improve.
He said it had added to its position in transportation equipment stocks and as such has added Toyota to the fund more recently. Elsewhere, the manager said the fund’s overweight position in mining hasn’t changed and has benefited more recently from the rise in commodity prices.
Additionally, he has moved to overweight positions in the real estate and steel sectors having taken profits from the utilities sector.
“Having shifted the portfolio more decisively towards areas of the market which are inevitably sensitive to growth in the economy, at the moment. In nature that would leave me more exposed to any disappointment in that growth” he said.
“But the very fact I’ve done it is that I have more short-term evidence that this growth is more broad-based and likely to be sustainable.”
The manager said that the biggest risk would be a much bigger shock to markets than he is currently expecting, such as a reversal of monetary policy, profit growth or economic growth.
Chesson has managed the fund since 2000 and was joined by co-manager Tony Roberts in 2009.
Year-to-date the fund has returned 3.44 per cent compared with an 8.62 per cent total return for the average IA Japan sector fund, which the fund is also benchmarked against.
Over three years the fund has delivered a total return of 55.04 per cent compared with a 62.47 per cent gain for the sector average, as the below chart shows.
Performance of fund vs sector & benchmark over 3yrs
Source: FE Analytics
“This is a ‘best ideas’, high conviction fund, run by an experienced fund manager who has spent his career investing in the Japanese stock market,” noted analysts at Square Mile Research.
“The manager's valuation led approach can result, and indeed has resulted, in strong variable performance relative to a stock market index, for good or ill, and is unlikely to suit investors who are seeking indexlike returns.”
The fund has an ongoing charges figure (OCF) of 0.93 per cent.