Japan does not always follow the trends in other developed countries. Even when Covid-19 case counts are low, almost everyone voluntarily wears a mask, almost all of the time. Inflation and rising interest rates are top of mind in many other countries but show no signs of materialising in Japan. When many companies cut or suspended dividends early in the pandemic, Japanese companies returned cash to shareholders.
There are reasons that Japan’s economy, companies and equity markets sometimes behave differently than their peers; understanding these drivers is critical to successful investing in Japan. That’s why the JPMorgan Japanese Investment Trust’s highly experienced 25-person team is based in Tokyo, allowing members to gain a more subtle understanding of the corporate and consumer behaviors that ultimately drive Japanese equity performance.
Daring to be different
Although investing in smaller companies may increase the trusts’ risk profile, the portfolio managers seek both large and small companies for the Trust that they can envision holding for the next five to ten years. This requires a sharp and disciplined focus on the sustainable, long-term growth potential for every investment, paying careful attention to the strength of the company in terms of its balance sheet, ability to generate free cash flow and competitive positioning. The investment process also takes into account the performance of companies across a range of environmental, social and governance (ESG) factors.
The resulting portfolio tends to look quite different from the TOPIX (Tokyo Price Index) benchmark. In fact, the Trust’s active share – the percentage of the portfolio that differs from the benchmark – is 93%. The portfolio’s aggregate return on equity (ROE), a measure of profitability, tends to be higher the index, as is its average price to earnings (PE) ratio. While a higher valuation is not always desirable, in this case, the team views it as a reflection of significantly better long-term prospects for the companies in the Trust.
The single market in which the Trust primarily invests, in this case Japan, may be subject to particular political and economic risks and, as a result may be more volatile than more broadly diversified companies; However the focus on long-term drivers of growth means that the portfolio managers will rarely adjust the portfolio based on near-term events, often because these issues don’t significantly affect the underlying investment case. Inflation is a good example; although it is picking up globally, there are no signs yet of wage inflation in Japan. And while some signs of commodity price increases are emerging, including higher petrol prices, many of the companies in the Trust are likely to have pricing power, given their strong competitive positioning. Furthermore, while inflation could have an impact on the overall level of consumption, we do not believe it is likely to impact the rapidly growing market share of online shopping, a trend to which the portfolio is well exposed.
The value of corporate governance
In contrast to more cyclical concerns, such as inflation, the portfolio managers consistently consider corporate governance, which has particular relevance – and presents a particular opportunity – in Japan.
The portfolio managers believe that the potential for improvement in Japanese corporate governance is the single biggest reason for the persistent discount in Japanese equities and is a trend that can play out over many years.
In previous decades, many large Japanese companies were notorious for complicated corporate structures that had little external oversight, often leading to inefficient operations and a lack of focus on shareholder returns. A combination of factors forced changes in recent years and corporate governance has improved by many measures.
One especially noteworthy example is the improved focus on shareholder returns, something the Trust is highly focused on. Going into 2020, more than half of Japanese non-financial companies had a net cash position, suggesting ample ability to return cash to shareholders, but the Covid pandemic hit and severely impacted revenues for many companies. In Europe and the US, many companies cut or suspended dividends, but Japanese companies still returned cash to shareholders. That was a big test and increased the portfolio managers’ conviction that corporate governance reforms are taking hold.
Despite measurable improvements in some areas, much work remains in other areas of corporate governance. For example, Japanese corporate boards are behind their international peers in terms of diversity and independent oversight. Continued improvements in corporate governance over the coming years are therefore likely to be one of the greatest long-term opportunities to increase overall returns.
The JPMorgan Japanese Investment Trust’s successful long-term track record reflects its focus on the true long-term drivers of value and thoughtful approach to understanding of the way these trends might play out in Japan’s unique economy and corporate culture. Whilst past performance is not necessarily a guide to future performance, the Trust has generated annualised excess returns of 5.03% over 10 years, 6.80% over five years and 11.50% over three years, as of 31 October 2021 (net of fees, geometric excess returns)1 .