Sudden changes in market direction can be unsettling for investors, especially when they are not grounded in long-term fundamentals – or even seem to go against them.
The rotation in the Japanese equity market in the first couple of months of 2022 has been extreme. However, a careful look at the drivers reveals why it is likely to prove temporary and how a focus on individual companies with long-term drivers of growth generates better returns over time.
We’ve been here before
The Japanese equity market is not immune to broader market forces. Concerns about rapidly rising inflation, especially in energy, and accelerated interest rate increases in several regions have sparked a rotation in global equity markets towards Value stocks, which tend to outperform Growth stocks when inflation and interest rates are rising.
In the first two months of 2022, the cheapest companies in the Japanese market – those with the lowest price-to-book (P/B) ratio – have had their second strongest performance in 30 years. Value-oriented industries, such as banks, energy, commodities, steel and autos, rallied sharply. At the same time, investors traded out of many Growth companies related to long-term trends, such as the continued migration of activity online and automation, despite no changes to their fundamentals.
Inflection points in the market can create favourable or challenging environments for portfolios, depending on the investment style. The JPMorgan Japanese Investment Trust benefited significantly in the early stages of the pandemic due to kinds of companies the portfolio owns for the long term – for example, lots of companies related to e-commerce and other internet businesses, whose growth exploded as in-person activity moved online almost overnight.
We have also been through similar rotations that went against the portfolio’s long-term positioning, most recently in early 2021, following the announcement of a Covid-19 vaccine, when Value areas of the market rebounded in anticipation of a big cyclical recovery.
As experienced investors, we have seen enough of these inflection points to understand that while they may feel dramatic at the time, they are not unusual. The portfolio’s long-term track record supports our investment strategy of staying focused on long-term growth of individual companies.
Steel and banks? No thanks
The portfolio remains invested in the innovative and fast-growing Japanese companies that we expect to own for years. Our long-term view on most of these companies helps explain why we remain confident in their abilities to withstand the current market environment and why we’re quite happy not owning some of the recent outperforming stocks.
Many of the companies that have rallied recently were cheap for a reason: They are in industries we believe have key structural issues. Increased global focus on the environment will continue to negatively impact steel manufacturers, which are highly polluting, while traditional autos are facing mounting competition from electric vehicles. Japanese banks have only a 5% return on equity (ROE) that is trending lower as its aging population does not need to borrow money and many households have large cash positions; they also risk disruption from fintech companies.
Investing in a more digital, automated and greener future
Long-term secular growth themes in Japan, such as digitisation, automation, ecommerce, renewable energy and an aging population, are all trends that we believe will continue to support growth for solutions providers and market leaders for many years. In some cases, this is because trends that have played out in other regions have been slower to take hold in Japan: E-commerce still accounts for less than 10% of total retail sales, while the use of cashless payments and digitisation similarly lags other countries.
The companies we seek to invest in have real sustainable growth prospects that are not dependent on the near-term changes in the global economy, such as rising inflation and interest rates. Inflation is an interesting point because its impact is likely to be different in Japan, and particularly at the companies we own. Across all sectors, the high-quality companies we favour, which have healthy competitive positions and balance sheets, are better able to cope with inflation because they tend to enjoy strong pricing power.
More broadly, we don’t see inflation taking hold in Japan the way it is in other parts of the world, such as in sticky wage inflation, although there may be some impact from rising energy prices, given Japan’s status as a net importer. However, this does not materially impact the long-term prospects of many of the companies we own. In fact, higher energy prices may help Japan’s shift toward renewable energy, which is one of the long-term growth opportunities we have identified and invested in. Wage inflation in other parts of the world may also focus managements on cost savings from automation and robotics, which could benefit some of the Japanese companies we own that are global leaders in these areas.
Our past experience with sudden – but typically short-lived – changes in market direction gives us the confidence to remain excited about the many long-term growth opportunities in Japan we have identified. Some great companies may be trading at discounted prices and we’ve got our shopping list ready.