Since the elections in December 2012, which Shinzo Abe and his Liberal Democratic Party won by a landslide, everyone has been talking about Abenomics, the set of policy measures that are expected to lead Japan out of its economic slump and end its persistent deflation. The present article intends to give an overview of what Abenomics is, why it has been implemented, what risks are associated with it, and how it influences our investment decisions in Japan.
Abenomics – What? Why? How?
The new prime minister Abe and his government have launched one of the most aggressive policy moves in the history of the country. The aim of the program is to revive Japan's economy that has been stagnant for decades and to break out of the deflationary spiral that puts a drag on corporate investments and private consumption. The following chart, inspired by the "Abenomics Handbook" by Nomura, gives an overview of the proposed measures and the intended outcomes for the program's three pillars: monetary policy, fiscal stimulus and structural reforms. Mr. Abe likes to refer to these three elements as three arrows, that alone can be easily broken, while considered together they are very difficult to bend.
For a deeper insight into the subject, I refer readers to an article by Matthew Boesler, published on Business Insider , which provides a more detailed explanation of the three different aspects of Abenomics.
Renowned Keynesian economists like Joseph Stiglitz and Paul Krugman have already given their blessing to Abenomics, indicating, in the case of Mr. Stiglitz, that "there is every reason to believe that Japan's strategy for rejuvenating its economy will succeed." Mr. Krugman points to the early successes of the program, indicating that "the early signs are good", as stock prices have been soaring and the decline in the yen has made the country's exports more competitive.
The risks associated with Abenomics
Since the government and the Central Bank have only started with the implementation of the program, it is stilltoo soon to tell if they are right and how this "experiment" will turn out in the long run. Several observers are sceptical that the structural reforms, key to the long-term success of Abenomics, can be successfully implemented. Liberalization of the rigid labor market laws are inevitable but could face opposition from labor unions, while agricultural reforms are difficult to implement, given that they would inevitably hurt small farmers, who constitute an important support base to Mr. Abe's party. A recent article from The Economist points todifficulties in implementing drastic reforms, an concludes that most of the more radical reform ideas failed to make it into the strategic plan for economic growth presented by the government at the beginning of June.
There are other risks associated with the first two pillars of Abenomics as well. Although the magnitude of the program might be unprecedented, part of these measures, for instance the combination of fiscal policy with aggressive monetary easing, have already been conducted in most other industrialised countries with several troublesome consequences. In his blog post "End of the crisis?", Guy Wagner has pointed out that the main issues associated with these policies are increasing levels of debt, and artificially and unsustainably low interest rates. This bodes particular ill for a country like Japan, where public debt levels are already very high and where any uptick in yields could put an additional strain on the state budget, knowing that almost half of Japan's debt comes to maturity in the next 3 years. A scenario of higher bond yields can however not be excluded, as the success of Abe's politics of creating inflation and boosting consumer sentiment could lead to dwindling demand for JGB's. Consumers could be inclined to free up money parked in the bond market in order to spend it and/or see their savings decline because of higher living costs. Because of the structural demographic headwinds, the savings rate in Japan is already at one of its lowest points in history and is bound to decline even further, as more and more people are set to retire and draw on their savings.
Government gross debt and household savings ratio in Japan
Source: Bloomberg
Other risks associated with these aggressive policies are also apparent. If parts of Abenomics do not play out as intended, Japan's consumers may have to face an increasing gap between their income and living costs, as the lower yen leads to increasing import prices, while companies could still remain reluctant to raise wages. Consumption tax, that currently stands at 5% is also bound to rise. All this could lead to the unexpected effect of lower domestic consumption, the contrary of what Abenomics wants to achieve. As consumption is by far the highest component of GDP, such a shortfall could not be compensated by higher exports or higher public spending.
The risk that the expansionary monetary policy leads to the creation of new financial bubbles also exists. This is a global problem fundamental investors like us are facing, as no one can assess the possible outcomes of the unorthodox monetary and fiscal policies and their impacts on stock markets. After the announcement of the elections in mid-November, the stock market went on an impressive 80% upswing, followed by a sharp downturn in mid-May, which has unsettled many investors. The fact that volatility has spiked is clearly a reflection of high uncertainty and does not help to restore investor confidence or promote rational investment behavior in Japan.
Investing in light of Abenomics
After decades of disappointments, the mood on the Japanese stock market does not go in favour of fundamental investing. Most Japanese avoid the stock market and only a small portion of their savings is invested in equities. Those that act on the market often see it more as a gamble than an investment opportunity. Most global investors are underweight on Japan and many of those that want exposure to the Japanese market tend to periodically play certain themes, without paying too much attention to company fundamentals or valuations. Clearly, the investment theme that is currently playing out in Japan is Abenomics, with investors driving up stock prices based on assumptions that have yet to come true and initial achievements that have yet to prove sustainable.
The shortcomings of our investment approach
We apply a bottom-up fundamentals-based investment methodology and do not base our investments on macroeconomic trends and themes. This approach leads us to buy profitable companies with strong balance sheets, that benefit from a competitive edge that allows them to create shareholder value over time. Company valuation is also very important. We only invest in a company when its stock price offers a discount to its intrinsic value. As we have a long-term investment horizon, we are not willing to take short term bets on a positive outcome of Abenomics by investing in the obvious beneficiaries of the success of these policies. Since the start of the rally, investors have been essentially on the hunt for high-beta stocks and stocks in sectors like brokerage or real estate. Highly leveraged companies have generally performed better than more conservative companies, whereas small cap names have outperformed large caps. All this did not really play into our cards.
Investors have also been driving up prices of big quality growth companies that were already expensive before the rally and which have now become even more expensive. Companies like Fast Retailing, the operator of the Uniqlo clothing stores, Shimano, world leader in bicycle parts, or Sysmex, a global leader in clinical diagnostics, have benefited from the liquidity-driven stock rally, as they are well-know and obvious candidates for investors looking for growth in Japan. Fast Retailing, for instance is by far the largest constituent of the Nikkei 225 and makes up 10% of the index. These companies would fit perfectly well into our portfolio based on their fundamentals, however, as they trade with a significant premium to their intrinsic value, they are currently not eligible for investment.
Attractive returns with lower volatility
Applying our methodology in the current environment and to a stock market where there is no real culture for fundamental, long-term investing, can sometimes be frustrating. We are however convinced that the approach to buying quality businesses at the right price pays in the end, even in Japan. The time will come when investors will again make the distinction between good and bad companies and pay attention to the price they pay. The companies we invest in will be able to deliver good earnings in a favorable environment, but should also prove resilient in the event that Abenomics does not live up to expectations. Over the long term, these companies should deliver good returns with much lower volatility than that of the market. The performance and volatility figures of our Japanese equity fund since its inception, in comparison to the overall market, seem to support our conviction.
Performance and volatility of BL-Equities Japan compared to the Topix TR since inception (28/06/2011 - 31/08/2013)
Which companies do we invest in?
While we do not base our investments on macroeconomic trends, we still want to have exposure to companies that operate in sectors that offer growth prospects. We clearly want our companies to benefit from a potential success of Abenomics, without however being dependent on its success. Due to their good positioning in their respective segments, we are convinced that this is the case for most of our investments. Here are some examples:
Exporting companies
Abenomics has already lead to a weakening of the currency, which, if sustainable, should lead to an increase in exports. Companies like Fanuc or Keyence with a strong position in factory automation, or companies like Murata Manufacturing or Nitto Denko, that are leading suppliers for highly added value components for mobile devices, are well positioned to benefit from this. Even if Abenomics fails, these companies still stand out because of their technological lead over their foreign competitors.
Leaders on the domestic consumer market
Abenomics should also result in higher domestic consumption. Retail companies like ABC-Mart, Don Quijote or Nitori Holdings that are customer-centric and strongly committed to growth and profitability, are well positioned to benefit from this. Even if Abenomics fails they should continue to win market share at the expense of weaker and less profitable competitors.
Know-how in health care
Abenomics calls for the promotion of Japanese know-how in health care, which should be beneficiary to companies like Nihon Kohden, a specialist in monitoring equipment in cardiology and neurology, or Terumo, Japan's biggest medical equipment supplier and leading global supplier of blood transfusion equipment. Even if Abenomics fails these companies are well positioned to grow their business in a structurally favorable environment.
Investments in infrastructure
Reconstruction efforts, public works spending and the promotion of infrastructure exports should be beneficiary to companies like Komatsu, a leading mining and construction equipment manufacturer, and JGC, one of the world's largest engineering companies and a specialist in developing industrial sites for transforming natural gas to liquefied natural gas. Their expertise, size and service quality have enabled these companies to carve a strong reputation in their respective business fields, which they should be able to defend, even if Abenomics does not prove successful.
Focus on quality will pay in the end
If the Japanese authorities can sustain their policy shift and follow through with growth-friendly regulatory reforms, without losing the support of the population, then the outlook for the world's third largest economy could brighten and the multi-decade long bear market in Japan could end. The risks associated with it are however enormous. We are not willing, nor do we have the capacity, to bet on any possible scenario, but we are convinced that our focus on buying quality companies at a discount to their intrinsic values will pay; whatever the outcome of Abenomics will be.
