A Full Quiver of Arrows

The expansion of the Bank of Japan’s quantitative easing programme at the end of October coupled with Prime Minister Shinzo Abe’s re-appointment in December snap elections can be viewed by some as affirmation of Abenomics extending into 2015.

Here at Henderson Global Investors, we believe that certain Japanese companies are poised to benefit from the continuation of the Prime Minister’s "arrows" to economic recovery. There are a few reasons driving this argument.

Growth drivers

Firstly, the political stability which followed Abe’s election as Prime Minister has greatly improved sentiment toward the Japanese market. Prior to this, there was no political visibility and therefore no certainty regarding Japan’s fiscal policy.

Since his appointment, Abe’s government has also enacted various initiatives designed to muster support for domestic companies. The Nippon Individual Saving Accounts programme, for example, was launched in January last year with the objective to unlock the dormant wealth held by Japanese households and redirect this substantial capital into the economy. Additionally, our recent conversations with management reveal Japanese companies are being encouraged to focus more on achieving higher return on equity (ROE) levels. An illustration of this is how the Tokyo Stock Exchange has set up the Nikkei 400 index- the selection criteria for listing on the Nikkei 400 includes maintaining a high ROE for the past 5 years.

Part of the goal of Abenomics includes improving corporate governance levels of Japanese companies. Corporates are encouraged to have at least one or two outside board members. This is significant since Japanese companies have tended to be very internally-focused, prioritising company interest above all else. By having an external voice to weigh in, companies are able to make more fair and balanced business decisions.

Further making the case for Japanese companies, many of these entities had already been reducing their fixed cost over the decade while the yen was still robust. Now these companies have become even more competitive against their contenders in Asia and Europe as value seekers turn their eye to Japan in order to capitalise on the significantly weakened yen. In fact, recent reports have revealed that Japanese companies delivered some of the strongest corporate earnings growth figures globally, and while there have been views in the market of a weak yen benefiting large companies but detrimental to small companies, our take is that a weak yen actually benefits both segments. This becomes evident when you compare the weak yen period which started from December 2012 upon Abe’s appointment, against the small cap benchmark which has outperformed large caps from December 2012 to date.

The final factor, and what must be the biggest surprise for us in 2014, has been the changing attitudes of some Japanese companies toward shareholders. Management at some local companies have traditionally had close ties with local banks and generally been quite aloof toward shareholders. But over the past year, we noticed these companies have become much friendlier and more receptive to external views and ideas, with some even seeking our advice on how to improve their share prices.

We believe a combination of these factors is compelling almost all Japanese companies to evolve in a positive manner and this will be a key market driver for the next several years.

Think Small Cap, Think Japan

Abenomics has had profound impact on all participants in the Japanese market, but over the long term, we think it is the smaller companies that are best positioned to benefit from Abe’s policies. By virtue of their smaller size, any advantage brought about by internal or external forces will impact smaller companies more significantly than more sizable corporates. In other words, given Japanese companies are now focusing more on improving ROE and corporate governance on the back of Abenomics, we think Japanese smaller companies are set to enjoy excellent upside potential, which should ultimately be reflected in their share prices. Additionally, foreign holdings in smaller companies are generally low. These companies, as a result, are relatively free from external pressures such as having to deliver shareholder return. The case for Japanese small caps is clear, but as with all investments, there are risks involved.

Treasure Hunting

The biggest risks we envision for Japan and Japanese smaller companies in 2015 are connected to external factors. The US, European and Chinese markets are intrinsically linked to Japan. A correction in the US market, for instance, will likely cause a drop in Japan, although probably to a lesser degree.

Despite this, we believe that there are undiscovered gems in Japanese equities, particularly in the small cap space, which are more likely to outperform on a down market. Here at Henderson, we invest significant time and effort in order to identify these gems. One key part of our process is intensive communication with the management of these small companies. This is inevitable since sell side coverage of smaller companies is significantly lower than that of large companies. A conglomerate like Toyota Motors, for example, may have 20 to 25 analysts covering the company. On the other hand, over half of listed Japanese small companies have no broker coverage at all. This is why we spend the larger part of our research efforts talking to company management for all our holdings and watch list.

In the face of ongoing market turbulence, we believe that on-the-ground presence coupled with regular conversation with management will continue to be the key to unlocking investment opportunities in Japan. Together with the factors mentioned above, we believe Japanese small caps are a worthy addition to a well-balanced portfolio over the long term.