Is Japan’s equity rally over?
As the Nikkei 225 continues to hit new highs, the question for many investors seems to be: is this it, is the rally done?
We think Japan’s equity market remains a trove of quality, competitive, high-earning and undervalued companies, which is now benefitting from an accelerating wave of reforms in corporate governance and financial regulation.
Despite the recent rally, Japanese equities remain below 1989 levels. Market valuations are still attractive: ~1/3 of listed companies have 40% more cash than their market capitalisation while ~45% trade at less than 1x tangible net assets and ~60% are debt-free.
Recent updates to the corporate governance code, which pressure listed companies to offload their large equity cross-holdings, could result in ever increasing M&A and MBO activity as controlling shareholders try to fend off the risk of shareholder activism.
Further support could come from the ripple effects of the introduction last year of the Tokyo Stock Exchange’s 1x Price-to-Book rule, which requests listed companies trading below book value to explain their action plans to generate returns above the cost of capital and close the valuation gap. This should help drive greater management focus on shareholder value and further accelerate the pace of buybacks.
Retail inflows into equities could also increase after last year’s revision to Japan’s tax-free individual investment accounts, which is aimed at freeing ~€12.6 trillion in household financial assets mostly held in cash deposits.
Geopolitics should also help: Japan is increasingly seen as a play on China’s possible economic recovery without its geopolitical and domestic policy risks.
An uncontrolled Yen appreciation as a result of higher interest rates could have an impact on Japan’s equity market (mainly via negative effects on exporters) but it is also conceivable that at least a part of the funds which would repatriate following the break of the carry trade could find their way into domestic equities.
By focusing on companies not covered by the sell-side, our Orphan Companies project invests in a market niche which is even more undervalued than the wider Japanese mkt, offering thus investors a further margin of safety.
Sell-side coverage is often essential to attract investors and boost valuations but coverage can be expensive and time demanding and after 30 years of challenging markets many brokers have cut the number of companies under coverage.
As a result these companies trade a huge discount versus their peers, a discount which normally closes at initiation of broker coverage (or in the event of corporate action).
These are deep value opportunities: the 168 small and micro cap companies in our Orphan Companies portfolio trade an average PE of about 9x, a price to tangible book-value of about 0.6x and a net cash to market-cap ratio above 120%.
For further details see our Japanese Orphan Companies Project presentations.
For any questions email us on: info@nicheam.com
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