Japan's Undervalued Companies Offer Opportunities

Not all Japanese exporters will benefit. Electronics companies without a strong competitive advantage have not seen their emerging Asian sales grow in the same manner in the past seven years as others eat into their market shares. As a result, we prefer to stick to local leaders with strong intangibles that can be exported to other markets, as well as those that benefit from switching costs.

We especially like companies that have an exposure to external demand that we view as sustainable over the next five to 10 years. We think it's important to look at sustained earnings external growth opportunities, given Japan's shrinking population that will put pressure on domestic demand growth.

Since structural reform policies aimed at tackling these challenges are still not on the table, we prefer to focus on potential gains from the government's continued focus on driving inward tourism to boost growth. The upcoming Tokyo Olympics in 2020 should further raise Japan's profile. We think this will sustain regional interest in "Made in Japan” brands.

Japan's recent macroeconomic indicators are positive, with second-quarter 2017 GDP growth up 2.0% year over year, marking the sixth consecutive quarter of growth. Domestic spending is recovering from the hike in the consumption tax in 2014. According to the government, this reflects the impact of the prior fiscal stimulus.

The global recovery and the rise in the stock market may have also contributed to the improved sentiment. However, key structural challenges remain, as there is little sign of wage increases to drive consumer spending on a prolonged basis, and the country's aging demographics remain a key hindrance.

Prime minister Shinzo Abe's third arrow, which targets structural reform to achieve sustained growth, is still missing key initiatives. With the general election due to occur in 2018, significant policy change seems unlikely in the short term. A recent IMF report on Japan indicates the government needs to incentivise corporates to raise wages, address a shrinking labour pool, and reduce public debt.

These are not new concerns, and we think these issues can only be addressed in the longer term. Key aspects such as a more proactive and open immigration policy remain unpopular. In the meantime, the next round of hikes in the consumption tax could occur in 2019. Unless global growth picks up, we think there is a risk that Japan's domestic demand could pull back.

Fiscal spending is likely limited, given that debt levels are already high. Japan’s public spending makes up an average 19% of GDP since 2000. For comparison, US public spending makes up around 35-40% of GDP. We think this deviation partly reflects limited flexibility for the Japanese government to increase spending because of its high debt, which is at around 200% of GDP. According to the IMF, commitments such as pension payments mean that Japan’s government debt could rise to 300% of GDP by 2020, compared with 150% for the US.

Immigration Conundrum

For the majority of the Japanese consumer companies we cover, we have assumed flat domestic sales volumes. Unless the government addresses the immigration conundrum, we expect slow domestic spending coupled with marginal public spending over the medium to long term. Furthermore, the government may be forced to raise tax revenue, which could dampen domestic spending.

Not all companies are able to capture the sustained benefits of selling to emerging Asia or China, despite the stronger economic growth in this region. For companies with significant ex-Japan sales, we think companies with competitive advantages are more likely to sustain positive growth in the fast-growing emerging Asia and or China markets, as they are best able to avoid losing market share as Chinese or other competitors enter the market.

In looking at the Japanese companies in our coverage with significant China or Asia ex-Japan sales, the average compound annual growth rate (CAGR) since 2010, or from when the geographic breakdowns were available, is 14% excluding consumer electronic names. Consumer electronic companies averaged a compound annual decline of 2% over the same period. Our narrow-moat-rated companies posted sales CAGRs ranging from around 10% to 32%.

This doesn't mean that companies without identifiable competitive advantages will not see strong sales in the region. Diversified companies have seen strong sales through selling a variety of products in the region, which has helped them capitalise on various needs in emerging Asia. However, the products that possess competitive strength may be offset by others that don't. As such, we think their overall economic profitability could be at risk from homegrown competitors.

Currency, Geopolitical and Macroeconomic Risks

The short-term share price performance of Japanese companies remains sensitive to currency headwinds. At this stage, the currency market reflects a gradual appreciation of the Japanese yen. Japan's supportive monetary policy, coupled with the prospect of rising interest rates in the US, should support this scenario in the absence of another financial crisis that sends investors to safe-haven currencies such as the yen.

Geopolitical risks also dampen sentiment, but we think these should have limited sustained fundamental impact. In addition, these are market risks and are not specific to individual companies. We don't expect companies' cash flows to be markedly impeded to the point of decreasing our fair value estimates.

There are also macroeconomic risks, with tourists turned off if a country gets too expensive to visit or if security is a concern. Notably, tourist arrivals dipped in 2011 in the aftermath of the Great Tohoku Earthquake and in 2013 on the Senkaku Islands dispute with China. Anti-Japanese sentiment could run deep in China, and boycotts of Japanese car makers did have an impact on their car sales in China. It's difficult to factor these events into our estimates, and our base-case scenarios would not include these assumptions. However, subsequent tourist arrivals did pick up in Japan, and we continue to anticipate that these would be short-lived hurdles.

Monetary policy remains supportive, and with little inflation pressure, we think the Bank of Japan should keep interest rates low for a prolonged period. Inflation has fallen short of targets, which can be attributed to the current weak oil prices. And as mentioned above, wage pressure is likely to remain limited in the absence of policy reform to encourage large corporates to pay more. Competitive pressures should continue to drive consolidation in some industries, and with the shrinking labour pool, greater mechanisation is more likely. Because of these long-term challenges, we think Japan's government will continue to promote areas of potential growth and aspects to enhance productivity.

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