Japanese market remains ripe for contrarian pickings

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Japan has already been a strong performer over the past few years for the UK-based investor, thanks in part to the fall in sterling. Nevertheless, some sectors still offer outstanding value following a prolonged period in which they lagged the wider market.

Japanese equity markets had an eventful 2016, with the introduction of negative interest rates last January ushering in an extreme risk-off environment in which defensives and bond proxies outperformed while cyclicals and financials underperformed.

While that trend began to reverse in the second half of the year, prompting the Japan CoreAlpha team to sell some holdings into share price strength, we believe key pockets of value remain that should not be overlooked by investors seeking opportunities in under-priced sectors.

In particular, we think stocks within the financial sectors, especially banks, and those with ties to depressed commodities have suffered for such an extensive period that valuations continue to appear attractive to value investors.

We are contrarians, focused on buying low price-to-book stocks, and we primarily concentrate on the stocks everyone hates. Right now in Japan that means the banks, and some cyclicals - especially iron and steel companies.

So why are these sectors so appealing versus the wider market?

BANKS

Financials have underperformed since 1987, and the weighting of financials relative to the Tokyo market fell last June to 10 per cent, its lowest level since 1969.

It means banks are very undervalued, with some of them on discounts of 50 per cent in terms of price-to-book compared to the wider market.

To put that in context it is worth considering that the Japanese banking sector has never been better capitalised, and it has been very profitable, despite low lending margins.

Indeed, when interest rates go up it is anticipated banks will be earning a better return on equity than the wider market. In our view they should not be rated lower than global banks and as such we are very happy to hold them.

Stocks within the portfolio that have performed well recently include Mitsubishi UFJ Financial, and Sumitomo Mitsui Financial.

The CoreAlpha strategy has 27 per cent in financials, well ahead of its peers. Our financials exposure is quite a distinction compared to the crowd, which holds pharma, telecoms and rail companies.

IRON AND STEEL GIANTS

Steel is a highly cyclical sector and it is now one of our biggest overweights in the strategy. There are two main companies in this sector and they have been improving their businesses for many years.

However, their valuations peaked a decade ago, so despite being top-class steelmakers, they have underperformed for a long time.

We now have 9 per cent in the sector, and we are comfortable holding that. Recovery cycles in that market are very violent, and it means as an investor you will almost always be early.

Share prices have risen sharply since July, yet remain at historically very depressed levels.

A CAVEAT

As contrarian investors, the team is always mindful of the possibilities for short-term price volatility.

The CoreAlpha strategy has outperformed TOPIX by more than 20 per cent net of fees since July 2016, when its investment style returned to favour.

However, we believe valuations across the portfolio remain historically very attractive when compared to the total market.

Stephen Harker is lead manager of the Man GLG Japan Core Alpha strategy fund.


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