With US stocks notching record highs this year, significantly outperforming their Japanese counterparts, the spread between the two equity markets’ valuations has widened meaningfully in recent months (Figure 1).
Why the performance dispersion? Japan’s relatively slower COVID vaccine rollout and the disappointing lack of economic support provided by the (previously) much-anticipated Summer Olympics have clearly weighed on market sentiment of late, but equity investors’ apathy toward Japan actually dates back several years. One might even say that it has become entrenched.
The good news? The valuation gaps between Japan equity and its global peers have arguably reached compelling levels, creating a range of potential opportunities for contrarian investors.
Navigating a depressed landscape
To be sure, Japan faces some very real economic challenges that have understandably caused many investors to shy away from its market in recent years — seemingly intractable deflation, the demographics of an aging population, and the ongoing impact of the COVID-19 pandemic. Solutions to these problems have proven hard to come by. Many Japanese companies (and their shares) have suffered in tandem and may not fully recover anytime soon, if at all.
That’s precisely why we would caution equity investors against “blindly” investing in Japan. In our judgment, successfully navigating this market requires a discriminating investor armed with a consistent, highly disciplined approach to bottom-up security selection. Equally important, with Japanese equities squarely out of favor with investors for some time now, investing in this market also calls for a contrarian mindset — an ability and willingness to go “against the grain,” so to speak, and perhaps outside of one’s investment comfort zone.
Discerning market participants who can adopt such a mindset may be rewarded down the road. In fact, we believe there are many investment gems to be found dotting Japan’s depressed equity valuation landscape, each with its own unique business catalysts that can potentially drive the stock price higher and deliver attractive results to investors. These opportunities can also provide diversified exposure to the market because they span the spectrum from small- to large-cap stocks, growth to value, and cyclicals to defensives.
Unearthing investment gems
In our view, the best contrarian investors don’t limit their search for opportunities to any particular investment theme or area of the equity market. Instead, they simply look for situations where “bad news,” often stemming from short-term obstacles, may have led investors to become too myopic in their focus and to overlook the longer-term performance potential of a certain company or industry.
With that said, here are a few investable themes that we think are worth pursuing in today’s Japanese equity market, along with generic descriptions of stock-specific examples:
- Company transformations/turnarounds: For instance, we like the upside potential of a leading convenience store operator in Japan with substantial exposure to the US and other overseas markets, whose stock price had declined sharply for two consecutive years (through late 2020) amid mounting concerns over market saturation.
- Structural growth opportunities: One example is a company that dispatches qualified manufacturing employees to plants of companies in the semiconductor, electronics, automobile, and other industries. It aims to grow its EBITDA (earnings before interest, taxes, depreciation, and amortization) by at least 30% over the next four years.
- Economic reopening plays: The Japanese market has a cyclical tilt, meaning it looks well-positioned to benefit from a global economic rebound. We see some ways to play this “reopening trade,” including a heavy industrial company whose core business of airplane engines was hit hard by the COVID-induced drop-off in global travel and may bounce back as said travel picks up going forward.