Not all of Japan’s companies will profit from the new economic environment – investors should no longer view the Japanese stock market in isolation – valuations in Japan are converging with global markets. Carlo Capaul, managing director, Swiss & Global Asset Management, takes a look at the unfolding situation in Japan. The views expressed here are those of the author, and not necessarily shared by the editors of this website.

If, when you started reading the title, your thoughts turned to Return of the Jedi, the sixth episode in US film producer George Lucas’ “Star Wars” saga, then you weren’t that far off the mark. The rollercoaster of emotions the film takes its audience through has some similarities with the experiences of seasoned investors in the Japanese market. The light and dark sides are in constant conflict. The question as to whether good will ultimately prevail – or in our case whether a position in Japanese equities will pay off – has long since had considerable dramatic potential. We need only think of the consequences of the earthquake and the reactor catastrophe at Fukushima.

Japanese equities have been in the media spotlight since Japan’s new Prime Minister Shinzō Abe announced that the government would be spending an additional 10.3 trillion yen (around $106 billion) to get the economy on a higher growth path. Over and above this, the Abe administration wants to create an operating environment for sectors such as agriculture, pharmaceuticals, and electricity utilities that is significantly more conducive to competition than has been the case to date.

Where do we go from here?

Shinzō Abe is very popular in Japan, and according to the opinion polls he is likely to secure a majority in the elections to the upper house of the Japanese parliament in July 2013. Time will tell whether he will then be able to put all of his plans into practice. It also still remains to be seen what impact the implemented measures will have on the purchasing power of consumers and on corporate earnings in various sectors over the medium to long term. The short-term assessment of (foreign) investors is clear, however. There would appear to have been a shift in perception: in the quarterly investor survey conducted by Bloomberg on 14 May 2013 gauging opinion on outlooks for the coming twelve months, Japan was the most favoured region after the US, even coming in ahead of China.

As a result of the exceptionally good performance through to the end of May, the Japanese equity market - which was cheaply valued two years ago - has now closed the gap on the World Index. Both indices are now at around nine times operating income (cash flow), which is in line with the 42-year average and does not yet represent an overvaluation. However, the valuation also implies that the profitability of Japanese firms will have to improve going forward, otherwise there will be the threat of an overvaluation. There is still room for improvement. The current price/earnings ratio (P/E) is relatively high at around 24 for the TOPIX.

The development of the Japanese equity market going forward should not be considered in isolation, but instead be viewed together in context with the global market. As long as the US, Japan and Europe maintain their expansionary monetary policies and there is no marked slump in corporate earnings, investors will place additional capital on the equity markets, and thus also on the Japanese bourse. High unemployment rates and moderate inflation expectations do not yet indicate a shift in opinion with regard to monetary policy. Investors still need to pay special attention to the yen exchange rate. The depreciation over the past seven months has been pronounced. The yen has lost around 20 per cent versus sterling, and a further 10 per cent to 20 per cent [depreciation] would be conceivable. That said, changes on such a scale lasting several years have been very rare occurrences since the beginning of the 1970s.

Sorting out the wheat from the chaff

“Abenomics” and the new circumstances have done nothing to change the fact that solid stock picking will achieve better results on the Japanese equity market than passive forms of investment. The longer this rally persists, the more important a considered, active approach will become. As in previous years, it will pay to invest on the one hand in companies in growth industries, with solid business models and cost-conscious management. These “diamonds” – for example tyre manufacturer Bridgestone – have been able to maintain their high earnings level even in difficult phases, such as the economic setback in 2008/9, the serious Tohoku earthquake, and the floods in Thailand in 2011.

The focus must also be on exploiting good, short-term opportunities, by systematically analysing the current valuations of value stocks and strategically adding them to the portfolio where appropriate. Stocks such as Sumco, a producer of silicon ingots and wafers, were undervalued for a long time as most investors assumed that their profitability would continue to be hit by pricing pressure on their sales markets. There would appear to have been something of a rethink since the start of Abenomics.

Relying on the current economic environment remaining constant is certainly not a promising investment strategy. Incidentally, like George Lucas, Shinzō Abe studied at the University of Southern California in Los Angeles, albeit not at the School of Cinematic Arts, but rather at the School of Policy, Planning, and Development. But both learned how to come up with interesting storylines.