CIO Insights 2Q2023

One of the distinctive traits in our global investment program throughout the years has been a sizable and steady allocation in carefully chosen Japanese equities. Over time, it has delivered a significantly positive contribution to our strategy’s compound net return. Longtime investors will remember that at peak exposure around a decade ago, Japan-listed stocks made up nearly half of overall portfolio composition. This weighting has gradually adjusted downwards as we have been able to take profits and dispose of several holdings whose prices have reached our conservative estimate of intrinsic value. But even today, Japan represents the highest single country share, oscillating in a range between 15-20%.

In May the Nikkei Stock Average made headlines when it reached a 33-year high. A variety of arguments have been proposed by market watchers to explain its recent strength, namely: shareholder friendly measures being taken by companies’ boards of directors, notably in the form of higher dividend payouts and stock buybacks; a record number of investor proposals aiming to induce additional value enhancing actions; a weak yen boosting firms’ revenues from foreign business activities; a geographic market perceived to constitute a lower-risk, less controversial investment alternative compared to other Asian regions; and influential, widely-followed foreign investors starting to make positive statements about Japanese stocks.

Given the portfolio’s heavy Japan exposure, we would certainly be in an excellent spot to further benefit in case the current tailwinds behind the market will persist. But whatever the future may bring, our valuation discipline indicates that our equity selections there are still inexpensive and hence highly attractive when viewed from a strict bottom-up, absolute return perspective. We attribute the big discounts offered to us to three main structural factors.

First, Japanese business customs traditionally revolve around a holistic “stakeholder” model, embracing the perspective of employees, customers, business partners and society at large. In some respect this runs counter to Western investors’ expectations primarily conditioned to take a narrower shareholder perspective. Second, despite efforts by regulators and stock exchanges asking companies to beef up their investor relations capabilities, first-hand company information is still harder to obtain in Japan than in the West. This represents a big hurdle for overseas investors in case they need to apply the same analytical checklists as in their home markets. On top of that, broker research on Japanese equity securities is on a less consummate level than in other developed markets because it has been such an unpopular investment area for decades. This lack of analytical depth and breadth causes inefficiencies in terms of stock pricing, especially among medium and smaller capitalized firms. And third, many Western investors hesitate to buy Japanese stocks due to other hindrances, including: arguably unfavorable demographic trends; a perception of encountering a prevalence of seemingly unexciting firms with mediocre margins and growth prospects; a hitherto depreciating foreign exchange rate which is a concern to currency-sensitive investors; as well as accessibility and communications inconveniences such as the big time difference for traders located in Western financial hubs and the considerable language barrier.

In sum, notwithstanding the current upward trajectory in Japanese stocks, the proverbial “wall of worry” remains steep and rocky in the eyes of global asset allocators. Some of these obstacles and preoccupations will slowly but surely diminish over time if businesses can build on their recent accomplishments with respect to fundamental improvements in corporate stewardship.

Irrespective of what other market participants decide to do, the compound return for our global portfolio strategy shows that, despite all adversities, we have been able to climb the Japanese wall of worry quite successfully. We are confident that we will be able to continue to do so.

Sincerely,

Gregor Trachsel
Chief Investment Officer SG Value Partners AG