Japan is an especially rich hunting ground for equity investors looking to achieve long-term capital growth with a market neutral approach, explains Teruhiko Nishimura, Head of Total Return Japanese Equities at Pictet Asset Management.
For Japan, August 2, 2018 was a momentous occasion.
That was the day when the country’s stock market overtook China’s to become the world’s second biggest, regaining the title it lost four years earlier.
Valued at just over USD6 trillion, Japan’s stock market is undoubtedly one of the most liquid in the world. However, ironically, it is also among the most inefficient: share prices can deviate markedly from fair value.
FIG. 1 MIND THE GAP
Analyst estimates and company guidance for Nintendo's FY2019-2020 operating profit in JPY bln
Source: Bloomberg, Pictet Asset Management, data as of 30.10.2019
Why these discrepancies? It’s partly to do with information scarcity. Compared with its peers, the Japanese stock market is under-researched – about 42 per cent of companies listed in the TOPIX index have no sell-side analyst coverage whatsoever.
This compares with about 1 per cent for the equivalent index in the US, the S&P 1500.1 But even those companies which do have broker coverage experience a wide dispersion in analyst estimates - there is often a significant gap between company guidance and what counts for consensus market forecasts.
Take the case of gaming and entertainment giant Nintendo. Among 21 analysts who cover the firm, there’s a 40 per cent gap between the highest and lowest estimates for the operating profit for fiscal year ending March 2020 (see FIG. 1).
The company's own guidance, in line with the most conservative estimate, stands 15 per cent below the consensus forecast. And Nintendo is not an isolated example – the experience is the same for many other Japanese companies, which can lead to wild swings in share prices during earnings results seasons.
Another distinguishing feature of Japan’s stock market is its investor base. Its deep liquidity and low transaction costs have made it popular with foreign investors, who make up on average at least half of daily trading volume.2
That has a significant bearing on market dynamics. During episodes of stress, such as an emerging market crisis or a China-driven sell-off, this group of investors tends to liquidate their Japanese assets, regardless of corporate fundamentals, and use the money to cover losses elsewhere.
Conversely, during rallies foreign investors tend to chase the market higher, often reacting to specific corporate events or domestic developments (see FIG. 2). As such, their presence tends to expose the market to swings in global investor sentiment, which can lead to higher volatility.
FIG. 2 GAIJIN INFLUENCE
TOPIX moves (%) and net purchase by foreigners on a 12-week moving average basis in JPY bln
Source: Bloomberg , data covering period 15.06.2001 and 11.10.2019
At the same time, the market is host to another distinctive block of investors whose trading activities do not always pay regard to corporate fundamentals.
These include the Bank of Japan and the Government Pension Investment Fund, which together are the biggest shareholders in well over 400 companies on the Tokyo Stock Exchange’s first section, nearly one quarter of all issues. What is more, the BOJ now owns nearly 80 per cent of Japan’s exchange-traded fund market, having bought almost JPY29 trillion of the product since 2013.3
It is because of these idiosyncrasies that the Japanese stock market lends itself especially well to alternative investment approaches.
Market neutral for Japan
We believe investors looking to improve the diversification of their current allocation should consider an equity market neutral approach focused on Japan.
This distinctive investment style combines long and short equity positions and seeks to produce returns almost exclusively from “alpha” – or the security-specific return generated by a skilled investor manager.
At the same time, it aims to limit “beta” exposure, or risks stemming from overall market movements. It seeks to generate superior risk-adjusted returns in all market phases, without relying on the overall direction of the equity market.
Our market neutral portfolio, or PTR-Akari, combines bottom-up stock selection with insight into Japan-specific, technical market factors. The strategy, which invests in liquid and mainly large cap stocks, aims to identify attractive investment opportunities while achieving a low correlation to the broader market.
The portfolio, managed by a team of experienced investment professionals based in Tokyo, is made up of individual “strategies” within the various sub-sectors.
Each strategy contains a combination of long and short positions designed to extract uncorrelated, company-specific sources of returns independent of market moves – we hold single or multiple long or short positions and hedge them against single stocks, or sometimes a customised basket.
Japan’s wide market breadth, as well as its low stock borrowing cost – the cheapest in Asia – mean that we can find optimal hedges within each industry sub-sector.
While targeting overall beta to be neutral,4 we also take steps to diversify our industry exposure. At the same time, we seek to identify and hedge other common systematic risks – they include moves in foreign exchange and interest rates as well as broader stock market shifts driven by style rotations. This fine-tuning helps ensure our portfolio's returns are not correlated with those of the market.
Japan's wide market breadth and its low stock borrowing cost mean that we can find optimal hedges within each industry sub-sector.
Global value chain analysis
To identify investment opportunities, we typically analyse Japanese companies from the perspective of their global value chains – the full range of activities involved in the production of a good or service.
For example, a smart phone may be designed in one country but assembled in another, using labour and materials from several suppliers from around the world. All of these sub-sectors make up a smart phone value chain.
This approach allows us to analyse companies beyond the traditional industry framework used by mainstream equity benchmarks and gives us a broader perspective, which helps to determine how competitive or profitable a particular Japanese firm is in the context of the global economy.
This also helps us to identify sources of return that cannot be replicated easily by exchange-traded funds.
We form our strategies by analysing relevant stocks within a certain value chain and anticipating domestic or global events which could trigger changes in their earnings outlook or financial positions.
For example, when we look at the electric appliances sector, we consider it through the value chains of technology, machinery and chemical goods. We see demand picking up for electric components after years of stagnation because industries such as automobile are using more electric parts to enable automation and data analysis. Similarly, the rollout of faster 5G networks is creating diverse investment opportunities across value chains.
Dynamic investment process for a diversified portfolio
Our investment process starts with screening around 2,200 Japanese companies for liquidity and market capitalisation.5
Among those which make the cut, we analyse corporate fundamentals from the perspective of global value chains, meeting company management in the process. We put a particular focus on market moves and forecast changes around the earnings season – a period when we tend to find rich trading opportunities given significant gaps in sell-side earnings estimates.
Here, our investigations go far below the surface. For example, we may gather intelligence from a diverse set of companies – including small-cap in which we do not invest – to validate a growth outlook of a certain firm we’re looking to invest into. This also helps us gauge the extent of the gap between various sell-side estimates and our own earnings forecasts.
This screening takes the potential investment candidates down to about 200-300. We then use our extensive industry experience in buy-side, sell-side and running proprietary trading books to choose optimal entry and exit points and maximise opportunities which the market presents.
In doing so, we take into account Japan-specific technical factors, including supply and demand of stocks, different trading patterns of domestic and foreign investors, seasonality and share buybacks.
FIG. 3 NO ATTACHMENT
Monthly correlation of various investment strategies
Source: Bloomberg, Pictet Asset Management. Calculated for the period 30.10.2016 – 30.09.2019
We fine-tune the portfolio, taking into account factors such as size, liquidity and technical signals. At the same time, we seek to eliminate residual market risks.
Our final portfolio has around 150 positions across up to 80 strategies.
Japan is a market that is often overlooked but offers potentially rewarding opportunities. Our distinctive investment approach focusing on the world's third largest economy has proven to be resilient during times of market stress and should therefore appeal to investors who wish to diversify their existing global equity portfolios with returns that are uncorrelated with those of other asset classes.
FIG. 4 DOWNSIDE PROTECTION
Five worst months of the TOPIX vs Strategy, %*
Strategy’s relative performance since inception during worst five months for TOPIX.
Source: Bloomberg, Pictet Asset Management, data as of 30.09.2019
1) Source: Pictet Asset Management and Bloomberg as of 07.09.2018
2) Tokyo Stock Exchange’s first section trading volume data as of 18.10.2019. Source: Tokyo Stock Exchange
3) Source: Nikkei
4) We aim to limit the range of beta to be between -0.2 and +0.2. vs Topix Index
5) The initial universe includes companies listed on TOPIX, Nikkei, Tokyo Stock Exchange Mothers. Only the 500 or so stocks which either have market capitalisation of over USD1 billion or average daily trading volume of over USD10 million form our investable universe.
* For illustrative purposes only. The representative strategy performance is composed of actual gross returns for the Japanese Equities L/S segment within PTR-Diversified Alpha from 10.10.2016 to 30.09.2018 and actual gross returns for the PTR-Akari JPY fund from 01.10.2018, the first full month since the fund was launched, to present. During the period, the segregated segment followed the same investment approach as the PTR-Akari fund and was managed by the Akari investment team. The PTR-Diversified Alpha fund is a Luxembourg SICAV that invests primarily in market-neutral strategies managed by selected Pictet AM teams. These investment strategies have exposure to various financial assets (equities, bonds and other debt-related securities, financial derivatives) globally. Note: All performance data are shown in JPY, gross of fees and based on daily returns. Please note that a standalone vehicle will be subject to fees and expenses such as management, performance, administration, operational etc. that will result in lower net returns for your investment. Past performance is not a reliable guide to future performance. Performance data does not include the commissions and fees charged at the time of subscribing for or redeeming shares. The value of investments and the income from them may fluctuate and investors may not get back the full amount invested. The strategy is unconstrained by a benchmark. TOPIX is a reference index, provided for comparison purposes only. This reference index does not influence the portfolio construction process and the securities included in this index may differ from the strategy’s investment universe. Source: Pictet Asset Management, as of 30.09.2019.
More from Pictet AM’s Total Return Team
About the author
Teruhiko Nishimura joined Pictet Asset Management in 2016 as Head of Total Return Japanese Equities and co-manager of the Total Return Japanese Equities strategy.
Prior to joining Pictet, Teruhiko was Chief Investment Manager at Mizuho, responsible for an in-house hedge fund.
Teruhiko was the head of Asian capital goods team at Credit Suisse and covered Japanese and Korean equities before taking an MBA from INSEAD.
Teruhiko is currently working on a doctoral dissertation on management science at Kyoto University.
Über Pictet Asset Management
Pictet Asset Management ist ein unabhängiger Vermögensverwalter mit einem verwalteten Vermögen von 176 Milliarden EUR, das wir für unsere Kunden in Aktien, Festverzinsliche, alternative Anlagen und Multi-Asset-Produkte investieren. Wir verwalten Einzelmandate und Anlagefonds für einige der größten Pensionsfonds, Finanzinstitute, Staatsfonds, Finanzintermediäre und deren Kunden weltweit. Bei unserem auf Anlagen basierenden Geschäft verfolgen wir einen langfristigen Ansatz mit einer einzigartigen Kundenorientierung. Unser Ziel ist es, der bevorzugte Anlagepartner unserer Kunden zu sein. Wir schenken ihnen unsere ungeteilte Aufmerksamkeit, bieten Pionier-Strategien und fühlen uns der Exzellenz verpflichtet.
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