The Japanese equity market has turned around significantly in the past year. In the 1-year period ending 31 August 2004, the MSCI Japan Index rose 17.2%, and year to date the index has returned 6.1%. The rally has been accompanied by strong economic data. Real GDP is expected to grow 3.4% in 2004 and 2.2% in 2005. Economic indicators are also looking up, and most importantly, consumer sentiment and business confidence have shown marked improvement.

There are other factors that suggest the rally is real and sustainable notes Jeremy Hall, lead manager for the Henderson Japanese Equity Fund. He says Japan is increasingly becoming less reliant on exports. Instead he points to improving consumer sentiment, which has a much bigger impact on the economy. The domestic market in Japan accounts for 60% of its GDP, and Hall says there is room for the domestic economy to grow, as consumption expands. There's also another underlying driver for the equity market. Japanese companies have been restructuring and cleaning up their balance sheets, and many have improved their profitability. This should support continued upside in the equity market.

The Henderson Japanese Equity Fund invests in a mixture of large, middle and small cap stocks. This recently launched feeder fund has a strong bias towards large cap stocks (click here for the factsheet). The fund has been awarded a 4-star rating by Mercer, and has a concentrated portfolio of 30 to 35 stocks. It's diversified across a range of sectors including consumer staples, financials and technology. Hall adds the fund's weighting in small cap stocks has been coming down even further, as the discount premium for them has narrowed. It now comprises only 3-5% of the fund. In this interview, he talks more about the Japanese economy and the fund.

Bharathi Rajan: The Japanese equity market has had a pretty strong rally this year. Is this likely to continue?

Jeremy Hall: There are two things to look at, namely the short-term and the long-term picture. The long-term picture is rather different from what we had in the previous decade. We have seen slow changes in the last ten odd years since the bubble economy days. But now we are seeing the benefits of these accumulated changes, and the long-term structural position of Japan is now much more attractive, particularly in the financial sector where the direction taken in tackling the problems is right.

The fundamental position is healthier than in a decade. External shocks will have an impact, but clearly the economy is able to deal better with external shocks coming from a decline in the global economy. There is a perception that Japan would be affected because of its dependence on exports.

BR: But isn't Japan more reliant on the domestic economy these days, rather than exports?

JH: From one angle, it's true that Japan is reliant on exports because for the last 10 years, the sole source of profits in the economy has come from the exporters. That's mainly because the domestic economy has been chronically unprofitable. But, looking at exports as a percentage of GDP, Japan is the second lowest after the US. In other words, Japan has the potential for autonomous domestic demand, and the rest of Asia bears no comparison. The contribution to profit growth from exporters has now diminished, while that from the domestic economy has increased. From the fiscal year of March 2002 to March 2003, two-thirds of the profits growth came from the exporters. We expect this figure to drop to 20% in this coming fiscal year to 2005. With time, it's likely the domestic economy will stand on its own two feet.

BR: Is the Japanese market valuation still cheap at this point?

JH: Yes, it is at about 17 times this year's earnings. Compared to global blue-chips, Japanese blue-chips' valuations are trading at a discount. Historically, at this stage of the cycle, valuations are in the region of 30-40 times PE (price-to-earnings ratio), but now they stand at 17-18 times PE. Japan is also cheap on a price-to-book basis as well. We are in the third year of record operational profits. At the end of next year, return on equity would be at a record level of about 10%.

BR: What kind of small-cap companies do you have in your fund?

JH: Again, we are very stock specific in small-cap companies. Conventionally we have about 20% in small companies versus about 7% in index. At the moment we have the lowest small-cap weighting since 4-5 years. Small cap companies now account for less than 10% of the fund (as at end August 2004). We recently sold Tokyo Steel after holding it for a very long time - it rose by from 300 yen to 2000 yen, a rise of about 6 times. Another company we held is Otsuk Shokai. It's officially a computer software company, but it's more of an office equipment wholesaler and it did extremely well as it's very much linked to the health of the economy.

BR: The fund is rather distributed between consumer staples, finance and technology. Does that come from conscious diversification or does it reflect where you are finding value?

JH: It's a bit of both. We are a bottom-up stock picking fund in a top-down investment house. We have that infrastructure at our finger tips, and we use inputs from the economist and quantitative team for our portfolio construction. We've been closing the sector bets as they have been paying off. The position now is to move away from the aggressive cyclical stories to overlooked blue chip companies at this stage of economic recovery.

BR: What are the major risks that investors should look out for in the Japanese equity market?

JH: The first would be an unexpected global slowdown led by the US. Other things include oil prices going to US$100 a barrel and staying there, and terrorist incidents or attacks on oil pipelines. On the domestic side, there isn't much bad news so that's encouraging. There may be policy mistakes, for example, the risk of a tight fiscal policy, just like in 1997 when consumption tax was raised causing the economy to fall over. But this is quite unlikely. Monetary policy is likely to remain sensible until deflation is truly beaten.

Related Topics:

Henderson Japanese Equity Fund Seminar