Japan… tide finally turning?

March 21, 2012

Until recently, when you mentioned  “Japan” in the investment context, you could almost hear a collective sigh of disappointment — it was all about recession, deflation and poor investment returns.

However, sentiment does seem to be finally changing, not least because Tokyo stocks have rallied almost 20 percent since the start of the year, outperforming benchmark world and emerging indexes.

The yen has also been on a (rare) declining trend since the start of February, with the selling momentum accelerating since the Bank of Japan set an inflation goal of 1 percent in a surprise move and boosted its asset buying programme by $130 billion on Feb 14.

A closely-watched survey by Bank of America Merrill Lynch showed record optimism on Japan’s growth among fund managers, with a net 91 percent of Japanese fund managers saying they expected the domestic economy to strengthen. That’s up from a net 47 percent two months ago.

Overall, survey partipants worldwide slashed their underweight positions on Japanese equities to a net 4 percent in March from 23 percent last month. This is the smallest underweight position on Japan since August. According to Gary Baker, head of European equity strategy at BofA Merrill:

There’s quite a change in sentiment towards Japan. If you have global growth then Japan… is a big cyclical region to benefit from that. While investment story is the same, what changed there is the yen weakness… it becomes easier to play the story.

David Baran, co-CEO of Tokyo-based hedge fund Symphony Financial Partners has a different investment approach. He says Japanese markets can bring sizzling returns — but not via buying and selling the equity index.

One of Symphony’s funds targets “unloved”, small/medium Japanese enterprises which are cash rich. The fund takes advantage of depressed share prices to build stakes of 15-20 percent in these firms —  large enough to influence management policy.  Then it works with the management to conduct managed buyouts (MBOs) to take the company private, with the financing for the MBOs provided cheaply by banks that are keen to lend to cash-rich SMEs.

The difference between the share price the fund pays initially to build stakes and the price the fund gets from buyers (average premium is around 50%) is the return Symphony makes. The process — from the entry to exit — usually takes about 2-5 years. Baran says:

There’s miscommunication about how big Japan is — the equity market is actually very small. Our fundamental view is that trading the equity market doesn’t work. Our brain is wired towards owning the thing, building stakes. These are real, tangible supply chain companies. The management is not bad, but they are not aggressive in taking risks.

MBOs are hot in Japan, Baran says, thanks to low valuations, the high cost of maintaining a stock market listing and cheap bank financing.

Since its inception in 2003, the fund has made accumulated return of 52.66 percent (compared with Topix Small Cap Index accumulated return of 0.09%), or an annualised return of 5.2 percent.

At one of its recent exits in December, Symphony sold stakes of 23% in a machinery company at a 135% premium — one of the largest tender offer premiums in Japan.

“Managers are becoming the new class of Japanese equity buyers,” Baran says.

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